Cardinal Principles

The cardinal principles are general principles from which all the subsidiary rules and principles of bankruptcy emanate. They are like constitutional principles from which all the bye-laws originate.

Principle I: Pre-liquidation rights shall be respected:

All the rights of individuals who acquired a right against the debtor before the latter is declared bankrupt shall be respected. Even if the debtor is declared bankrupt, the person who acquired a right before the date of declaration of such bankruptcy should not be affected. In other words, the fact that the debtor is declared bankrupt should not affect the rights of a person who is already entitled to a right before the date of declaration of bankruptcy. The person could be either the creditor of the debtor or otherwise. Declaration of bankruptcy does not affect the rights and remedies of those who own property in the possession of the debtor or who hold a security interest over all or any of his assets. For instance, assume that Ato Mogese is a debtor who failed to pay the debt he owes to his creditors. Because of fulfillment of the requirements, Ato Mogese was declared bankrupt on September 5, 2004. On August 5, 2004 Ato Mogese sold his car to W/ro Ayalnesh. The title of document was not handed over to W/ro Ayalnesh till the date of declaration of bankruptcy of Ato Mogese. In this case, even if the title of document is not yet transferred to W/ro Ayalnesh on the date of declaration of bankruptcy of Ato Mogese, the right of the former over the car would not be affected. W/ro Ayalnesh acquired the right on the date of conclusion of the contract of sale of the car. Therefore, it would not be legal to refuse to transfer the car to the buyer because of the fact that the seller is declared bankrupt before transferring the car.

Do you think that the above discussed principle is without exception? I am sure that your answer would be “No”. If you answered so, it is correct. You see, there are two important exceptions to the principle. The first is the case of undervalued transaction. Even if the third party has acquired the right before the date of declaration of bankruptcy of the debtor, where the right is acquired as a result of undervalued transaction, then the right shall not be respected. For example, assume that Ato Bogale is a debtor who could not pay his debts towards his creditors and as a result declared bankrupt on October 10, 2004. A month before the date of the declaration of bankruptcy, Ato Bogale sold his machinery to W/ro Meselech. The machinery was one he was using in his factory for the production of goods for sale. The market price of the machinery was 80,000 Birr, but Ato Bogale sold it for a price of 30,000 Birr. In this case, even if W/ro Meselech acquired the right over the machinery before the date of declaration of bankruptcy of Ato Bogale, her right would not be respected. This is because she acquired the right as a result of undervalued transaction. While the market value of the machinery is 80,000 Birr, Ato Bogale sold it for a price of only 30,000 Birr, which is very much lower than the market price. As the transaction is undervalued, W/ro Meselech would not succeed in claiming the right over the machinery. The assumption here is that the debtor entered in such undervalued transaction with the view to affect the interest of the creditors. In other words, it is presumed that the debtor, knowing that he would be declared bankrupt and the properties are going to be attached, he deliberately entered in such undervalued transaction with the view of getting the property sold and converted into money. Note, however, here that the presumption is irrebutable one. In this relation you may also refer the provisions of Article 1995 and 1996 of the Civil Code, which read as follows:

Art. 1995- Debtor’s fraud

A creditor may, in his own name, challenge the validity of acts whereby the debtor, in fraud of the creditor’s rights alienated property or entered into obligations.

Art. 1996- Fraudulent acts

(1)   An act shall be deemed to have been done in fraud of the rights of creditors where it was done by the debtor so as to become insolvent, or with the knowledge that he was thereby increasing his insolvency.

(2)   The payment of mature debts may not be challenged by the creditors.

The second exception to the principle is that where the right is acquired as a result of improper preference to a creditor. Basically the principle under bankruptcy law is equality of creditors. As a result, it would not be proper if the debtor gives improper preference to one or more of the creditors. If that happens, even if the right is acquired before the date of the declaration of bankruptcy of the debtor, it shall not be respected. For example, assume that Ato Dawit could not pay his debts towards the debtors and as a result declared bankrupt on January 1, 2005. There were four creditors (Abera, Addisu, Gete, and Fanaye) who claim debt from Ato Dawit. Two weeks before the date of declaration of his bankruptcy, Ato Dawit concluded a contract of donation with one of his creditors, i.e., Gete. The debt of all the creditors is due and all of them were to demand payment from Ato Dawit. In this case, the creditor for was benefit the contract of donation is concluded (Gete) acquired the right as a result of improper preference. While he was nor doing was the same favor to the other creditors, Dawit improperly gave preference to that creditor. The assumption here is that had the thing given through donation not been given solely to one of the creditors, it would have been available for the benefit of all the creditors. But as a result of the preference, it is only the creditor to whose benefit the donation is made (i.e. Gete) that gets benefit of it.  Therefore, the right of Gete would not be respected even if it was acquired before the date of declaration of bankruptcy of Ato Dawit.

Principle II: Only the properties over which the debtor has interest are caught:

There may be different properties under the possession of the debtor on the date of declaration of bankruptcy. Some of them may belong to the debtor himself and others belong to another person. The debtor might have received the properties belonging to other persons either on hire, bailment or other reasons. As a result of declaration of bankruptcy, the properties of the debtor are to be attached and realized for the benefit of the creditors. Assets are available for distribution among creditors only to the extent that the debtor has or acquires a beneficial interest in them. Property in the possession of the debtor, but belonging to another is returnable to its owner, subject to any right which the debtor may have to keep in his possession (e.g. under a lease). This is not an asset available for distribution to creditors. Even if they are under possession of the debtor on the day of declaration of bankruptcy, the properties which belong to other persons should not be the subject of attachment and realization. In other words, it is only the properties over which the debtor has interest that have to be attached. For example, assume that W/ro Tsehay is a debtor who could not pay her debts towards her creditors and as a result declared bankrupt. On the date of declaration of bankruptcy, W/ro Tsehay possessed a refrigerator which belongs to Ato Zegeye. The refrigerator was possessed because of contract of pledge between Zegeye and Tsehay. In this case, the refrigerator shall not be considered as the property of W/ro Tsehay and be the subject of attachment. Rather it has to be given to Ato Zegeye, subject to the rights to which W/ro Tsehay is entitled against Zegeye.

What type of interest of the debtor do you think is to be considered? Did you answer “rights of ownership?” If your answer is so, that is correct. As we have seen earlier, the debtor may become possessor of properties belonging to other persons because of different reasons. He may become possessor because of pledge, mortgage, usufruct, bailment, etc. Where the possession is as a result of relationships other than those entitling to ownership, the rights of the real owner shall not be affected by the fact that the debtor is declared bankrupt. But where the debtor has acquired possession of the property as a result of a legal relationship that confers him the right of ownership, such property would be the subject of attachment and be realized for the benefit of the creditors.

To the rule that the trustee can take only assets belonging to the debtor at the date of commencement of the bankruptcy or acquired by the debtor thereafter, there are two principal statutory exceptions:

A)    The assets available to the general body of creditors may be swelled by the amount of payments or transfers made by the debtor before declaration of bankruptcy under a transaction which is void or voidable at the instance of the liquidation. Where the debtor has already made payments to persons entitled before the debt of declaration of his bankruptcy, that payment affects the assets available to the creditors. Where the debtor has already transferred certain properties belonging to him before the date of his declaration, still this affects the assets available for the general body of creditors. The trustee, representing the estate, takes what is available at the beginning of the bankruptcy proceedings. This is with the deduction of those payments or transfers made before the date of declaration of his bankruptcy.

B)    In a compulsory bankruptcy, all dispositions of the debtor’s property made after the presentation of the bankruptcy petition are void unless authorized or ratified by the court. The fact that a petition to the bankruptcy of the debtor could not prevent the debtor from entering into different transactions. The debtor may dispose his properties though an application to his declaration of bankruptcy is already presented. Such disposition of the properties of the debtor would be valid only where there is court authorization. In the absence of court authorization or ratification of the disposal already made to the properties of the debtor, the transaction would be void. But where the court has ratified the disposition or has authorized for such disposition, the trustees take what remains after such disposition.

Principle III:  Personal Rights would be converted into rights of proof

One of the important principles of bankruptcy law is that all the creditors shall stand at equal footing without any discrimination. In other words, all the creditors are expected to compete to get a certain portion from the proceeds of sale of the properties of the debtor. In order to compete, all the creditors are expected to prove their respective rights before the responsible bodies. Even if the debtor admits that he is indebted to a certain creditor, after the declaration of his bankruptcy, there would be no way to get the right without passing through the process of proving his claim. For example, assume that Ato Kebede is a debtor who is declared bankrupt because he could not pay his debts towards his creditors. After the declaration of bankruptcy, one of the creditors approached the debtor and claimed payment of the whole or part of his claim from the debtor. In this case, the debtor cannot pay to the creditor because all his properties are administered by other persons.

In order for the creditor to get payment, he shall enter the procedure of proving his claim just like the other creditors. Had the debtor not been declared bankrupt, the creditor would have got payment without going into the procedure of proving debts. It would have been possible for the creditor to personally approach the debtor and satisfy his claim. On the part of the debtor, it is also possible to admit that he is indebted to the creditor and pay the whole or part of the debt he owes to the creditor. Generally, it is a cardinal principle of bankruptcy that purely personal rights against the debtor, whether to money, property or the performance of services, ceases to be exercisable by action and become converted into rights to prove in competition with other unsecured creditors. This characteristic marks off real rights from personal rights. The former are in principle unaffected by the bankruptcy process, for the trustee takes subject to them; by contrast, bankruptcy puts an end to a creditor’s ability to enforce purely personal rights of an individual unsecured creditor to a share in realization of assets.

The unsecured creditors get pari pasu distribution

It is an underlying principle that the unsecured creditors rank pari pasu and are thus entitled to a dividend proportionate to their respective claims. As you know unsecured creditors are those creditors who held nothing in security that guarantee performance of the obligations by the debtor. The antithesis of unsecured creditors is secured creditors. The refers to those creditors who took possession of a certain property or the title to ownership of properties with the view of assuring performance of obligations by the debtor.

The overall objective of the bankruptcy proceeding is to collect the properties of the debtor and realize them for the satisfaction of the claim of creditors. In the process, those creditors who are secured would satisfy their claims from the property at their hand. As a result, it is the unsecured creditors who compete to get a certain share from the proceeds of sale of the properties of the debtor. In the process of distribution, each of the unsecured creditors could not get what he claimed. Rather the proceeds of sale, after certain expenses such as administration costs and the costs of carrying out the bankruptcy proceeding are deducted, would be distributed among the unsecured creditors based up on their claims.

What do you understand by pari pasu distribution? Did you answer saying, “it refers to proportionate distribution”? If your answer is so, that is great. It is distribution of the proceeds of sale of the properties of the debtor based upon the claim of each creditor. For instance, Ato Menbere is a debtor who is declared bankrupt for he failed to pay his debts towards the creditors. After all expenses are deducted, the proceeds from the sale of the properties of the debtor was 100,000 Birr. There were three creditors who proved their debts and claimed from Ato Menbere. One of the creditors, Ato Tesfu, claimed 30,000; the second creditor, W/ro Tizita, claimed 50,000 Birr; and the third creditor, Ato Geleta, claimed 100,000 Birr. In this case the claim of the creditors and the proceeds of sale of the properties of the debtor are not compatible. Therefore, what is available after sale has to be distributed proportionately among the three creditors in proportion to the claim of each creditor.

The principle of pari pasu distribution, which has been the feature of bankruptcy law, is often diminished because of certain reasons. First and foremost by the extensive range of security rights and analogous devices that have evolved over the years. As a result of development, creditors usually get a certain kind of security to guarantee the debtor’s discharge of his duties. The existence of such securities enables the creditors to satisfy their claims from the securities in their hands. As a result, no competition would be with the other creditors for the proceeds of sale of properties of the debtor. Second, by the massive expansion of the range of debts made preferential by laws. Different laws recognize certain debts to be preferential and therefore the creditor would have preferential right against the debtor. In such cases, it is the other creditors, who are neither secured nor preferred, that compete for proportionate distribution of the proceeds of sale of properties of the debtor.

Do you agree that creditors who acquire a right after declaration of the debtor’s bankruptcy are also entitled to pari pasu distribution? Did you answer “No?” If so, you are correct. The principle of proportionate distribution applies only in relation to unsecured creditors who acquired a right before the declaration of bankruptcy. As we have discussed earlier, it is pre-liquidation rights that are to be respected. Those creditors who become creditors as the result of contract entered into by the trustee/liquidator are entitled to have their claims treated as expenses of the bankruptcy process and paid out of the assets in priority even to the claims of preferential creditors. For example, assume that Ato Tadesse is the debtor who is declared bankrupt on June 1, 2005. Before his declaration of bankruptcy there were four creditors to whom he is indebted. On declaration of his bankruptcy, W/ro Yodit was appointed as trustee to carry out the bankruptcy proceeding. With the view of carrying out the bankruptcy process, W/ro Yodit entered into a contract for the hire of a warehouse belonging to Ato Kebede. In the contract, it was agreed that Ato Kebede was entitled to the payment of 40,000 for the service he renders and the money would be paid after a month. In this case, even if he acquired the right after the declaration of bankruptcy of Tadesse, Kebede’s claim would be paid in priority to the other creditors. The four unsecured creditors would get proportionate distribution of the proceeds from the sale of properties of the debtor. In other words, the proportionate distribution does not apply as regards the claims of Ato Kebede.

The rationale behind such a priority is that to enable the trustee/liquidator or the commissioners obtain goods or services during the bankruptcy process. Where there is no such a distinct right the bankruptcy proceeding would not be carried out properly and speedily. No one would be willing to enter into transactions with a person or the representative of a person who is already declared bankrupt. But where one knows that he will be entitled to priority right in the distribution and not to compete for proportionate but full payment of his claims, then he would be encouraged to enter into transactions that can facilitate the bankruptcy process. In the above given example, had Kebede known that he would compete with the other unsecured creditors for pari pasu distribution, he would not have entered in such a transaction. As a result of the pari pasu distribution he would have got less than what he claimed (less than 40,000), while the priority right entitles him for the full amount he claims.

Do you accept that there could be instances where the pre-liquidation creditors can get priority right? If you answered “Yes”, that is correct. Even pre-liquidation creditors will be able to jump the queue where the trustee is dependent on their continuing to supply goods or services and they make it a condition that existing debts must first be paid. In such a case, the liquidator is entitled to pay the pre-liquidation claims in question as being expenses of the liquidation necessary to preserve the debtor’s business or its other assets. For example, assume that Ato Debalke is the debtor who is declared bankrupt for he could not pay his debts to the creditors. Before his declaration of bankruptcy, he concluded a contract for the supply of a raw material with W/ro Yemisrach. The latter used to supply the agreed quantity of raw material to the factory of Ato Debalke. After the declaration of bankruptcy of Ato Debalke, the court ordered for the continuity of the business for justifiable reasons. For the business to continue, it is necessary that the raw material continues to be supplied. As a result, the trustee is to continue the relationship with W/ro Yemisrach. In case Yemisrach demands prior payment of the debts due and not yet paid before the declaration of bankruptcy, the trustee can pay in priority to other unsecured creditors. It is necessary to facilitate the bankruptcy process and therefore, W/ro Yemisrach is entitled to get payment in priority.

Subsidiary Principles

The following subsidiary principles buttress the above mentioned cardinal principles.

• Contracts entered into by the debtor before liquidation remain in force until disclaimed

Before the adjudication of bankruptcy, the debtor is as free as any other person. As a result, he can enter into different contracts by which he may be creditor or debtor. Where he becomes creditor as a consequence of a contract entered before the date of declaration of his bankruptcy, the trustees can claim the right from the debtor of such contract during the bankruptcy proceedings. In other words, for the mere reason that the creditor is declared bankrupt the debtors of such contract could not refuse to discharge the obligations arising from the contract. Where he becomes debtor of the contract, the creditor of such contract can participate in the bankruptcy proceedings by proving his claims like any other creditor. Therefore, the principle is that the contract would not terminate as a consequence of declaration of bankruptcy of one of the parties. But where the contract is disclaimed, it shall not remain in force.

• On liquidation, the debtor ceases to be the beneficial owner of its assets

As you know, liquidation involves the realization of assets of a person into money. The process of liquidation is to be carried out not by the person found to be a debtor by another neutral person. In the case of bankruptcy, liquidation is to be carried out by the trustees. It is obvious that the trustees are not the owners of the properties belonging to the bankrupt person. In principle, it is the owner who can transfer valid title to another person. During liquidation, therefore, in principle the trustees could not transfer a valid title. Since one cannot transfer what he does not have, the debtor ceases to be the beneficial owner of the assets. In effect, by operation of the law, the ownership right is conferred on the trustees and as a result the debtor loses such right.

• No unsecured creditor has any interest in specie in the debtor’s assets or realization

Basically, the right of unsecured creditors is a right in personem, and it is not a right in rem. In other words, the unsecured creditors have a right against the debtor, but not against the properties of the debtor. As their right is a right against the debtor and not against the assets, they cannot claim to take the properties of the debtor in distribution. Nor can they claim to participate in the realization of the properties of the debtor. What normally they are entitled to is to get distribution of the proceeds of sale of the properties of the debtor. To this effect, the properties of the debtor have to be identified and realized by a neutral body of persons, usually the commissioner and the trustees. Where the assets are not sufficient to cover the claims of creditors not secured, they are to get proportional distribution of the proceeds of sale. But as regards secured creditors, since they hold either movable or immovable properties belonging to the debtor, they have a right and interest in specie in those properties or the realization of such properties.

Bankruptcy Compared to Winding up

Do you think that winding up is the same to bankruptcy? If you answered “Yes”, that is not correct. As we have seen earlier, bankruptcy is the judicial process by which the debtor is found not able to meet his commitments towards his creditor.  On the other hand, the Black’s Law Dictionary defines winding up as:

“process of settling the accounts and liquidating the assets of a partnership or corporation, for the purpose of making distribution of net assets to shareholders or partners and dissolving the concern.” What one can infer from this definition is that winding up presupposes a company or another business organization where there are shareholders or partners.

Points of similarity and difference

• Winding up on the ground of insolvency may start by resolution of members of the company or the business organization. In this case, it is commonly known as members’ voluntary winding up since it is their voluntary resolution that is the cause for the winding up. Similarly, bankruptcy may be adjudicated based on the petition of the debtor himself. We will have a separate discussion on petition as one of the grounds for adjudication of bankruptcy later in this material.  The fact that a company is in voluntary winding up does not debar a petition for it to be wound up by the court. Petition could be presented and the court orders the winding up of the company or corporation. There might be instances where the winding up process resulting from the resolution of the members stacks due to different reasons. In such cases, the court orders winding up and such order is to be effected.

• Winding up may also start by a winding up order on a petition by a creditor or other party having a locus standi to present a petition. In this case, it is known as compulsory winding up for it is not the members who wanted the winding up but the creditors or other persons having legal right against the company or the business organization. Regarding bankruptcy, one or more of the creditors can present petition to the effect that the debtor be declared bankrupt. Not only the creditors, but also the court and the public prosecutor can present petition for the declaration of bankruptcy of the debtor.

• Winding up does not divest the company of title to its assets but makes it in effect a statutory trustee of the assets for its creditors. As a consequence of the winding up process, the company would not totally lose the right of ownership over its assets. Normally, if the company or corporation loses the right of ownership, no one remains the owner until the property is sold. On sale, the buyer becomes the owner. But in the time between the beginning and end of the winding up process, the company or corporation remains the owner. Though it is the owner, there is no right to dispose or enjoy the fruits or even to make use of the properties. The company or corporation simply remains the trustee who keeps the asset properly. The same is true in the case of bankruptcy. The debtor remains the owner of his assets till the trustees transfer to other persons on sale.

• Control of the company passes to the liquidator (either the official receiver or an outsider or by the creditors). As a consequence of start of the winding up process, the company falls under control of the liquidator to be appointed to carry out the winding up process. In the case of bankruptcy also control of the assets and the business of the debtor falls into the hands of the commissioner and the trustees to be appointed for the purpose of carrying out the bankruptcy process.

• The liquidator is usually assisted by a liquidation committee and certain of his powers may be exercised only with the sanction of that committee or of the court. In the case of bankruptcy, however, the commissioner is to be assisted by the trustees and the creditors’ committee. The court of jurisdiction is also to overlook and supervise the whole bankruptcy proceeding.

• The liquidator is responsible for getting in and realizing the assets, ascertaining the debts and distributing dividends. The trustees, in the case of bankruptcy, are responsible to collect and preserve the rights of the debtor, to realize the available assets and to distribute the proceeds among the entitled creditors.

• When all the assets have been got in, the liabilities established and the distribution completed, the winding up process is at an end. The final process is dissolution of the company, which terminates its legal existence. In the case of bankruptcy also, the process comes to an end on the final distribution of the proceeds of sale of the assets.

Conditions of Bankruptcy

As we have discussed earlier, the Commercial Code did not define the concept of bankruptcy. It simply dealt with the conditions of bankruptcy. As per the Code, there are two important conditions that need to be fulfilled for the existence of bankruptcy. The two conditions are suspension of payments and declaration of bankruptcy. In the absence of any of these two conditions there is no bankruptcy. In other words, the two conditions are cumulative rather than alternative. You can read the following provision as regards the conditions of bankruptcy:

Art. 969- Conditions of bankruptcy

Any trader who has suspended payments and has been declared bankrupt shall be deemed to be   bankrupt.

What do you think amounts to suspension of payments? In other words, when can one say that there is suspension of payments? Reading of the provisions of Article 971 of the Commercial Code will enable you answer these questions.

Art. 971- Facts constituting suspension of payments

Suspension of payments shall result from any fact, act, or document showing that the debtor is no longer able to meet the commitments related to his commercial activities.

As you read in the above-given provisions the situation of suspension of payments arises from any fact, act, or document showing that the debtor is not able to meet his commitments. There are important issues to be raised in that relation. The first one is as to what facts can show that the debtor is no longer able to meet his commitments. Can you guess what facts could be considered? I hope that you have tried to list down certain facts that may show that the debtor is no longer able to meet his commitments. One fact could be that the debtor’s business has continuously fallen from time to time for a long period of time. In other words, where the fact that the business has been falling down instead of growing up is clear, it can be inferred that the debtor has suspended payment.

The second issue is as to what act could indicate that the debtor is no longer able to meet his commitments. Can you guess possible acts that can show that the debtor is no longer able to meet his commitments? If you do so that is great. Here, note that the act that can show that the debtor is no longer able to meet his commitments is the act of the debtor himself and not that of other persons. Accordingly, if the debtor has absconded without leaving or representing an agent to carry out the business, it could be a good example of an act to show that the debtor is no longer able to meet his commitments. Another example of an act could be where the debtor misappropriates or misuses his properties. Where it is corroborated with other circumstances, the unusual act of the debtor to misappropriate or misuse the properties could be a ground to infer the situation of suspension of payments. For example, assume that Ato Mesfin is the debtor of ten creditors. He has been performing commercial activities for the last seven years. During those times he has never misappropriated his assets and has properly managed them. But his conduct changed since the last two weeks in that he unusually misuses the assets. He drives the cars carelessly and even sells certain properties for a value much lesser than the market price. In this case, the act of Ato Mesfin can indicate that he is no longer able to meet his commercial commitments.

The third important issue is about documents. What documents are you going to consider saying that there is a situation of suspension of payments?  You might have mentioned books of account, if any. If that is so, you are correct. In order to establish that the debtor is no longer able to meet his commitments, books of account, balance sheet and other similar documents can be good indicators. You can have a look at of the provisions of Article 973 of the Commercial Code, regarding the important documents to indicate suspension of payments.

Art. 973- Documents to be annexed to the notice

(1) The following documents, dated and signed, shall be annexed to the notice given under Art. 972:

a)      the balance sheet of the firm;

b)      the profit and loss of account;

c)      a list of commercial credits and debts, with the names and address of the creditors and debtors.

(2) Reasons shall be given in the notice where any of the documents required under sub-art. (1) cannot be provided or is incomplete.

Even though the documents are expected to be presented along with a notice of suspension of payment by the debtor himself, the law considers such documents to assist the court to decide that a person should be declared bankrupt because he suspended payments.

Do you agree that the fact that one has suspended payments is sufficient for the bankruptcy of a person? Did you answer “No?” If your answer is so, you are right. Your answer is well supported by the provisions of Article 970 of the Commercial Code.

Art. 970- Bankruptcy of fact

(1)   Where no judgment in bankruptcy is given, bankruptcy shall not result from mere suspension of payments.

(2)   A sentence may be passed by a criminal court in respect of bankruptcy or any offence connected with bankruptcy notwithstanding that suspension of payments has not been established by a judgment in bankruptcy.

As you can read from the provisions of sub-article (1) of the above given Article, the mere fact that one has suspended payments could not suffice to his bankruptcy. Though the fact that he has suspended payments could be proved from different facts, acts, or documents, this by itself does not suffice bankruptcy. There should be judgment of bankruptcy of the same person along with the suspension of payments. In other words, the suspension of payments has to get court recognition as a result of which there has to be judgment of bankruptcy.

Another important point to be considered from the above mentioned Article is in relation to criminal matters. As we have seen earlier, for the existence of bankruptcy, the conditions of suspension of payments and declaration of bankruptcy are necessary. Even though these conditions are not fulfilled, a court should not be prevented from deciding on criminal matters related to bankruptcy. In other words, the conditions of bankruptcy should not be a pre-condition for the court to entertain criminal cases related to bankruptcy. Where suspension of payments is proved, even though it is not established by court declaration, a criminal court can pass judgment on matters of crime related to bankruptcy.

As we have discussed earlier in the part dealing with the historical background of bankruptcy, in the earlier times bankruptcy applies to persons who involved in commercial activities. That is to say, it is only persons who involved in commerce that can be the subjects of bankruptcy. But later, because of the influence of Spanish law, persons who did not engage in non-commercial activities were made the subjects of bankruptcy proceedings.

Do you agree that the bankruptcy proceeding applies to all citizens of the country who failed to pay debts to their creditors? I hope your answer would be “No”. If you answered so, that is great. Assume that one of the distance learners of the Alpha University College (Ato Messay) borrowed 50,000 Birr from you. He has never carried out commercial activity. After you made repeated requests to get the loan paid, he refused because of different reasons. In this case, do you think that you can apply to the court demanding the student to be declared bankrupt? Did you answer “No”? If so you are correct. As far as the scope of application of bankruptcy proceeding in our country is concerned, Ato Messay would not be declared bankrupt. Then, the question remains as to who is the subject of the bankruptcy law.

Assume that in the above given hypothetical case, Ato Messay is a businessman who carries on one or more of the activities enumerated under Article 5 of the Commercial Code. Do you agree that Messay should be declared bankrupt in case he is not in a position to pay the debt he owes to you? I am sure that your answer will be “Yes”. If you answered so, you are correct. Being a trader, within the meaning of Article 5 of the Commercial Code, Ato Messay would be declared bankrupt. What then follows is that one of the subjects of the bankruptcy proceeding is a trader. It has, however, to be noted that the person should carry on one or more of those activities professionally and for the purpose of earning profit out of such activity to be taken as a trader.

Do you agree that business organizations are also the subjects of the bankruptcy proceeding? If you answered “No”, it is not correct. All commercial business organizations, except joint ventures, are the subjects of bankruptcy. The commercial business organizations are defined in different ways as per the provisions of the Commercial Code. Article 10 of the said Code defines based on the objectives and nature of the business organization. Based on the objective, every business organization established with the objective of carrying out one or more of the activities enumerated under Article 5 of the same Code are commercial business organizations. Based on the nature, a share company is always a commercial business organization. A share company, even if it is formed to carry out an activity different from those enumerated under Article 5, shall always be commercial business organization and therefore is the subject of bankruptcy proceedings.

On the other hand, Article 213 of the Commercial Code recognizes all business organizations, except ordinary partnerships, to be commercial business organizations. In spite of that, Article 968 makes all commercial business organizations, except joint ventures, the subjects of bankruptcy proceeding. The notion of commercial business organization is as it is defined by the provisions of Article 10 of the Commercial Code and not otherwise. Therefore, it follows that even if an ordinary partnership is not a commercial business organization within the meaning of Article 213 of the Commercial Code, it is the subject of bankruptcy proceeding as per the provisions of Article 968 of the Commercial Code.

From the discussion made above, it is clear that the scope of bankruptcy applies to any trader, within the meaning of Article 5, and any commercial business organization within the meaning of Article 10, with the exception of joint venture. This can be understood from the provisions of Article 968 of the Commercial Code, which reads as follows:

Art. 968- Scope of application

(1)   The provisions of this Book shall apply to any trader within the meaning of Art 5 of this Code and to any commercial business organization within the meaning of Art. 10 of this Code with the exception of joint ventures.

(2)   Without prejudice to such provisions as are applicable to physical persons only or to the provisions of Title VI applicable to business organizations only, the provisions of Titles I, II, and V of this Book shall apply to traders and commercial business organizations.

Do you agree that the state as a legal person could be declared bankrupt? I am sure that your answer will be “No”. If you answered otherwise, that is wrong. As you know, the state acts in two different capacities. It acts in both public and private capacities. In its public capacity the state represents the public at large and discharges different functions. It is expected to defend the country against foreign aggression, maintain peace and order of the society, and provide public goods and services. In this capacity, it is not for the purpose of earning profit out of its activities but only to serve the interests of the society. But in its private capacity the state can involve in any kind of business that can bring about profit like any individual businessman.

One of the points of difference between the public finance and private finance is that while the government can stay for a long period of time with a deficit financing, the private cannot do so. The fact that there is deficit financing should not lead us to conclude that the state should be declared bankrupt if it is found that it could not pay all its debts in a given year. Normally, it would not be proper to think about bankruptcy of the state in its public capacity. This is mainly because its function is different from commercial activities and the state by its nature is eternal (even if governments may change from time to time, the state exists forever so long as there is society). Since it is not a trader or business organization, we cannot think of bankruptcy of the state.

As regards the private capacity of the state, it can carry out one or more of the activities under Article 5 of the Commercial Code. In that case, the state is to be bound by the laws and regulations governing the different private entities that have legal personality. Just like any trader or business organization, the firm that belongs to the state could be declared bankrupt and therefore be made the subject of bankruptcy. As they have distinct personality and different objectives, bankruptcy of a given state-owned enterprise or company does not amount to bankruptcy of the state in its public capacity.  For example, the Commercial Bank of Ethiopia is a share company owned by the state. Here the state acts in its private capacity. In case the bank could not pay its debts to the creditors, it could be declared bankrupt and made the subject of the bankruptcy proceeding. In that case, we could not say that the state went bankrupt.

Another important issue that needs to be addressed as regards the scope of bankruptcy is as to what aspects of a person could be basis for the declaration of bankruptcy. In other words, can declaration of bankruptcy arise from all matters of a given person?  The trader can have matters falling outside his commercial activities. While he keeps books of account as regards matters falling within his commercial activities, he does not keep book of account for other matters that do not relate to the former. In case, he fails to pay debts related to matters other than his commercial activity. Do you think that he should be declared bankrupt? I hope your answer will be “No”. If that is so, you are correct. The ground for declaration of bankruptcy should be failure to pay debts related to the commercial activities of the debtor. You can read the last phrase of Article 971 of the Commercial Code, which reads as:

Art. 971- Facts constituting suspension of payments

Suspension of payments shall result from any fact, act or document showing that the debtor is no longer able to meet the commitments related to his commercial activities. (Emphasis added)

Elders witness that in Ethiopia the ancient society experienced similar practices like that of Romans. In the earlier times failure to perform promises (i.e. failure to pay back loans) which were given in monetary form or in exchange of goods for goods or bartering entails punishment. The punishment imposed on defaulting persons was either imprisonment in the home of the creditor or enslavement. This trend gradually abolished during the reign of His Imperial Majesty Haile Sellasie. Before Hailesellasie's regime, Menilik II officially prohibited slavery but it hiddenly existed until mid of the 19^th C.

Like all other legislations, commercial legislations probably began to play important role in Ethiopia under Menilik II and developed particularly during the reign as Regent and Emperor of His Imperial Majesty Haile Sellasie I. Scholars witnessed that there was no complete record and documentation as what was promulgated and what the contents of the legislation convey. Together with other proclamations there appears to have been bankruptcy law, which was promulgated in 1933 inspired by the French law. It was said that the said law was published in French and Amharic languages which holds about 96 Articles. The French text beers the date of "12 July 1933" but the printed Amharic text leaves the space for the date blank. M. Marein noted that there was no unanimity of opinion as to whether the so called Bankruptcy law was draft only or whether it was ever promulgated. One of the drafters of the Commercial Code, J. Escara in his avante project 'de code de commerce' stated that it was only draft law. This is clear indicator of the fact that there was a law dealing with bankruptcy before the coming into existence of the Commercial Code, which is currently in force.

The second half of the 19^th C. in Africa as a whole and in Ethiopia particularly had unforgettable history with marked change in the laws. It was during this time that the existing laws including the Commercial Code came to existence. With regard to its source the 1960 Commercial Code is somewhat eclectic. The then drafters noted that:

all traders buy in order to resell, all enter into contract whether of sale, agency, or carriage, and all use forms of banking credits. Bill of exchange, share companies, private limited companies, bankruptcy and other collective procedures of liquidating the goods of a trader are all institutions known almost every where. Thus, to use comparative law as an element of legislative policy is less dangerous in commercial matters than in the domain of pure civil law

However, there are indefinable differences in the continental law approach and common law approach in areas like persons subject to bankruptcy, number and nature of procedure, effect of bankruptcy on debtor, judges’ role in the proceeding, freedom left to creditors, intervention of administrative authority and defining circumstance under which a person could be declared bankrupt.

J. Escara also noted in his avante project and in the discussions before the sub-commission, that some of the differences are negligible. To exemplify, whether the circumstance under which a person can be declared bankrupt are defined in generic terms or enumerative list which does not create difference. This is because the general definition itself incorporates the limitative enumerative list. He conducted delicate selection of principles from different sources. Hence, in practice the Latin and Germanic institutions are the sources of the continental principles of the Ethiopian Commercial Code. But the existence of Anglo-American commercial practice and on the other hand, the excellent solutions furnished on more than one point by the written commercial law of England and the United States has also contributed to the Ethiopian law. Hence, the source and development of Ethiopian bankruptcy law has similar history with many other countries and it cannot be traced to a single country as a source or limited legal family as the only source.

It is proper to define the term bankruptcy before delving into the discussion on the concept. Some literatures reveal that the term bankruptcy is used only for individual debtor's insolvency whereas the term liquidation is used for insolvency of business organization. However, many jurisdictions use the term bankruptcy interchangeably with insolvency and sometimes use bankruptcy as general term applied for natural as well as for legal persons.

Let us see the dictionary definition. A Dictionary of Modern Legal Usage traces the origin of the term and then defines it. It begins with shading light from where the term was coined and hence Bankruptcy in French or Latin bancus "table” plus ruptus "broken". This is literally to mean ‘broken table’, and then extended the three definitions as follows:

• the fact of being financially unable to pursue one's business and meet one's engagements;
• the fact of having declared bankrupt under a bankruptcy statute;
• the field of law dealing with those who are unable or unwilling to pay their debts.

Some other literatures provide various accountancy definitions for the term insolvency. These are:

Balance-sheet insolvency

This has regard to the person’s assets and liabilities, and looks to see whether there is an overall net surplus or deficit. Under this definition, if assets minus liability show deficit (negative) that person is insolvent.

Commercial insolvency

This test is not concerned with the assets position, but with liquidity. It is some times called practical insolvency or insolvency on a cash-flow basis. Here, the person concerned may have substantial assets, but is unable to pay his debts as they fall due. This would happen when the wealth is tied up in property that is not readily realizable or which is over-spent in research and development for a new project, which is still on the drawing board.

Ultimate insolvency

Here, the concern is with the final outcome of the events. The debtor's assets have been sold for a value that is found appropriate given the prevailing state of affairs. In other words, the assets are to be sold for what they will fetch. Perhaps in a forced state, on a break-up basis the costs of realization and of administering the estate are taken into account.

It has been stated above, there are a lot of disparities among scholars and academicians with respect to the definition of bankruptcy. In any case, when these definitions are condensed to a conventionally acceptable definition, one can draw, possibly, two fundamental working definitions. These are: Bankruptcy is status of a person who has been made the subject of the application of bankruptcy law and who has been declared as bankrupt by a court of law. Bankruptcy is a situation whereby a person by his acts and conducts affords evidence of his inability to pay or his intention to avoid payment of his debts.

Little to say about the working definitions; in the first case it shows that the adjudication of a debtor as bankrupt in the competent court of law which has power to do so when the legal requirements are satisfied. The adjudication can be initiated by the interested parties as the laws of various jurisdictions may provide. The second definition reveals the conduct or acts of the debtor must show his unwillingness to pay his debts due. To exemplify this, the creditor may provide to the debtor execution order which he obtained from the court of law and he may fail to get payment from the debtor. In addition, criminal charge may be filed against the debtor for his fraudulent conduct as per criminal code for his tendency to defraud and this can also be a condition to evidence his conduct. The intention of the debtor could also be disclosed when he absconds and his whereabouts is not known.

It has been said that the terms insolvency and bankruptcy are interchangeably used in many literatures. However, one could be misled by the terms. To make distinction between the terms is of no importance for practical purpose. But for better understanding and academic purpose it is possible to draw distinction. Hence, with some reservation one can say, insolvency presupposes bankruptcy or bankruptcy is an outcome of insolvency. It is also possible to draw another distinction and one can also say that all insolvencies may not lead to bankruptcy and all bankruptcies are not an outcome of insolvency. This is because the course of business does not depend on solvency. If there is sufficient liquidity, a debtor can discharge his debts running his business on credit basis. A business may be prevented from paying creditors and still have more assets than liabilities. However, if it lacks liquidity then it is deemed to be in a state of bankruptcy. Liquidity is the status or condition of a person or a business in terms of his or its ability to convert assets into cash. It is the degree to which an asset can be acquired or disposed of without danger of intervening loss in nominal value.

Definition of Bankruptcy under the Ethiopian Commercial Code

Book V of the Commercial Code under Article 969 and 970 defines, as to what bankruptcy is, in two different ways. As a principle, under Article 970 (1) the Code states that bankruptcy shall not result from mere suspension of payments, unless a judgment in bankruptcy is given or factual conditions are fulfilled in the way the law requires. The two situations provided to define bankruptcy are stated as follows: First, “Any trader who has suspended payments and has been declared bankrupt shall be deemed to be bankrupt.” Second, a sentence passed by a criminal court in respect of bankruptcy or any offence connected with bankruptcy not withstanding that suspension of payments has not been established by a judgment in bankruptcy shall be deemed to be bankruptcy of fact (emphasis added Article 970 (2) of the Commercial Code).

The first definitional provision indicates declaration of bankruptcy through judgment by competent court after investigation. To declare someone as bankrupt the main test is suspension of payments. This can be called judicial bankruptcy or legal bankruptcy. The second definition envisages the factual bankruptcy. In this case criminal court may pass sentence on the debtor even though suspension of payment is not proved by court as alleged by interested party. The offence under which the debtor is sentenced shall be connected with bankruptcy or in respect of bankruptcy.

What kind of offences are connected with bankruptcy or, in respect of bankruptcy, would be point of discussion to make the second definition more understandable? In this regard it is proper to refer to the Penal Code of Ethiopian. The 1957 Penal Code of Ethiopia provides ten provisions under Book VI Title II Chapter II. of The heading of this chapter reads "Offences Relating to Proceedings of Debt, Execution and Bankruptcy". For instance, if we see Article 683 within the same chapter; "a debtor subject to proceedings by way of execution against whom a declaration of default has been delivered, and who with intent to prejudice his creditors has reduced his assets, whether materially or fictitiously, is punishable with a simple imprisonment or in grave cases, with rigorous imprisonment not exceeding five years.” Also as provided under Article 684, if a debtor misappropriates or destructs property subject to pledge or lien to obtain profit or to procure a benefit to third party, or to cause damage to his creditors he will be punished. Hence, as exemplified, any debtor found guilty of related offences and sentenced, even though there is no proof of suspension of payment, the person is deemed to be under factual bankruptcy. The rationale behind this definitional provision could be to save the creditors from further damage and to secure their rights on the immediately existing properties.

Definition and Evolution of the Law of Bankruptcy

Bankruptcy law governs the rights of creditors, on the one hand and that of an insolvent debtor, who cannot pay his debts, on the other hand. The term was derived from the Renaissance custom of Italian traders, who did their trading on benches in town market places. Creditors literally "break the bench" of a merchant who fails to pay his debts. The term bancarotta (broken bench) thus came to apply to business failures.

Default or non-payment of debt has long been an essential feature of a system of promise enforcement, centuries before bankruptcy law became integral part of the collection scheme. The Holy Scripture (Bible) has the following evidence:

"At the end of every seven years you must cancel debts. This is how it is to be done: every creditor shall cancel the loan he has made to his fellow Israelite.  He shall not because the Lord's time for canceling debts has been proclaimed. You may require payments from foreigners, but you must cancel any debt your brother owes you. However, there should be no poor among you.” Deuteronomy 15:1-4

This Biblical Jubilee shows society's past attempt to balance rightful demands for payments with some possibility of escape. Closer reading of the scripture illuminates that there was cancellation of debts and discharge of debtor when he/she happened to be poor or unable to pay debt at the end of each seven years.

The medieval Italian cities enacted statues dealing with the collection and distribution of the assets of a debtor, especially merchants, who absconded or fraudulently caused insolvency. Life for the medieval debtor was likely to be nasty, brutish and short. Just as the charging of usury by money lenders was regarded as contrary to the laws of God, and was punishable according to both the church and the power temporal so also was falling into debt considered moral sin. In addition, medieval Spanish law restored the judicial cession bnorum, which is an ancient Roman law by which privilege given to debtors to alleviate his hardship by relinquishing voluntarily his assets to his creditors by petitioning a magistrate. The Site Partides, a codification published by authority of Don Alfonso X the wise king of Castile and Leona, during the second half of the 13^th century, contained detailed provisions relating to insolvent debtors, applicable to merchants and non-merchants. The Site Partides is a Spanish Law which is the most important monumental code that was influenced by Roman and Canon law and by the customs of Castile.

Laws dealing with the property of absconding and fraudulent debtor, modeled after the statute of medieval Italian cities spread throughout Western Europe. Provisions of this type were adopted in the commercial centers of France, Brabant, and Flanders during the 15^th and 16^th centuries. Emperor Charles V, as count of Flanders, inserted stringent provisions for the repression of bankruptcies in his Decree for the administration of justice and good order in 1531. But these were measures designed for the protection of the individual creditors; more than 250 years were to elapse before the notion took hold of official collection and realization of a debtor's estate for the purpose of distribution among his creditors generally. This was introduced in the State of Hennery VIII (1542), which is the first bankruptcy statute to be enacted in England. As literature reveals, this statute was not a measure designed for the relief of debtors but was inspired by the Northern European models and entirely pro-creditors.

In France, national rules on insolvency and bankruptcy were inserted into the Ordinance du Commerce of 1673. The rules regulated both voluntary assignments for the benefit of creditors made by indebted merchants and the proceedings, and effects following from bankruptcy. It was interpreted to restrict bankruptcy proceedings to merchants only, and laws of many other countries followed the French lead. Thus, in Spain the limitation of bankruptcy to merchants was adopted by the ordinance of Bilbao, which were sanctioned in 1737 and subsequently applied in Latin American countries, especially in Argentina.

As has been said earlier, ancient legislations were entirely restricted to persons engaged in commerce. The restriction of bankruptcy legislations to persons engaged in commerce created a need for liquidation proceedings applicable to other debtors. On that basis, a Spanish jurist of the 17^th C, Salgado de Somoza, elaborated detailed rules for the initiation and conduct of voluntary liquidation proceeding which were "concourse of creditors"  or a suit or remedy to enable creditors to enforce their claims against an insolvent or failing debtor. His tract, entitled Labyrinthus Creditorum, influenced the course of Spanish law and also had great impact on the common law of the German States. As a result, Spanish law developed two classes of liquidation proceedings, one for merchants and the other for non-merchants. Spanish law in that respect was the model for the legislation in Portugal, Argentina, Brazil and other Latin American countries. Other nations, including Australia, Germany, England, the United States and nations influenced by English law brought the case of both merchants and non-merchants under their bankruptcy laws.

Around the 19^th C, as time went on, the trend against debtor who fails to pay his debt was changed. Another assumption came into play, which was that the debtor could be honest but unfortunate. And hence, bankruptcy laws should widen their umbrellas not only to creditors but also should direct the focus of their concern to relieving the honest debtor from the burden of oppressive indebtedness and permitting him a fresh start. This is in effect freeing him from obligations and responsibilities consequent up on business misfortune which he cannot satisfy by his own efforts. Thus, the already existing legalistic approach was abandoned in favor of the economic approach aiming at debtor’s rehabilitation and corporate reorganizations. In recent times, however, a great effort has been made to remove the disgrace attached to bankruptcy. Even the terms ‘bankrupt’ and ‘bankruptcy’ (or their equivalents in other languages) are less used and less frequent in the statutory languages. Modern French Legislations, for example, totally suppress the traditional term “faillite” for liquidation proceedings and restrict it to special procedures entailing the imposition of disqualifications on insolvents guilty of commercial misconduct.