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Bulgaria: Contractual Netting as Quasi-Collateral in Commercial and Financial Transactions

The Supreme Court has upheld the parties’ freedom to contractually modify any of the conditions precedent to set-off under Bulgarian law, thereby allowing for various quasi-guarantee arrangements in commercial and financial contracts which creditors may avail themselves of.

Prerequisites for legal compensation in Bulgaria

Under Article 103 of the Bulgarian Law on Contracts and Obligations (the “certificate of authenticity“), if two parties must1 of money or other replaceable securities, each of the parties whose claim is due and “liquid” (i.e. indisputable as to legal basis and amount) may deduct it from its obligation to the other part. This mechanism is called “legal compensation”, since each of the parties can resort to it when the conditions required by law (i.e. art. 103 COA) exist. As the “liquidity” requirement under “legal netting” is quite onerous, sophisticated creditors try to avoid it through “contractual netting”, i.e. agreeing with their counterparty for netting effects to occur where one or all of the preconditions (and especially “liquidity”) for “legal netting” do not exist.

The purpose of this bulletin is to highlight some important developments in the case law in Bulgaria confirming the validity of contractual netting and to summarize its practical importance.

Validity and scope of contractual compensation, derogating from legal compensation

As there has been some uncertainty among legal scholars and some lower courts as to the possibility of contractual set-off, it is important that there is now confirmation by the Supreme Court of the validity of contractual set-off – Judgment No. ° 156 of November 15, 2019 in the context of commercial case no. 2875/2018, II-th commercial section of the Supreme Court of Cassation, reported by judge Tatiana Varbanova (the “Judgement“). The court of first and second instance in this case ruled that a contractual compensation claimed by the Bulgarian state agency “Road Infrastructure” due to a contractual penalty for delay in performance in relation to a part of the cost of building a road was ineffective, since the existence and amount of the penalty was disputed by the defendant Black Sea Autobans AD, i.e. it was not “liquid The lower courts accepted the argument that contractual netting can only be effective if the preconditions for -off, including the requirement of “liquidity”, exist.

The Supreme Court rejected this argument and reversed the judgments of the lower courts. It held that contractual compensation is permitted under Bulgarian law (i) based on the concept of freedom of contract within the meaning of Art. 9 COA, according to which “the parties are free to agree on any matter within their contract if this does not violate mandatory laws and good faith”, and (ii) since the conditions precedent to legal set-off are decisive, that is, they apply only if the parties have not agreed otherwise.

The justification for the judgment was recently reaffirmed – again at the level of the Supreme Court – in resolution no. 197 of April 14, 2021 in the context of commercial case no. of cassation, reported by judge Emilia Vassileva. These developments should reassure creditors wishing to avail themselves of contractual compensation as collateral for their commercial or financial agreements.

Practical importance of the stop

The judgment is very important for parties who have so far not actively used contractual compensation due to doubts about its applicability, for example investors wishing to offset a contractual penalty (which can potentially be challenged by their contractor ) against part of a project price owed by them (i.e. on facts similar to those referred to in the judgment), these players can now include contractual compensation arrangements among the tools protecting their interests . Although in theory netting is considered a “quasi-collateral”, in practice it is a “super-collateral” compared to most traditional securities. By invoking it, creditors settle their debts immediately, without formal and costly proceedings and in the event of insolvency, they can do so before all other secured creditors.

The halt is equally important for some sophisticated players like banks and financial institutions that routinely use contractual netting as a risk mitigation tool in case their counterparties default in financial transactions. These players now have more arguments to rely on offsetting, including before the regulatory authorities for capital relief purposes.

However, parties wishing to invoke contractual set-off should not expect courts to easily infer the existence of such arrangements. On the contrary, much of the older case law rejecting the admissibility of contractual set-off was based on the absence of a clearly expressed intention of the parties to deviate from legal set-off. Therefore, clear, explicit and appropriate provisions should be put in place to replace legal compensation requirements and replace them with contractual clauses.

Particular attention should be paid to the potential insolvency of a Bulgarian counterparty. Unlike some other jurisdictions which treat set-off as an unauthorized preference, Bulgarian law allows set-off in insolvency when the conditions precedent to it occur. However, to enhance the smooth enforceability of contractual set-off in insolvency, some special additional arrangements should be considered by sophisticated creditors.