CHAPTER 8 Insolvency and Bankruptcy Considerations in Germany

• Jurisdiction: United States

CHAPTER 8 Insolvency and Bankruptcy Considerations in Germany

A. Overview of the German Legal System

Germany is a federal republic consisting of 16 states (landers). Competences in legislation are shared between the federal state and the lander. Insolvency law and the laws governing directors' liability are federal laws.

In civil and criminal law, the competent courts are the local courts (amtsgerichte) as trial courts, the district courts (landgerichte), which can be trial or appellate courts depending on the subject matter, and the appeal courts (oberlandesgerichte). The supreme civil and criminal court is the German Federal Supreme Court (Bundesgerichtshof, or BGH).

B. The German Insolvency Process

The legal basis of German insolvency law is the German Insolvency Code of Jan. 1, 1999 (Insolvenzordnung), referred to as InsO; the European Council Regulation (EC) No. 1346/2000 of May 29, 2000, on insolvency proceedings, referred to as the European Insolvency Regulation or EIR; and the Introductory Act to the German Insolvency Code, referred to as EGInsO. The UNCITRAL Model Law on Cross-Border Insolvency has not been adopted in Germany.

InsO has been subjected to a major reform focusing on the following:

• choice of a bankruptcy trustee (insolvency practitioner or IP)
• introduction of debt/equity swaps
• limiting the rights of minority creditors and shareholders
• strengthening and incentivizing debtors in possession (DIPs).

The reform became effective on March 1, 2012, and based on historical experience, the shape of this reform will change until the creativity of IPs and advisors and the wisdom of the courts define clear and accepted practical applications for the innovations and changes.

The European Commission is currently reviewing the EIR, and several interest groups have made recommendations for changes thereto. The process will likely take a few more years, but changes to the EIR are to be expected in the medium term.

Whereas the U.S. Bankruptcy Code features different processes of filing for insolvency, German insolvency law only offers one type of filing for both a debtor and its creditors. After the opening of the proceedings, creditors will decide whether the process should be a winddown, a sale of the business or a reorganization.

1. Insolvency Triggers

German insolvency law features two mandatory insolvency triggers, viz., over-indebtedness and illiquidity, and one optional insolvency trigger, imminent illiquidity. In the latter case, only the debtor may commence insolvency proceedings, not its creditors. Thus, the opening of the insolvency proceeding is not subject to the debtor's discretion but requires the existence of certain conditions.

a. Over-Indebtedness

"Over-indebtedness" is an insolvency trigger only for companies with limited liability (corporations or limited partnerships), but not for individuals. Over-indebtedness is defined in Sec. 19 InsO as the condition in which a debtor's liabilities exceed its assets. The ordinary (year-end) balance sheet is, however, unsuitable to determine the presence or absence of over-indebtedness. For the purpose of determining the existence of this status, the assets and obligations must be reflected and valued on a liquidation basis.

In an attempt to mitigate the impact of the financial crisis, the German legislature (Bundestag) decided in October 2008 that the over-indebtedness test is only relevant where a company does not have a "more than likely" medium-term going concern (fortbestehensprognose). This prognosis requires that the debtor's funding, objectively and more than likely, is sufficient for the survival of the business.⁶²⁷ This going concern must be assessed by the directors of the company, acting reasonably, on a continuous basis. The going-concern test must be based on cash-flow projections for the current and subsequent financial year or for at least 18 months. This analysis requires a detailed and realistic medium-term business plan establishing that the company's operations and funding are appropriate to ensure its survival and that, during this period, insolvency of the company is unlikely to occur. The debtor's cash situation is particularly important as a criterion for ascertaining a likelihood of more than 50 percent for the business to continue as a going-concern.

The changes concerning over-indebtedness as an insolvency trigger were introduced only temporarily, and this easing of the filing requirement is currently scheduled to expire on Dec. 31, 2013. ⁶²⁸ Under prior law, the over-indebtedness test was mandatory in its application. The valuation scenario may use going-concern values, but only if a going concern is more likely.

b. Illiquidity

Pursuant to Sec. 17 InsO, illiquidity is established if the debtor is not able to meet its obligations currently due and past due. This has been specified by the German Federal Supreme Court as follows: If the liquidity shortfall amounts to 10 percent or more of the obligations presently due or past due, illiquidity is assumed unless it is highly likely that the shortfall will soon be covered entirely or almost entirely. A mere short-term insufficiency of funds (generally, up to three weeks) shall not constitute illiquidity. ⁶²⁹

c. Imminent Illiquidity

Sec. 18 InsO grants the option to the debtor of whether or not to file for insolvency in the case of imminent illiquidity. This option differs from actual illiquidity, as it operates as a prediction of the debtor's capability to meet the obligations that will mature in the future. Imminent illiquidity requires a predominant probability of illiquidity in the future. Most authors agree that this forecast of illiquidity must be limited to a period of not more than two years, since predictions become less reliable the further they are extended. Nevertheless, jurisprudence has not yet defined the required forecast period.

2. Directors' Liability

In contrast to businesses run by individuals, the liability of a corporation's shareholders for business debts is generally limited. Once the shareholders have contributed their capital share, there is no obligation for them to contribute further to that fund. This doctrine creates a risk of nonpayment of creditors' claims against an insolvent corporation.

To address this risk, Sec. 15a InsO creates a duty for any managing director to file for insolvency in the case of a company's over-indebtedness or illiquidity, with the intention of maintaining a maximum level of assets to satisfy the claims of its creditors. Directors are required to carefully monitor the financial situation of the company. Whenever there are indications that the company might be unable to pay its debts when they mature or the risk of being over-indebted is high, each managing director is under a personal duty to immediately implement controls to assess the company's financial situation at short intervals. Once the company is deemed illiquid or over-indebted, the potential future estate must be maintained and further payments must not be made. Otherwise, the directors who have authorized these payments are liable for their reimbursement to their company.⁶³⁰

If a director has established a mandatory insolvency trigger, he is required to file for...