A blind bailout

At the end of September and in the early days of October, the German government decided to guarantee all private customer deposits with banking institutions for an unlimited amount and started work on a stabilisation programme.

The programme came into force on October 18 2008 under the Financial Market Stabilisation Act (Act), the Act on the Formation of a Financial Market Stabilisation Fund and the Act on the Acceleration and Simplification for Acquisitions by the Fund of Equity in and Risk Positions of Financial Institutions (Acceleration Act).

The objective of the Act is to overcome the tight liquidity of financial institutions and to improve their equity. Under the Act, through a state-owned fund, the Sonderfond Finanzmarktstabilisierung (Fund), the government will:

• guarantee financing obligations of financial institutions incurred between October 18 2008 and December 31 2009 and with a term of up to 36 months;

• take equity or similar stakes in financial institutions, up to a maximum of €10 billion ($13 billion) per institution; and

• assume risk positions of financial institutions incurred before October 13 2008.

All measures can be combined. The Fund can give guarantees of up to the aggregate amount of €400 billion and can take further equity stakes and financial risk exposures up to the aggregate amount of €80 billion. The bailout is limited to financial institutions, which includes credit and finance service institutions, insurance companies, pension funds, capital investment companies and owners of stock exchanges. Leasing companies and foreign financial institutions (as long as they have not incorporated a German legal entity to run their business) cannot apply for aid.

The fund will receive a consideration of market conditions, which is expected to be at least 2% of the guaranteed amount or obligation.

Like UK measures, the Fund imposes conditions on financial institutions taking aid regarding the business, the dividend distribution policies of the institution and the remuneration levels of their executive board members or directors.

In order to achieve its objectives, the Act has had to implement a number of amendments to corporate and capital market laws, economic laws relating to the recapitalisation of financial institutions and taxation.

For example, in order to ensure a timely realisation of the objectives of the Act, the German government passed the Acceleration Act, which has cleared a number of obstacles. The aims are as follows.

• The transfer of risk positions cannot be challenged following an insolvency.

• Legal restrictions to transfer (including options, change of control clauses and preemptive rights) do not hinder a transfer of legal positions to the Fund. The same applies in the case of collateral securitisation.

• If a contract is transferred by a financial institution to the Fund, the contractual partner of the underlying relationship (a borrower, for example) cannot terminate its contract for cause.

• The terms and conditions used and applied by the Fund will not be subject to the Act on General Terms and Conditions. Therefore, any dispute regarding whether the contractual terms and conditions are fair is categorically excluded.

Whereas in the UK banks need to agree to raise their capital in order to take part in the government scheme, in Germany the stabilisation measure will only be granted if the distressed business "warrants a solid and prudent business policy". How this test will be applied really needs to be seen in action. In any event, the Fund needs to apply strict and impartial rules regarding competition among financial institutions. It would be best advised to negotiate and enter a contract with the institution, including provisions for applicable consequences in the event of violations of the agreed terms and conditions.

The board of the company must declare that it will comply with the business, dividend and compensation policies as required under the Act.

The terms and conditions for the recapitalisation of a distressed business will be more strict than other stabilisation measures because the Fund can provide that the business will:

• not take certain risks and activities for certain types of business or markets;

• accommodate for the needs of credit-taking small-and medium-sized businesses in general;

• review its models and levels of compensation; and

• limit compensation levels for management or members of the board to a maximum that is deemed not excessive (€500,000 per year), as well as not paying any bonus or other discretionary compensations on top of the named remuneration.

These terms are similar to but slightly more onerous than those of the UK.

German insolvency laws have turned back the clock and reinstated the previous version of Section 19 of the Insolvency Act. The new (old) section provides that as of November 2 2008 an insolvency can be avoided if there is a predominant likelihood that the "financial strength of the business will be sufficient to carry on the business". The temporary two-year amendment of Section 19 (until December 31 2010) is not limited to the financial industry but applies to all and any businesses that fall within the scope of the German Insolvency Act.

Also, as in the UK, the balance sheet rules for financial instruments will be amended in order to prevent a further need for value adjustments. A first step was taken by the International Accounting Standards Board and the amendment of IAS 39 and IFRS 7. It will therefore be possible (under narrow circumstances) to re-qualify financial instruments that are shown in the balance sheet with their actual value and continue them with the acquisition costs or another, lower value. The Commission has transformed this amendment on the European level by an EU Directive of October 15 2008.

The government bailout has been received by the market with initial reluctance. Deutsche Bank, the market leader, expressely refuses to take government money (even though it assumed a leading role in creating the stabilisation programme) and has been subject to strong criticism because it is believed that banks will not risk credibility and disclose their weak position as long as market leaders refuse to do so.

Unlike the UK plan, the German bailout plan has been criticised by experts and academics, regardless of the widespread view that it has prevented a systemic breakdown of the financial market at the last minute. There is no conception of how the German banking system might look after the crisis – and there has been no discussion of this so far. Without any real restructuring concept and simply armed with the vague idea of somehow helping financial institutions to survive, the government has admitted that it has no restructuring plan. This is substantially different from the Swedish banking crisis of 1992, when the Swedish government enforced a removal of the banking sector and created A-, B- and C- banks. C- banks were closed and their profitable business was transferred to other banks. The Swedish government even made an eventual profit on the bailout. Neelie Kroes, the EU competition commissioner, has criticised the approach, demanding a restructuring plan, not just a "blind bailout".

There are also a number of legal issues that may affect the effectiveness of the bailout. For instance, the board can ask the government to come in simply because they would like to take advantage of the aid available or use the opportunity to raise fresh capital, whether they need it or not. By the same token, shareholders will be diluted, literally within a few days. In effect, the management changes the ownership of the business at their discretion.

Though it is envisaged that the government will ultimately sell the acquired bailout shares, it will do so at market price and not necessarily to the original shareholders. Management, in collaboration with the government, may be able to change the entire landscape of an institution without shareholder approval. In effect, then, the bailout may constitute a violation of the German Constitution (Grundgesetz) and the concept of a free and liberalised market.

As an investor, the government will have a significant say in business and dividend policies and management compensation levels. But are these government managers actually any good? History has shown that state-owned banks have proved to be some of the worst-managed.

Will the German government also save the auto industry and its large suppliers, the electronic, chemical and other industries (all of whom would argue that they are of paramount importance)? The present discussion of the insolvency of General Motors in the US and its consequences for its German subsidiary Opel gives a clear demonstration of what can be expected. Dieter Zetsche, CEO of the Daimler-Benz Group, said that it does not intend to ask for aid but will be watching government reactions to the crisis. He explicitly does not rule out changing his point of view if the government helps others. Given the fact that over 10% of all employment in Germany depends directly or indirectly on the auto industry, Zetsche and others may well raise some powerful arguments that could even have some legal merit.

The measures provided in the Act are unprecedented in the economic history of Germany and Europe. This is true not only with regard to the amount of aid and the speed at which the package came into force but also with regard to the agreed measures and their effects on the legal relationships of distressed businesses, as well as their management and shareholders under the Act. However, even though the Act may temporarily ease the market situation, it is only the starting point for further measures, which must lead to an entire reform of the financial markets. It remains to be seen whether distressed financial institutions will accept the aid offered and subject themselves to the far-reaching terms and conditions so that the objectives of the Act can be achieved quickly and the Fund can withdraw from distressed businesses by December 31 2009.

We will see more government intervention in all industries. The liberal free-market atmosphere will be on hold for the foreseeable future. The regulatory authorities' failure to manage the growing bank risk is one of the biggest lessons to learn from this crisis.

In the meantime, there will be numerous legal issues regarding the application and consequences of the Act.

By Klaus P Grossmann and Jacqui Hatfield of Reed Smith