The booming German credit and capital markets came to a sudden halt when Germany went into a general lockdown in March 2020. Corporates, sponsors and investors immediately switched their focus from new money and repricing deals to protecting their businesses and investments. Many businesses, fearing impending draw-stops and credit crunches, utilised their existing credit lines in full while at the same time trying to access the newly-established German state-aid schemes.
German state-aid: KfW loans
German state-aid regimes were enacted by the government to provide liquidity to Covid-19-affected businesses. Such businesses were offered subsidised loans through the German state-owned bank KfW, predominately through two KfW programmes.
First, the expanded entrepreneurial loan programme No. 037 which provides for a back-to-back (re-)financing of commercial banks by KfW. Under this programme, KfW takes up to 80% of the credit risk of the extended loan.
Second, the newly established KfW programme No. 855 for direct participations in syndicated facilities which provides for KfW to become a lender of record alongside commercial banks in syndicated facilities. The commercial banks have to take at least 20% of the credit risk in such syndicated facilities. KfW’s special Covid-19 programme for subsidised loans runs until year-end 2021.
German state-aid: Economic Stabilisation Fund
In addition, the Economic Stabilisation Fund was established which provides financial support to businesses in all sectors of the economy (other than the financial sector) by means of federal guarantees for borrowed capital and/or recapitalisation measures. Such recapitalisation measures range from equity injections through silent partnerships to subordinated loans.
These state-aid programmes remain available until year-end 2021, although the demand has significantly decreased following the reinvigoration of the financial markets and the general economy.
German state-aid: other subsidies
Apart from the financing support through KfW and the Economic Stabilisation Fund, direct, non-repayable subsidies were made available for businesses affected by the lockdowns in November and December 2020 under the so-called November and December support programmes and also for other business under the so-called bridge support programmes.
In addition, the access for businesses to the federal short-term working benefits programme, to compensate employees of businesses for the loss in wages resulting from down periods, was facilitated.
Actions taken by the legislator: short term
With a view to avoiding insolvencies of companies who became distressed due to the Covid-19 pandemic, the German legislator comprehensively modified the German insolvency regime with retroactive effect as of March 1 2020. These modifications addressed nearly all insolvency-related obligations and restrictions which typically apply to insolvent companies, their directors and their creditors, including a suspension of directors’ insolvency filing duties. The modified regime expired at the end of April 2021, i.e. the ‘normal’ regime is fully applicable again.
The state-aid programmes, which in aggregate had an initial volume of €1,100 billion (approximately $1.285 billion), and the suspension of the insolvency-related restrictions have provided substantive relief to distressed companies. Actual insolvencies were few and far between and, mostly, hit companies which had financial difficulties already pre-Covid-19. According to the German Federal Statistical Office, corporate insolvencies in 2020 were around 16% lower than in 2019. In the first half of 2021, corporate insolvencies were around 18% lower than in the first half of 2020 and around 23% lower than in the first half of 2019.
Actions taken by the legislator: long term
Recognising the need for a pre-insolvency restructuring regime in light of the economic distortions caused by the Covid-19 pandemic, the German legislator has introduced the long-awaited new German restructuring scheme at the beginning of January 2021.
The availability of this new German scheme closes the gap between fully consensual out-of-court restructurings and in-court restructurings by providing a pre-insolvency restructuring instrument which allows for a cram-down of creditors and/or shareholders. In practice, the mere possibility to outvote or cram-down hold-out stakeholders often enables a fully consensual restructuring.
For non-consensual restructurings, two restructuring instruments are generally available in Germany. First, the new German restructuring scheme, a pre-insolvency restructuring regime aiming at a sustainable restructuring of the debtor by means of a restructuring plan to be adopted by the affected stakeholders. Second, insolvency proceedings as a comprehensive in-court restructuring (or liquidation) regime.
In addition, German law governed bonds can also be restructured pursuant to the German Bond Act by means of a bondholder vote without any court involvement. The German Bond Act allows for a holistic restructuring of the bonds, including, for example, haircuts, maturity extensions, debt-to-equity swaps and the acceptance of exchange offers, with a qualified majority of 75% of the voting bondholders.
Apart from a temporary modification of the insolvency regime for businesses hit by the devastating floods in Germany in July 2021, there are currently no legislative projects aiming at an amendment of the restructuring regime for businesses.
On a European level, the EU initiative for increasing convergence of national corporate (non-bank) insolvency laws in order to encourage cross-border investment is ongoing as part of the general effort to strengthen the EU Capital Market Union. The public consultation process has been finished in March 2021 and the adoption by the European Commission is planned for the second quarter of 2022. The effects for Germany are currently difficult to predict as Germany already has, as a consequence of various reforms, a rather sophisticated and efficient insolvency and restructuring regime.
Processes and procedures
Directors’ duties under German law
Directors of entities with limited liability, i.e. entities without at least one individual as directly or indirectly personally liable shareholder, are subject to certain specific statutory duties in a ‘crisis’ situation of such entities.
A ‘crisis’ generally means a situation where the entity experiences commercial and/or financial distress to an extent that it could possibly result in an insolvency or otherwise endanger its corporate existence. Typical symptoms of a crisis are a decrease of earnings before interest, taxes, depreciation, and amortisation (EBITDA) and equity, accompanied by an increase of financing costs and net leverage ratio (i.e. the ratio of total net debt to EBITDA).
It should be noted that the omnipresent ‘cov-lite’ term loans or incurrence-based high yield bonds typically do not provide for a trigger enabling lenders or investors to act in the event of such deterioration of the borrower’s financial situation, which vice versa may eliminate the need of the borrower to react to the situation early on. Hence, the visibility of, and the reaction to, the crisis may be delayed.
Statutory directors’ duties, however, continue to apply and are often exacerbated due to the crisis situation. E.g. the duties of directors in a crisis situation comprise an intensified monitoring obligation with a specific focus on the financial status of the company (in particular, its liquidity) and an obligation to closely coordinate with the other corporate bodies, in particular the supervisory board.
If the crisis is aggravated, directors may be required to file for insolvency. The German Insolvency Code imposes an obligation on directors to file for insolvency in the event of ‘illiquidity’ or ‘over-indebtedness’. In the event of an ‘imminent illiquidity’, i.e. if it is not more likely than not that the debtor will be able to honour all of its payment obligations which become due and payable from time-to-time within the applicable forecast period of generally 24 months, directors may, but are not required to, file for insolvency. Any insolvency filing solely on the basis of imminent illiquidity generally requires shareholder approval.
Illiquidity is generally presumed if a debtor ceases to make payments when due. Irrespective of a cessation of payments, the state of illiquidity is generally attained if the debtor cannot pay its creditors within a three weeks’ timeframe and this affects more than 10% of the outstanding payment obligations.
Over-indebtedness occurs if the debtor’s assets at liquidation values are insufficient to cover its liabilities and, in addition, it is not more likely than not that the debtor will be able to honour all of its payment obligations which become due and payable from time to time within the applicable forecast period of generally 12 months.
Each director must file for insolvency proceedings without undue delay and in no case later than three weeks after the occurrence of illiquidity and six weeks after the occurrence of over-indebtedness. Directors are only allowed to wait for the full three or six weeks, as applicable, if there is a realistic chance of a sustainable improvement of the financial situation of the company which eliminates the insolvency reason.
Further, no payments may be made by the directors following the occurrence of an illiquidity or over-indebtedness unless the relevant payment is reconcilable with the diligence of a prudent businessman. Payments made to existing creditors which have already discharged their obligations for delivery etc. vis-à-vis the company are generally irreconcilable with the diligence of a prudent businessman.
Lastly, it should be noted that there is generally no ‘shift of directors’ duties’ in Germany. The management generally owes its duties to the company and its shareholders until the occurrence of actual insolvency (i.e. illiquidity or over-indebtedness). However, such shift of directors’ duties does occur following the entry of the debtor into the new German restructuring scheme proceedings (see below).
German restructuring scheme proceedings
Both, the new German restructuring scheme and insolvency proceedings are available to all debtors whose centre of main interests (COMI) is located in Germany irrespective of the debtor’s legal form. Certain specific rules apply to insolvencies of financial institutions which are precluded from German scheme proceedings.
The new German restructuring scheme is available to debtors which are in the state of imminent illiquidity without yet being insolvent. The institution of insolvency proceedings requires that the debtor has entered the state of imminent illiquidity, illiquidity or over-indebtedness (see Directors’ duties under German law above).
Both processes provide for the option of staying any enforcement action of secured or unsecured creditors with a view to preserving the opportunity for a continuation of the business operations. Ipso-facto clauses, i.e. termination clauses which are triggered by the commencement of German scheme proceedings or insolvency proceedings, are null and void, although other termination rights, including upon default of the debtor, remain unaffected.
The new German restructuring scheme is a debtor-initiated process. Only the debtor is entitled to propose the restructuring plan and to submit it for adoption by its affected creditors and/or shareholders. A pre-packed solution is, however, possible. Court-involvement is not necessarily required. However, especially for more complex, controversial or cross-border restructurings, debtors will require the involvement of the competent restructuring court to cram-down dissenting stakeholders.
Creditors and, if their rights are affected, shareholders have to be allocated into different classes. An adoption of the restructuring plan requires its acceptance by each class with a majority of 75% of the voting rights. A cross-class cram-down is possible if, essentially, the crammed-down creditors are not worse off compared to their position in the absence of the restructuring plan and such creditors participate appropriately in the value allocated by the restructuring plan to the stakeholders. This generally requires compliance with the so-called ‘absolute priority rule’.
This rule in principle provides that no stakeholder ranking junior to the crammed-down class may be awarded any economic value by the restructuring plan unless such economic value compensates a corresponding contribution by the subordinated stakeholder into the debtor’s estate.
On the other hand, insolvency proceedings are always an in-court process and in practice often aim at a liquidation of the debtor’s assets rather than a restructuring. Insolvency proceedings, however, do provide several different possibilities to restructure the debtor. A debtor can be restructured in insolvency proceedings by means of an insolvency plan (including a debtor-in-possession administration) or by way of a transfer of assets of the debtor (so-called ‘restructuring by transfer’).
In insolvency plan proceedings, similar to the German scheme, the creditors and, if their rights are affected, the shareholders have to be allocated to classes. The adoption of the insolvency plan requires acceptance by each class with a simple majority of participating class members by headcount and claim value with the option for a cross-class cram-down if, essentially, the crammed-down creditors are not worse off compared to a regular liquidation of the insolvency estate and such creditors appropriately participate in the value distributed by the insolvency plan to the stakeholders (which requires compliance with the absolute priority rule). The insolvency court has to sanction the insolvency plan before it becomes effective.
In regular insolvency proceedings, the insolvency administrator usually pursues a restructuring through the sale of the business of the insolvent debtor, typically by means of an auction process. The sale as such is implemented through an asset deal. This allows the insolvency administrator to comprehensively reorganise the debtor and its assets and liabilities by transferring the ‘good’, i.e. valuable and competitive, part of the business of the debtor to the purchaser and leave the ‘bad’ part of the business (and the corresponding liabilities) behind in the insolvency estate.
In insolvency proceedings of larger companies, a creditors’ committee regularly has to be established. It comprises representatives of secured creditors, large claims creditors, small claims creditors such as suppliers, the Federal Employment Agency and, if pension obligations are affected, the German Pension Insurance Fund. The creditors’ committee represents the interests of the creditors as a whole and has to monitor the insolvency administrator.
No group restructuring or insolvency concept and no consolidation
Under German law, there is no group restructuring or insolvency concept, i.e. despite the economic ties between various entities within one group of companies, there will be one separate insolvency or restructuring proceeding for each of the entities. Each of these proceedings is legally independent from all other insolvency or restructuring proceedings (if any) within the group.
In particular, there is no consolidation of assets and liabilities of a group of companies in the event of insolvency and no pooling of claims among the respective entities of a group. However, the German Insolvency Code contains provisions to facilitate the coordination of and cooperation between insolvency proceedings of group companies.
Under the German Insolvency Code, the insolvency administrator may challenge transactions, performances or other acts that are deemed detrimental to insolvency creditors and which were effected prior to the opening of formal insolvency proceedings during applicable avoidance periods.
Generally, if transactions, performances or other acts are successfully challenged by the insolvency administrator, any amounts or other benefits derived from such challenged transaction, performance or act will have to be returned to the insolvency estate. The administrator’s right to void transactions can, depending on the circumstances, extend to transactions having occurred up to 10 years prior to the filing for the commencement of insolvency proceedings.
As regards the recognition of insolvency proceedings, German insolvency proceedings are to be recognised by the EU member states under the European Insolvency Regulation. As regards non-member states, recognition has to be awarded under the individual national recognition regimes. Generally, also due to the harmonisation of the recognition regimes on the basis of the UNCITRAL Model Law on Cross-Border Insolvency (1997), German proceedings should be recognised if the debtor has its COMI in Germany. The same principles apply vice versa to the recognition of foreign proceedings in Germany.
Recognition of pre-insolvency restructuring proceedings such as the German scheme should, as regards EU member states, be awarded under the so-called Brussels 1a Regulation, the pre-Brexit approach for the recognition of English law schemes of arrangements. From July 2022 onwards, German scheme proceedings can also be conducted as public proceedings, having the effect that the venue, hearing dates and court decisions will be announced. In this case, the German scheme proceedings will be eligible for recognition under the EU Insolvency Regulation.
Looking ahead, the following main trends are likely materialise: More restructuring cases and potentially more insolvency cases should evolve in the mid-term once the relief granted by Covid-19-related state-aid programmes abates. Long-term structural trends, such as digitisation and structural transformation of certain sectors, e.g. automotive, energy and high street retail, will keep putting pressure on businesses. Moreover, businesses which are not able to meet the now ubiquitous environmental, social and governance (ESG) criteria of commercial banks and institutional investors should increasingly face difficulties in accessing equity and debt financing sources.
Furthermore, it is expected that the new German scheme should become the instrument of choice for financial restructurings of debtors with a diversified capital structure, in particular if the debtor is financed through Schuldschein loans or various bilateral credit agreements due to the possibility to cram-down passive or hold-out creditors. Lastly, with the implementation of the EU preventive restructuring framework in the various EU members states, such as the German scheme, the English law scheme of arrangement may become less attractive for non-UK domiciled companies. This trend towards a certain re-nationalisation of restructurings is aggravated by the legal uncertainties around cross-border recognition of English schemes of arrangement and the overall tendency of current jurisprudence to take a more critical view on COMI shifts.
T: +49 69 7191 143447
Mathias Eisen is a partner in Milbank’s financial restructuring and European leveraged finance/capital markets group. He specialises in financial restructurings and leveraged finance transactions.
Mathias advises banks, non-bank/direct lenders, funds/financial institutions, sponsors and corporate borrowers on the complete range of restructuring solutions from initial debt reviews and options analyses to in-court and out-of-court restructurings, as well as claims recovery and insolvency advice. He also advises on leveraged buyouts, syndicated loans, bank/bond financings, hybrid instruments, non-recourse and asset-based financing solutions, and is a trusted adviser for both finance and financial restructuring transactions.
Mathias studied law at the University of Passau and holds a doctorate degree from the University of Frankfurt. He is the co-author of ‘Hölters – Handbuch Unternehmenskauf’, Otto Schmidt Verlag, Cologne. He is admitted to the German bar. Before joining Milbank, he worked in the Frankfurt and in the London office of a major German law firm, as well as for an investment bank in London.
T: +49 69 7191 143441
Robert Kastl is a member of Milbank’s financial restructuring and European leveraged finance/capital markets group. He represents creditors, debtors and other stakeholders in distressed situations, including financial restructurings and insolvency matters.
In addition, Robert regularly advises financial institutions, investors, sponsors and corporate clients on all aspects of leveraged finance and corporate finance transactions.
Robert studied law at the University of Regensburg and is admitted to the German bar. Before joining Milbank, he worked in the Frankfurt and New York offices of an international law firm.
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