On 1 January 2011 two amendments to the German Insolvency Code (Insolvenzordnung) will come into effect. They were only recently adopted by the German Bundestag as part of the Act Accompanying the Budget (Haushaltsbegleitgesetz).
The changes relate to:
- taxes payable by the debtor during preliminary insolvency proceedings and
- the possibility to continue insolvency proceedings despite payment of outstanding debts by the debtor.
In consequence, the continuation of the business during preliminary and main insolvency proceedings will become more challenging due to the increased liquidity needs. Another planned amendment that would have privileged German tax authorities by granting them better set-off rights was not implemented by the new law.
1. Taxes during preliminary proceedings
§ 55 German Insolvency Code will be amended to include a provision that will turn any tax liability incurred by the debtor during preliminary insolvency proceedings into liabilities of the estate (Masseverbindlichkeiten). This leads to a privilege of such tax liabilities (in particular incurred value added tax) in that they have to be paid before any other unsecured regular insolvency claims are paid by the administrator. In addition a (preliminary) insolvency administrator may become personally liable if liabilities of the estate cannot later be paid. Currently, in general only debt incurred after the opening of the main insolvency proceedings and debt incurred by actions of a "strong" preliminary insolvency administrator are liabilities of the estate.
Critics expressed concerns that the change will have negative effects on the continuation of businesses during preliminary proceedings as much needed liquidity will have to be withdrawn to satisfy tax liabilities. In addition, some critics argue that insolvency administrators might hesitate to continue the debtor's business due to fears of becoming personally liable if the incurred tax debts cannot be paid. This seems to be a valid point as in particular at the beginning of preliminary proceedings it is difficult to predict whether in the end enough money will be available to satisfy preferred creditors.
2. Effect of debtor's payment on opening of proceedings
In addition, § 14 German Insolvency Code will be amended to make it more difficult for debtors to prevent insolvency proceedings by paying the creditor that initiated preliminary proceedings. In German insolvency law the debtor and its creditors may file for proceedings against the debtor. The creditor must have a valid legal interest in initiating insolvency proceedings. By paying to the creditor any amounts currently outstanding, the debtor was under the old rules able to make a creditor's petition to open insolvency proceedings inadmissible at any time before opening of the main proceedings. In such case the preliminary proceedings were terminated without determining whether the debtor was indeed insolvent.
The amendment to § 14 German Insolvency Code will allow the preliminary proceedings to continue despite payment of the creditor's claim if the current proceedings were initiated by the second insolvency petition against the debtor within two years. In addition, the debtor will be obliged to bear the costs of the (preliminary) proceedings if they are terminated merely due to payment by the debtor. The amendments to the law were enacted before the background that German social security insurances sometimes had to file repeatedly against the same debtor.
3. "Fiskusprivileg"
A third change originally planned by the federal government received the most attention in the media, and was not included in the final draft of the bill. The proposed change intended to give tax authorities special privileges for set-off in insolvency proceedings, effectively increasing the state's options for satisfying its tax claims. This change was generally rejected by insolvency experts throughout Germany due to the negative effect it could have on restructurings and the equal satisfaction of creditors. The government coalition parties therefore withdrew this change during the legislative process.
The debate on these set-off privileges was associated with the term "Fiskusprivileg" which was historically used in reference to the priority in rank of tax claims that existed until the German Insolvency Code was implemented in 1999. It merely translates to "privilege of public authorities".
4. Our view
From our perspective the amendment to § 14 (see no. 2 above) is nice to have but will rarely become relevant in practice. The changed treatment of taxes during preliminary proceedings (see no. 1 above) is however more essential: It obliges the (preliminary) insolvency administrator to actually pay the taxes, in particular the value added tax collected from the debtor's customers, to the tax authorities even during preliminary proceedings. It will reduce the money administrators have available to keep the business running, as value added tax is normally paid on a monthly basis. Since suppliers usually demand direct payment of deliveries once preliminary proceedings commence, any further reduction of the usually scarce liquidity can be problematic.
For this, and for the perceived increase of administrators' risks, the new law has been much criticised. On a more dogmatic level, some have even considered the new law to be a violation of the principles of equal treatment of creditors.
a. Equal treatment of creditors
With regard to this later issue, a look at the background of the regulation may be helpful: Forced creditors (Zwangsgläubiger), i.e. creditors that cannot chose whether to continue business with the debtor, are in a particularly unfortunate position in preliminary proceedings. Originally, the position of "strong" preliminary insolvency administrators was introduced with the implementation of the German Insolvency Code in 1999 to make continuing a debtor's business easier. "Strong" administrators manage the debtor's business instead of the debtor and all liabilities incurred by their actions turn into liabilities of the estate once the main proceedings are opened. It was thought that these would be appointed when the debtor has a business worth keeping alive, as this would make it safer for creditors, in particular suppliers, to continue business with the debtor.
In practice, however, often only "weak" preliminary insolvency administrators are appointed who are usually equipped with a power of approval (Zustimmungsvorbehalt) in order to manage the business together with the debtor. Liabilities incurred in this way are generally not privileged. Regular business partners with a bargaining position can amend this deficit by structuring the transaction accordingly, in particular by constructing a cash transaction (Bargeschäft). Forced creditors, and among them in particular tax authorities, cannot. Business partners with difficult bargaining positions may face similar problems.
From this perspective it may be unfortunate that the act only contains a solution for the tax authorities. But the general direction of the new law does not seem inappropriate.
b. Risk of administrators
With regard to the perceived increase of the risks of preliminary administrators, a recent decision of the Federal Court of Justice (Bundesgerichtshof) should provide alleviation: The main worry voiced in this regard is that administrators could be liable if they misjudge the ability to pay the liabilities of the estate, in particular taxes. In a decision of 14 October 2010 the Federal Court of Justice now ruled that insolvency administrators are not personally liable if the estate is insufficient to pay value added tax incurred as liability of the estate (BGH, 14 October 2010, IX ZB 224/08). As the underlying principle is the same for other taxes, the worries of preliminary administrators about continuing a business in preliminary proceedings should be eased by this court decision.
c. Liquidity
The main problem, the reduction of liquidity in the most cash-strapped phase of proceedings, may be solved from two ends: On one end the preliminary administrator could try to negotiate with the tax authorities a deferment of tax payments. Usually, a deferment by tax authorities would require some indication that the debtor has the chance to recover and security to ensure that the tax debt will ultimately be paid. Either will be difficult to provide, in particular at the very early stages of proceedings. An appropriate stipulation could be included in the insolvency code as part of the pending reform. Else it will be important to observe how the local tax authorities will actually behave. On the other end, courts could appoint "strong" preliminary insolvency administrators more often. As creditors are generally more secured when dealing with "strong" administrators, suppliers would not be required to demand direct payment in full. In consequence, the need for immediate liquidity would be reduced.
d. Conclusion
Adequate methods for dealing with the challenges provided by the new law are available in German tax and insolvency law. It remains to be seen how practice develops. Due to the necessity of, and the economical and political desire to, support the restructuring of insolvent companies - this can not only save jobs but also provide creditors with better returns - we are hopeful that the available methods will be used. What remains is a slight decrease of the amount available for distribution at the end of the proceedings correlating to the amount that would have otherwise been "saved" on taxes.