The German Federal Ministry of Justice (Bundesjustizministerium, "BMJ") recently released its first official draft legislation for reforming the German Insolvency Code (Diskussionsentwurf für ein Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen). According to the BMJ, a reform in three steps is planned, the now proposed legislation is part of the initial step. To allow for more effective restructurings of debtors and more influence of major creditors, in particular the creditors' influence on the appointment of the insolvency administrator is increased, the regulations on insolvency plans are modified and the debtor-in-possession insolvency (Eigenverwaltung) is made more accessible for debtors.
Appointment of the insolvency administrator
The insolvency administrator is a key person in traditional German insolvency proceedings. He or she records and possibly disputes claims against the debtor and manages the debtor's business while the proceedings last. During the preliminary proceedings, directly after filing for insolvency, a preliminary administrator may be appointed by the court, who may already be assigned certain management tasks related to securing the estate. The decisions of the preliminary insolvency administrator may thus already pave the way towards restructuring or liquidation.
The insolvency administrator's work can be overseen by a creditors' committee (Gläubigerausschuss). Under the proposed new law, the insolvency courts shall be able to appoint a preliminary creditors' committee together with the preliminary insolvency administrator. This would allow creditors to better control the preliminary administrator's work and thereby influence to what end the proceedings will lead.
Moreover, insolvency courts would be required to hear the significant creditors before appointing an insolvency administrator. A majority of creditors (based on the amount of claims against the debtor) could then request a specific person to be appointed as administrator. The courts could only ignore such request under very limited circumstances. Essentially this would allow creditors to have an insolvency administrator of their reasonable choice appointed. Under the current law the influence of creditors on the appointment is merely informal and not provided for in statutory law.
Modifications to insolvency plan procedures
An insolvency plan, usually presented by the administrator and requiring approval by court, allows for more flexible agreements between creditors and the debtor. While so far insolvency plans have been utilised only in a small fraction of insolvencies, they have become slightly more popular in recent years. The proposed reform attempts to promote the insolvency plan proceedings by increasing the efficiency of proceedings and by – finally – allowing debt-to-equity swaps as part of insolvency plans.
In particular: Debt-Equity Swaps
The proposed reform would allow regulations on shares and membership rights to be included in the insolvency plan without the need for additional shareholder resolutions, which the current law does not. This would make debt-equity swaps possible even against the wishes of shareholders or individual creditors.
The group of shareholders would in return receive a vote on the insolvency plan when their shares are affected, theoretically granting them a chance to block the plan. As the shareholders shall be deemed appropriately satisfied if no creditor receives economic values exceeding the full amount of its claim and no other shareholder is better off due to the plan, it may be expected that shareholders will have little room for obstruction once the initial precedent cases have been decided. However, in some cases the valuation of goodwill and similar non-monetary assets could still provide for disputes.
The acquisition of equity for restructuring purposes would not lead to the subordination of remaining claims against the debtor pursuant to the shareholder loan subordination rules. Therefore the creditors undertaking debt-equity swaps would not have to fear the detrimental effects related to shareholder loans. However, the exemption from the treatment of claims as shareholder loans lasts only until the debtor has been fully restructured. As the German bar association (Deutscher Anwaltverein) recently pointed out, on a practical level it is often difficult to determine when one crisis ends and the next begins. If after complete restructuring the debtor becomes insolvent again before the remaining claims of the new shareholders are paid, remaining claims that were left outstanding by the new shareholders are no longer privileged and therefore subordinate in rank. Creditors taking part in debt-to-equity swaps must be aware of this and structure any remaining claims accordingly.
In particular: Procedural efficiency
With anti-obstruction mechanisms already in place under the current law, a key part of the reform is reducing court access of parties without significant reason to sue. Under the proposed new regulations, an insolvency plan could only be challenged when it has been credibly demonstrated to court that the claimant would be significantly worse off with the plan than without a plan and the plan provides no adequate compensation for such situation. This would make it more difficult for creditors (or shareholders, debtors) to appeal against insolvency plans. The required approval of the court to the insolvency plan shall protect against unfair plans.
In addition, certain measures, such as awarding creditors shares without transferring personal liability to them, no longer require the creditors' explicit consent. Instead consent is assumed if the affected entities do not reply within a deadline. Further, the timeframes for the court's initial decision on the plan and for parties to issue statements regarding the plan shall each regularly not exceed two weeks.
"Debtor-in-Possession" (Eigenverwaltung) insolvency
A process similar to the insolvency plan process is possible with the debtor remaining in possession of the assets. Until now such debtor-in-possession procedure is very rarely applied for and granted, which is unfortunate: Allowing the debtor to stay in possession may trigger earlier filing for insolvency, which could provide for more options of restructuring while there still is a chance. The proposed new regulation therefore attempts to ease access to debtor-in-possession insolvency and adds incentives for filing early.
One key change is that the insolvency court shall effectively leave a debtor applying for debtor-in-possession (insolvency) proceedings in possession even during the preliminary proceedings that prepare the actual opening of proceedings, unless the application for debtor-in-possession proceedings is obviously futile. This is fundamental, as under current law the debtor is in danger of losing control to a preliminary insolvency administrator even when successfully filing for debtor-in-possession proceedings.
A second key aspect of the reform is that the court must inform the debtor if it believes the conditions for debtor-in-possession proceedings are not met and the debtor has filed the application not because of existing illiquidity or over-indebtedness, but because of imminent illiquidity (drohende Zahlungsunfähigkeit). In such case the debtor must be given the actual chance to withdraw the application for insolvency proceedings before the court makes a formal decision. This gives debtors the chance to seek the protection of insolvency proceedings before the business is illiquid without the risk of losing control to an insolvency administrator after opening of proceedings. Already under the current law, an application may be withdrawn until the main proceedings are opened, but the debtor is not notified in advance if the application to stay in possession is rejected.
The third crucial innovation is the introduction of a restructuring phase during preliminary proceedings: If the debtor filed for debtor-in-possession proceedings due to the threat of future illiquidity and if restructuring is not obviously impossible, the court could give, on the debtor's request, a three month timeframe to present an insolvency plan before insolvency proceedings are actually opened. A preliminary custodian (vorläufiger Sachwalter) of the debtor's reasonable choice would be appointed for supervision and certain measures for the protection of assets against creditors could be ordered by court. These measures would generally not affect the control of the debtor and the debtor could still withdraw its application for insolvency before insolvency proceedings are actually opened. The explicit intention of the measure is to give the debtor a timeframe of up to three months to work out own solutions for the restructuring under the protection of the Insolvency Code. This phase is prematurely ended by the court, inter alia, if the debtor actually becomes illiquid. The court must then decide on the opening of proceedings without undue delay.
Whether to also allow the debtor to remain in possession during the main proceedings is decided as part of the decision on opening of proceedings. According to the proposal the debtor would no longer bear the burden of proof that leaving it in possession would not be detrimental to the creditors. Instead the debtor could be left in possession if no detrimental effects are known to court. While the proceedings will formally remain insolvency proceedings, no insolvency administrator is appointed. Instead a custodian (Sachwalter) is appointed to supervise the debtor. As already the case under current law, the permission for the debtor to stay in possession is rescinded after opening of proceedings if requested by the creditors' assembly (Gläubigerversammlung) and, under certain conditions, on request of individual creditors.
Miscellaneous
In the run-up to the official proposal there had been debate about the coalition government's intention to abolish privileges of social security insurances in insolvency proceedings. An unofficial earlier draft had included the striking of section 28 e, para 1 sentence 2 of the Social Security Code IV (Sozialgesetzbuch IV, "SGB IV"). According to this provision the part of social security contributions paid by the employer on account of the employee shall be deemed to have been paid from the estate of the employee. Between courts and within legal literature it is disputed whether therefore such payments may not be challenged in insolvency proceedings: After the Federal Court of Justice (Bundesgerichtshof) ruled in late 2009 that the regulation does not have this effect (5 November 2009, IX ZR 233/08), voices in legal literature accused it of overstepping its constitutional boundaries by ignoring the intention of the legislative. The Cologne Regional Court (Landgericht Köln) refused to apply the interpretation of the Federal Court of Justice (9 December 2009, 13 S 230/09), allowing the matter to return before the Federal Court of Justice by way of appeal. The appeal has not been decided so far.
In March 2010 the Minister of Justice, Mrs. Leutheusser-Schnarrenberger, had stated that the privileges of the social security insurances should be abolished, regardless of the rulings of the Federal Court of Justice. However, the official draft proposal released by the BMJ no longer contains clauses in this regard, possibly to avoid conflicts with the Bundesrat, in which the coalition parties lack a majority.
Perspective
The key changes outlined above are a welcome and generally useful enhancement of the current law. In particular the introduction of debt-equity swaps in insolvency plan proceedings may prove useful for creditors and debtors alike. The statutory possibility for creditors to determine the insolvency administrator is a very desirable exit from the grey area that has established in practice.
The provisions to ease access to debtor-in-possession insolvencies allow for earlier and more effective restructuring if debtors and creditors alike accept early initiation of debtor-in-possession proceedings as a chance to restructure. Financing agreements that define the threat of future illiquidity as event of default or reason for termination, as well as statutory termination provisions with simmilar effect, may, however, present a major obstacle: They could cause the threat of future illiquidity to become actual illiquidity upon filing for debtor-in-possession proceedings. The protected restructuring phase before opening of proceedings would end abruptly. While the debtor could still withdraw the application for proceedings, it might then be obliged to file for proper insolvency proceedings. This appears to be contrary to the intention of the proposal and could cause further legal debate also before courts.
Earlier this year, we were informed by the BMJ that the legislation shall be passed in 2010. This appears very ambitious, but even at a slightly slower pace the new regulations, if passed, should come to effect early next year.