Germany Failed to File Go Directly to Jail

Germany Failed to File Go Directly to Jail

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Editor's Note: In this European Update, we highlight the considerable personal liability risk to directors of German companies that do not commence a bankruptcy proceeding within the time limits required by German law. U.S. practitioners need to be aware of this risk in any group restructuring involving a German company. There is also a note on the new debt subordination measures in Spain and a reaffirmation of the rescue culture in the United Kingdom. We are all increasingly under the influence of U.S. chapter 11!

German insolvency law, although influenced to some extent by U.S. concepts, still has a number of peculiarities that may turn out to be pitfalls for the unwary. One of them, which sometimes causes astonishment among U.S. practitioners, lies in the fact that managing directors of German companies are under a statutory obligation to file a petition for the opening of insolvency proceedings if the company is insolvent. Once insolvency has occurred, each managing director is required to file the petition without undue delay, but within three weeks at the latest. A failure to comply constitutes a criminal offence, punishable by imprisonment of up to three years (if committed willfully) or up to one year (if committed negligently) or by a fine of up to 1.8 million Euros (about US$2.2 million), depending on the perpetrator's income. Furthermore, managing directors who violate their filing obligation may be liable for damages on grounds similar to the U.S. concept of deepening insolvency. ("Insolvency" for the purposes of these rules means either "illiquidity" or "overindebtedness.")

"Illiquidity" is a concept based on a cash-flow test. A company is illiquid if it is unable to meet its payment obligations when due. For a long time, there had been some uncertainty as to the level of rigor to be applied in this test: Does a brief delay in meeting the payment obligations constitute illiquidity? Apart from the time element, is the company illiquid if the shortfall in the available cash is relatively minor? In May 2005, the German Federal Supreme Court clarified these points as follows: If it can reasonably be expected that the company will meet its obligations within not more than three weeks from their due dates, the company is not illiquid. If the cash shortfall amounts to less than 10 percent of all obligations now due for payment, the company is considered illiquid only if specific circumstances warrant the conclusion that the shortfall is likely to increase to more than 10 percent in the near future.

"Overindebtedness," by contrast, requires a balance-sheet test. Roughly, the company is overindebted if its assets, valued at their fair market value, are insufficient to cover its liabilities and accruals (except to the extent that a subordination is in place). If there is a predominant likelihood that the company will be able to continue its operations over a period of at least one or two years, the assets may be valued on the basis of their going-concern values. If there is no such likelihood, the valuation must be based on liquidation values.

The obligation to file applies to each managing director individually. A managing director who has failed to comply cannot escape criminal and civil liability by claiming that he or she was not in charge of the company's finances but was only responsible for other departments (such as research and development).

Criminal convictions based solely on a failure to file a petition for the opening of insolvency proceedings (and without there being some additional element of fraud or embezzlement) are relatively rare. This is especially true for cases based on overindebtedness, given the inherent uncertainties in any valuation of assets. Also, to put things into perspective, it is fair to say that the actual sentences handed down in "failure to file" cases are usually far below the maximum penalties available under the relevant statutory provisions.

Nevertheless, managing directors of German companies would be ill-advised to take their filing obligation lightly. This warning seems especially appropriate for executives of U.S. companies who also serve as managing directors of their German subsidiaries. Experience shows that too little attention is often paid to the specific duties this appointment entails. Importantly (especially for readers of this Journal), executives should also be aware that a chapter 11 petition in the United States, even if it expressly includes the German subsidiary, will not usually satisfy the filing requirement under German law. The safe course is to seek advice early so that the considerable risk that this German filing obligation represents can be properly managed.

Spain: Subordination of Creditors under the Spanish Insolvency Act

In simple terms, "subordination" is where one creditor does not receive repayment of its debt until another creditor has (or all other creditors have) been paid in full. Subordination may arise by reason of an agreement between the parties or by application of law. This article considers one of the cases in which subordination of credit rights takes place by application of law under the Spanish Insolvency Act (Ley 22/2003, de 9 de Julio, Concursal or the Spanish Insolvency Act), which came into force on 1 September 2004.

When the Spanish Insolvency Act came into force, there was much interest in the new rules relating to subordination of creditors' rights in certain situations. However, for the sake of clarity, it should be pointed out that subordination of credit rights by application of law already existed in Spain before the enactment of the Spanish Insolvency Act. Specifically, Circular 5/1993 of 26 March, issued by the Bank of Spain,2 defined subordination financings and set out the requirements for them to be considered as equity of credit entities. In addition, Royal Decree-Law 7/1996 of 7 June3 regulates the requirements that a participative loan has to meet in order to be considered as equity for corporate law purposes. Both of these measures provide that the debts owing to lenders under these types of financing rank behind the ordinary creditors of the borrower.

Under the Spanish Insolvency Act, a fundamental distinction must be drawn between two basic types of liabilities: (a) debts that are deemed to be liabilities of the estate of the debtor and (b) the vast majority of debts, which are liabilities of the debtor. Debts that are deemed to be the liabilities of the estate of the debtor include, among others, debts arising from continuing the business of the company after insolvency has been declared, judicial expenses incurred in the course of the insolvency proceedings, and employee claims for unpaid salary for the last 30 days of work up to a specified cap. The aggregate amount of the liabilities against the estate of the debtor will be paid out of the assets of the debtor (although there are exceptions) and will be set aside before the other creditors of the debtor are paid.

Claims against the debtor are divided into three main groups: (a) preferential claims, (b) ordinary claims and (c) subordinated claims. Within each of these three main groups there are also subcategories of claims. Ordinary creditors will generally be paid after claims against the estate and preferential claims have been satisfied, and subordinated creditors will be paid once the remaining debts have been satisfied in full. Within each group of debts, each category of debt has priority over those below it.

The Spanish Insolvency Act ended the uncertainty in Spain as to the enforceability of subordination where there was opposition of third-party creditors, as it expressly recognizes the issue and the effects of subordination. Under the Spanish Insolvency Act, the following debts will be subordinated:

(a) claims that are reported late or that are inappropriately under the rules governing the insolvency proceedings;
(b) claims that are contractually subordinated to all other creditors;
(c) claims with respect to interest (including default interest), except those secured by mortgage or pledge up to the value of realisation of the secured asset;
(d) fines and other economic penalties;
(e) debts owed to a person "related to" the debtor (see below for more detail); and
(f) credit rights rescinded (i.e., terminated) by the commercial court.

Probably the most important of these for a U.S. lender who has lent or intends to lend money to a Spanish company (or a company with its centre of main interests in Spain) is subordination of credit rights where the lender is "related to" the borrower. The persons or companies that are deemed to be related to the debtor and whose rights will be subordinated include shareholders of the debtor holding at least 10 percent (or 5 percent, in publicly listed companies), companies within the same group of companies as the insolvent debtor, and shareholders of a company within the group as the debtor.


The Spanish Insolvency Act ended the uncertainty in Spain as to the enforceability of subordination where there was opposition of third-party creditors, as it expressly recognizes the issue and the effects of subordination.

Subordinated creditors are not allowed to vote in the creditors' meeting and, in the case of liquidation, will not be paid until the ordinary creditors have been paid in full. The effect of insolvency proceedings on subordinated credits varies depending on the manner of termination of the insolvency proceedings: settlement (subordinated debt subject to the terms of the settlement) or liquidation (subordinated debt subject to the rules on priority and voting set out above).

In our experience, the introduction of the debt-subordination provisions under the Spanish Insolvency Act has already had an impact on the structuring of certain leveraged finance transactions. One example of this is where orphan companies are established so that if the lender becomes a shareholder or a holder of the voting rights of the borrower company, it can be argued that the subordination of debt when the lender is related to the debtor should not apply. The lender would initially lend to the orphan company, and the orphan company would in turn lend the funds to the ultimate borrower.

Administration Expenses: Reaffirming the U.K. Rescue Culture

The Court of Appeal in England has recently heard three cases4 that raise an issue of importance to administrators, and indeed to administration as a restructuring process. The issue concerns the extent of administrators' liabilities to employees of a company in administration whose contracts of employment have been "adopted" by the administrators. Although at first glance this would appear to be quite a narrow point of law, it has far-reaching consequences for how administrations are conducted and even for the future of the "rescue culture" in the United Kingdom.

The court considered whether employees whose contracts were adopted by administrators had "super-priority" status with respect to the following payments:

  • liabilities for protective awards under Section 189 of the Trade Union Labour Relations (Consolidation) Act 1992;5 and
  • payments in lieu of notice.

If they had superpriority status, these liabilities would be payable in priority to the expenses of the administration and also in priority to most other debts. As a matter of construction, the Court of Appeal held that neither liabilities for protective awards nor payments in lieu of notice were entitled to super-priority status.6

Although the Court of Appeal reached its decision based on construction of the legislation, it went on to consider the question of whether protective awards should be given a super-priority status by reference to the wider context. Administration was introduced as a means of attempting to rescue potentially viable businesses—hence the expression "rescue culture." Although it is not a debtor-in-possession process, it is the closest the English regime comes to a chapter 11 approach. In practice, administrators will often continue the operation of the business of the company. To do this, they will need to retain some or all of their employees, and the Insolvency Act provides that employment contracts of retained employees will be "adopted" by the administrators 14 days after the appointment of the administrator. If employees have been dismissed within this 14-day period, they will have no entitlement to any super-priority status.

The importance of this 14-day deadline can be seen in the speed with which the Court of Appeal reacted. The appeal was heard on the same day as the original case, as the administrators of Granville Technology Group Ltd. (one of the companies making the application) had to decide whether or not to dismiss more than 150 employees of that company by the following morning, and that decision was to be determined by the outcome of the appeal.

The administrator for Ferrotech Ltd., one of the other companies making an application, explained the implications of an earlier High Court decision that protective awards and payments in lieu of notice should be granted super-priority status. He explained to the Court of Appeal that, if the law was as decided in the earlier case, "the administrators would not have been able to say, when seeking to put Ferrotech into administration, that the purpose of the proposed administration would have been likely to be achieved. That was because they would have anticipated having 'to make the entire workforce redundant within 14 days' of their appointment, which would have 'ruled out from day one the possibility of achieving a sale of the business as a going concern.'"7 The administrator went on to say that in relation to retention of employees, there was nothing exceptional about the administration of this particular company.

If the Court of Appeal had held that protective awards and payments in lieu of notice did have super-priority status, the administrators of a company would be more likely to make employees redundant, as the costs arising out of the adoption of contracts of employment by administrators would be substantially increased. This would put an increased burden upon a company already in severe financial difficulties and make the survival of the business (and long-term preservation of jobs) less likely. The Court of Appeal in this case has clearly chosen to exercise what discretion it had in interpreting the legislation in order to reaffirm the rescue culture.


Footnotes

1 Contributing authors are Alfried Heidbrink (Berlin), Vanessa Armas (Madrid) and Catherine Derrick (London). Return to article

2 Circular 5/1993, de 26 de marzo, del Banco de España, sobre determinación y control de los recursos propios mínimos. Return to article

3 Real Decreto-Ley, de 7 de junio, sobre medidas urgentes de carácter fiscal y de fomento y liberalización de la actividad económica. Return to article

4 In the matter of Huddersfield Fine Worsteds Ltd. (2) Globe Worsted Co. Ltd. sub nom Gerald Maurice Krasner (administrator of the above-named companies) v Barry Mcmath (representing the employees of the above-named companies); In the Matter of Ferrotech Ltd. sub nom Adrian Tipper (representing the employees of the above-named companies) v (1) David Kenneth Duggins (2) Robert Hunter Kelly (joint administrators of the above-named company); In the Matter of Granville Technology Group Ltd. sub nom Richard Harris (representing the employees of the above-named company) v (1) Martin Gilbert Ellis (2) Andrew Lawrence Hosking (3) Leslie Ross (joint administrators of the above-named company) [2005] EWCA Civ 1072. Return to article

5 Liabilities for protective awards may arise where a company has breached the requirement to consult with union representatives before firing more than 19 employees. A company can only avoid this duty if there are special circumstances and it has been held that the insolvency itself does not amount to a special circumstance. Where the consultation obligations have been breached, an employee can complain to an employment tribunal, who may make an award of up to 90 days' remuneration. Return to article

6 The only exception to this is one category of payment in lieu of notice where an employer gives proper notice of termination to his employee that he need not work until the termination date and gives him the wages attributable to the notice period in a lump sum. In practice, this would be highly unlikely in the context of an administration. Return to article

7 Paragraph 42 of the Court of Appeal judgment. Return to article

Journal Date: 
Thursday, December 1, 2005