February 1, 2006
A recent Munich High Court decision could have significant implications for intercompany cash-pooling systems that involve German companies. This could affect any US or other company with a German subsidiary that is organized as a German limited liability company (GmbH). Companies often move capital from one part of the business to another to respond to business needs and to optimize the group’s financial and liquidity planning, using cash-pooling systems, group clearing accounts, or similar mechanisms. On November 24, 2005 the Munich High Court (Oberlandesgericht München) delivered a painful reminder to companies that upstream or cross stream loans made by a German limited liability company (GmbH) under an intercompany cash-pooling system or clearing account mechanism violate German capital preservation laws, unless the registered share capital is sufficiently safeguarded. Furthermore, the High Court found the managing director of the GmbH personally liable for damages, even though the chief controller of the group instructed him to make the loans.
Under German law a GmbH is required to have a minimum registered share capital of ?25,000. While even GmbH acquisition vehicles used for larger transactions are customarily founded and operated with only the minimum amount, it is not uncommon for a GmbH to have a registered share capital equal to several million euros for business reasons. German law protects the registered share capital for the benefit of the creditors of the GmbH in two ways. First, during the formation of the GmbH and in connection with an increase of its registered share capital, the management of the GmbH must verify and confirm that the amount of the share capital is indeed paid in to an account of the GmbH and available to the GmbH to use for its own purposes (and discretion). In addition, during the operation of the GmbH, the management of a GmbH may not repay the registered share capital to direct or indirect shareholders. A shareholder resolution or instruction to this effect would be unlawful and the management should not comply with such resolution. For violations of the repayment prohibition, the shareholder or other recipient of the payment is liable to the GmbH for repayment, and management of the GmbH faces damage claims. Depending on the facts, the representatives of the shareholders and the management of the GmbH could even be held criminally liable.
The repayment prohibition applies if, at the time of an upstream or cross stream funds transfer, the book value of the net assets of a GmbH (i) is equal to or lower than the registered share capital, or (ii) if the payment would lead to such situation. The net asset value is determined on the basis of the GmbH’s balance sheet by deducting the liabilities (short and long term liabilities, accruals) from the book value of the assets. No benefit is given in this analysis for hidden reserves or the actual fair market value of the GmbH’s assets – only their book value is taken into consideration.
The repayment prohibition in principle applies to upstream or cross-stream loans and the grant of collateral as security for shareholder debt. However, before a decision by the German Federal Court (Bundesgerichtshof) of November 24, 2003, loans to a shareholder typically had no effect on the balance sheet of a GmbH under German GAAP. If a GmbH granted a cash loan to its shareholder, the GmbH simultaneously acquired a receivable against the shareholder in an equal amount. From a balance sheet perspective, the loan thus had no effect unless the claim for repayment was unrecoverable and had to be written off.
On November 24, 2003, the German Federal Court held that this balance sheet perspective is not sufficient to properly enforce the German capital preservation laws. The Federal Court held that the GmbH’s claim for repayment of the loan must be disregarded, even if recoverable, if the payment otherwise affects the registered share capital. The Federal Court argued that the financial situation of a GmbH and the chances of satisfying its creditors are worsened if the GmbH gives away liquid funds and instead acquires a non-liquid receivable against a shareholder that is due for payment only at a later stage. The Federal Court thus concluded that upstream loans may only be made up to the amount of profit reserves or other freely disbursable reserves as reflected in the GmbH’s balance sheet.
The Federal Court indicated that it might consider an exception only under certain strict criteria and in case of secured loans. The scope of the Federal Court decision was somewhat nebulous and led to much commentary in particular on the continued permissibility of intercompany cash-pooling arrangements.
The Munich High Court decision
The Munich High Court based its November 2005 decision on the following facts:
A German GmbH was controlled by a US domiciled parent company. The head of the US group’s financing department instructed the GmbH on several occasions during a six month period to transfer excess cash to a US sister company. The managing director of the GmbH complied with these requests. Three months after the first payment was made, the US parent company informed the GmbH that the GmbH was part of the global cash management system of the group and that sufficient funds would be provided to each group company if required. There was no written documentation of the cash-pooling system and it was unclear from whom, in which form and under which conditions a request for repayment could be made. When the GmbH required liquid funds a couple of months later, the request remained unanswered and the GmbH had to file for bankruptcy. The administrator in bankruptcy sued the managing director of the GmbH for repayment of the aggregate amount of the transferred funds.
The Munich High Court held that the prohibition against repayment of the registered share capital also applies to intercompany cash-pooling systems. The High Court acknowledged that cash-pooling systems normally also operate in the interest of the GmbH. But the GmbH does not benefit from a cash pooling system that puts the registered capital at risk, particularly if the cash-pool loans are not subject to market conditions, are unsecured, and are not properly documented.
As a consequence, in line with the ruling of the Federal Court in November 2003, the High Court held that a repayment claim of the GmbH against the cash-pool leader (which claim is generally booked as receivables against affiliates) must not be considered in calculating whether the cash pool loan affects the registered share capital.
The High Court further emphasized that management also violated its duty of care to the GmbH because of the informal and undocumented handling of the cash-pool loans, so that the GmbH could not rely on timely repayment or other financial support of the GmbH by the group companies.
Importance of the judgments/how to react
The decision is important for the following reasons:
Review existing cash-pool systems. Even though the decision is not yet final and will most likely be appealed, the case applies the reasoning of the November 2003 Federal Court decision to a cash-pooling scenario. As a consequence, if a parent and its German GmbH affiliates operate a group cash-pooling system, the group should review its operation and prepare proper documentation in line with the following principles:
Don’t forget other restrictions on cash-pooling systems. The above criteria safeguarding the protection of the registered share capital apply in addition to general principles established by German courts in respect of cash-pooling systems. In particular, the deduction of liquidity from a GmbH by way of participation in a cash-pooling system must at all times take into account the liquidity requirements of the GmbH and must not threaten the continuation of the business of the GmbH and its existence. Also, irrespective of the new jurisprudence, cash-pool loans may amount to hidden profit distributions if not made subject to market conditions, even if the registered share capital is not affected.
Restrictions apply on formation and whenever capital is increased. The cash-pooling restrictions also need to be taken into account at the formation stage of a GmbH and in the event of a capital increase. At the formation stage, the cash amount of the registered share capital should be paid into an account that is not subject to the cash-pooling, although the amount may be used for general corporate or operational purposes of the GmbH. The same principle applies in case of capital increases by cash. In the latter context, the German Federal Court has only recently on January 16, 2006 decided that the increased amount of the registered share capital which was initially paid into a separate account of the GmbH may not later be transferred to the cash-pooling account. Otherwise, the payment in of the increased amount is deemed not made and needs to be made again.
Application to stock corporations (AGs) and limited partnerships with GmbH general partners (GmbH & Co. KGs). Modified but essentially comparable principles apply with regard to the cash-pooling systems involving German stock corporations and German limited partnerships where the general partner is a GmbH. However, the scope of the prohibition to make upstream or cross stream payments varies due to the different statutory capital preservation regimes applicable to such entities.
Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or Christoph Kuhmann (+49 89 189 33-150; email@example.com) and Birgit Friedl (+49 89 189 33-151; firstname.lastname@example.org) in the firm’s Munich office.
© 2006 Gibson, Dunn & Crutcher LLP
The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.