August 17, 2010
Last month, the German Ministry for Justice and Legal Affairs (Bundesjustizministerium) published a draft law proposal aimed at further “facilitating the restructuring of businesses”. While it is important to note that this draft law is still at an early stage of discussion and may well undergo significant changes during the legislative process, the proposed changes to the German Insolvency Code (Insolvenzordnung, InsO) are nevertheless noteworthy and of great potential interest to German businesses, their shareholders, financial institutions and international and domestic investors alike.
The draft law recognizes that German insolvency law should become more flexible in order to improve the opportunities for successful restructurings within the framework of German insolvency proceedings. Several of the proposed changes would introduce rules that would bring German insolvency law more in line with principles and procedures that have long been established in several international bankruptcy laws, notably English law and Chapter 11 proceedings under US law.
The most important proposed changes are discussed below:
I. Increased Involvement of Shareholders and Debt Equity Swap
Traditionally, German insolvency law is guided by the principle of ensuring maximum satisfaction for the debtor’s creditors. The liquidation of an insolvent business (rather than its restructuring) has often been the result of German insolvency proceedings. The proceedings as such are repeatedly described as cumbersome and unpredictable when compared to English or American insolvency procedures. The well-publicized marquee cases of German-based companies trying to “escape” from Germany and filing for insolvency in England are one indication of the perceived shortcomings of German insolvency law.
The current financial crisis has shown in a number of high-profile cases that a successful restructuring typically requires the close cooperation between creditors and shareholders, including the possibility of converting creditor’s claims into equity (debt equity swap).
As things stand today, the shareholders of the insolvent entity are subordinated creditors who are not involved in the preparation of an insolvency plan (Insolvenzplan). The current law, consequently, does not allow the insolvency administrator (Insolvenzverwalter) and the creditors’ meeting (Gläubigerversammlung) to include provisions that directly affect shareholder rights. Thus, a debt equity swap whereby pre-insolvency creditors become shareholders of the debtor cannot be enforced by way of an insolvency plan without the consent of the shareholders as required under the respective corporate regime of the debtor.
Under the new proposal, a certain amount of pressure is put on shareholders of bankrupt companies. The shareholders of the debtor would formally become involved in the insolvency proceedings. They would be heard and involved in the setting up of restructuring insolvency plans. Pursuant to the proposed law, the insolvency plan could provide for a number of corporate measures (capital decrease or increase, debt equity swap) within the framework and formalities of insolvency law rather than applicable corporate law. The shareholders would henceforth be one of the (sometimes numerous) separate groups that vote on the insolvency plan. In accordance with existing principles of insolvency law, the required majority to approve the insolvency plan may be lower than the majorities currently required under corporate law to push through such capital measures.
Subject to existing principles like the prohibition to obstruct (Obstruktionsverbot) and minority protection, these changes of the law would increase the chances of successfully restructuring insolvent companies by giving the insolvency administrator an option of motivating all parties in interest to participate in such restructuring and, if a majority can be found, force dissenters to accept the insolvency plan. The insolvency plan would thus become an instrument with further reaching scope and a more genuine alternative to negotiated pre-insolvency measures aimed at restructuring the business.
II. Selection of Insolvency Administrator
A second focus of the reform is to strengthen the influence of the creditors in the early stages of the proceedings. Empiric studies suggest that key decisions for the eventual outcome of an insolvency proceeding are often already taken at the stage of preliminary insolvency proceedings, i.e. after the filing of the petition but before the insolvency court formally opens proceedings.
Taking this factor into account, the draft law provides for the insolvency court to be entitled to institute a preliminary creditors’ committee at an early stage. This should give the creditors an early say on what direction the proceedings should take. Furthermore, the proposed reform law accepts that the creditors, in keeping with several existing foreign laws, have a justified interest in having a say in selecting the insolvency administrator. Under the new law, the creditors would already be heard before a preliminary insolvency administrator is appointed. A candidate proposed by the majority of the creditors would be appointed by the court unless his/her independence is questionable.
This would be a departure from current practice where many insolvency courts have reservations when asked to appoint insolvency administrators proposed by either the debtor or by influential creditors.
III. Increased Scope for Debtor-In-Possession Proceedings
The third area where the reform aims at facilitating the restructuring of insolvent companies is the law on debtor-in-possession proceedings (Eigenverwaltung). While these proceedings already exist under the current law, they have in the past not been used regularly. The main reason is seen in the fact that the debtor who applies for debtor-in-possession proceedings has no way of predicting whether his/her application will be granted by the court or whether a regular insolvency administrator is appointed instead. This insecurity means that companies are reluctant to apply for the protection that insolvency proceedings can offer already at an early stage where the chances of a successful restructuring are still best. Instead they delay the filing and attempt to achieve a turn-around by negotiated solutions outside of the insolvency proceedings.
If the current draft becomes law, the debtor who files for insolvency early based on impending illiquidity (drohende Zahlungsunfähigkeit) will have to be notified by the court in case the judge intends not to accept such debtor-in-possession proceedings. The debtor would then have the opportunity to withdraw his/her filing, instead of losing control over the company and being faced with an unwanted insolvency administrator.
These changes would again bring the scope of German insolvency proceedings closer in line with foreign models, in particular Chapter 11.
IV. Outlook
Irrespective of whether this initial draft proposal now presented by the German Ministry for Justice and Legal Affairs will become law at all or how it may be amended during the legislative process, the reform proposal clearly highlights that German insolvency law has come under increasing pressure both from within the system and from competing foreign legal systems. The proposal moves the academic reform discussions of the past years to a new level. Politicians, banks, legal and business restructuring experts as well as insolvency administrators are now jointly promoting a reform. It is a step in the right direction. Nevertheless, it remains to be seen whether the changes now proposed are far reaching enough to give a new lease of life to the existing instruments of an insolvency plan and debtor-in-possession proceedings. In particular, it is unclear whether the new provisions will indeed result in sufficient flexibility for creditors, shareholders, the court and the debtor in those crucial early stages of crisis immediately before and soon after the insolvency petition is lodged.
With the possibility of this reform becoming law, German businesses as well as their shareholders and foreign investors will be well-advised to keep informed about their available restructuring tools and their application in practice in connection with a potential insolvency event. A clear understanding of these tools and the right timing can often make the difference between a successful restructuring and a painfully drawn-out insolvency.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have. Please feel free to contact the Gibson Dunn lawyer with whom you work or the following lawyers in the firm’s Munich office:
Dr. Markus Nauheim (+49 89 189 33 122, [email protected])
Dr. Birgit Friedl (+49 89 189 33 151, [email protected])
Dr. Marcus Geiss (+49 89 189 33 154, [email protected])
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