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The German Discussion on the Introduction of a Pre-insolvency Regime

Author(s)

Reinhard Bork
Professor of Law, University of Hamburg

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6 Minutes

In March 2014, the European Commission published a Recommendation for a new approach to business failure and insolvency. The objective of this Recommendation was to encourage Member States to implement early restructuring procedures so as to prevent insolvency and to give entrepreneurs a "second chance". The Recommendation sets out common principles regarding national insolvency procedures for businesses in difficulties, as well as measures aimed at reducing the length and cost of proceedings. While it is clear that the Recommendation has provided a useful focus for those Member States undertaking reforms in the area of insolvency, an assessment undertaken by the Commission and published in September 2015 shows that it has only been implemented partially, even in those Member States that have introduced reforms. Against this background, the European Commission drafted an Action Plan on Building a Capital Markets Union in September 2015 and included the announcement of the launch of a legislative initiative on business insolvency, which covered (amongst other topics) early restructuring and second chances.

Meanwhile, it is clear that the European Commission will revert to the following core features:

  • proceedings are to be commenced prior to, and for the avoidance of, substantive insolvency;
  • proceedings must be debtor in possession proceedings, with the option of appointing a supervisor;
  • moratorium must be possible, but on the application of the debtor only ;
  • proceedings must be restructuring plan proceedings with voting in groups, but with this only being open to the affected creditors;
  • cram down of opposing minorities must be possible;
  • protection of new financial resources must be guaranteed; and
  • restriction of court involvement is desirable (with it only being used for a moratorium or plan sanctioning).

While English law can refer to the scheme of arrangement proceedings, which fulfil most of these prerequisites (other than the moratorium requirement and the low-key court involvement) and which served as a role model for the EU initiative, Germany can be less certain that the Commission will be content with its contribution (by way of its laws) to early restructuring of distressed companies. Currently, all restructuring proceedings are regulated by the German Insolvency Act (Insolvenzordnung), which was amended in 2012 by the so-called “ESUG” (the Further Facilitation of Restructuring Businesses Act). This Act modified German insolvency law by implementing so-called “Protective Umbrella Proceedings”. However, these proceedings are still insolvency proceedings (initially preliminary, later on opened), which develop into a creditors’ vote after insolvency proceedings have been opened. The plan will be drafted and negotiated prior to the opening, but the creditors’ voting and the sanctioning by the court will take place after the opening. Hence, building on the features required by the European Commission, the following can be said about the current state of German law, as regards pre-insolvency restructuring:

  • proceedings can only be applied for where the debtor is imminently unable to pay their debts, but the application is still an application for insolvency proceedings;
  • proceedings are debtor in possession proceedings, albeit under the mandatory (and thus not optional) supervision of a preliminary supervisor or monitor;
  • a moratorium is possible where the debtor applies for it;
  • proceedings seek to propose an insolvency plan, but the plan comprises all creditors and not only those groups of creditors whose rights would be infringed;
  • a cram down of opposing creditor groups is possible;
  • new financing is protected (this is the subject of debate); and
  • courts are involved extensively.

Against this background, there is broad discussion in Germany as to how German law should be supplemented. So far, no legislative Act has been drafted by the Ministry of Justice. However, according to opinions and proposals published by the German Insolvency Practitioner Associations and commented on by German academics, the approach which is currently favoured can be described as follows.

First, pre-insolvency restructuring proceedings should be regulated in a new Act operating outside of, and independent of, current insolvency law; insolvency practitioners should be offered an additional tool to add to their restructuring toolbox. The new restructuring proceedings should aim at safeguarding and restoring economic viability outside of formal insolvency proceedings, mainly by restructuring the liability side of the balance sheet. All other creditors and third parties, especially employees, shall not be affected. Hence, the proceedings shall be minimally invasive, and they will not be comprehensive in the sense of necessarily comprising all creditors. However, the flipside of pre-insolvency proceedings is that typical insolvency tools, such as transactions avoidance or termination rights for current contracts, are not available.

Second, no “trigger moment” – such as imminent inability to pay debts – shall be required. There is broad discussion under German constitutional law as to whether restructuring proceedings can be imposed on opposing creditors where the debtor’s insolvency has not been ascertained. However, this is not a question of how to commence restructuring proceedings but rather a question of the sanctioning of the insolvency plan. In the pre-insolvency phase, the debtor and creditors may start negotiations and enter into formal proceedings, including voting on a restructuring plan, without a formal assessment of the economic status of the debtor’s business. It may suffice to rely on two built-in safeguards. The first is a high approval rating (of at least 75%) from those present and voting. For example, if three quarters of the creditors approve of a “haircut” of 20% of their claims, a strong presumption arises that the loss has been accepted, and furthermore that it is justified by the debtor’s economic situation, with the real value of the claims not exceeding 80%. Second, outvoted creditors can enjoy minority protection by asking the court to refuse the sanctioning of the plan on the grounds that they would receive less than in the alternative scenario of the company’s liquidation. On application, the court may assess the real value of the claims and check whether the interests of dissenting minorities have been justly trumped by those of the consenting majority.

Third, since the proceedings aim at restructuring the liability side of the balance sheet only, leaving other creditors and third parties unaffected, only those creditors whose rights would be infringed must be able to participate in the voting on the restructuring plan. These creditors can be divided into several groups, but they can also be pooled into one single group. It is not necessary to mention other persons in the restructuring plan unless they are expected to contribute to the restructuring, for instance as a surety or by bringing in fresh money.

Fourth, court involvement shall be limited as much as possible. No formal application is necessary to prompt a court decision to open restructuring proceedings. Consequently, it is not necessary to publish the commencement of the restructuring proceedings in the official gazette or on the internet.  Courts will only be involved where creditors’ rights are affected, for example by an individual enforcement ban, by cram down of opposing creditors or by sanctioning the restructuring plan. In addition, the appointment of a restructuring mediator (or monitor or supervisor) through the court shall be possible. The court shall be able to commission the mediator to assess the reasonableness and fairness of the restructuring plan as well as to ensure necessary transparency and a concerted effort to achieve a fair balance between all interests involved.

Fifth, a general moratorium is not envisaged. It is necessary to support restructuring negotiations through an enforcement ban against single opposing creditors, and courts shall be able to impose such bans on the debtor’s request. However, this shall be an exception and only permissible for a short period of time, and only insofar as it is necessary to protect current restructuring negotiations. The advantage is that general publication is not required if a general moratorium is not possible.

Sixth, the restructuring plan can only enter into force if it has been sanctioned by the court. The court has to check whether

  • the debtor is at least imminently unable to repay their debts; this requirement is considerate of the constitutional concerns mentioned earlier on in this talk;
  • the voting groups have been assembled adequately and fairly;
  • the proceedings have been transparent and followed the letter of the law;
  • the plan has been adopted by the required majority of (at least) 75% of those present and voting; and
  • no creditor who has voted against the plan and has challenged the voting shall receive less than they would receive in the alternative scenario of the company’s liquidation.

Finally, some additional points must be mentioned. First, new financing needs to be protected if restructuring fails and insolvency proceedings are therefore opened. It is generally accepted, albeit with some concerns, that German law currently grants such protection. Hence, no additional measures are necessary. Second, European recognition must be ensured. It is suggested that a new German Restructuring Regulation will meet the prerequisites of Article 1 of the recently recast European Insolvency Regulation, which nowadays covers not only classical insolvency proceedings (eg liquidation or administration) but also debt adjustment proceedings “commenced in situations where there is only a likelihood of insolvency, [if] their purpose is to avoid the debtor’s insolvency or the cessation of the debtor’s business activities”. Third, the German legislature should provide for a more concentrated approach within the local jurisdictions to hearing insolvency-related cases. Germany currently has 120 insolvency courts, which often do not hear enough cases to gain the experience and competence necessary to make fast and professional decisions on restructuring proceedings. It is therefore desirable to concentrate the new proceedings and task only one court in each of the German Bundesländer with administering these cases. At this point, Germany can certainly learn lessons from the English judiciary, ie the competent organisation and decisions of the High Court.

Reinhard Bork is a Professor of Civil Procedure and General Litigation Law at the University of Hamburg.

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