Germany: Reform Act On German Insolvency Law - New Opportunities For Distressed Investors?

Preliminary Remarks

On March 1, 2012, the Act for the Further Facilitation of the Restructuring of Companies (ESUG) came into effect. The main aim of the ESUG is to improve the prospects of an early and successful restructuring of distressed companies, to involve creditors in the selection process of the (preliminary) insolvency administrator and to improve the reliability and predictability of particular insolvency plan proceedings. The main changes of the ESUG to the current German insolvency law (InsO) comprise:

• Strengthening of creditors' influence on insolvency proceedings;
• Binding proposal of the preliminary creditors' committee for the appointment of the insolvency administrator;
• Enabling of debt-equity swaps as part of an insolvency plan proceeding; and
• Introduction of pre-insolvency restructuring proceeding (umbrella proceeding).

The New Preliminary Creditors' Committee

Prior to the introduction of the ESUG, creditors had little influence on preliminary insolvency proceedings, i.e. in the period between the filing of the insolvency petition and the opening of insolvency proceedings (approx. three months), during which the most crucial decisions need to be made. The establishment of a preliminary creditors' committee was reserved to the discretion of the insolvency court. The ESUG now provides for an obligation of the court to set up a preliminary creditors' committee following the filing of the insolvency petition if the debtor has satisfied at least two of the following three requirements in the preceding financial year:

• balance sheet total of at least EUR 4,840,000 (after deduction of a negative equity);
• revenue of at least EUR 9,680,000;
• at least 50 FTE.

The members of the preliminary creditors' committee are appointed by the insolvency court. The debtor or the preliminary insolvency administrator may, however, propose certain individuals to be appointed. Secured and unsecured creditors and representatives of the employees (e.g. members of trade unions) have to be represented on the preliminary creditors' committee. Even representatives of new creditors who become creditors upon the opening of insolvency proceedings are also eligible committee members. That may enable distressed investors to purchase debt at a low price prior to or after the filing of the insolvency petition, in order to gain a seat in the preliminary creditors' committee. Major customers (such as OEMs) or suppliers cannot be appointed as members to the preliminary creditors' committee. In the case of a syndicate of senior and mezzanine lenders, the insolvency court will (although it is in its Fried Frank Client Memorandum 2 discretion to choose the committee members) most likely appoint the security agent as representative for the senior and, based on the agent's irrevocable authorization in the intercreditor agreement, also for the mezzanine lenders.

The key rights of the preliminary creditors' committee comprise (i) the right to propose and select a preliminary insolvency administrator (please see no. 3. below) and (ii) to decide upon the opening of debtor-in-possession proceedings (please see no. 5 below). In addition, the preliminary creditors' committee may demand inspection of the company's books and records and may monitor its cash flow at a very early stage of the insolvency proceedings.

Appointment of Insolvency Administrator

The preliminary creditors' committee is entitled to make a proposal to appoint a specific individual to act as insolvency administrator, provided that such proposal is made unanimously. The insolvency court is then obliged to appoint the proposed candidate unless he is not qualified to act as administrator, e.g. lack of independence from the creditors, insufficient experience in the matter at hand. A conflict of interest shall, however, not exist if the proposed person has acted as advisor to the debtor in a general manner regarding insolvency proceedings and their consequences prior to the insolvency filing.

However, in case the creditors have prepared an insolvency plan as a pre-packaged deal with one advisor, they will have to propose a different advisor as (preliminary) insolvency administrator to implement the pre-packaged deal. In order to ensure a fast and easy appointment of the proposed candidate, the preliminary creditors' committee should ensure that the proposed person has confirmed in writing that there is no conflict of interest.

In practice, main creditors should get in contact with the management of the debtor and agree in advance on the name of the person to be proposed. Creditors should then reach an agreement with the management and present the proposal, including the names of the proposed members of the preliminary creditors' committee and the name of the administrator, together with the filing of the insolvency petition (which is to be made by the debtor's management in most of the cases).

Facilitating Debt-Equity Swaps in Insolvency Plan Proceedings

In the past, debt-equity swaps were implemented either (i) by way of a share capital decrease, followed by a share capital increase, with a contribution in kind of the creditors' debt claims or (ii) by way of a transfer of the respective shares to the creditor, followed by a waiver of claims. The problem was this required shareholder consent (which was often refused to be given, resulting in the failure of the overall restructuring process).

The ESUG has now significantly improved the opportunity of creditors to convert their debt into equity in the course of insolvency plan proceedings (similar to US Chapter 11). The reform now allows for including the debtor's shareholders in the insolvency plan. The shareholders will have a voting right to support or reject the proposed insolvency plan. However, should they not approve the plan, they can nevertheless be crammed down, if the dissenting shareholders are not put in a worse position than without the plan following its implementation. A debt-equity swap is, however, not permitted without the consent of the respective creditors (other than the debtor's shareholders).

Special termination and withdrawal rights (such as change-of-control rights) are barred in the case of debt-equity swaps. As a result, creditor shareholders do not face the risk that contractual partners to the debtor will exercise change-of-control clauses due to the debt-equity swap, thereby deteriorating the value of the debtor company.

Thus, the ESUG significantly reduces the ability of debtor companies' shareholders to block the proceedings and provides greater legal certainty to creditors willing to swap their debt for equity. This will give creditors and distressed investors more incentives to invest in the debt of stressed and distressed companies as it enables them to participate in the economic upside of such companies as shareholders. Such facilitation is, however, limited to insolvency plan proceedings. A debt-equity swap in out-of-court restructurings aimed at avoiding an insolvency proceeding still requires shareholder consent, as outlined above.

Facilitating Debtor-in-Possession Proceedings (Eigenverwaltung)

As an alternative to the administration of the debtor's business by an insolvency administrator, the insolvency court may allow the debtor to self-administrate the assets under the supervision of a trustee (Sachwalter). In practice, however, debtor-in-possession proceedings have been rarely used, mainly because they were only available upon the opening of proceedings, subjecting the debtor to the control of the preliminary insolvency administrator from the day of the filing of the insolvency petition until the opening of insolvency proceedings (i.e. usually for up to three months).

Insolvency courts could only allow debtor-in-possession proceedings if such proceedings did not lead to possible disadvantages to creditors. This rule has been amended: an application for debtor-in-possession proceedings filed by the debtor can only be rejected by a court where there are known concrete circumstances that might lead to the proceedings being disadvantageous to creditors. This means that mere doubts about the potential detrimental effects of proceedings will no longer hinder such proceedings. However, debtor-in-possession proceedings are deemed not to be to the detriment of the creditors if they are backed by a unanimous resolution of the preliminary creditors' committee. In addition, ESUG now provides that the insolvency court shall appoint a preliminary trustee (rather than a preliminary insolvency administrator) if the debtor applies for it when filing for insolvency and if their application is not evidently without merits.

New Umbrella Proceeding (Schutzschirmverfahren) to facilitate Pre-Packaged Deals

In order to facilitate the realisation of a pre-packaged insolvency plan, the ESUG introduced a new so-called umbrella proceeding (Schutzschirmverfahren):

If the debtor files an insolvency petition on the grounds of impending illiquidity (drohende Zahlungsunfähigkeit) or over-indebtedness (Überschuldung) and also applies for self-administration, the court grants a three-months moratorium on enforcement, during which time an insolvency plan can be prepared under the supervision of a trustee. Being so protected from its creditors, the debtor will have enough capacities and time to develop the measures necessary to restructure the business and to implement an insolvency plan on an expedited basis. In addition, the opportunity to file for umbrella proceedings may even allow for the debtor's management to exert some kind of pressure on the creditors prior to insolvency, in order to achieve an out-of-court restructuring agreement with them.

Upon request, the court allows the debtor to create administrative claims (Masseverbindlichkeiten), i.e. all debts incurred during the three-month period will be satisfied in full within the insolvency plan proceedings later on. This will give customers and other contractual partners comfort to support the restructuring and to continue their contractual relationship with the debtor. Following the expiry of the umbrella period, the court decides on the opening of insolvency proceedings. The insolvency plan, which has been prepared during the umbrella period, may then be implemented.

The court may also revoke to initiate umbrella proceedings before the expiration of the three-months period if:

• the debtor becomes actually illiquid;
• the envisaged restructuring measures become unachievable; or
• the preliminary creditors' committee has demanded a revocation of the umbrella proceedings.

Outlook

The ESUG will make the German Insolvency Law much more attractive for foreign investors, due to the enhanced influence creditors in particular have on the selection of the insolvency administrator. Distressed debt investors now have two major advantages:

• They may gain a seat on the preliminary creditors' committee by purchasing distressed debt, even after the filing for insolvency, at a very low price. As member of the preliminary creditors' committee, they participate in the selection of the insolvency administrator and the overall process.
• The opportunity to implement a debt-equity swap in insolvency plan proceedings will give distressed investors more incentive to invest in the debt of stressed and distressed companies, as it enables them to participate in the economic upside of such companies as shareholders.

However, it remains to be seen whether the opportunity to pursue a debt-equity swap in insolvency plan proceedings will often be utilized. Recent cases in Germany have shown that a debt-equity swap may also be implemented successfully prior to insolvency proceedings, resulting in all involved parties having been able to avoid any insolvency proceedings. The debt-equity swap within insolvency plan proceedings, however, provides for more predictability and legal certainty for all involved parties.

In addition, it remains to be seen whether the legislators will return to the former definition of over-indebtedness, with an effective date as of January 1, 2014. If so, a much stricter standard will apply, since it will not be possible any more to continue an over-indebted business solely on the basis of a positive going concern assumption (Positive Fortführungsprognose).

Overall, the ESUG provides for innovative concepts and will enhance the attractiveness of the German insolvency proceedings significantly. Foreign creditors and investors should also keep in mind that the preliminary insolvency administrator may, and usually will, apply for the allowance of insolvency wages (Insolvenzgeld), i.e. during preliminary insolvency proceedings, the debtor does not have to pay any wages or salaries, as they are borne by the Federal Employment Agency. Insolvency wages, therefore, also constitute an important instrument in enabling the continuation of the debtors' business, and are, as far as can be seen, unique in European Insolvency Laws.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.