The risks facing a lending bank if the borrower becomes insolvent are often twofold. Not only are outstanding repayments in jeopardy, but, in the case of debtor`s insolvency, there is also a risk of voidable preference (Insolvenzanfechtung), where the insolvency administrator may challenge repayments already received and loan collateral granted before the insolvency filing.

The insolvency administrator’s right to challenge pre-insolvency repayments or collateral made by the debtor hinges on whether the debtor was insolvent at the time such payments were made or collateral was granted. However, it may not be restricted to the critical three-month period prior to the insolvency filing. The rules on intentional disadvantaging of creditors allow the insolvency administrator to challenge transactions performed during the ten years before the insolvency filing. Courts generally endorse the insolvency administrator’s right to contest such transactions if the opposing party was aware that the debtor was at risk of insolvency. This makes it impossible for the bank to quantify the recoverability of the borrower’s payments and collateral.

Binding letter of comfort (harte Patronatserklärung)

On 19 May this year, the German Federal Court of Justice (Bundesgerichtshof - BGH) published a decision (BGH IX ZR 9/10) which has important implications for binding comfort letters. By providing a binding comfort letter the guarantor gives an undertaking to provide the debtor with sufficient financial resources to enable it to honour current and future liabilities in a timely manner. In this decision the BGH defines the criteria according to which a valid binding comfort letter removes the debtor’s objective insolvency.

The confidence which a bank places in a letter of comfort in favour of the debtor is therefore worthy of protection in two scenarios:

Debtor’s claim

The debtor ceases to be insolvent if it has itself a direct claim against the guarantor under the comfort letter and these claims can be realised within three weeks. In the BGH decision, the comfort letter had been made to the bank and the debtor was not able to assert a direct claim. The BGH found that this type of comfort letter did not remove the debtor’s insolvency.

Providing actual liquidity

Irrespective of whether the comfort letter provides the debtor with a direct claim, the debtor’s insolvency can continue to be avoided if the guarantor does actually provide the debtor with sufficient liquid funds to enable it to discharge its liabilities itself. However, strictly speaking, the bank bases its confidence on the debtor’s general liquidity and not on the comfort letter.

Subjective criterion

The BGH did not address the issue of whether knowledge of impending insolvency is a subjective criterion for voidable preference. Essentially, a court can assume that the beneficiary of the transaction was aware of the debtor’s impending insolvency if the debtor’s objective insolvency is not eliminated because, for example, the claim against the guarantor cannot be realised.

An exception would probably be made if the bank had been misled on the guarantor’s financial position and hence mistakenly assumed that the latter would be able to honour its obligations to provide the debtor with funds. Ultimately, voidable preference presupposes that the “insolvency creditor is aware of the actual circumstances which, assuming that these are correctly appraised, will inevitably lead to insolvency” (BGH judgment of 20 November 20112001, IX ZR 48/01, BGHZ 149, 178, 185).

If the bank has been misled regarding the guarantor’s financial standing, it lacks information on material circumstances regarding the debtor’s insolvency. The bank may invoke this argument to counter the insolvency administrator’s claim to challenge the transaction.

Practical implications

If the debtor becomes insolvent and the issue of voidable preference is raised, a binding comfort letter can work in the bank’s favour. In drafting the comfort letter it is vital to ensure that the subsidiary is granted the right to assert claims against the parent company.