On November 18 2014 the Federal Court of Justice (BGH II ZR 231/13) changed its previous jurisprudence on payments made after the occurrence of mandatory insolvency reasons. According to the law, such payments can trigger the personal liability of the managing director of the company which made the payments. In the past, it was difficult to define a safe harbour in respect of payments which were allowed irrespective of the occurrence of illiquidity or overindebtedness. Leaving aside specific payables (eg, social security contributions), a managing director was previously protected from this liability only when no insolvency reason existed. This could now change significantly. Managing directors may be able to defend themselves against a liability claim by pointing to the market-value consideration made to the company in exchange for the authorised payments. The underlying idea seems so logical that its novelty is surprising. A payment which was directly and fairly compensated is not to the company's, and thus not to its creditors', detriment and should not cause a liability claim. This should be independent of whether any consideration still exists at the time that the insolvency proceedings are opened.
Managing directors of a company in financial difficulties are exposed to personal liability risks. When assessing these risks, a number of legal provisions should be considered (including provisions of the Criminal Code). Conduct which can form the basis of a claim can be summarised as follows:
- breach of the director's obligation to file for insolvency (ie, generally within 21 days of the occurrence of a mandatory insolvency reason); and
- breach of the director's obligation to restrict business operations after the occurrence of a mandatory insolvency reason (in case the director does not file immediately).
The rationale behind the first obligation (ie, to file for insolvency) is mainly to protect new creditors which might otherwise enter into a contractual relationship with the insolvency debtor without knowing of its financial distress. In addition, an early insolvency filing is generally expected to favour larger insolvency estates which can be distributed to existing insolvency creditors.
The rationale behind the second obligation (ie, to restrict business operations) is to save what can be saved. This becomes particularly relevant for payments made during the 21-day period. Under certain conditions, a managing director can make use of the full three weeks in order to negotiate a rescue plan, but is required by law to keep the company's assets together.
The Federal Court decision did not concern the insolvency filing obligation and the legal regime regarding the 21-day rule accordingly remains unaffected by the new case law. It was the duty to restrict payments after the occurrence of insolvency reasons that the Federal Court had to deal with in its November 2014 decision. This duty derives from provisions of company law, not the Insolvency Code. For limited liability companies, the relevant provision is Section 64 of the Code of Limited Liability Companies; for limited partnerships, the rule is anchored in Section 130(a) of the Commercial Code. According to these provisions, which have almost identical wording, a manager must reimburse to the company payments which were made after the occurrence of illiquidity or overindebtedness, unless these payments were in line with the due care of a prudent businessperson.
The prudent businessperson exception applies only in rare cases (eg, if the payments were absolutely required to keep the business running or in case of social security contributions). However, the issue has always been highly disputed. These uncertainties and rare exceptions made the liability provisions an attractive and frequently used means to increase the insolvency estate by asserting a claim against the former management – typically only with the aim of allowing the insolvency estate to benefit from the manager's directors' and officers' liability insurance. Insolvency administrators' typical strategy involves instructing an expert to provide an opinion on the date on which illiquidity or overindebtedness occurred (which is arguably often long before the insolvency filing) and then requesting reimbursement of most payments made following that date, after – for the sake of decency – the deduction of a few obviously allowed payments.
Apart from the prudent businessperson exception, directors were not liable for payments made after illiquidity or overindebtedness if the reduction in insolvency assets caused by these payments was compensated by a consideration directly related to the payments. However, according to previous court rulings, this consideration still had to exist in the insolvency estate (as such and not only in value) when insolvency proceedings were opened.
In its groundbreaking November 2014 decision, the Federal Court explicitly moved away from its previous case law and ruled that it is sufficient if the consideration compensated the reduction in the insolvency assets at the time the consideration was made. Going forward, it will be irrelevant whether the consideration still exists at the point when the insolvency proceedings are opened.
The case was brought by the insolvency administrator of a limited partnership. The defendant was the company director. The company entered into a loan agreement with its parent shareholder for a revolving loan of €150,000 at a time when the company was already illiquid. According to the agreement, the company had the right to demand disbursement of the loan entirely or in part over a three-month period. If the company repaid the loan during this period, its claim to demand disbursement of the loan arose again.
The shareholder disbursed the entire loan to the company, the company repaid it 10 days later and the loan was disbursed again seven days later – all during a period in which the company was permanently and technically illiquid.
The insolvency administrator took the view that the loan repayment by the company to its shareholder was forbidden by company law (and therefore repayable by the director) because it was made after the occurrence of illiquidity and was not in line with the due care of a prudent businessman.
The court held that the director could not be held liable by the insolvency administrator, since the loan repaid by the company was in turn disbursed again to the company at the same amount and as an immediate consequence of its previous repayment.
The court clarified that directors must reimburse payments after the occurrence of illiquidity or overindebtedness only if the payments were not compensated. According to the court, a payment to the company can compensate the reduction caused by the allegedly illicit payment only if there is a direct relation to the payment authorised by the director. However, if such a relation exists, the court considers it sufficient that the consideration compensates the reduction in the insolvency estate at the time it is made; it need not necessarily still exist in the insolvency estate when the insolvency proceedings are opened. The court thereby deviated explicitly from its previous case law.
As the reason for its change in approach, the court referred to the aim of directors' liability which is to protect the insolvency estate from reductions to the creditors' detriment and not to enrich the insolvency estate irrespective of consideration payments. The liability could be revived if the consideration were spent by the director again. However, this would be a new potentially illicit payment which must be assessed independently. The court left open the question of whether and under which circumstances the arising of a claim against the recipient of the payment could be sufficient to compensate the reduction in the insolvency estate.
This decision is expected to bring major changes to the regime of directors' liability. As a rule, companies do not make gifts – this is also true of companies in financial difficulties. If it is the court's view that no director's liability for illicit payments arises if the company received direct and fair consideration, the majority of payments made in the ordinary course of business should be exempt from liability under the relevant provisions. Previously, it was frequently impossible to use the considerations as a line of defence, since the consideration is generally quickly spent by distressed companies, which have typically only small working-capital buffers; therefore, the consideration does not survive as such until the opening of insolvency proceedings. This question is now irrelevant.
In a liability process initiated by an insolvency administrator, the Federal Court decision will enhance the managing directors' position. However, the decision is far from being a basis for careless behaviour in a distressed situation. First, each payment must be compensated by directly related consideration. It is unclear whether the decision will also apply to wage payments, leasing instalments or loan repayments (in the absence of a revolving loan mechanism), since consideration in such cases is more difficult to define. Second, the judgment has no influence on the obligation of directors to file a petition for the opening of insolvency proceedings within three weeks of the company becoming illiquid or overindebted. In many cases, a personal liability claim can be based alternatively on breach of this duty (Section 823(2) of the Civil Code in connection with Section 15(a) of the Insolvency Code).
For further information on this topic please contact Stefan Sax or Joachim Ponseck at Clifford Chance LLP by telephone (+49 69 7199 01), fax (+ 49 69 7199 4000) or email (email@example.com or firstname.lastname@example.org). The Clifford Chance website can be accessed at www.cliffordchance.com.
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