The German Parliament has, in response to the ongoing crisis in the financial markets, extended a legislation, which originally came into force on October 18, 2008, amending, inter alia, parts of the German Insolvency Code. These amendments, which had in certain cases lead to a relaxation of the obligation to file for insolvency, will now be valid without limitation in time. It can be expected that it will be published and come into force already this year.

Obligation to File for Insolvency

Management boards or directors (“management”) of corporations, limited liability companies and other legal entities are obliged to file for insolvency if the entity is either “illiquid” or “over-indebted”, subject to a cure period of up to three weeks. If the filing does not take place within this timeframe, the management render themselves liable to criminal prosecution for the delay and, moreover, become personally liable for damages vis-à-vis the entity’s creditors.

The permanent amendment to the Insolvency Code is concerned with the obligation on the management of an “over-indebted” entity to file for insolvency. An entity is said to be over-indebted when its assets no longer cover its liabilities.

The old Law on Over-Indebtedness

Under the old law in effect before October 18, 2008, if the value of the entity’s existing assets (taking into account hidden reserves) did not fully cover its liabilities, a filing for insolvency was mandatory (subject to the three-week cure period). The management of an entity which was in financial difficulties was required to continuously monitor its asset and liability position. Further, when valuing assets, if there was a “predominant probability” of continuation of the business (the so-called “positive continuation forecast”), assets could be valued on a going concern basis. Otherwise, liquidation or fire sale values (which are often much lower) were to be used. If the value of the assets did not cover the entity’s liabilities, then an insolvency filing was mandatory even in case a positive continuation forecast existed.

Amendment of the Concept of Over-Indebtedness

The legislation passed in 2008 amended the application of the concept of over-indebtedness. If a positive continuation forecast could be made, there was no obligation to file for insolvency solely on the grounds of over-indebtedness. Hence, going forward, the question whether an entity’s assets are sufficient to cover its liabilities will not be a concern as long as a positive continuation forecast exists. However, this relaxation of the obligation to file for insolvency was initially applicable only until December 31, 2010 and was later extended to December 31, 2013. This legislation has now been declared as permanent.

In its explanatory statement addressing the new legislation, the Federal Government specifically noted that the current financial crisis has led to significant losses in asset values, especially in relation to stock and real estate, which could trigger the over-indebtedness of an affected entity. The new legislation is designed to avoid the need for those entities for which there is a “pre-dominant probability” of continuation of the business to file for insolvency solely on the grounds of over-indebtedness.

The ultimate removal of the time limit responds to the fact that the current concept of over-indebtedness has done well in daily practice.

What Does the new Legislation Mean in Practice?

The new permanent legislation brings about a relaxation of the obligation to file for insolvency for legal entities which may be over-indebted but for which a positive continuation forecast exists. For such entities, the obligation to file for insolvency only exists in the case of “illiquidity” (as opposed to over-indebtedness). Whether or not the assets of the entity still cover the liabilities or whether a loss of asset value was caused by the current financial crisis is irrelevant.

Consequently the question under what circumstances management will be entitled to assume a positive continuation forecast is essential. Currently, this requires that a plausible profit forecast and financial planning be prepared demonstrating that it is “predominantly probable” that the entity will be able to continue in business in the medium term (as a general rule, at least until the end of the following business year). However, a management that elects, on the basis of a positive continuation forecast, not to file for insolvency should be aware that the plausibility of their profit forecast and financial planning may be scrutinized by the courts at a later date. Therefore, a proper documentation is essential.

Please note, however, that the obligation upon management to file for insolvency if the entity is “illiquid” (as opposed to being over-indebted) remains unchanged.