German Parliament passes “Act for the Further Facilitation of the Restructuring of Companies“ (Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen, ESUG)
On 27 October 2011, the German Parliament (Bundestag) finally passed the “Act for the Further Facilitation of the Restructuring of Companies“ (Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen, ESUG, BT-Drs: 17/7511) (ESUG). The Federal Council of Germany (Bundesrat) will vote on ESUG in late November or early December 2011. The aim of this substantial insolvency reform is to make German insolvency law more competitive. In the past, it has been routine for creditors to consider and, in some cases implement, a shift of the debtor company’s center of main interest (the so called COMI) abroad in order to benefit from foreign insolvency legislation. In order to supersede this type of forum shopping, the German legislator has significantly improved the influence of creditors in insolvency proceedings, has introduced innovative options to swap debt into equity and has cut back on the means by which minor creditors and shareholders of debtor companies can commence capricious appeals. Moreover, the legislator has substantially improved the insolvency plan proceedings and the Chapter 11-like debtor-in-possession (DIP) proceedings which were initially incorporated into the German Insolvency Act of 1999. The reform will give rise to new opportunities, especially for banks and hedge funds, but also for distressed companies.
The new Preliminary Creditors’ Committee
In order to allow creditors to have more influence at the early stages of insolvency, a new form of statutory creditor participation, the “Preliminary Creditors’ Committee” (vorläufiger Gläubigerausschuss), has been introduced (sec. 22a ESUG-InsO). A Preliminary Creditors’ Committee shall be set up during preliminary insolvency proceedings where the debtor company satisfies two of the following three requirements: a balance sheet total in excess of EUR 4,840,000, revenues of at least EUR 9,680,000 in the twelve months prior to the last balance sheet date and/or fifty or more employees. As German insolvency law does not provide for unitary group insolvency proceedings, multiple Preliminary Creditors’ Committees may have to be appointed where there are multiple insolvency proceedings within one group of companies.
The Preliminary Creditors’ Committee will be able to participate in certain important insolvency court decisions. It will have, for example, the power to influence the following: the selection of (preliminary) insolvency administrators (vorläufige Insolvenzverwalter and Insolvenzverwalter), orders for DIP proceedings (Anordnung der Eigenverwaltung), and appointments of preliminary trustees (Sachwalter).
In order to maximize the influence of the Preliminary Creditors’ Committee, creditors should, ideally, prepare the appointments to the committee before filing for insolvency. If there are multiple insolvency proceedings within one group, creditors should ensure the proper coordination of all appointments. Moreover, creditors should agree in advance on the name of the person who will be the preliminary insolvency administrator. Creditors should present the proposal, which includes the names of proposed members of the Preliminary Creditors’ Committee and the name of the proposed preliminary insolvency administrator, together with the filing for insolvency. Whereas the insolvency courts have the power to decide not to set up a Preliminary Creditors’ Committee where this will lead to a delay that is financially detrimental to the debtor company (sec. 22a para. 3 ESUG-InsO) (thereby frustrating early stage creditor influence), by filing this proposal together with consent forms executed by the proposed members, the court is obliged to pursue with the setting up of the Preliminary Creditors’ Committee (sec. 22a para. 2 ESUGInsO).
Increased Influence of Creditors on the Appointment of Insolvency Administrators
Prior to the appointment of the insolvency administrators and preliminary insolvency administrators, the insolvency court will have to request comments from the Preliminary Creditors’ Committee (sec. 56a para. 1 ESUG-InsO). The Preliminary Creditors’ Committee can then provide the criteria for the appointment of the potential administrator. Moreover, the committee can propose to the courts the names of certain individuals to act as insolvency administrators. The process of coordinating these proposals should be initiated at an early stage as the court is not obliged to request the criteria if this leads to a delay that results in the financial deterioration of the debtor company.
If the Preliminary Creditors’ Committee has suggested certain criteria which should be fulfilled by an insolvency administrator, the court has to take such criteria into account. Where a Preliminary Creditors’ Committee unanimously agrees on a person as insolvency administrator, the insolvency court may only disregard the proposal if the person presented is unqualified to act as an insolvency administrator (sec. 56a para. 2 ESUG-InsO).
The previous draft of the ESUG contained a provision allowing for the appointment of advisors as insolvency administrators who had prepared an insolvency plan (Insolvenzplan), together with the creditors and debtors, prior to their appointment. This provision was unfortunately deleted in the legislative process. This has meant a limitation on creditors having an insolvency plan prepared and implemented by one advisor (Pre- Packed Deal). However, a Pre-Packed Deal has not been rendered impossible. The creditors will have to prepare the Pre-Packed Deal with one advisor and then present a different advisor as insolvency administrator who will implement the pre-agreed insolvency plan. In this manner, creditors will be able to save a significant amount of time, minimizing stakeholder erosion and improving the prospects of the debtor company to continue as a going concern.
In any event, the Preliminary Creditors’ Committee should ensure that the proposed preliminary insolvency administrators have executed statements confirming the non-existence of conflicts of interest. This enables the insolvency courts to appoint preliminary insolvency administrators within hours.
Facilitation of Debt-Equity- Swaps
The ability of creditors to convert their debt into equity has been significantly improved by the insolvency reform. The facilitation of Debt-Equity-Swaps gives creditors 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. In Germany, Debt-Equity-Swaps are implemented through share pledge enforcements or capital decreases followed by capital increases subject to an exclusion of the old shareholders’ subscription rights and a contribution in kind of the creditors’ debt. In the past, creditors depended on the old shareholders’ cooperation for Debt-Equity-Swaps. However, such Debt-Equity-Swaps did not only fail on account of a lack of shareholder cooperation, but also due to strict German capital contribution rules. Creditors contributing their claims in a distressed financial situation of the debtor company faced severe risks of liability as a court might have later held that their contributed claims were booked at an overvalue (secs. 9 and 56 para. 2 GmbHG).
Pursuant to the new insolvency rules, Debt-Equity-Swaps can also be implemented through insolvency plans (sec. 225a para. 2 ESUG-InsO). Following the approval of the insolvency plan by the insolvency court, creditors no longer face the risk of liability for breach of capital contribution rules as claims based on an alleged overvaluation of contributed claims cannot be brought once the insolvency plan has been approved (sec. 254 para 4 ESUG-InsO). As consideration for their dilution, old shareholders will be granted voting rights in the decision with respect to the insolvency plan (sec. 222 para. 1 s. 2 no. 4 ESUG-InsO). These voting rights do not increase nuisance value as shareholder votes can be crammed down (sec. 245 ESUGInsO). Therefore, 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. A Debt-Equity-Swap that lacks the consent of the respective creditors is not permitted under the new insolvency rules (sec. 225a para. 2 s. 2 ESUG-InsO).
The general form requirements applicable to corporate measures, in particular notarization requirements, do not apply if such measures form part of the insolvency plan (sec. 254a para. 2 ESUG-InsO). Subscriptions for shares in Debt-Equity-Swaps pursuant to an insolvency plan will therefore be possible without notarization pursuant to sec. 55 para. 1 GmbHG.
One crucial feature of Debt-Equity- Swaps under an insolvency plan has been added in the last step of the legislative process: termination and withdrawal rights of third parties are barred in the case of Debt-Equity-Swaps (sec. 225a para. 4 ESUG-InsO). As a result, creditors do not face the risk that the Debt-Equity-Swaps will trigger change-of-control-clauses thereby deteriorating the value of the debtor company.
Strengthening of Debtorin- Possession-Proceedings (Eigenverwaltung)
Another important aim of the insolvency reform was to promote the use of DIP proceedings (Eigenverwaltung). Although provided for in German legislation in 1999, these proceedings have rarely been used in Germany. Insolvency courts could only order DIP proceedings if such proceedings did not lead to possible disadvantages to creditors (sec. 270 para. 2 no. 3 InsO). This rule has been amended: an application for DIP proceedings filed by a debtor company can only be rejected by a court where there are known concrete circumstances that might lead to the proceedings being disadvantageous to creditors (sec. 270 para. 2 no. 2 ESUG-InsO). This means that mere doubts about the potential detrimental effects of DIP proceedings will no longer hinder such proceedings. The Preliminary Creditors’ Committee can also influence the granting of orders for DIP proceedings. The committee will be entitled to be heard prior to an order for DIP proceedings. If the application for DIP proceedings is backed by unanimous consent by the members of the Preliminary Creditors’ Committee, the presumption will be that such proceedings do not have any detrimental effects on the creditors (sec. 270 para. 3 ESUG-InsO).
Having the DIP proceedings prior to the opening of an insolvency proceeding (sec. 270b ESUG-InsO) is a new concept under German insolvency law. Such Preliminary DIP proceedings protect debtor companies facing imminent illiquidity and/or over-indebtedness from creditor enforcement actions for up to three months. Accordingly, Preliminary DIP proceedings are also perceived as “debtor protection proceedings”. During the three months protection period, debtor companies shall, together with their creditors and a preliminary trustee (vorläufiger Sachwalter), prepare an insolvency plan (pre-pack) which ideally will be implemented in DIP proceedings after formal insolvency proceedings have been opened.
If creditors are of the opinion that DIP proceedings are inappropriate, for instance because management caused the economic downturn of the debtor company, they have the opportunity to object to the DIP proceedings. The Preliminary Creditors’ Committee can request that the Preliminary DIP proceedings be set aside (sec. 270b para. 4 ESUG-InsO). The proceedings then continue as regular preliminary insolvency proceedings. If no Preliminary Creditors’ Committee has been appointed, creditors can ask for the Preliminary DIP proceedings to be discontinued. In order to be granted this request, they have to furnish prima facie evidence that the Preliminary DIP proceedings will have a detrimental effect on creditors (sec. 270b para. 4 ESUG-InsO). A proposed provision leading to the discontinuation of Preliminary DIP proceedings where the debtor company becomes illiquid was deleted in the latest draft of the legislative proposal. Creditors cannot therefore obstruct Preliminary DIP proceedings by rendering the debtor company insolvent by terminating credit agreements.
Applicability on Insolvency Proceedings in 2012
The insolvency law reform will come into effect three months after its publication in the Federal Law Gazette, hence the new rules will apply as from Spring 2012. Creditors involved in insolvency proceedings initiated prior to that will not benefit from the new rules. Creditors should therefore consider, on a case by case basis, whether insolvency filings can be postponed until after the insolvency reform comes into effect. It remains to be seen whether under the new rules, German companies will be restructured through formal insolvency proceedings more frequently or whether — due to a continued stigma of insolvency — restructurings will continue to mostly be out-of-court.