German insolvency law, unlike US insolvency law, only recently introduced (in 2012) the so-called protective shield proceedings (Schutzschirmverfahren) to enable potentially illiquid and/or over-indebted debtors to restructure the company on the basis of a so-called insolvency plan. Thereby, the liquidation of a company by a future insolvency administrator can be avoided.
In general, protective shield proceedings are fairly comparable to US Chapter 11 proceedings. However, comparable to the history of Chapter 11 proceedings, the number of cases remains at a low level since 2012 compared to the absolute numbers of insolvency proceedings. The same applies to the numbers of debt-equity-swaps (DES) carried out under protective shield proceedings. But with regard to current debt developments and based on the facilitated formalities for DES under protective shield proceedings, it is expected that the number of cases of DES under protective shield proceedings will rise in the near future – similar to past developments in the US.
In particular if the company is potentially insolvent but its core business operations are profitable, a DES under the protective shield proceedings becomes attractive, providing the creditors with direct participation in them, by either the acquisition of shares in the company or by DES.
In a DES, existing claims are used to acquire (newly issued) shares in the company.
The advantage of DES in such cases is obviously that outstanding debts are converted into equity, i.e. new shares (without any encumbrances) which are transferred to the creditors, cutting down the overall outstanding debt value and hence, the company’s indebtedness. As the latter is one of two criteria for the determination of insolvency under German insolvency law (over-indebtedness or inability to pay its (due) debts), a reduction of the grade of indebtedness may also lead to the termination of insolvency proceedings and enable the company to resume normal business operations.
Such a DES generally is executed by a four-step-plan.
- Firstly, the existing shareholders pass, in the shareholders meeting, a shareholders’ resolution increasing the registered capital of the company and issuing new shares.
- To increase the registered capital, the company needs an equivalent contribution to its capital account by either a payment or a so-called contribution in kind.
- Such contribution in kind, in the case of a DES, is done by interested creditors of the company by way of transfer of their claims against the company to this company.
- The new shares will be distributed exclusively to the creditors participating in a DES, who become the new shareholders of the company.
Under normal (non-insolvency related) circumstances DES may be difficult to establish since it is (in theory) at the discretion of the existing shareholders of the company whether to increase existing capital and issue new shares. This can be a burden especially in case of insolvent companies, when there is a conflict of interest between the company’s existing shareholders, its management team and creditors.
Also the risk of so-called differential liability (Differenzhaftung) exists. Differential liability may result in material liabilities for the new shareholder if the value of the transferred claims (in exchange for the transfer of newly issued shares) is determined subsequently to have a lesser value (which may occur in particular with regard to junior debts) than the actual contribution owed. This means that even though the creditor made a contribution in kind for subscribing the new shares (by transferring his claims against the company), the value of the debts is less than the actually contribution owed. Hence, the creditor as the new shareholder is obliged to pay in cash any difference between the subsequent determined value and the amount of the contribution owed.
Here is where the protective shield proceedings step in and facilitate the process to the advantage of creditors interested in a DES for investment purposes by favouring creditors’ interest and preventing conflicts between the involved parties, in particular with the existing shareholders of the company:
Under protective shield proceedings, the filing for insolvency may be combined with a request to start protective shield proceedings. If this is accepted by the insolvency court, the management remains authorized to manage the company, merely supervised by a so-called insolvency monitor instead of an insolvency administrator. Within a certain time period, the parties involved need to draft an insolvency plan which needs to be approved by the insolvency court and by the creditors.
In general, the purpose of an insolvency plan is to stipulate how the assets of the insolvent company shall be distributed, satisfying creditors and to sell profitable parts of the insolvent company to interested investors. But the insolvency plan may also stipulate how to continue business operations whilst restructuring the debt structure of the company – exactly the goal of a DES.
The newly introduced rules on the protective scheme expressly allow DES to the advantage of creditors, making investment in insolvent companies more attractive than that which is stipulated in Sec. 225a para. 2 sentence 1 German Insolvency Code (Insolvenzordnung – InsO).
The above stated burdens of a DES may be overcome by the insolvency plan, which substitutes the required shareholders’ resolutions, sec. 225a para. 2 sentence 3, 228 InsO. The insolvency plan would consequently need to stipulate the steps which would have been required to establish a DES under non-insolvency related circumstances (see above). With regard to the justification of the exclusion of subscription rights of the existing shareholder, the implementation of the insolvency plan and the contribution by the investors to restructure the company are considered to be a sufficient justification for excluding original rights of the existing shareholders – on the other hand the investor is obliged to transfer his claims against the company.
Even though an equity participation of the creditors is created by a DES, the existing shareholders remain in place – which might be considered a burden for the re-start of business operations. Hence, creditors may also need to consider how to replace the existing shareholders. This can be achieved under protective shield proceedings by a reduction of the company’s registered capital to zero and at the same time by a re-raising of the registered capital.
The consequence of reducing the registered capital to zero is that existing shares are extinguished, whereas the reduction can go below the necessary minimum registered capital (in case of a GmbH of EUR 25,000) if at the same the registered capital will be re-raised at least to that minimum amount. The re-raised registered capital will then create new shares.
Further, the normally required shareholder’s participation (by way of a shareholder resolution) will be substituted by the regulations of the insolvency plan. However, due to corporate restrictions, the minimum registered capital required by law must be contributed by the new shareholders by a cash payment, whereas the amount exceeding the registered capital (in case of a GmbH of EUR 25,000) can be contributed in kind, i.e. in case of a DES by the transfer of existing claims against the company to that company.
Consequently, the insolvency plan needs to provide for:
- an decrease/re-raise of the registered capital above the minimum registered capital;
- a mixture of contribution in cash, EUR 25,000 and contribution in kind (the latter by way of a DES);
- issuance of the new shares and excluding the subscription rights of old shareholders; and
- distribution to the investors solely
Finally, under protective shield proceedings, the DES does not result in the risk of differential liability; making it more attractive for creditors to invest in their debtor. According to Section 254 para. 4 InsO, the insolvency plan under the protective scheme excludes the new shareholder’s liability in the event that the contributed claims have a lower value than initially determined. Hence, the creditor participating in a DES under protective shield proceedings is not required to maintain cash for any possible and uncertain differential liability. Further, it makes it easier to prepare the investment and of course the Internal Rate of Return (IRR) is higher if there is no need to withhold cash reserves, which subsequently can be invested in the event that the company leaves insolvency proceedings.
In order to secure the creditors interests and rights whilst the insolvency plan is negotiated or prepared, it is also recommended that investing creditors enter into an investor agreement with the company and the insolvency monitor supervising the protective shield proceedings, before preparing the insolvency plan and stepping into further obligations. An investor agreement serves to protect the creditor from any liabilities which may occur during the process, in particular in the time period between voting on the insolvency plan and its effectiveness. Such liabilities could be the obligation to subscribe for the new issued shares and hence, contributing cash and claims to the company, even though certain other restructuring measures in the insolvency plan were not accepted, jeopardizing the success of the restructuring.
Hence, the investor agreement should stipulate the company’s obligations to include respective measures into the insolvency plan. Whereas the creditor’s obligation should be subject to the condition precedent that the insolvency plan becomes effective and should be combined with a right to withdraw from the investor agreement.
Further, certain covenants should be included, such as the company shall not enter into material agreements without the creditor’s consent during the time period between effectiveness of the insolvency plan and registration of the measures related to the registered capital and subscription of the new shares.
Finally, the creditor would need to consider the tax implication on the restructuring profit (Sanierungsgewinn), if the restructuring of the company is successful and the creditor finally participates in the new profitable business of the company.
In summary, the new regulations on DES under the protective shield proceedings provide a comfortable way for creditors to invest successfully in the business opportunities of their debtors without having the “normal” trouble with “old shareholders” and providing additional cash contributions, but still a DES should be prepared with diligent care to prevent any liabilities in order to enjoy the investment in a reviving company.