In a March 5 2015 ruling the Federal Court of Justice set out the requirements for subordination agreements designed to avoid insolvency.(1) The court used the opportunity to clarify a number of basic and previously disputed questions concerning the nature and required content of such agreements, which are one of the typical restructuring tools designed to stabilise a company in a crisis.
German law provides that if a company becomes illiquid (cash-flow insolvent) or over-indebted (balance-sheet insolvent), its management must file for insolvency without undue delay within a maximum of 21 days. Failure to do so may result in civil and criminal liability for company management.
While liquidity issues are typically cured by means of a standstill regarding due and payable liabilities, it is advisable to exclude the possibility of over-indebtedness by restructuring the balance sheet. For the specific purposes of the insolvency test, an over-indebtedness balance sheet will be established. The establishment of an over-indebtedness balance sheet follows different principles from the establishment of the company's commercial or tax balance sheet – in particular, hidden reserves or hidden losses need to be dissolved. Although German law provides that a company is technically not over-indebted if it has a positive continuation forecast, it is often too risky to rely on this prognosis alone. An exclusion of over-indebtedness can be achieved on a more solid footing if, based on an over-indebtedness balance sheet, the company has more assets than liabilities.
There are two options for achieving this goal – the equity can be increased or the debt can be reduced. However, in a crisis, providers of new equity are typically hard to find. The company therefore needs to be stabilised by reducing its liabilities, at least for the purposes of the over-indebtedness test.
This does not necessarily require a waiver of the respective liabilities. German law provides that liabilities can be disregarded on an over-indebtedness balance sheet without a waiver if the parties declare the liability to be subordinated (Section 19 of the Insolvency Code). The subordination agreement should state that the claim shall not be satisfied in insolvency proceedings until all other creditors – including creditors which are automatically subordinated as a matter of mandatory law – have recovered their claims in full.
In contrast to a subordination agreement, a waiver would be risky, as it could trigger undesired tax consequences. The complete removal of the claim from the balance sheet could be deemed by the tax authorities as a taxable extraordinary profit. Legal advisers must try to achieve the impossible by making liabilities disappear from the over-indebtedness balance sheet while at the same time remaining on the tax balance sheet. Based on decisions of the Federal Financial Court, legal practice has developed relatively safe wording to cover this tax risk. However, a number of unresolved questions regarding the correct wording for subordination remain:
- The wording of Section 19 of the Insolvency Code requires a specific ranking within insolvency proceedings. Must a subordination agreement take effect before proceedings are opened?
- As the subordination agreement is a contract agreed between the creditor and the debtor, can the agreement be terminated consensually in accordance with the general rules?
The Federal Court of Justice decision has provided answers to at least some of these open questions.
The insolvent company was a borrower under mezzanine financing. The relevant credit agreements subordinated the lender's claims to those of all other creditors of the borrower. Approximately six months before the insolvency filing, the company made interest payments on the subordinated loans. The borrower's insolvency administrator filed a claim against the lender for restitution of these payments.
The insolvency administrator lost at first instance and brought the claim before the Federal Court of Justice, which held that the insolvency administrator was entitled to demand restitution of the interest payments.
The court based its decision on the following guiding principles:
- A qualified subordination agreement constitutes a debt rearrangement agreement which provides that the creditor's claim will not appear on the balance sheet and may be satisfied only if the company has more assets than liabilities.
- If a payment is made for a claim which is subject to a qualified subordination agreement, despite the existence of over-indebtedness or illiquidity, restitution of that payment can be demanded based on general legal principles.
- Such a payment may be challenged as gratuitous performance based on insolvency law provisions.
Apart from the official guiding principles, many of the most relevant statements were made in the reasoning behind the Federal Court of Justice decision, which is summarised below.
Subordination rules apply to claims other than shareholder loans
If interpreted literally, the law provides that only subordinated claims under shareholder loans can be disregarded on an over-indebtedness balance sheet. Even prior to the decision, subordination agreements were concluded in respect of claims other than shareholder loans. The parties and their lawyers always expected that this subordination would have the desired effect for the over-indebtedness test. The Federal Court of Justice has confirmed that Section 19 of the Insolvency Code applies to shareholder loans as well as to all other types of claim (eg, mezzanine financing). This confers legal certainty on a well-established practice.
State-of-the-art subordination agreement and pre-insolvency effect
The court emphasised that the effects of a subordination agreement depend on the wording that the parties have chosen. For example, the parties can choose to agree a ranking between specific creditor groups only and provide that this ranking applies exclusively in insolvency proceedings (comparable to waterfall provisions in inter-creditor agreements). The court also made it clear that if the parties want to achieve the goal of restructuring the company's over-indebtedness balance sheet, the subordination agreement must fulfil certain requirements.
This includes the requirement that the subordination agreement has an effect on the subordinated claim prior to the opening of insolvency proceedings. An agreement on the ranking exclusively in insolvency proceedings is allowed, but will not be relevant for the over-indebtedness test. If the claim on the over-indebtedness balance sheet is disregarded, the parties need to agree – implicitly or explicitly – that a payment to the subordinated claim cannot be demanded if the company is illiquid or over-indebted. If the debtor is illiquid or over-indebted, the agreement needs to provide that the claim is not payable. That is, the subordination wording needs to protect the company from becoming insolvent in the first place (by creating an objection to the payment demand), instead of only regulating the ranking within insolvency proceedings when it is too late.
In the case at hand, the Federal Court of Justice found that the subordination agreement had a pre-insolvency effect. As the company was materially insolvent when the interest payment was made, the bank was not entitled to demand payment of the subordinated debt. This was the basis of the insolvency administrator's right to demand restitution of these payments – if the undue payment were still made, the insolvency administrator could claim restitution based on general unjust enrichment provisions or, alternatively and more importantly, recovery provisions based on insolvency. The payment qualified as gratuitous performance, which can be challenged when effected during the suspect period of four years prior to the opening of insolvency proceedings (Section 134 of the Insolvency Code).
Subordination agreements as contracts for benefit of third parties
Subordination agreements are concluded as contracts between the debtor and the creditor only. Generally, the parties to an agreement are free to terminate their own agreement consensually – explicitly or implicitly. In the case at hand, the company decided to make the payment (although it did not have to) and the creditor accepted this payment. The court had to answer the question of whether this behaviour constituted an implicit consensual revocation of the subordination agreement.
The court answered in the negative and took the view that a state-of-the-art subordination agreement qualifies as a contract for the benefit of third parties – namely, for the benefit of all other creditors of the debtor. Therefore, the parties cannot simply reverse the agreement without the beneficiaries' consent – at least as long as the company is materially insolvent. All creditors would have had to agree to the consensual revocation.
The court emphasised that the parties are free to make clear that their subordination agreement will not be for the benefit of third parties. However, if they do so, the subordination will not be relevant for the over-indebtedness test, which is typically the purpose of the subordination.
Since the subordination agreement in question allowed for an interpretation that benefited third parties, the court ruled that it was not possible to interpret the payment as an implicit consensual termination of the subordination agreement.
Creditors and debtors of subordinated debt might want to check the wording of their subordination agreements. Most of them will realise, perhaps surprisingly, that there is nothing in the wording which clearly shows that the subordination agreement has a pre-insolvency effect or that it is designed as a contract for the benefit of third parties. The reason is that these requirements were only set by the court in this recent decision; before then, subordination agreements focused closely on the wording of Section 19 of the Insolvency Code, without making any statement regarding the issues recently raised by the court.
The question remains of whether old subordination agreements need to be revised. Generally speaking, the answer is no. As long as the wording of the subordination agreement is close to the wording of Section 19 and the purpose is clearly to enhance the over-indebtedness balance sheet, the terms 'pre-insolvency effect' and 'contract for the benefit of third parties' need not be explicitly set out. The courts can be relied on to interpret the agreements in accordance with the purpose that the parties wanted to achieve. An exception to this general rule applies if the wording of the subordination agreement can be interpreted to mean that the parties wanted to exclude a pre-insolvency effect or a contract for the benefit of third parties. In this case, the agreement should be amended to make sure that it achieves its purpose in the context of the balance sheet insolvency test.
By contrast, when it comes to drafting future subordination agreements, it would be advisable to reflect on the requirements set out by the exact wording of the Federal Court of Justice.
For further information on this topic please contact Stefan Sax or Joachim Ponseck at Clifford Chance LLP by telephone (+49 69 7199 01) or email (firstname.lastname@example.org or email@example.com). The Clifford Chance website can be accessed at www.cliffordchance.com.
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