The Duty to File in Germany: How Much Leeway Do Cross-Border Businesses Actually Have?

By Simon Eickmann and Bella V. Jiménez

Under certain circumstances, filing for insolvency in Germany is a duty. Breaking it exposes decision-makers, often managing directors, to great personal and criminal liability. In cross-border businesses, German thresholds are often unknown to international stakeholders, leading to misunderstanding, risk and higher bills. This article sheds light on key pain points and highlights some ways that companies and directors can protect themselves.

The Duty to File

Section 15(a) of the German Insolvency Code requires managing directors to file for insolvency if the company becomes illiquid or overindebted. Both grounds to file are determined by arithmetic calculations well-defined by statute and precedent. In the extraordinary case that the company temporarily has no management (“Führungslosigkeit”), members of the supervisory board can also have an obligation to file.1 In the past, this obligation included shareholders and de facto managing directors (e.g., authorized representatives), too.

The deadline to file is three weeks in case of illiquidity and six weeks for overindebtedness. During this time, company leaders can attempt to close the liquidity (or overindebtedness) gap and to eliminate the duty to file. In addition, they must implement the so-called “Notgeschäftsführung,” a special management mode during which specific rules apply on payments and business continuation. However, if managers do not make it on time or never file, they can be held personally liable for every single payment they made since the obligation arose. Management will have the burden of proving that each payment was done with the “due care of a prudent and conscientious manager.” If they fail to do so, according to § 15b, they have to refund the payments out of their own pockets.

Criminal Liability

Not filing for insolvency or filing too late is also punishable as a crime with a jail sentence. Negligence alone carries fines or jail sentences of up to a year if it is determined that it was intentional.2 Convictions for intent, a feature of German criminal law, can include conditional intent (“bedingter Vorsatz”). This is when “the perpetrator considers the occurrence of a result as possible and still accepts the risk,” even if the result is not his primary intention.3 A textbook example would be a director who misses the filing deadline, thinking things will turn around with a big contract or a new investment, aware that if they do not, creditors might lose more money. He/she knows that is a possibility but takes the risk anyway.

In addition, a German managing director is by law required to obtain clear information about the company’s current and future financial situation, and must be able to always assess the company’s potential obligation to file, especially if signs of crisis appear. Delegating such analysis to an external expert can protect directors from liability, but only if they ensure the collection and disclosure of sufficient and correct data.4 For international stakeholders, taking such risks does not seem far-fetched, especially if they are based in jurisdictions where filing is a not an obligation and damage claims based on fiduciary duties are not a thing.

Personal liability arises for the obligated persons if the company was insolvent and they did not file before the deadline expires. Both criminal and civil liability can be incurred. These risks should be hedged. Let’s discuss what triggers the duty to file, and how to avoid it.

Ground A: Illiquidity

According to § 17 of the German Insolvency Code, a company is illiquid when it is unable to meet its mature payment obligations. The existence of illiquidity is determined by subtracting all due liabilities from all liquid means available (e.g., cash in the bank accounts, liquid securities and unused credit lines) as of a specific test date. Simple enough. However, it can be an interesting exercise to sit down with a company’s management and discuss exactly what due liabilities are comprised of. Some common pitfalls are contingent liabilities, correct assessment of trade balances, intercompany relations, and proof of committed financing.

Contingent Liabilities

Contingent liabilities are liabilities that may or may not arise and may or may not be due, depending on the outcome of a future event, such as a court’s ruling. Generally, contingent liabilities must be considered pro rata in relation to their probability. For example, let’s imagine that a company is involved in ongoing litigation where it will be decided whether it has to pay $10 million to a creditor. The probability of the court ruling in the company’s favor is 40 percent. For the liquidity test, 60 percent of the amount, or $6 million, may need to be considered. Therefore, one key to decreasing risk is getting a numerical probability assessment from licensed legal professionals as soon as the contingent liability arises.

Shifting Trade Balances

Trade balances are the amounts owed to and from creditors and debtors. Usually, they are booked in so-called open-items lists. These lists can be comprised of thousands of lines and are, hopefully, handled through accounting software that sums up all entries for each creditor or debtor automatically. A debtor’s overpayments sometimes lead to switching a debtor’s balance to a credit and hence have to be considered as liability in the liquidity test, while at other times it is creditors who might owe the company. However, without the explicit right to set off obligations, all due invoices from such creditors still must be considered due. These issues can add up to big distortions in the liquidity assessment. If significant, they can be resolved and even leveraged to reach a positive insolvency assessment by procuring additional agreements clarifying payment terms.

Intercompany Relations

Just as with trade balances, intercompany payables need to be considered unless a written agreement stating otherwise exists. Further, schemes such as cash-pooling or profit-transfer agreements should be considered if they are binding.

Proof of Committed Financing

One must tread carefully with what can be counted as future available cash, such as credit lines promised by the bank but pending closing, when calculating whether a company is insolvent. Based on past court rulings, future financing must meet strong probability standards, which vary depending on the party that is committing to finance the company. When financing or any other restructuring contributions come from third parties, there is no need for it to be legally binding. It is required that the contributions can more likely than not be expected — that is, a probability of more than 50 percent.5

On the other hand, nonbinding shareholder commitments can only be considered in special exceptional cases (e.g., if a payment can be expected based on the shareholder’s creditworthiness, interests or previous conduct). However, managing directors always retain the burden of proof that the financing could be seen as expected back then.6

What Can Be Done If a Company Is Illiquid?

If the test as of a certain date shows a liquidity gap, the next step is to assess the cash-flow projection of the next three weeks. If the gap can be closed, it will be assumed that payments are delayed (“Zahlungsstockung”), and no obligation to file arises. However, if it shows that the gap cannot be closed, the amount of the remaining shortfall will be decisive:

• If the gap is more than 10 percent in the next three weeks, the only chance to avoid a filing obligation is if, with “a probability near certainty,” it can be expected that the liquidity gap will be completely closed. In exceptional cases, this period can be up to six months if creditors can reasonably be expected to wait for their payments.
• If the gap remains at less than 10 percent, usually only a delay of payments, but not a reason to file, is assumed. However, a cash-flow projection for the next three to six months needs to be developed. Should this projection show a permanent liquidity gap or an increase of the gap to more than 10 percent, then an obligation to file for insolvency arises.7

Ground B: Overindebtedness

According to § 19 of the German Insolvency Code, overindebtedness exists if the debtor’s assets no longer cover the existing liabilities, unless the continuation of the company as a going concern is predominantly probable throughout the next 12 months. Hence, overindebtedness has two components: the balance-sheet test, and the going-concern forecast.

The Balance-Sheet Test

Overindebtedness is calculated by subtracting all liabilities, whether due or not, from all assets at liquidation value. Liquidation values are calculated as if the company had ceased operations. Hence, they do not always match the more favorable market or book values. The company’s balance sheet is the starting point. However, off-balance-sheet items are to be added back, assets are to be adjusted to actual values, and contested receivables are to be considered according to expected recovery. The careful assessment and preparation of each item is key.

It is good advice not to rely solely on a positive balance sheet, as the items and values considered can easily be questioned. The best way to beat an overindebtedness filing ground is to present a well-founded, positive going-concern forecast.

The Going-Concern Forecast

A negative balance-sheet sum does not lead to overindebtedness if the company can produce a positive liquidity forecast covering the next 12 months. The assessment of the company’s situation is based on the “knowledge available to a prudent manager at the specific date.”8 A margin of judgment is allowed for the liquidity forecast. However, it should fully comply with insolvency law to exclude liability risks for the company’s leadership.

The going-concern forecast derives from the profit-and-loss and cash-flow forecasts. It requires directors to estimate earnings and expenses, if and when customers pay, and whether financing inflows come in, among others. Therefore, the courts accept a degree of uncertainty. To address these uncertainties, the courts differentiate between two sources of inflow: shareholders and third parties.

Imminent Insolvency

A third ground for filing is imminent insolvency. A debtor is deemed to face imminent insolvency if it is likely that he will be unable to meet his payment obligations on the date of their maturity. The forecasting period is generally 24 months.9 Imminent insolvency leads to a right and not an obligation to file. In addition, the statutory period of review can be extended into the future if liabilities can already be identified and individualized. Hence, solid liquidity monitoring and forecasting are crucial. However, managing directors have been charged with fraud in the past (e.g., for the acceptance of prepayments while the company was in a state of imminent insolvency), which also applies in the case of a negative 12-month going-concern forecast.

Shareholders’ Contributions

When a shareholder wants to vouch in front of third parties for the financing of its subsidiaries or offers to provide additional cash, he or she might consider signing a letter of comfort. Letters of comfort alone can therefore turn a negative going-concern forecast into a positive one. However, they need to be legally binding.10 “Soft” letters, which only declare the intention of the parent company to cover for the subsidiary, are, in principle, not enough. Management can only rely on them if payment is more likely than not. The creditworthiness, special interests and previous conduct of the shareholder are used to assess this probability. The burden of proof, however, remains on the directors. When your neck is on the line, nothing is more reassuring than “legally binding.”

Third-Party Contributions

On the other hand, third-party contributions can be considered as soon as the chance to receive them overcomes the threshold of a 50 percent probability. Hence, management has some leeway in forecasting liquidity resulting from third-party contributions. However, these forecasts need to be monitored and adjusted in short intervals to the actual occurrence or cancellation of cash flows, especially if the company’s liquidity situation keeps deteriorating.11

Hedging the Risk in Cross-Border Businesses

Most directors of German companies are unaware and cautious of their duties and liabilities during a crisis at their full complexity, despite being threatened by criminal and civil liability risks. These risks are even larger if leaders of cross-border businesses are directors on paper of portfolio companies, investment vehicle entities and local subsidiaries, but are likely not involved in the day-to-day business of every subsidiary. Hence, they often become targets of the above-mentioned fines and penalties. Other usual suspects are acting managing directors and board members with special knowledge.

The best practice in this sense is to not only closely monitor cash flows but also to keep a diligent recording of fluctuations and adjustments. The burden of proof of prudent business management lies with managing directors — or whomever acts as such. Local advisors, both from the legal and financial side, are key to ensuring that all activities done and measures taken are sufficient to meet legal obligations. Better safe than sorry.

Simon Eickmann, a partner with PLUTA Management GmbH in Munich, is a financial advisor to companies in restructuring and bankruptcy. He studied business administration in Bayreuth, Beijing and Hamburg, focusing on finance, accounting and controlling. Bella Jiménez is a consultant in the same office and specializes in restructuring and distressed M&A.