Germany Failed to File Go Directly to Jail

Journal Issue

Dec/Jan 2005

Column Name

Citation

ABI Journal, Vol. XXIV, No. 10, p. 18, December/January 2006

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Editor's Note: In this European Update, we highlight the considerable personal
liability risk to directors of German companies that do not
commence a bankruptcy proceeding within the time limits required by
German law. U.S. practitioners need to be aware of this risk in any
group restructuring involving a German company. There is also a note on
the new debt subordination measures in Spain and a reaffirmation
of the rescue culture in the United Kingdom. We are all
increasingly under the influence of U.S. chapter 11!

</blockquote>

German insolvency law, although influenced
to some extent by U.S. concepts, still has a number of peculiarities
that may turn out to be pitfalls for the unwary. One of them, which
sometimes causes astonishment among U.S. practitioners, lies in the fact
that managing directors of German companies are under a statutory
obligation to file a petition for the opening of insolvency proceedings
if the company is insolvent. Once insolvency has occurred, each managing
director is required to file the petition without undue delay, but
within three weeks at the latest. A failure to comply constitutes a
criminal offence, punishable by imprisonment of up to three years (if
committed willfully) or up to one year (if committed negligently) or by
a fine of up to 1.8 million Euros (about US$2.2 million), depending on
the perpetrator's income. Furthermore, managing directors who violate
their filing obligation may be liable for damages on grounds similar to
the U.S. concept of deepening insolvency. ("Insolvency" for the purposes
of these rules means either "illiquidity" or "overindebtedness.")

"Illiquidity" is a concept based on a cash-flow test. A company is
illiquid if it is unable to meet its payment obligations when due. For a
long time, there had been some uncertainty as to the level of rigor to
be applied in this test: Does a brief delay in meeting the payment
obligations constitute illiquidity? Apart from the time element, is the
company illiquid if the shortfall in the available cash is relatively
minor? In May 2005, the German Federal Supreme Court clarified these
points as follows: If it can reasonably be expected that the company
will meet its obligations within not more than three weeks from their
due dates, the company is not illiquid. If the cash shortfall amounts to
less than 10 percent of all obligations now due for payment, the company
is considered illiquid only if specific circumstances warrant the
conclusion that the shortfall is likely to increase to more than 10
percent in the near future.

"Overindebtedness," by contrast, requires a balance-sheet test.
Roughly, the company is overindebted if its assets, valued at their fair
market value, are insufficient to cover its liabilities and accruals
(except to the extent that a subordination is in place). If there is a
predominant likelihood that the company will be able to continue its
operations over a period of at least one or two years, the assets may be
valued on the basis of their going-concern values. If there is no such
likelihood, the valuation must be based on liquidation values.

The obligation to file applies to each managing director
individually. A managing director who has failed to comply cannot escape
criminal and civil liability by claiming that he or she was not in
charge of the company's finances but was only responsible for other
departments (such as research and development).

Criminal convictions based solely on a failure to file a petition for
the opening of insolvency proceedings (and without there being some
additional element of fraud or embezzlement) are relatively rare. This
is especially true for cases based on overindebtedness, given the
inherent uncertainties in any valuation of assets. Also, to put things
into perspective, it is fair to say that the actual sentences handed
down in "failure to file" cases are usually far below the maximum
penalties available under the relevant statutory provisions.

Nevertheless, managing directors of German companies would be
ill-advised to take their filing obligation lightly. This warning seems
especially appropriate for executives of U.S. companies who also serve
as managing directors of their German subsidiaries. Experience shows
that too little attention is often paid to the specific duties this
appointment entails. Importantly (especially for readers of this
Journal), executives should also be aware that a chapter 11
petition in the United States, even if it expressly includes the German
subsidiary, will not usually satisfy the filing requirement under German
law. The safe course is to seek advice early so that the considerable
risk that this German filing obligation represents can be properly
managed.

<h4>Spain: Subordination of Creditors under the Spanish Insolvency
Act</h4>

In simple terms, "subordination" is where one creditor does not
receive repayment of its debt until another creditor has (or all other
creditors have) been paid in full. Subordination may arise by reason of
an agreement between the parties or by application of law. This article
considers one of the cases in which subordination of credit rights takes
place by application of law under the Spanish Insolvency Act (Ley
22/2003, de 9 de Julio, Concursal or the Spanish Insolvency Act), which
came into force on 1 September 2004.

When the Spanish Insolvency Act came into force, there was much
interest in the new rules relating to subordination of creditors' rights
in certain situations. However, for the sake of clarity, it should be
pointed out that subordination of credit rights by application of law
already existed in Spain before the enactment of the Spanish Insolvency
Act. Specifically, Circular 5/1993 of 26 March, issued by the Bank of
Spain,<a href="#2" name="2a">2</a> defined
subordination financings and set out the requirements for them to be
considered as equity of credit entities. In addition, Royal Decree-Law
7/1996 of 7 June<a href="#3" name="3a">3</a>
regulates the requirements that a participative loan has to meet in
order to be considered as equity for corporate law purposes. Both of
these measures provide that the debts owing to lenders under these types
of financing rank behind the ordinary creditors of the borrower.

Under the Spanish Insolvency Act, a fundamental distinction must be
drawn between two basic types of liabilities: (a) debts that are deemed
to be liabilities of the estate of the debtor and (b) the vast majority
of debts, which are liabilities of the debtor. Debts that are deemed to
be the liabilities of the estate of the debtor include, among others,
debts arising from continuing the business of the company after
insolvency has been declared, judicial expenses incurred in the course
of the insolvency proceedings, and employee claims for unpaid salary for
the last 30 days of work up to a specified cap. The aggregate amount of
the liabilities against the estate of the debtor will be paid out of the
assets of the debtor (although there are exceptions) and will be set
aside before the other creditors of the debtor are paid.

Claims against the debtor are divided into three main groups: (a)
preferential claims, (b) ordinary claims and (c) subordinated claims.
Within each of these three main groups there are also subcategories of
claims. Ordinary creditors will generally be paid after claims against
the estate and preferential claims have been satisfied, and subordinated
creditors will be paid once the remaining debts have been satisfied in
full. Within each group of debts, each category of debt has priority
over those below it.

The Spanish Insolvency Act ended the uncertainty in Spain as to the
enforceability of subordination where there was opposition of
third-party creditors, as it expressly recognizes the issue and the
effects of subordination. Under the Spanish Insolvency Act, the
following debts will be subordinated:

<blockquote>
(a) claims that are reported late or that are inappropriately under the
rules governing the insolvency proceedings; 
(b) claims that are contractually subordinated to all other
creditors; 
(c) claims with respect to interest (including default interest), except
those secured by mortgage or pledge up to the value of realisation of
the secured asset; 
(d) fines and other economic penalties; 
(e) debts owed to a person "related to" the debtor (see below for more
detail); and 
(f) credit rights rescinded (i.e., terminated) by the commercial
court.
</blockquote>

Probably the most important of these for a U.S. lender who has lent
or intends to lend money to a Spanish company (or a company with its
centre of main interests in Spain) is subordination of credit rights
where the lender is "related to" the borrower. The persons or companies
that are deemed to be related to the debtor and whose rights will be
subordinated include shareholders of the debtor holding at least 10
percent (or 5 percent, in publicly listed companies), companies within
the same group of companies as the insolvent debtor, and shareholders of
a company within the group as the debtor.

<blockquote><blockquote>
<hr>
<big><center>
The Spanish Insolvency Act ended the uncertainty in Spain as to the
enforceability of subordination where there was opposition of
third-party creditors, as it expressly recognizes the issue and the
effects of subordination.
</center></big>
<hr>
</blockquote></blockquote>

Subordinated creditors are not allowed to vote in the creditors'
meeting and, in the case of liquidation, will not be paid until the
ordinary creditors have been paid in full. The effect of insolvency
proceedings on subordinated credits varies depending on the manner of
termination of the insolvency proceedings: settlement (subordinated debt
subject to the terms of the settlement) or liquidation (subordinated
debt subject to the rules on priority and voting set out above).

In our experience, the introduction of the debt-subordination
provisions under the Spanish Insolvency Act has already had an impact on
the structuring of certain leveraged finance transactions. One example
of this is where orphan companies are established so that if the lender
becomes a shareholder or a holder of the voting rights of the borrower
company, it can be argued that the subordination of debt when the lender
is related to the debtor should not apply. The lender would initially
lend to the orphan company, and the orphan company would in turn lend
the funds to the ultimate borrower.

<h4>Administration Expenses: Reaffirming the U.K. Rescue Culture</h4>

The Court of Appeal in England has recently heard three cases4 that
raise an issue of importance to administrators, and indeed to
administration as a restructuring process. The issue concerns the extent
of administrators' liabilities to employees of a company in
administration whose contracts of employment have been "adopted" by the
administrators. Although at first glance this would appear to be quite a
narrow point of law, it has far-reaching consequences for how
administrations are conducted and even for the future of the "rescue
culture" in the United Kingdom.

The court considered whether employees whose contracts were adopted
by administrators had "super-priority" status with respect to the
following payments:

<ul>
<li>liabilities for protective awards under Section 189 of the Trade
Union Labour Relations (Consolidation) Act 1992;<a href="#5" name="5a">5</a> and

</li><li>payments in lieu of notice.
</li></ul>

If they had superpriority status, these liabilities would be payable
in priority to the expenses of the administration and also in priority
to most other debts. As a matter of construction, the Court of Appeal
held that neither liabilities for protective awards nor payments in lieu
of notice were entitled to super-priority status.<a href="#6" name="6a">6</a>

Although the Court of Appeal reached its decision based on
construction of the legislation, it went on to consider the question of
whether protective awards should be given a super-priority status by
reference to the wider context. Administration was introduced as a means
of attempting to rescue potentially viable businesses—hence the
expression "rescue culture." Although it is not a debtor-in-possession
process, it is the closest the English regime comes to a chapter 11
approach. In practice, administrators will often continue the operation
of the business of the company. To do this, they will need to retain
some or all of their employees, and the Insolvency Act provides that
employment contracts of retained employees will be "adopted" by the
administrators 14 days after the appointment of the administrator. If
employees have been dismissed within this 14-day period, they will have
no entitlement to any super-priority status.

The importance of this 14-day deadline can be seen in the speed with
which the Court of Appeal reacted. The appeal was heard on the same day
as the original case, as the administrators of Granville Technology
Group Ltd. (one of the companies making the application) had to decide
whether or not to dismiss more than 150 employees of that company by the
following morning, and that decision was to be determined by the outcome
of the appeal.

The administrator for Ferrotech Ltd., one of the other companies
making an application, explained the implications of an earlier High
Court decision that protective awards and payments in lieu of notice
should be granted super-priority status. He explained to the Court of
Appeal that, if the law was as decided in the earlier case, "the
administrators would not have been able to say, when seeking to put
Ferrotech into administration, that the purpose of the proposed
administration would have been likely to be achieved. That was because
they would have anticipated having 'to make the entire workforce
redundant within 14 days' of their appointment, which would have 'ruled
out from day one the possibility of achieving a sale of the business as
a going concern.'"7 The administrator went on to say that in relation to
retention of employees, there was nothing exceptional about the
administration of this particular company.

If the Court of Appeal had held that protective awards and payments
in lieu of notice did have super-priority status, the administrators of
a company would be more likely to make employees redundant, as the costs
arising out of the adoption of contracts of employment by administrators
would be substantially increased. This would put an increased burden
upon a company already in severe financial difficulties and make the
survival of the business (and long-term preservation of jobs) less
likely. The Court of Appeal in this case has clearly chosen to exercise
what discretion it had in interpreting the legislation in order to
reaffirm the rescue culture.

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> Contributing authors are
Alfried Heidbrink (Berlin), Vanessa Armas (Madrid) and Catherine Derrick
(London). <a href="#1a">Return to article</a>

<a name="2">2</a> Circular 5/1993, de 26
de marzo, del Banco de España, sobre determinación y
control de los recursos propios mínimos. <a href="#2a">Return
to article</a>

<a name="3">3</a> Real Decreto-Ley, de 7
de junio, sobre medidas urgentes de carácter fiscal y de fomento
y liberalización de la actividad económica. <a href="#3a">Return to article</a>

<a name="4">4</a> In the matter of
Huddersfield Fine Worsteds Ltd. (2) Globe Worsted Co. Ltd. sub nom
Gerald Maurice Krasner (administrator of the above-named companies)
v Barry Mcmath (representing the employees of the above-named
companies); In the Matter of Ferrotech Ltd. sub nom Adrian Tipper
(representing the employees of the above-named companies) v (1) David
Kenneth Duggins (2) Robert Hunter Kelly (joint administrators of the
above-named company); In the Matter of Granville Technology Group
Ltd. sub nom Richard Harris (representing the employees of the
above-named company) v (1) Martin Gilbert Ellis (2) Andrew Lawrence
Hosking (3) Leslie Ross (joint administrators of the above-named
company) [2005] EWCA Civ 1072. <a href="#4a">Return to article</a>

<a name="5">5</a> Liabilities for
protective awards may arise where a company has breached the requirement
to consult with union representatives before firing more than 19
employees. A company can only avoid this duty if there are special
circumstances and it has been held that the insolvency itself does not
amount to a special circumstance. Where the consultation obligations
have been breached, an employee can complain to an employment tribunal,
who may make an award of up to 90 days' remuneration. <a href="#5a">Return to article</a>

<a name="6">6</a> The only exception to
this is one category of payment in lieu of notice where an employer
gives proper notice of termination to his employee that he need not work
until the termination date and gives him the wages attributable to the
notice period in a lump sum. In practice, this would be highly unlikely
in the context of an administration. <a href="#6a">Return to article</a>

<a name="7">7</a> Paragraph 42 of the Court
of Appeal judgment. <a href="#7a">Return to article</a>

Journal Authors

Sandy Shandro

Journal Date

Thursday, December 1, 2005 - 12:00

Bankruptcy Rule

2005