The New German Rules on International Insolvency Law

In March 2003, Germany, for the first time in its legal history, adopted a comprehensive set of statutory rules
governing cross-border insolvencies. In light of the intense economic relations between the United States and
Germany and the growing number of bankruptcies in both countries, the new legislation will be of significant
practical relevance for U.S. and German bankruptcy practitioners alike.

</p><h3>Brief Historic Overview</h3>

<p>Ever since the original German Bankruptcy Code became law in 1879, German bankruptcy proceedings have
claimed universal effect on all of the debtor's assets worldwide. By contrast, German courts have held for almost a
century that bankruptcy proceedings pending abroad had no effect on assets located in Germany, except as provided
in some rare bi-national treaties. This "territorial" approach to foreign bankruptcy proceedings faced increasing
criticism from legal scholars during the decades after World War II. Nevertheless, it was not until 1985 that the
German Federal Supreme Court changed course and held that foreign bankruptcy proceedings are to be given effect
in Germany, subject only to considerations of international jurisdiction and German public policy. The courts
subsequently developed a body of case law refining this principle. However, many details remained unclear, in
particular with respect to the exact scope of application of the foreign country's bankruptcy law.

</p><p>The situation did not change much when in 1999 the German Bankruptcy Code was replaced by a new act,
known as the Insolvency Code. To be sure, one provision in the Introductory Act to the Insolvency Code affirmed
the principle that foreign bankruptcy proceedings are recognized in Germany subject to the foreign bankruptcy
court's international jurisdiction and subject to German public policy considerations. However, most of the specific
implications of this principle were not addressed. This legislative self-restraint was due to the fact that efforts were
underway on a European Union (EU) level to create a body of EU-wide international insolvency law. The German
legislative authorities considered it wise to await the completion of this European process.

</p><p>The EU-wide efforts came to fruition in 2000 when the Council of the European Union adopted the EC
Regulation on Insolvency Proceedings. The EC Regulation became law on May 31, 2002, in all EU member states
except Denmark. In a nutshell, the EC Regulation deals with the effects in one member state of insolvency
proceedings initiated in another member state. The Regulation therefore has no relevance for U.S. bankruptcy
proceedings and their effects in Europe, nor does it address the effects an insolvency proceeding opened in a EU
member state has in the United States. The same applies in relation to other non-EU countries such as Canada or
Japan.

</p><p>Soon after the EC Regulation had come into force, the German legislative authorities turned their attention
to the goal of promulgating a set of German international insolvency rules. Following a swift legislative process,
the new rules—which were incorporated into the Insolvency Code as a separate chapter—became effective on March
20, 2003. The new German rules are preempted by the EC Regulation wherever the latter is applicable. Thus, the
effects in Germany of an insolvency proceeding in Britain or France are exclusively governed by the EC Regulation.
By contrast, when it comes to assessing the effects of U.S. or Canadian proceedings in Germany, the new German
legislation controls.

</p><h3>Automatic Recognition of Foreign Proceedings</h3>

<p>Of the new statutory provisions, the most fundamental one is §343 of the Insolvency Code. Like its
predecessor in the Introductory Act to the Insolvency Code, this provision states that the opening of a foreign
insolvency proceeding is recognized in Germany, unless the foreign country lacks jurisdiction according to German
jurisdictional rules and unless the recognition would be manifestly incompatible with German constitutional rights
or other essential principles of German law.

</p><p>In analyzing this provision, it is important to note that the foreign insolvency proceeding is recognized
automatically. No exequatur judgment or other confirmatory action by a German court is necessary to bring about
the recognition of the foreign proceeding in Germany. Instead, an exequatur judgment is necessary only if
enforcement measures are sought on the basis of a foreign insolvency decree. This is the case, for example, if a
foreign receiver seeks to compel the debtor to hand over assets that are located in Germany and are in the debtor's
possession. It is equally noteworthy that recognition of foreign insolvency proceedings is not tied to reciprocity.

</p><p>While §343 is silent as to what does and does not constitute an "insolvency proceeding," one can infer
from the legislative materials that this term is meant to encompass reorganization proceedings as well as
proceedings aimed at a liquidation of the debtor. Chapter 11 proceedings are therefore covered as well as liquidations under chapter 7.

</p><p>Section 343 refers to the "opening" of a foreign proceeding. This is based on the notion that a bankruptcy
judge, following a petition by the debtor or one of its creditors, issues a decree to the effect that the insolvency
proceeding is formally opened (or, to put it differently, that the debtor is formally "declared insolvent"). This
concept, deeply rooted as it may be in the domestic bankruptcy laws of Germany and many other European
countries, is obviously not the reality in U.S. bankruptcy proceedings under chapter 11 or chapter 7. However,
§343 does not expressly require that the foreign bankruptcy proceeding be opened by a "court." Hence, the
commencement of the proceeding with a petition filed by the debtor or a creditor (in the latter case accompanied by
the "order for relief" entered by the bankruptcy court) should be sufficient. Although no published German court
decision has ever confirmed this, it is therefore fair to conclude that chapter 11 and chapter 7 proceedings, once
commenced in accordance with the applicable provisions of the U.S. Bankruptcy Code, can be deemed "opened" for
the purposes of §343 and are thus eligible to enjoy automatic recognition in Germany.

</p><p>A possible obstacle to the recognition of some U.S. bankruptcy proceedings in Germany is the "lack of
jurisdiction" exception provided in §343. German courts will accept their own jurisdiction to open bankruptcy
proceedings only if the "center of the debtor's independent economic activity" or, if there is no independent
economic activity, the debtor's seat or residence is in Germany (see §3 of the Insolvency Code). Pursuant to §343,
recognition of a foreign insolvency proceeding in Germany requires that the courts of the foreign country meet the
same test. This means that U.S. bankruptcy proceedings will not be recognized in Germany if the U.S. court has
based its jurisdiction only on the fact that the debtor owns certain assets in the United States or conducts some
limited commercial activity there. By contrast, the "lack of jurisdiction" exception will not be an issue if the debtor
in the U.S. proceeding is a U.S. entity whose main presence is in the United States. In other cases, the situation
may be less clear. For example, if the debtor is a German entity with a U.S. parent and all or most management
decisions of the German debtor are made in the United States, an argument can be made that jurisdiction under the
applicable German rules is vested in the U.S. courts, and that therefore a proceeding pending in the U.S. court is
recognized in Germany. One can infer from the wording of §343 that the burden of proof lies with the party who
claims that the foreign court lacked jurisdiction.

</p><p>The other exception to recognition under §343—incompatibility with German constitutional rights and
other essential principles of German law—will not normally be an issue in relation to U.S. bankruptcy proceedings.
This exception might prevent recognition in cases where the foreign bankruptcy law discriminates against German
creditors, such as where due-process rights are violated.

</p><h3>Effects of Foreign Insolvency Proceedings in Germany</h3>

<p>Sections 335 ss. of the Insolvency Code govern the effects in Germany of a foreign insolvency proceeding
that is recognized by virtue of §343. The principle is set forth in §335: Except as otherwise provided, the effects of
the foreign insolvency proceeding in Germany are governed by the laws of the jurisdiction where the proceeding has
been opened. The provisions following §335 state some important exceptions to this principle. By way of example,
the effects of the insolvency proceeding on purchase or lease agreements with respect to real property are governed
by the laws of the jurisdiction in which the real property is located; a creditor who has a right of setoff under the
law governing his debt vis-à-vis the debtor remains entitled to setoff irrespective of the foreign insolvency law; a
transaction that is subject to avoidance under the foreign insolvency law on fraudulent transfer or preference grounds
is exempt from avoidance if it is not subject to avoidance or similar challenges under the laws governing the
transaction itself; and the foreign insolvency proceeding has no effect on a creditor's security interest in collateral
located in Germany.

</p><p>As a consequence of these rules, the automatic stay triggered by the commencement of U.S. bankruptcy
proceedings is enforceable in Germany, save to the extent that any of the exceptions set forth in §335 ss. applies.
Specifically, the debtor will be able to use the automatic stay as a defense against a lawsuit filed against the debtor
in Germany and against an enforcement in Germany of a pre-petition judgment obtained against the debtor. To the
extent that termination notices by a creditor and <i>ipso facto</i> termination clauses are considered unenforceable under
U.S. bankruptcy law, their effect in Germany will be deemed suspended as well (except of course to the extent that
they fall within one of the exceptions provided in §335 ss. as discussed above). The automatic stay will not,
however, prevent a creditor from foreclosing on collateral in Germany under a pre-existing security interest, nor will
it be in the way of a creditor exercising a right of setoff that is available under the laws governing the creditor's
obligation to the debtor. Needless to say, any creditor who considers taking advantage of the exceptions to the
automatic stay under §335 ss. should carefully evaluate the risk of being held in contempt by the U.S. Bankruptcy
Court. The same applies to any creditor who, in a case where the U.S. bankruptcy proceeding is not recognized in
Germany by virtue of the "lack of jurisdiction" exception, considers ignoring the automatic stay altogether.

</p><h3>Secondary Proceedings in Germany</h3>

<p>Even if a pending foreign bankruptcy proceeding is recognized in Germany under §343 of the Insolvency
Code, creditors as well as the foreign insolvency administrator can apply to the competent German court for the
opening of a German insolvency proceeding whose effects are limited to the debtor's German assets. However,
unless the debtor has an "establishment" (most notably, a branch office) in Germany, creditors have this right only
if they can show that their position in the foreign proceeding is likely to be substantially weaker than it would be in
the German proceeding. A separate question arises if, as is typically the case in chapter 11 proceedings, there is no
"administrator" (or "trustee," "receiver," etc.) in the foreign proceeding. Although the new statutory provisions as
well as the legislative materials are silent on this issue, it seems reasonable to argue that in this case the
debtor-in-possession (DIP) has the right to request the opening of a secondary proceeding in Germany. So far,
however, there is no case law clarifying this point.

</p><p>A secondary proceeding in Germany paves the way for a comprehensive application of German insolvency
law with respect to the debtor's assets. Therefore, creditors as well as foreign administrators (or DIPs) may see a
benefit in initiating such a proceeding if they determine that the applicable German rules are more favorable to their
position than the foreign rules that would otherwise apply.

</p><h3>Conclusion</h3>

<p>This article is no more than a brief introduction to some of the key aspects of the new German legislation
on cross-border insolvencies. There is little doubt that the courts will substantially refine the new rules in the next
few years with active help from practitioners in the United States, Germany and other countries.

</p><hr>
<h3>Footnotes</h3>

<p><small>^{<a name="1">1</a>}</small> Alfried Heidbrink is a partner in the Berlin office of Freshfields Bruckhaus Deringer. <a href="#1a">Return to article</a>