German corporate bankruptcy law will soon undergo a major reform when the proposed Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen (ESUG, or the Company Restructuring Facilitation Act) passes through legislation. The objective of the ESUG is to facilitate the restructuring of companies, strengthen the role of creditors and advance debtor-in-possession (DIP) type orders (eigenverwaltung) and reorganization plans (insolvenzplan). In addition, the ESUG will expand the special protection of central counterparties in financial systems and increase the efficiency of insolvency courts. The ESUG could be enacted as early as the fall of 2011, and aims at preventing forum shopping out of Germany.
The ESUG’s general approach is to improve restructuring tools that are already available but are currently underutilized. At present, in many traditional German corporate reorganizations, once the insolvency petition is filed, the insolvency court still appoints an independent preliminary insolvency administrator to secure the estate. During the weeks following the appointment, the preliminary administrator reviews the grounds of the petition and the court commences or refuses to commence the (permanent) insolvency proceeding and appoints the (permanent) insolvency administrator in charge of the restructuring. The ESUG intends to leave more control over the debtor’s business with the debtor and his creditors and to enable more DIP orders and (prepackaged) reorganization plans in the future.
Selection of the Insolvency Administrator
A key element of the ESUG deals with the requirement of § 56 of the German Insolvency Act (Insolvenzordnung, InsO) that the insolvency administrator must be independent from the creditors and the debtor. Many insolvency courts interpret “independent” very narrowly and automatically disqualify a potential candidate who has been recommended by any stakeholder for that case. This makes planning the insolvency process very difficult.
In a two-step approach, the ESUG first provides for the mandatory installment of a preliminary creditors’ committee if the debtor has an ongoing business that meets two out of three criteria: (1) at least EUR$2 million in total assets, (2) at least EUR$2 million in total revenues in the preceding financial year and (3) more than 10 employees. However, no preliminary creditors’ committee is appointed if it is inappropriate considering the value of the estate’s assets or if an appointment would cause delays with negative implications for the assets of the (future) estate.
In the second step, the court must hear the preliminary creditors’ committee before appointing the insolvency administrator, unless this evidently prejudices the assets of the estate. If the preliminary creditors’ committee unanimously recommends a certain person as insolvency administrator, the court may only disregard the recommendation if the person is not fit for the position. The court must give reasons for its decision. In particular, the amended Insolvenzordnung will expressly state that an insolvency administrator does not automatically lose his or her “independence,” if he or she has been recommended by a creditor or the debtor, if he or she has advised the debtor in general terms or if he or she has assisted in the preparation of a reorganization plan.
These provisions still leave great discretion to the insolvency court on whom to appoint as preliminary or permanent insolvency administrator. Nevertheless, soon the statute will show clearly that the insolvency court and the stakeholders shall cooperate in the selection of the insolvency administrator.
It will still be advisable to know the court’s practice and sensitivities and adjust the format, reasoning or scope and variety of the recommendation for insolvency administrators, to increase the likelihood of the intended person being appointed.
Strengthening of DIP Rules and Umbrella Provision
Under the ESUG, the debtor and creditors will obtain more control over the insolvency proceeding through new rules regarding the appointment of a DIP and the protective umbrella provision. At present, German insolvency practice very rarely uses DIP orders. In the large majority of corporate restructurings, the insolvency court appoints the preliminary and then the permanent insolvency administrator who has control over the debtor and the debtor’s assets. The ESUG now makes it considerably easier for debtors to be appointed as DIP at the commencement of the proceeding. Contrary to the normal debtor, the DIP is only supervised by a trustee (sachwalter), but keeps full control over his or her assets and business. The trustee is appointed by the insolvency court and is usually a person that would otherwise qualify to be appointed as an insolvency administrator.
Under the ESUG, courts generally have to issue a DIP order unless concrete evidence shows that the DIP order prejudices the creditors (§ 270 InsO). Such evidence is deemed not to exist, if the preliminary creditors’ committee unanimously approves a DIP motion. The preliminary creditors’ committee has to be heard on a DIP motion, unless in the rare case that this would evidently damage the estate. Under current practice, individual creditors can effectively prevent the issuance of a DIP order; this will no longer be the case under the ESUG. A DIP order cannot be appealed. Only the creditors’ meeting—not the creditors’ committee—and individual creditors (under strict conditions) can move for the DIP order to be vacated.
Although these changes relate to the permanent insolvency proceeding, the ESUG also provides greater powers to the future DIP during the preliminary insolvency proceeding (§ 270a InsO). Namely, the insolvency court shall let the debtor freely dispose of his or her assets under the mere supervision of a preliminary trustee. The trustee is responsible for notifying the court if he or she discovers any harm to the estate that could result from the debtor’s conduct during this preliminary insolvency proceeding.
In addition to the insolvency petition, a debtor who is still able to pay his or her current liabilities (imminent insolvency) and whose reorganization seems feasible, may apply for a protective umbrella (§ 270b InsO). The court will then give the debtor up to three months to file a reorganization plan, appoint a preliminary trustee and—if the debtor so requests—prohibit any foreclosure action. The court may issue other protective orders, for example, ordering parties not to withdraw from the estate assets that are subject to security interests. Should the debtor become unable to pay his or her current liabilities, or if the restructuring becomes impossible or upon request of the preliminary creditors’ committee, the court must lift the protection of the umbrella provision and decide on the commencement of the insolvency proceeding. Thus, the protective umbrella may give a debtor that still has some liquidity up to three months to organize his or her restructuring without risking losing control over the business as a result of an enforcement action by uncooperative creditors or the appointment of an insolvency administrator.
Strengthening the Reorganization Plan: Debt-to-Equity Swap Plans Allowed
Besides giving debtors and creditors more procedural rights, the ESUG also makes it easier to restructure a company through a reorganization plan. The most significant change is that under the ESUG, a plan may also affect the rights of shareholders of a corporate debtor. As in many other countries (e.g., the United States), the confirmation of a plan will be able to implement the execution of the equity measures required (e.g., for the various steps of a debt-to-equity swap) even against the will of the shareholders. Until now, a reorganization plan could not directly modify any shareholder rights in Germany.
This change of law, together with the aforementioned procedural improvements for the creditors and the debtor, make a prepackaged reorganization plan a more attractive tool in German restructurings. Creditors and debtors will be able to plan a debt-to-equity swap and work out a reorganization plan—either solely as a DIP (possibly under the umbrella provision) or together with a trustworthy preliminary insolvency administrator—that are more likely to be approved by the court and implemented in the insolvency proceeding.
In addition, the right to object to the approval of a plan and appeal from an order approving a plan is further restricted. Under the ESUG, in order to appeal from an order approving a plan, a stakeholder must make a timely objection, have previously voted against the plan and produce evidence that the plan leaves him or her significantly worse off. Otherwise, the court will not hear any objection or appeal against a plan confirmation by such stakeholder.
Special Protection for Central Counterparty Systems in Financial Markets (§ 104a InsO)
The ESUG reform introduces a new provision to increase the protection of multipolar (i.e., clearing) systems operated by a central counterparty in financial markets. Section 104 para. 2 InsO currently provides that outstanding options, futures, swaps and other financial instruments etc. (“trades”) are terminated and—if subject to a master agreement—netted automatically at the commencement of the insolvency proceeding. Under the ESUG, in order to minimize disruptions from the insolvency of a debtor who is a system participant, the new § 104a InsO entitles the central counterparty (under certain conditions) to transfer the rights and obligations (including financial securities) of the debtor (and his or her client, an indirect system participant) to another system participant. Alternatively, the central counterparty may close out each trade with the debtor (and also the trades between the debtor and his or her client) by entering into a reciprocal countertrade with such debtor and then setting off the mutual claims. Only if the central counterparty neither transfers nor closes out the trades with the debtor does § 104 para. 2 InsO still apply. This provision will enable the central counterparty to settle all trades of an insolvent system participant quickly, in order to protect the system from the delays and the uncertainty involved with having open trades with an insolvent participant. However, the central counterparty is liable to the insolvency creditors of the debtor, if it can be shown that the transfer or close-out netting prejudiced the insolvency creditors.
Additional changes that will occur under the ESUG, which will not be discussed at length here, include the concentration of insolvency judges to larger courts and the introduction of an Insolvency Statistics Act. This change in particular has been the subject of much political discussion.
The ESUG reform has promise to remarkably improve the legal framework for corporate restructurings. Political discussions about some of its details continue, but most points of the ESUG proposal are final: The creditors and the debtor will find it easier to base a corporate restructuring on a prearranged concept, which may also curtail the rights of shareholders in the debtor. We will see whether these incentives lead companies with German “center of main interests” to file insolvency petitions in a timely manner and to submit earlier to the protection that German insolvency law offers. In any event, the passage of the ESUG seems almost certain to result in more restructurings through reorganization plans than before.