New German insolvency code

June 2012 | TALKINGPOINT | BANKRUPTCY & RESTRUCTURING

financierworldwide.com

FW moderates an online discussion on Germany’s new insolvency code between Joachim Englert at PricewaterhouseCoopers AG, Annerose Tashiro at Schultze & Braun, and Andreas Lehmann at Squire Sanders.

FW: Could you explain the key elements of Germany’s new insolvency code? What are the main objectives of the reforms?

Lehmann: As of 1 March 2012, the German Insolvency Code (InsO) has been amended by the Law for the Further Facilitation of the Restructuring of Enterprises (ESUG). This reform addresses some major deficiencies of the German insolvency regime, including the general lack of predictability of the proceedings. It also addresses the limited influence of stakeholders, for example over the appointment of the insolvency administrator, and the unavailability of debt-equity swaps without shareholders’ cooperation. Further, it addresses the unpredictability of insolvency plan implementation due to obstruction by individual creditors, and the limited role of self-administrations. Key elements of ESUG are the early involvement of the preliminary creditors committee as well as the streamlining and strengthening of the role of self-administrations and insolvency plan proceedings, including the possibility of debt-equity swaps.

Tashiro: The purpose of the new law is to facilitate the reorganisation of distressed companies. The expansion of creditor participation in insolvency proceedings represents one of the central aspects. The introduction of a preliminary creditors committee in insolvency proceedings as a key feature allows that it may influence the selection of the insolvency administrator. In a related change, an insolvency administrator may no longer be ruled out as insufficiently independent simply because he or she was proposed by the debtor or a creditor or had generally advised the debtor prior to the filing of the insolvency petition. The ESUG has further developed and streamlined the insolvency plan procedure. The new consideration of shareholders’ rights is significant. Shareholders now form a group of creditors and are allowed to participate as interested party.

Englert: The changes made by ESUG provide a move towards strengthening the position of debtors and increasing the predictability of proceedings for creditors, in response to criticisms of the previous German insolvency law from both angles and thereby increasing the likelihood of a restructuring rather than a liquidation in an insolvency proceeding. Key elements from a debtor perspective include the strengthening of the debtor in possession concept and the newly established protective shield proceeding (‘Schutzschirm’). Both will act to move the law closer to a debtor friendly US-style concept. In theory, both concepts – together with the changes made to the insolvency plan proceeding – should allow for more successful implementations of ‘pre-packed plans’. Key elements from a lender’s perspective are the opportunity to influence the appointment of the administrator and the opportunity to form a preliminary creditors committee. Creditors will certainly use this influence to get a more business oriented and going concern oriented administrator appointed. It is hoped that this will improve the predictability of insolvency proceedings.

FW: What options are now available to companies entering formal restructuring proceedings in Germany?

Tashiro: As for the ‘old’ rescue sale, insolvency plan procedure and winding-down options, debtors and creditors are both to be given more certainty in planning with respect to the course of insolvency proceedings. Opportunities for obstructing insolvency proceedings are also to be limited. However, the ESUG puts various measures into place in order to make self-administration, or debtor-in-possession, more attractive and even the rule. A debtor is now entitled to have self-administration ordered in cases in which factors which would militate against this process cannot be positively established. Recently, the debt-equity swap has gained importance as a means of restructuring the balance sheet. Now, claims by creditors may also be converted to shareholder rights in the corporate debtor as part of insolvency plan proceedure even without the cooperation of the legacy shareholder. This results in a debt-equity swap over the objection of the legacy shareholder – previously this had only been possible with the cooperation of the legacy shareholder.

Englert: Companies can enter into the newly created ‘Schutzschirm’ proceeding, a kind of pre-insolvency proceeding which provides an automatic stay before an administrator has been appointed. The new proceeding will act to protect both the interests of debtors and creditors at the critical time of distress before an insolvency appointment is made. For the regular insolvency proceeding, agreement for self administration is generally now the rule, if requested, and not the exception as it was previously. All these changes aim to make managing directors file earlier for insolvency protection, thereby making a successful restructuring more likely. But in fairness to ‘Übertragende Sanierung’, the historically common tool in German insolvency cases, it does not act to save the company but at least to save the business itself – protecting jobs and securing ongoing trade. Interestingly enough, even in the US, 363-sales are becoming more and more favoured as a tool to use.

Lehmann: The new option introduced by ESUG, the so called ‘protective shield proceedings’ (‘Schutzschirmverfahren’), means that a debtor, who is not yet illiquid and can provide an expert opinion that the proposed restructuring is not evidently futile, can request that the insolvency court allows a self-administration for a period of up to three months, during which time the debtor has to present an insolvency plan. The debtor can request that the court protects it from creditors’ enforcement actions and allows it to create estate claims (‘Masseverbindlichkeiten’) in the future insolvency proceedings. Upon submission of the insolvency plan, formal insolvency proceedings shall also be opened with the debtor’s self-administration. These new arrangements should give the debtor’s management some comfort in that by entering into formal proceedings early on they will be able to retain control over the process.

FW: What is the function and purpose of the preliminary creditors committee? Could you outline the increased influence creditors having in appointing insolvency administrators, and why is this important?

Englert: Under the new regime, lenders will have the opportunity to form a preliminary creditors committee (§ 22a InsO) even before the proceeding has been officially established, thereby increasing their influence on a proceeding with regards to the appointment of the administrator (§ 56a InsO). A preliminary creditors committee is required to be established when the case meets certain size criteria. The composition of the committee is subject to court ruling. From a business perspective the ability of the lender to influence the appointment of the temporary insolvency administrator is significant. Creditors will certainly use this influence to get a more business oriented and going concern oriented administrator appointed rather the ‘next man on the court’s list’. In the event that a legitimate proposal is made by the preliminary creditors committee, the courts are bound by such proposals. It is hoped that this will improve the predictability of insolvency proceedings.

Lehmann: Given the strong position of the insolvency administrator during the whole insolvency proceedings, the lack of predictability and of creditor influence on who will be appointed as preliminary insolvency administrator has been one of the most criticised aspects of the former InsO. Under ESUG, in insolvencies of major corporations with an ongoing business, a preliminary creditors committee will be established to identify criteria for the appointment of the preliminary insolvency administrator and also to make a recommendation on who shall be appointed. The insolvency court shall only be entitled to reject a unanimous recommendation of the preliminary creditors committee when the proposed person is not qualified for the position or not sufficiently independent of the debtor or the creditors. The preliminary creditors committee also has the right to replace a preliminary insolvency administrator who has been appointed without its involvement. Furthermore, the preliminary creditors committee shall be consulted in the decision on self-administration.

Tashiro: As part of the preservation measures, a preliminary creditors committee must be appointed by the court if the debtor satisfied two-thirds of the thresholds during the prior financial year: total assets of €4,840,000, turnover of €9,680,000, or at least 50 employees on average. The debtor, the preliminary insolvency administrator or a creditor may apply, provided that a complete listing of its creditors marking the persons who may be considered for the preliminary creditors committee is attached and the application includes declarations of consent from the potential members. Besides its supporting and supervising function, the provisional creditors committee must be heard on the selection of the insolvency administrator. In addition, unanimous suggestions by the provisional creditors committee on the person to be appointed may only be refused by the court, in the event that individual is incapable. Should the provisional creditors committee stipulate the criteria for the insolvency administrator, the court has to observe them and base its selection on them.

FW: What are the new rules and procedures surrounding debt-equity swaps? Should this help to facilitate corporate restructurings?

Lehmann: ESUG allows corporate restructurings as part of an insolvency plan, permitting shareholders to be included in the plan as a separate group. A debt-equity swap can thus become part of an insolvency plan. Should the shareholders vote against such plan, the insolvency court will be able to overrule their rejection in many circumstances. So, ESUG cancels the hold-out position shareholders could exercise before effectively blocking any debt-equity swap. It is expected that because shareholders are now subject to a potential debt-equity swap scenario in an insolvency plan, they may, even prior to formal insolvency proceedings being initiated, be more receptive to agree to an out of court restructuring by way of a debt-equity swap.

Tashiro: Claim holders may acquire participation in a company by either increasing capital through in-kind contributions, or via a share deal. Previously required cooperation of the legacy shareholders is no longer required. Respective shareholder rights may be impaired and crammed down by the insolvency plan. The ability to force a change in share ownership had previously been rejected by lawmakers. Compared to other reorganisation vehicles, the debt-equity swap offers a series of advantages, including the elimination of potential over-indebtedness, an increase in the debt-to-equity ratio and a decrease in financing costs, resulting increases in profitability and company creditworthiness, and retention of the operating entity. Especially in cases where the operation is not too distressed, and the insolvency is only caused by a balance sheet test, this will be very effective. Here, Germany is following trends in the UK and US.

Englert: The majority of the new rules aim to further increase the likelihood of a successful restructuring of a company in crisis which has been put into a formal insolvency proceeding. This is attractive to debtors as well as certain creditors. In an insolvency proceeding, the method of recovery for the business would normally take the form of a formal restructuring or insolvency plan, similar to Chapter 11 in the US. Under the old regime, insolvency plans were rarely used as a restructuring tool as the legal framework made them difficult to implement in practice. Under the new regime, equity holders have become recognised as a class of claim in the insolvency plan proceeding. By allowing equity holders to be crammed down just like any other claims holder, debt-equity swaps have therefore become much more easily to establish and the insolvency plan proceeding becomes a much more attractive tool, especially for debt holders, and more particularly for ‘loan-to-own’ investors. All this will help to facilitate corporate restructurings.

FW: Do you expect to see a rise in the number of companies applying for self-administration? What are the benefits of doing so under the new code?

Tashiro: There will be a most certainly a rise in the number of self-administrations. The former percentage was very small. In the past, doubts with regard to ordering self-administration have always been resolved against the debtor. An application could be rejected merely due to concerns on the part of the court. By contrast, under the ESUG, self-administration must be ordered if no circumstances which could lead to the creditors being disadvantaged are known. Therefore, the court is obliged to determine specific facts – grounds for rejection of an application must be given. There is thus a right to have self-administration ordered. As a result, self-administration, where it is applied for, will become the legal norm and the appointment of an insolvency administrator will by contrast become the exception. With the self-administration, debtors can hire their own in-house insolvency expert for the in-court insolvency proceedings and do not have to rely on the external insolvency administrator. This expert will then deal with the custodian appointed to oversee the self-administration. In that respect, prior preparation of the restructuring concept and some certainty in the implementation are the great advantages of self-administration.

Englert: Under the new regime, acceptance of self administration is generally the rule, if requested, and not the exception as previously. This should remove a common fear of the management teams that an outsider, namely the administrator, takes over all power and leaves the management team behind. This will also help to facilitate the focus on business issues rather than legal issues, thereby increasing the chance of implementing going concern solutions. The strengthening of self administration should also help to overcome cultural issues in Germany with regards to the stigma attached to insolvency. With management teams staying in power, negative effects on reputation and trading can be minimised, especially when management is supported by an active communication strategy. Overall, only experience with real life cases will show if the changes to the law will help to remove the ongoing stigma of insolvency in Germany, where the association of a company or brand with insolvency can have devastating consequences on the ability to continue trade.

Lehmann: ESUG allows the management of companies that can be restructured, and which have the respective support of the creditors, to use the protective shield proceedings and the self-administration process to maintain control over the business through the insolvency. How often this opportunity will be used in the future will depend on the outcome of the first proceedings under the new regime. If, as expected, restructurings are initiated earlier so that the likelihood of success is higher, and the outcome of the proceedings is in fact successful, a new culture of restructurings using self-administration could develop. However, self-administration can only work for those companies that can successfully be restructured, so it will not be available in all those situations where the debtor’s business is not viable and not a suitable restructuring case.

FW: To what extent have the new rules come under criticism?

Englert: The new rules have just been established. However, in another round of changes to the German insolvency law one might hope that, for example, a concept of ‘group insolvency’, such as the ‘substantive consolidation’ concept which exists under the US Bankruptcy Code, and a restructuring tool like a ‘Scheme of Arrangement’ as we know under English law, will be implemented. This is especially relevant in light of the latest court decisions in Germany, where efforts to cram down bondholders using the new German ‘Schuldverschreibungsgesetz’ have been blocked. Other helpful improvements for future changes to the law might be certification for administrators and concentration of insolvency courts. Another shortfall is funding of proceedings – this will remain difficult as long as priority rules are not changed. Finally, the future of the over indebtedness test as reason to file for insolvency has not yet been decided. Discussions are ongoing, however it is clear that temporary solutions have not been very helpful in trying to solve restructuring cases.

Lehmann: Initially, it had been proposed in the draft ESUG to reduce the number of insolvency courts in Germany. The fact that this proposal was not incorporated into the final law is seen by many as a missed opportunity to improve the professionalism of the insolvency courts and judges. Also, insolvency judges question the practicability of the new rules regarding the preliminary creditors committee, and insolvency administrators have voiced concerns that influential creditors, in particular banks, may install insolvency administrators who have a track record of not pursuing voidance claims against such creditors. Others are concerned that the protective shield proceedings may not be used in practice because formal insolvency proceedings will generate publicity. Having said that, the vast majority of restructuring and insolvency practitioners in Germany views ESUG positively and agrees that, if properly applied, it will provide a useful tool kit for future restructurings.

Tashiro: There are always people who complain that new rules are too extensive or too narrow. However, overall the perception is fairly positive and professionals are almost enthusiastic about the opportunities with ESUG. Creditors’ rights are now more restrictive. It has become a real challenge to effectively oppose, for example, an insolvency plan, but this serves the purpose of restructuring struggling enterprises.

FW: What issues have arisen in terms of courts and judges applying the new rules? For example, have there been any recent cases where it was decided not to use the new rules?

Lehmann: ESUG is law, and will therefore of course be applied by all courts and judges. In fact, in many cases insolvency courts have already applied, to the maximum extent possible under InsO, the new rules before ESUG became effective in March 2012. However, ESUG can be, and has been, applied in ways which, though in accordance with the wording of InsO, nevertheless contradict the legislator’s intention and the spirit of the law. One example is the Q-Cells insolvency, where the insolvency judge did not appoint the preliminary insolvency administrator proposed by management and supported by those creditor representatives present at the court at the time of the insolvency filing. He also did not involve the preliminary creditors committee in his decision whom to appoint, as requested by ESUG, stating that “such committee has not yet been constituted and that there are doubts whether the proposed constituency would comply with the statutory requirements for such a committee”. In a subsequent insolvency case, however, the same insolvency court fully applied the new ESUG rules in accordance with the insolvency filing, which shows that there is also a learning process for the parties involved.

Tashiro: There is little in the way of case law or decisions at this stage. The new rules apply to all proceedings commenced on or after the 1 March 2012. The new rules are the law now, no matter what. The judges will become more involved in the insolvency plan procedure, which previously had been a task undertaken by the clerks. Also, it will be necessary to learn how to effectively set up the new provisional creditors committees and organise them so that they can effectively do their job, especially in respect of nominating an insolvency administrator. This is, however, a learning-by-doing process. Creditors and courts will get used to it and develop practical measures.

Englert: Early cases clearly indicate that the new rules are being well received, with Dura Tufting and Drescher being dealt with under a self administration regime and with administrators for Draftext and ADA Systemhaus being ‘selected’ by the creditors. Only time will tell if judges accept the creditors’ increasing influence on administrators’ appointments. Self administration can only gain support in the future if cases are being handled by savvy management teams augmented with experienced restructuring advisers. Although the idea of ‘Schutzschirm’ proceeding appears to be in line with other jurisdictions, for example France, such proceedings appear to be difficult to handle due to legal risks. Self administration appears to be the way to go.

FW: Overall, do you believe the new rules will benefit Germany as a forum for insolvency proceedings?

Tashiro: Two of the major criticisms against German law have been diminished – namely, the influence of creditors on appointing the insolvency administrator and the possibility of pushing through a debt-equity-swap against the old shareholders. The cooperation and interrelation between creditors and the court is a new field of experience and practice for everyone involved, but once people have learned how to use it, it will be a positive development.

Englert: Overall, we have not seen many cases of bankruptcy tourism or forum shopping in insolvency proceedings over the past 12 to 24 month. Only the UK scheme of arrangement as a tool to restructure certain classes of debt has encouraged cases to move away from Germany, with Schefenacker, Rodenstock and PrimaCom being the most notable examples. Given that the new law does not provide for a similar instrument, this is unlikely to change going forward. However, the new German insolvency law provides a more attractive toolset to restructure a company and, therefore, there is a hope that managing directors and restructuring advisers will use the new law much more proactively than in the past, leaving insolvency not only as a last resort but making it an instrument to help restructure and rescue companies.

Lehmann: In the past, the unfavourable legal framework had created reservations about investment in the German marketplace – in particular among Anglo-Saxon investors who are used to having control over the process in an insolvency. ESUG improves the German legal framework to internationally accepted standards. We anticipate a lot of interest by foreign investors in ESUG and the new options it allows, and hope that the first success stories of positive implementation of the new tools will be seen soon. Provided that the new framework works in practice, those investors should no longer see a ‘country risk’ for investment in Germany based on the insolvency laws, which in turn should result in more financing from international investors being available in Germany. This will benefit the whole country and its economy much more than just the insolvency law regime.

Dr Joachim Englert is partner in PwC’s restructuring practice in Germany. He specialises in financial restructurings and operational turnarounds, IBRs and going concern analysis (‘Sanierungsgutachten’). He has extensive experience in the development and execution of strategic, operational, and financial improvement initiatives for comprehensive value creation, both for debtors and lenders. He can be contacted on +49 (0) 69 9585 5767 or by email: joachim.englert@de.pwc.com.

Dr Annerose Tashiro is a partner at Schultze & Braun. She specialises in cross-border corporate recovery and insolvency work and is the head of Schultze & Braun’s International Team. She has acted domestically and internationally for many companies involved in debt restructuring and turnaround as well as working for office holders on several high profile German and international insolvencies. She can be contacted on +49 7841 708 235 or by email: ATashiro@schubra.de.

Andreas Lehmann is a partner based in Squire Sanders’ Frankfurt office and a member of the firm’s financial services and restructuring & insolvency practice groups. His practice focuses on financial services and corporate finance transactions, covering all aspects of debt financing including syndicated loans, corporate bonds, securitisations, receivables finance and asset based lending. He regularly advises on corporate and financial restructurings and (pre-)insolvency situations, and has represented bondholder committees and advised opportunity funds and other investors on the acquisition of NPLs and on other distressed investments in Germany and also worked on the refinancing of real estate acquisitions. He can be contacted on +49 69 17392 420 or by email: andreas.lehmann@squiresanders.com.

THE PANELLISTS

Joachim Englert

PricewaterhouseCoopers AG

Annerose Tashiro

Schultze & Braun

Andreas Lehmann

Squire Sanders