Germany's leveraged finance lawyers have welcomed the country's wide-ranging company law reforms. Stefan Kilgus reports

On 26 June, the German Parliament passed the Companies Law Reform Act (MoMiG). While it still needs the approval of the council of states (Bundesrat), the Act is expected to come into force by November.

The reform is far-reaching and primarily affects the two most significant corporate forms in Germany, the private limited liability company (GmbH) and the limited partnership, where a GmbH is the general partner (GmbH & Co. KG), although it also has some effect on stock corporations (AG). The public focus has been on the possibility of using a so-called 'entrepreneur's company' (Unternehmergesellschaft), a special GmbH, which will not require equity contributions but will require retained earnings until a certain equity level has been reached. Also, it will be possible to rely on shareholder lists filed with the commercial register.

While the introduction of MoMiG will mostly affect the corporate practice, its implementation has also been eagerly awaited by leveraged finance lawyers, thanks to an expected clarification of the use of upstream guarantees and securities. As usual in acquisition finance transactions, the purchaser of the target group and borrower will only acquire shares, relying on distributions from the target to serve the bank debt. The lender will also expect to hold security over the operating assets and to see the target group jointly liable under a guarantee.

Under German law, upstream securities and guarantees are critical under capital maintenance rules and destructive intervention rules. In the case of stock corporations (AG), financial assistance rules are also relevant. Capital maintenance rules disallow payments, loans, guarantees and securities to or for the benefit of its parent to the extent they lead to a reduction of the capital i.e. the difference between the assets and the liabilities other than issued capital, below the issued capital. Destructive intervention means a step taken for the benefit of a parent company to remove liquidity or other items, such as client relationships, from a company, if such measure causes the insolvency of the company.

The financial assistance rules prohibit a target company from giving assistance to the purchaser regarding its own acquisition. The target may not grant loans, issue guarantees or securities in view of a purchase of its own shares. The breach of each of these rules may trigger a liability of the defaulting parent company and a personal liability of the directors of the company.

Borrowers have therefore sought to protect against any such breach. Traditionally, the following instruments have been used: (i) post-closing merger; (ii) entry into a domination and profit and loss-pooling agreement; and (iii) limitation language. However, lenders have not always accepted limitation language since it reduces the value of guarantees and securities in an enforcement scenario.

Capital maintenance

Capital maintenance was seen as particularly critical. In a judgment of November 2003, the Federal Supreme Court appeared to disregard virtually all reimbursement claims against beneficiaries of upstream payments with the effect that there was a real risk of a breach of capital maintenance. This judgment was seen to have a widespread effect.

In leveraged finance transactions, upstream guarantees and securities were seen as critical, given that the reimbursement claims against the shareholder would have to be disregarded for insolvency. There was even a growing argument that domination and profit and loss pooling agreements would also have to be disregarded in case the shareholder was not in a position to serve the debt at least in case of an insolvency of the subsidiary (as would be expected in case of an acquisition vehicle).

Cash pooling systems were also seen to be affected, even though they were generally thought to be of benefit for each member of a group. MoMiG will clarify the position. Reimbursement claims will have to be reflected in principle. Hence, the scope of limitation language can be narrowed.

Domination and profit and loss pooling

Also, the current language of MoMiG means that the mere existence of a domination agreement or a profit and loss pooling agreement will mean that the capital maintenance provisions and hence the financial assistance provisions will not apply. Hence, these instruments can be used in the same way as a merger. This applies not only to the corporate forms of GmbH and GmbH & Co. KG, but also to AGs.

Destructive intervention

The reform has not addressed destructive intervention. Borrowers were concerned, since lenders were largely unwilling to accept limitation language. However, in two recent judgments (Trihotel and Gamma), it has become clear that the Federal Supreme Court accepts upstream securities to the extent that it is unlikely at the time of creation that they will be enforced. The same should apply to upstream guarantees. Hence, these rules should not be critical in typical leveraged transactions, where the bank case allows for repayment of the facility in accordance with its terms.

The reform also deals with the rules of statutory subordination of shareholder debt. Under these rules, shareholder debt was given a rank junior to all other debt in case of a crisis of the company.

Subordination of all shareholder debt

Under the reform, the rules apply to all shareholder debt irrespective of whether a crisis has arisen or not. This means that any lender, directly or indirectly holding an equity stake in the company other than insignificant positions, will have to consider all its loans subordinated. It will no longer be possible to avoid a subordination by acceleration immediately after a crisis occurs.

Qualified subordination

While all shareholder debt is subordinated, there is a subtle distinction between simple shareholder debt and shareholder debt with a qualified subordination. The distinction is made to determine whether the debt needs to be reflected in the insolvency balance sheet or not. Qualified subordination places shareholder debt on par with equity. This debt will not need to be reflected in an insolvency, whereas simple shareholder debt will. Hence, lenders will continue to demand qualified subordinations from shareholders.

Treatment of bank debt as shareholder debt

In a 1992 judgment, the Federal Supreme Court also applied these rules to a bank which had taken a share pledge and had taken a position comparable to that of a shareholder in the distress situation. As a consequence, the facility agreements used by leverage finance practitioners did not apply certain undertakings to German borrowers. Instead, information undertakings were applied.

The lenders could object to measures taken and in case the borrower decided to take the measure after all, the lender would be entitled to accelerate the loan. These rules will not be affected by the reform and the practice will continue.

Stefan Kilgus is a partner in the international project and structured finance group at Watson Farley & Williams in Hamburg.

GermanyJuly2008