A controversial state programme aims to breathe confidence back into Germany's stricken financial sector

In early October, the German Government started work on a stabilisation programme, deciding to guarantee all private customer deposits at banking institutions without limit. The programme came into force on 18 October, under the Financial Market Stabilisation Act.

The objective of the Act is to overcome the liquidity squeeze affecting financial institutions and to improve their equity. Under the Act, through a state-owned fund, the Government will:

• guarantee financing obligations of financial institutions involved in court proceedings between 18 October, 2008 and 31 December, 2009 with a term of up to 36 months;
• take equity or similar stakes in financial institutions, up to a maximum of E10bn (£8.6bn) per institution; and
• assume risk positions of financial institutions which have been incurred before 13 October, 2008.

The fund can give guarantees of up an the aggregate amount of E400bn (£346bn), and can take further equity stakes and "financial risk exposure" up to an aggregate amount of E80bn (£69bn).

The bailout is limited to financial institutions. Leasing companies and foreign financial institutions (which are not incorporated as German legal entities) cannot apply for aid. Stabilisation measures will only be granted if the distressed business "warrants a solid and prudent business policy", the implications of which are vague. Like the UK measures, the fund imposes conditions on financial institutions taking aid. These relate to the dividend distribution policies of the institution and the remuneration levels of their executive board members and directors.

The terms and conditions for recapitalisation of a distressed business will be stricter than other stabilisation measures because the fund will require the business to: (1) not take certain risks and activities for certain types of business or markets, (2) accommodate the needs of credit-taking small and medium-sized businesses in general, and (3) review its models and levels of compensation, limiting the compensation for management or members of the board to a maximum of E500,000 (£433,050) per annum, including bonuses and other discretionary compensation. To achieve the objectives of the Act amendments to corporate and capital markets laws have had to be made. For example, under the new regime, an insolvency can be avoided if there is a predominant likelihood that the "financial strength of the business will be sufficient to carry on the business".

The bailout has been received by the market with initial reluctance. In particular, Deutsche Bank, the market leader, expressly refused to take Government aid. However, pressure is mounting on distressed businesses as more and more banks disclose their weak – or even desperate – positions. Experts have criticised the German bailout plan, as there is absolutely no concept of how the banking system might look after the crisis and there have been no discussions to this end thus far. Instead, it is simply led by the vague idea of somehow helping financial institutions to survive.

There are also a number of legal issues that may affect the bailout. For example, a board can ask the Government to come in regardless of whether the business actually needs help, opening up the possibility of companies taking advantage of the aid available to raise fresh capital. By the same token, Government intervention will allow shareholders to be diluted, literally within a few days. Thus, in effect the management can change the ownership of a business at their discretion.

Moreover, the Government will ultimately sell the acquired shares. However, the Act does not provide for all the possibilities associated with such a sale. In particular, it is not clear under what conditions, and to whom, the Government will sell the shares. Therefore, management, in collaboration with the Government, may be able to change the entire landscape of an institution without shareholder approval. As a result, the bailout may even constitute a violation of the German Constitution.

As an investor, the Government will have a significant say in business and dividend policies. But is the Government actually a good manager? State-owned banks have, after all, proved to be some of the worst-managed in the country. And will the Government also save other industries which could argue that they are of paramount importance? Given the fact that more than 10% of all employment in Germany depends directly or indirectly on the car industry, auto-company managers may raise some powerful arguments in favour of their organisations receiving state aid.

The measures provided in the Act are unprecedented in the economic history of Germany and Europe. However, the Act is only the starting point for an entire reform of the financial markets. We look set to see more Government intervention in all industries, and the free market concept may be doomed for the foreseeable future. n

Klaus Grossman is a partner in the corporate team at Reed Smith in Munich.