A temporary change in Germany's debt laws gives flexibility to companies struggling with insolvency, but Daniel Weiss reveals how the new rules leave much unclear

It is common knowledge among professionals active in the German restructuring market that the country's insolvency law is characterised by stringent insolvency filing obligations triggered not only by illiquidity, but also over-indebtedness. This sets Germany apart from other European jurisdictions and often strongly influences transaction structuring and timing.

Due to a recent change in law, the concept of over-indebtedness has been modified. The new legal environment intends to provide more flexibility but remains open for interpretation in some key issues. While some views suggest that the concept of over-indebtedness has practically been abolished, others take the view that not much has changed compared to the status quo ante.

The new concept

Effective 18 October, 2008, the Financial Markets Stabilisation Act defines over-indebtedness as a status whereby the assets of the debtor no longer cover its liabilities, except if the continuation of the business enterprise is predominantly likely given the prevailing circumstances.

This new concept provides for a two-tier test: In the first step, technical over-indebtedness is tested on a basis of a liquidation balance sheet. If the balance sheet shows positive equity, there is no filing obligation due to over-indebtedness.

Otherwise, management needs to determine in a second step whether the company has a positive continuation outlook. The outcome would then determine whether the company is obliged to file for insolvency due to over-indebtedness.

Balance sheet over-indebtedness is tested on the basis of whether a balance sheet reflects liquidation asset values, i.e. expected proceeds from a hypothetical liquidation of the company's assets minus related costs such as closure and redundancy costs or adviser fees. On the liability side, obligations towards shareholders and third parties need not be recorded to the extent subjected to an appropriate subordination agreement.

The second element of the new over-indebtedness concept, the continuation outlook, is primarily based on the management's business forecast. In principle, a positive continuation outlook can be established if the company has sufficient funds in a medium-term period.

While the appropriate duration of such period is disputed, the prevailing view, based on a recommendation of the German Institute of Chartered Accountants, seems to be that the current and next financial year be taken into consideration. In addition, a positive continuation outlook requires the company can permanently continue its business after such a period. In particular, significant foreseeable liability risks need to be addressed.

A law with an expiry date

The legislator intended the new concept of over-indebtedness to provide immediate relief to the financial crisis but was reluctant to generally relax insolvency filing obligations. Against this background, the new law comes with the peculiar feature of an automatic re-instatement of the status quo ante as of 1 January, 2011. This implies that the old and more stringent over-indebtedness concept will again apply from that day onwards, unless the legislator decides otherwise to extend the application of the current rules.

The old, and probably future, over-indebtedness test is exclusively based on a liquidation balance sheet. Filing for insolvency due to over-indebtedness is required if the liquidation balance sheet shows negative equity. This is on the condition that the assets may be valued on an ongoing basis if the company has a positive continuation outlook and otherwise needs to be recorded at liquidation values. A positive continuation outlook will therefore in itself no longer suffice to prevent an insolvency filing obligation.

Expanded options

Under the old legal regime, the time available for the negotiation and implementation of a restructuring was often severely limited by imminent insolvency filing obligations due to over-indebtedness or illiquidity. The new law gives parties additional timing flexibility for an out-of-court restructuring provided that a positive continuation outlook can be maintained or re-established.

This is particularly helpful during a market situation such as the current one, which is characterised by rapidly declining earnings before interest, taxes, depreciation, and amortisation (EBITDA) across many industry sectors. These factors can safely be assumed to significantly increase the number of business enterprises in technical over-indebtedness due to the resulting asset devaluation. Given the flexibility on the timeline, it can be expected that the number and complexity of out-of-court restructuring transactions will increase in the German market.

From a legal adviser's perspective, a key challenge lies in establishing appropriate criteria for the positive continuation outlook, given that the new law is silent on this issue. In a restructuring situation, the debtor is typically no longer authorised to draw further funds under existing financing arrangements.

This implies that the positive continuation outlook needs to assess the likelihood that, the company's restructuring will result in sufficient funds being available for the debtor in order to continue its business on a sustainable basis. Post-restructuring, it is unclear the level of certainty required as to available funds. While some views advocate that a particularly high degree of probability or even binding agreements might be required, there is other authority that suggests the normal 50% probability threshold should apply.

This open issue requires particular attention by the debtor if the three-week insolvency filing period has already been triggered. In this scenario, the debtors management will need to be satisfied that the implemented steps suffice to re-establish the positive continuation outlook to avoid triggering a wrongful failure to file for insolvency and severe legal risks.

While it remains to be seen how this issue will be addressed by the courts, in legal writing and by the relevant market practice, it is expected that a combination of subjective criteria mainly relating to a reasonable assessment by the management, as well as certain objective criteria relating to the expected future financing, will be required.

Temporary solutions

The new law may allow parties to defer the implementation of definitive restructuring solutions under certain circumstances. Consider, for example, a consensual enforcement scenario whereby the equity holder is unwilling to put further funds into the defaulted borrower and therefore consents to 'hand over' to the lenders.

At the same time, a share disposal might be unattractive to the lenders given the current pricing levels, and the lenders might also be unwilling to participate in a balance sheet restructuring involving significant debt cuts for various reasons. In such a situation, the new law may facilitate the transfer of the debtor's shares into a trust structure established for the purpose of disposing the shares in a future, more favourable market environment. The lender's claims would, in principle, remain outstanding in full and only be compromised if and to the extent required to secure the liquidity of the debtor. Upon an eventual share disposal, any remaining debt not covered by the disposal proceeds would be waived.

Historically, such a structure would not have been possible without a write-off or subordination of debt to the extent required to remedy balance sheet over-indebtedness. Under the new legal regime, incurring these economic disadvantages on the part of the lenders is no longer required (at least for the time being) if the positive continuation outlook can be maintained or re-established in the course of the restructuring.

From a legal perspective, the transaction structure will need to take into account the old legal regime reinforcing on 1 January, 2011. This implies that the satisfaction of the positive continuation outlook test according to the current law will also need to provide a solution for the change of legal regime. While this creates additional challenges probably unintended by the legislator but inevitable given the clear letter of the law, current experience shows that appropriate practical solutions are available.

The new law does come with certain pitfalls which are capable of being addressed by appropriate structuring. It can therefore be expected that it will support a growing number of successful out-of-court restructurings in the current challenging market environment.

Daniel Weiss is a partner in Hengeler Mueller's Frankfurt office.