Insolvency law

The negative economic impact of the COVID 19 pandemic is causing a high and ever-increasing risk of insolvency for many companies across all sectors of the economy.

The aim of the newly enacted COVID Insolvency Suspension Act (COVID-Insolvenz-­Aussetzungsgesetz – COVInsAG) is to facilitate the continuation of companies affected by the COVID-19 pandemic. The affected companies and their representatives shall be put in the position and have time to take the necessary measures required, in particular, to take advantage of state aid made available for this purpose or to make financing or restructuring arrangements with creditors and capital providers. By limiting the risk of liability and avoidance, the legislator intends to create a framework in which loans can be restructured and existing business relationships, e.g. between suppliers or leasing partners and the debtor, can be preserved.

Suspension of the obligation to file for insolvency

The main problem for managing directors of a company in crisis is the duty, set out in section 15a of the German Insolvency Code (Insolvenzordnung – InsO) and punishable by up to three years‘ imprisonment, to file a petition for the opening of insolvency proceedings in the event of insolvency or over-indebtedness.
This duty of the managing directors is in principle suspended by the COVInsAG until 30 September 2020.

The suspension of the obligation to file for insolvency does not apply only if (i) the insolvency is not due to the effects of the COVID-19 pandemic or (ii) there is no prospect of avoiding an existing insolvency. The burden of proof lies with the party claiming the existence or breach of the obligation to file for insolvency.

In addition, the managing directors are protected by the fact that, if the company was solvent on 31 December 2019, it is assumed that (i) the grounds for insolvency are due to the COVID-19 pandemic and (ii) there are prospects of eliminating an existing illiquidity. According to the explanatory memorandum to the draft legislation, the purpose of this mechanism is to ensure that current uncertainties and difficulties in proving causality and the predictability of further developments are in no way detrimental to managing directors who are obliged to file an application. Although the presumption is rebuttable, it serves the purpose of effectively relieving the party required to file an application of the existing difficulties in proving and forecasting causality. According to the express wording of the explanatory memorandum, a rebuttal may only be considered in such cases where it is beyond doubt that the COVID-19 pandemic did not trigger insolvency and that insolvency would not successfully be avoided – both of which are high requirements to be met.

The suspension of the duty to file also includes the otherwise existing duties of the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) or other responsible authorities to make use of their respective right to apply under section 46b para. 1 of the German Banking Act (Kreditwesengesetz – KWG), section 43 para. 1 of the German Capital Investment Act (Kapitalanlagegesetzbuch) in conjunction with section 46b para. 1 KWG, section 21 paras  4 and 5 of the German Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz) and section 312 of the German Insurance Supervision Act (Versicherungsaufsichtsgesetz). The right to file, however, is expressly kept intact.

In addition, the opening of insolvency proceedings in respect of applications filed by creditors (so-called third-party applications) will be suspended for a period of three months from the entry into force of the COVInsAG (unless the grounds for insolvency already existed on 1 March 2020).

The regulations apply retroactively from 1 March 2020, both with regard to the suspension of the obligation to file for insolvency and the consequences of the suspension described below. Therefore, the law also covers cases where the period for a managing director‘s obligation to file for insolvency has already begun to run or expired, new financing has already been granted, services have already been rendered on the basis of contractual relationships, or payments which are permitted under the new regulations have already had to be made in order to maintain business operations.

Because the opening of insolvency proceedings by third-party applications is being suspended, only those applications for insolvency where grounds existed on 1 March 2020 will be opened. As things presently stand, it is unclear how insolvency applications filed before the COVInsAG entered into force, but for which no decision on the opening of proceedings has been taken at the time of entry into force, will be treated. The wording of COVInsAG would also allow for the consideration of insolvency grounds that occurred after 1 March 2020 (but before the COVInsAG entered into force), but this outcome would contradict the purpose of the legislation.

The suspension of both the obligation to file for insolvency (including the consequences linked to the suspension period described below), the right of third parties to apply for the opening of insolvency proceedings as well as the possibility of refusing discharge of residual debt may be extended until 31 March 2021 by way of ministerial order.

Payment prohibitions („emergency operation“)

The COVInsAG is intended to also enable a managing director to take all necessary measures to continue running the company in the ordinary course of business. In order to protect a managing director from personal liability, payment prohibitions applicable under existing law during a period of imminent insolvency are therefore suspended.

The regulatory framework regarding so-called emergency operations that applied up to now was very restrictive and difficult to navigate. Only payments that served to maintain realistic chances of restructuring in the interest of creditors were permissible, which led to considerable difficulties in determining whether payments would fall in that category.
According to the COVInsAG, all management measures taken in the ordinary course of business are deemed to be compatible with the diligence of a prudent and conscientious manager and therefore permissible. This includes not only measures taken to maintain or resume business operations, but also measures taken to reorganise business operations and the business model of the company in the context of restructuring. The new regulation thus grants managing directors considerably more room to manoeuvre.

Restructuring loans (including shareholder loans) – 
privileged treatment of „fresh money“

The granting of loans to companies in need of restructuring was subject to strict conditions under existing law. Lenders were faced, inter alia, with the risk of  avoidance of certain transactions in insolvency. The COVInsAG provides for a far-reaching privileged treatment of new loans under avoidance rules in order to encourage the provision of additional liquidity by granting such loans.

Firstly, the scheme protects creditors of new loans provided as additional liquidity, includ­ing trade credits and other forms of credit provision. Such creditors should not have to fear that they will be obliged to repay interim payments or lose access to collateral pro­vided when granting the new loans if efforts to rescue the borrower‘s business subsequently fail and insolvency proceedings are nevertheless opened. The intention is to remove any doubts new lenders may have about the insolvency-proof nature of such new loan agreements, or the collateral provided for third-party lenders, where they are granted for the purpose of rescuing companies.

However, this only refers to a new loan (fresh money) that is granted. In the case of a mere novation, prolongation and economically comparable circumstances, the privileges de­scribed above do not apply.

The COVInsAG also aims to offer incentives to shareholders to provide the company with additional liquidity during the crisis and therefore makes it clear that the repayment of loans made by shareholders is also protected under the same conditions as the repayment of third-party financing. Serving the same purpose, of the subordination of shareholder loans and receivables from economically comparable legal acts under insolvency law are suspended (limited to payments made until 30 September 2023). This refers to such shareholder loans that are new loans which have been granted in order to provide additional liquidity. In particular, the prolongation or new grant of a previously subordinated shareholder loan effected for the purpose of improving the ranking of such loan is not covered by the new protections. Also expressly carved out of the protections is the collateralisation of shareholder loans from the assets of the company.
Payments of such loans and loan collateral provided to secure these payments are not considered to be disadvantageous to creditors and are therefore not subject to avoidance in any subsequent insolvency proceedings. This applies both to payments to repay the capital provided and to appropriate interest payments. However, payments must be made by 30 September 2023. As such, this protects short and medium-term support measures.
The above privileges apply for an unlimited period of time to financing within the framework of state aid programs granted by the Kreditanstalt für Wiederaufbau (KfW) and its financing partners or other institutions due to the COVID-19 pandemic. This includes not only the parts of the financing provided by KfW itself but also parts to be provided by third parties. In such cases, the privileges apply even if the loan is granted or secured after the end of the suspension period. The repayment of loans covered by this scheme is also protected for an unlimited period.

Restructuring loans – lender‘s liability

In addition to the risk of insolvency avoidance described above, under existing law lenders were always faced with the risk of liability under tort law for delay in filing for insolvency pursuant to section 826 of the German Civil Code (Bürgerliches Gesetzbuch – BGB) (so-called lender‘s liability). In this respect, the COVInsAG provides for a far-reaching privilege regarding the treatment of new loans or the prolongation of existing loans.

In comparison with the new rules for insolvency avoidance described above, the exclusion of lender‘s liability in certain respects goes much further and covers every credit grant and collateralisation that takes place during the suspension period. According to the explanatory memorandum, it is expressly not required that such loans constitute new loans in terms of additional liquidity. Prolongations and novations are also covered. This significantly increases the legal certainty for lenders, as lender‘s liability could also cover extensions or the maintaining of existing credit lines if the lender was not contractually obliged to do so (e.g. because there was no obligation to pay out further loans due to the existence of grounds for termination).

However, it needs to be taken into account that prolongations and novations of existing loans (and their collateralisation) are not within the scope of the privileged treatment described above with respect to insolvency avoidance. While the risk of insolvency avoidance should be rather low for prolongations of existing loans, any mere novation and/or collateralisation of existing loans should be carefully evaluated in each individual case.

Avoidance protection for other types of contract

The COVInsAG affords protection against avoidance not only to lenders but also contrac­tual partners of continuing obligations such as lessors, landlords and suppliers. If, in such cases, the contractual partners were to fear that they would have to return payments received in the event of the failure of restructuring efforts due to insolvency avoidance, this would be an incentive to terminate the contractual relationship by the fastest means possible and would frustrate the restructuring efforts.

For this purpose, the COVInsAG provides that contractual performances (including the granting of security) that are delivered as agreed shall not be subject to avoidance if the recipient was not positively aware that the debtor‘s restructuring and financing efforts were not sufficient to remedy an insolvency that had occurred.

Express protection is also afforded to contractual performance in lieu of or on account of performance, assignments of claims in lieu of cash payments and payments by third parties on the instruction of the debtor, because such payments are economically equivalent to performance by the debtor. The exchange of collateral without increasing the collateral value is also protected in order not to impede the debtor‘s commercially reasonable use of collateral security. The protection is extended to any accommodations made for payment, because such flexibility strengthens the liquidity of the business and in this respect has a similar effect as the granting of a new loan. A shortening of payment terms is also protected, which gives further incentive to business partners to continue their contractual relationship. For example, if a supplier of essential components is only prepared to con­tinue to supply the debtor company if payment periods previously agreed in a framework agreement are shortened, that supplier should not be forced to terminate the agreement completely simply because the amendment of the agreement would expose him to the risk of avoidance.

An action for avoidance may still be made if the other party was aware that the debtor‘s restructuring and financing efforts were not suitable to eliminate the grounds for in­solvency. The burden of proof lies with the party seeking to invoke the avoidance. The other party does not have to obtain proof that the debtor has made suitable restructuring and financing efforts. Only positive proof of the absence of restructuring and financing ­efforts or of the obvious unsuitability of the restructuring and financing efforts would render the protection against avoidance void.
It continues to be possible to contest contractual performance, such as benefits, which has been provided prematurely or which otherwise deviates from what was agreed and favours the recipient.

Protection of enterprises in any legal form and protection prior to an ­insolvency having occurred
Enterprises not subject to the rules on filing for insolvency, such as retail merchants and limited partnerships with a natural person as general partner, will also have access to further financing under the planned reliefs outlined above and they together with their contractual partners will also be able to benefit from the relief from avoidance.

The law also takes into account those enterprises that are in serious economic difficulties as a result of the COVID-19 pandemic but are not yet insolvent. The aim is to enable these debtors to obtain further financing even before they become insolvent, to enable their contractual partners to continue contracting with them and to avoid uncertainty.

For this purpose, the privileges under avoidance and liability rules for restructuring loans, shareholder loans and business partners – but not the regulations on payment prohibitions („emergency operations“) – also apply to companies that are not subject to a duty to file for insolvency, as well as to debtors that are neither insolvent nor over-indebted.