In the aftermath of the collapse of Lehman Brothers, which saw assets and shares plunge in value, the German government had acted to amend section 19 of the German Insolvency Code (InsO), a statutory definition of insolvency. Prior to the original amendment of 18 October 2008, a company director was under a statutory obligation to file for insolvency within a period of three weeks once book liabilities exceeded book assets (i.e. the company was over indebted). Breach of the duty is pursued in both the criminal and civil courts. Since the amendment, which was due to expire on 31 December 2010, a company director (re)gained a good defence to the charge of trading while over indebted: he need show there were circumstances which made it reasonably probable that the company would survive such a phase. (“... die Fortführung des Unternehmens ist nach den Umständen überwiegend wahrscheinlich.”, section 19 para. 2 InsO.)

Just before Germany’s general election, the German Parliament cleared the way to extend this amended definition of insolvency until 31 December 2013. On a political level, this is a clear statement that the effects of the financial crisis are ongoing for German business and remain so for the medium term.

The amendment is meant to assist the survival of domestic companies subject to InsO. According to the German Justice Ministry’s own website promotion, the benefits are not restricted to banks and other investment firms, though the executive’s primary focus undoubtedly remains the increased stability of domestic financial markets. Even small and medium-sized companies (Mittelstand), long deemed the backbone of the German economy, are supposed to draw relief from the amended definition of insolvency: a company just needs to show that it has just bagged a contract and will, consequently, be through a phase of being over indebted in just a matter of weeks.

While German businesses continue to complain of restrictive bank borrowing, the amendment seems perhaps good news for debtors and creditors alike. There is a downside, however, since the life of Opel may be prolonged at the pain of creditors and of the German taxpayer. For there is little doubt among professional commentators that the car industry suffers from over capacity and needs a drastic shake up.

Beyond the case of Opel the effects of the amendment for the Mittelstand are not likely to be as far reaching as the Justice Ministry makes out. The most common and primary reason for opening insolvency proceedings has long been a company’s inability to pay creditors as its debts fall due (section 17 InsO). Yet filing for insolvency for the single reason of being over indebted has only ever played a smaller role. At most the amendment will thus provide company directors with a short gasping space and a reasonable defence to charges under section 15a para. 4 InsO (which gives notice of the penalty for failing to file for insolvency in good time: a fine or up to three years’ imprisonment). Once the state of inability to pay debts threatens, a company’s days of survival are probably numbered – with or without the amendment to InsO.

This takes us back to where we were prior to the tinkering: before serious financial troubles can no longer be fended off and the dash to the nearest insolvency court becomes inevitable, companies and their management remain better off taking professional advice on how to work out and implement a plan to restructure.

Dr Annerose Tashiro
Attorney at Law in Germany
Head of Cross-Border Insolvency & Restructuring

Pre-MoMiG law
Previously, under German case law contributions to the registered share capital at the formation or after a capital increase of a GmbH were deemed invalid and frequently had to be paid again, if the amounts were directly on-transferred to cash pooling accounts. In a disputed November 2003 decision the BGH also adjudicated that an upstream loan granted by a GmbH to its shareholder while the registered share capital of the GmbH is or becomes impaired constitutes a prohibited repayment of the registered share capital regardless of the valuation of the claim against the shareholder for the repayment of the loan. This resulted in a strict liability of the GmbH’s managing directors. Intra-group cash pool arrangements are based on loans and set-offs between group companies and the account bank and were often in conflict with the old GmbH Act’s capital protection provisions.

Post-MoMiG law
The capital protection provisions of the amended GmbH Act now provide with retroactive effect – in summary – that (i) if a cash contribution to the registered share capital has to be considered economically and on the basis of a prior arrangement to be in fact an undisclosed contribution in kind (verdeckte Sacheinlage), upon registration of the GmbH the value of the contribution in kind can be deducted from the remaining obligation to provide a cash contribution (section 19 para. 4); (ii) if a contribution to the registered share capital of a GmbH is directly (i.e. on the basis of a prior arrangement) retransferred to the contributing shareholder (Hin- und Herzahlen) without falling under sent. (i) above, the shareholder has to make its contribution again, unless the GmbH has a fully valued repayment claim which is due and payable or can be rendered due and payable at any time (section 19 para. 5 sent. 1); and (iii) regardless of an impairment of the registered share capital, payments to a shareholder of the GmbH do not violate the capital maintenance rules, if the GmbH has a fully valued repayment claim against the shareholder (section 30 para. 1 sent. 1 and 2).

Adaption by the Federal Court of Justice
In the last months, the BGH has decided the first cases on the basis of the new GmbH Act. The court adheres to the principles of the reform, however, it underscores that the amended GmbH Act has created significant new liability issues in particular for managing directors.

In the MPS case in December 2008 the court indicated that it would follow the balance sheet approach of the MoMiG and allow upstream payments, if the company in turn receives a fully valued repayment claim. Nevertheless, the court emphasized the duty of the managing directors to monitor upstream loans continuously. Once the creditworthiness of the shareholder is impaired, managing directors must secure the GmbH’s interests by demanding security or by accelerating the loan, or else they incur liability themselves.

The Cash Pool II-decision from July 2009 applies the new provisions of the GmbH Act cited above under (i) and (ii) to a zero balancing cash pool in which the contributing shareholder was also the cash manager and account holder of the settlement account. The BGH explains that to the extent the GmbH has a negative balance on the settlement account to which the capital contribution is paid, the GmbH does not receive a cash contribution but a release from its debt. This constitutes an undisclosed contribution in kind (verdeckte Sacheinlage). The shareholder’s remaining obligation to make a cash contribution is reduced by the value of this contribution in kind which depends on the creditworthiness of the GmbH.

If, however, the account balance was not negative, the shareholder’s contribution to the settlement account is considered a loan by the GmbH to the shareholder and, thus, a direct retransfer to the contributing shareholder (Hin- und Herzahlen). In the Cash Pool II-case the GmbH’s repayment claim was neither due and payable nor could it be rendered due and payable at any time. Consequently, the shareholder would have to make the contribution again.

As in the Quivive-decision in February 2009, the BGH insists in Cash Pool II that – in addition to the above stated requirements – a contribution can only be valid despite of a Hin- und Herzahlen if the managing director discloses the Hin- und Herzahlen (i.e. the cash pool) to the register at the filing of the formation or the capital increase of the GmbH (section 19 para. 5 sent. 2). In practice, most managing directors will not even be aware of the legal qualification of a contribution as Hin- und Herzahlen, although the failure to disclose may lead to civil and criminal liability.

The recent decisions highlight only some of the unknown liabilities for managing directors in particular. In sum, the reform has clarified some overly rigid case law, but cash pooling remains a risky business for shareholders and managing directors alike.