German Insolvency Insurance

Germany, amongst many others, was hit hard by the banking crisis leaving German banks and companies affected. In this article we provide insight on questions that are typically raised when persons are exposed to insolvency situations, which involve proceedings initiated in Germany or abroad but have a connection to Germany in certain aspects.

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When does German Insolvency Law apply?

There are two distinct sets of conflict of insolvency law regimes which coexist in Germany, each of them applying to different categories of entities and with respect to different cross-border situations.

The EU Insolvency Regulation applies to insolvency proceedings for all entities except for certain financial enterprises in most of the European Union member States. If the German entity is a financial enterprise (e.g. bank or insurance company) or if the counterparty is established in a state, which is not subject to the Regulation, the section on international insolvency law in the German Insolvency Code (GIC) applies.

The principle, which is common to both legal regimes, however, is that international jurisdiction is derived from the “centre of commercial interest” which is the place where the interests of the insolvent entity are managed (often the country where the insolvent entity is domiciled). The exception to this concept is that the insolvency laws of other jurisdictions may become relevant in case of, inter alia, rights in rem with regard to property, labour contracts, set-off rights or the termination of derivative contracts (closeout-netting).

What are the German Insolvency Code’s objectives?

The objective of German insolvency proceedings is to satisfy creditors either by:

• Liquidation of the insolvent entity’s assets and distribution of the proceeds (Liquidation Proceedings),
• By reaching an arrangement by means of an insolvency plan procedure in order to restructure the insolvent entity (Insolvency Plan Proceedings).

What are the grounds for filing for insolvency?

Insolvency Proceedings can be initiated against an entity for:

• Illiquidity (incapacity to pay);
• Over-indebtedness (balance-sheet insolvency - in response to the recent financial crisis, the German Government has recently amended the definition of over-indebtedness in order to alleviate otherwise solvent corporations from having to file for insolvency merely on the basis of balance-sheet insolvency; here, a positive business forecast may also be taken into consideration to circumvent over-indebtedness);
• Imminent illiquidity.

Who can file for insolvency?

Both the insolvent entity and any creditor can file in the case of illiquidity and over-indebtedness, and only the insolvent entity in the case of imminent illiquidity. In the case of illiquidity and over-indebtedness, the insolvent entity’s management is obliged to file for insolvency proceedings in order to avoid civil and criminal liability.

Where the insolvent entity is a financial institution, the initiation of Insolvency Proceedings is under the control of BaFin (Federal Financial Supervisory Authority) which can appointment a supervisor before any actual suspension of payments, impose or refuse the start of Insolvency Proceedings, or impose the option between recovery and liquidation. Only upon a formal filing by BaFin with the competent insolvency court can Insolvency Proceedings be initiated against the financial institution. Also, the insolvency court must consult with BaFin prior to appointing an insolvency administrator.

What happens after the filing?

The Insolvency proceeding can be divided into the preliminary insolvency proceeding and the final Insolvency proceeding. Both of these stages are set out and supervised by the court. Proceedings commence when the initial financial problem of the company has led to an Insolvency situation within the meaning of the Insolvency code, which in turn prompts the management, or potentially shareholders, to file for insolvency to the court in order to avoid personal criminal and financial liability.

Filings for Insolvency by creditors is also a possibility and common.

The Insolvency Court will react to the filing by appointing a preliminary creditors committee and an administrator who will be tasked to secure assets and prepare for the courts decision as to whether it should open final insolvency proceedings.

What are the rights of the creditors?

Unsecured creditors

Unsecured creditors may not execute against the assets belonging to the insolvent estate. Set-off rights are limited due to special provisions in the GIC (German Industry & Commerce). Unsecured creditors are the last group of creditors to receive distribution from the insolvent estate and are bound to accept their respective portion of the surplus proceeds of the liquidation after the secured creditors and costs have been paid.

Secured creditors

Secured creditors may be entitled to a selection right (Aussonderung) if they can prove that title to a specific asset lies with them and not with the insolvent entity.

These creditors are not considered insolvency creditors. They have an in rem-claim for return of the asset, which is enforceable independently from the insolvency proceedings by means of individual enforcement. Rights giving rise to separation include:

• Ownership,
• Other rights in rem (reservation of title, life tenancies, heritable building rights)
• Intellectual property rights.

A second group of creditors who enjoy insolvency-specific privileges are creditors who may demand that a particular asset is disposed of separately (Absonderung) and that the proceeds realised are preferentially used to settle secured claims. Rights entitling to separation include transfer by way of security, liens or land charges. Such creditors are considered insolvency creditors and may only conduct private enforcements on a limited basis.

Preferential creditors (Massegläubiger)

Creditors whose claims arise only after the opening of Insolvency Proceedings and which are caused by the insolvency administrator are treated preferentially, i.e. these creditors are paid before the insolvency creditors from the proceeds of the insolvency administrator’s enforcement of the assets belonging to the insolvent estate (as long as sufficient). In a lot cases preferential creditors have a right to enforce their claims individually.

How are pending transactions/contracts affected?

As a general principle, the insolvency administrator can decide whether it wants to honour or terminate any bilateral contract that has not been performed completely by either party. If the insolvency administrator opts for continuation, both parties are obliged to meet their obligations; the claims of the insolvency creditors are privileged claims, which are paid from the insolvent estate. Should the insolvency administrator decide to terminate, the counterparty cannot claim full payment for services already rendered. Instead, it can only seek compensatory damages due to non-performance. Such claim is to be filed as an ordinary insolvency claim.

The insolvency administrator may not terminate loan agreements after the loan has been disbursed. Special termination provisions apply, inter alia, for financial derivatives contracts. Almost always they will be subject to the closeout-netting regime. Cherry picking is therefore prevented with respect to those transactions.

How does the insolvency proceeding end?

In Liquidation Proceedings, after the proceeds have been distributed, the insolvent entity will be dissolved and the residual claims of the creditors are essentially of no value. The effect of an insolvency plan, however, is to finally settle the rights of all creditors.

The insolvency plan, inter alios, describes if and to what extent the unsubordinated creditors’ rights may be reduced, deferred, secured or subjected to other rules, which may have been agreed. If there is no specific rule or regulation provided for in the insolvency plan, claims of subordinated creditors are deemed to be waived. Once the creditors have agreed the insolvency plan on it is legally valid and binding on all creditors.