In Germany, directors of financially distressed companies must carefully navigate complex legal requirements to avoid personal liability. This article provides an overview of such requirements, highlighting the most important considerations for directors in connection with managing a financially distressed German company.
In Germany, directors of financially distressed companies must carefully navigate complex legal requirements to avoid personal liability. This article provides an overview of such requirements, highlighting the most important considerations for directors in connection with managing a financially distressed German company.
General Duty of Care
German law requires directors of German companies to act with the diligence of a prudent and diligent businessperson managing a company. This broad general diligence requirement comprises numerous specific obligations, including compliance with applicable law, adherence to the company’s articles of association, and the implementation of decisions of the competent corporate body such as the supervisory board or shareholders’ meeting. Although directors generally owe their duties to the company – not the shareholders, creditors, or employees of the company – there are exceptions to this rule, and directors have to take into account the interests of other stakeholders in specific circumstances.
As long as the company is solvent, directors must promote the success and sustainability of the company, which is also in the interests of its shareholders. If the organization becomes financially distressed, preserving the assets of the company in the interests of creditors and ensuring that the company does not engage in (further) detrimental transactions becomes more important. This shift emphasizes the need for directors to balance the interests of various stakeholders while prioritizing the company’s long-term viability.
Directors are obligated to continuously monitor developments that might endanger the company’s continued existence and take appropriate countermeasures if such risks arise. Depending on the size of the company, directors must set up early warning systems to identify potential threats to the financial stability of the company. They are required to immediately report any such threats (such as a loss impairing the stated capital of the company) to their competent supervisory bodies, such as the supervisory board or the shareholders’ meeting.
Insolvency Filing Requirements
The most important guidance for directors of companies in Germany in distress is to never file too late. Directors must file for insolvency within three weeks of the company becoming illiquid and within six weeks if the company is over-indebted. This filing requirement applies not only to companies organized under German law, but to all companies having their center of main interest in Germany, including those organized under non-German law.
A company is considered illiquid if it is unable to perform its payment obligations as they become due, i.e., if the company’s available funds are permanently inadequate to meet its due payment obligations. This is the case if:
A temporary liquidity gap generally does not constitute illiquidity, provided the company can reasonably expect to pay its due debts within a short period of time, or if the unpaid portion of due debts is less than 10% of the company’s total due debt.
A company is considered over-indebted if the survival of the company’s business as a going concern appears to be rather unlikely (the so-called “outlook test”); and the company’s assets do not cover its current liabilities (the so-called “balance sheet test”). The outlook test is heavily reliant on a forward-looking analysis by management, based upon a realistic and comprehensive assessment of the company’s financial condition and prospects. If the outlook test is negative, the balance sheet test requires the preparation of a special insolvency balance sheet to assess whether the company’s assets at liquidation values cover its liabilities.
Insolvency Filing Requirements
The most important guidance for directors of companies in Germany in distress is to never file too late. Directors must file for insolvency within three weeks of the company becoming illiquid and within six weeks if the company is over-indebted. This filing requirement applies not only to companies organized under German law, but to all companies having their center of main interest in Germany, including those organized under non-German law.
A company is considered illiquid if it is unable to perform its payment obligations as they become due, i.e., if the company’s available funds are permanently inadequate to meet its due payment obligations. This is the case if:
A temporary liquidity gap generally does not constitute illiquidity, provided the company can reasonably expect to pay its due debts within a short period of time, or if the unpaid portion of due debts is less than 10% of the company’s total due debt.
A company is considered over-indebted if the survival of the company’s business as a going concern appears to be rather unlikely (the so-called “outlook test”); and the company’s assets do not cover its current liabilities (the so-called “balance sheet test”). The outlook test is heavily reliant on a forward-looking analysis by management, based upon a realistic and comprehensive assessment of the company’s financial condition and prospects. If the outlook test is negative, the balance sheet test requires the preparation of a special insolvency balance sheet to assess whether the company’s assets at liquidation values cover its liabilities.
In addition, the directors may file the company for insolvency if the company is imminently illiquid. A company is considered imminently illiquid if, based upon a liquidity forecast for a generally two-year period, it appears more likely than not that the company will be unable to meet its future payment obligations. In contrast to the company being illiquid or over-indebted, imminent liquidity does not require the directors to file the company insolvent, but certain actions (such as incurring new debt or making payments) may result in director liability if the company eventually becomes insolvent.
In addition, the directors may file the company for insolvency if the company is imminently illiquid. A company is considered imminently illiquid if, based upon a liquidity forecast for a generally two-year period, it appears more likely than not that the company will be unable to meet its future payment obligations. In contrast to the company being illiquid or over-indebted, imminent liquidity does not require the directors to file the company insolvent, but certain actions (such as incurring new debt or making payments) may result in director liability if the company eventually becomes insolvent.
Reasons for Insolvency Under the German Framework
Reasons for Insolvency Under the German Framework
Navigating Financial Distress and Potential Sources of Liability
Continuous Vigilance and Countermeasures:
Directors must implement reasonable monitoring systems to monitor the financial condition of, and financial risks to, the company. Such systems must allow the early detection of financial distress and timely countermeasures. Early warning signs of a potential insolvency include deteriorating liquidity, increased use of supplier credit, reminders by creditors, (significant) losses, demands for repayment of shareholder loans, and employee layoffs. Recognizing these signs early is crucial for adjusting strategies to mitigate risks effectively.
If a company becomes distressed, directors must consider reasonable countermeasures to avoid the insolvency of the company. Early warning signs that do not directly threaten the continued existence of the company might require increased vigilance with tighter liquidity control and business forecasts. If the company is already in (serious) financial distress, additional measures such as the subordination of shareholder loans, waivers of debt, capital increases, payment deferrals, or other financing and restructuring measures (including a full financial and operational restructuring) must be considered.
Since directors often lack the necessary expertise to cope with the challenges of a company becoming seriously distressed, they should also carefully consider obtaining advice from independent restructuring and legal experts in order to avoid personal liability.
Finally, during a company’s financial crisis, directors must continuously update their supervisory bodies of the company’s financial condition and proposed countermeasures.
If directors violate any of such duties during a period of financial distress, they could become liable for damages. Generally, such damages would be enforced by (i) the insolvency administrator after the company has become insolvent, or (ii) the company if it does not ultimately become insolvent but suffers damages from the director’s actions or omissions. However, directors may generally rely on the business judgment rule when taking decisions, provided all necessary requirements are met and can be demonstrated. In order to rely on the business judgment rule, directors should carefully consider the various options, seek independent advice, and properly document their decisions.
Late Filing
The most important sources of liability for directors are late filings (i.e., not within the relevant statutory period), not filing at all, or making incomplete or incorrect filings. To mitigate this risk, directors should continuously monitor the company’s liquidity and, where necessary, prepare short- and mid-term liquidity forecasts to assess the company’s solvency, recognize specific triggers for insolvency, and assess whether the company can endure the financial crisis. If the company cannot be successfully restructured, the directors must be prepared to file the company insolvent within the applicable period.
If directors file for insolvency too late (or not at all), they face criminal and civil liability. Generally, the insolvency administrator would enforce claims for damages resulting from the late filing, such as a lower insolvency quota due to a decrease in value of the company’s assets. However, creditors entering transactions with the company after it became insolvent may claim their losses in full directly from the responsible directors.
Prohibited Payments
Another important source of liability for directors are payments after the company has become insolvent. Generally, managing directors are personally liable for payments by, and any other kind of performance of, the company after it has become illiquid or over-indebted if no appropriate consideration was paid to the company in a timely manner.
Prohibited payments include (i) payments on receivables that are more than thirty days old; (ii) payments of social security contributions and taxes (which puts the director between a rock and hard place, because not making such payments can also result in civil and criminal liability, see next paragraph); and (iii) performance for prepaid deliveries and services.
In contrast, directors generally may still pay for deliveries and services required to maintain the company’s business operations, provided payment and performance are closely connected (i.e., generally made within a period of no more than three weeks).
Other
In addition to the above, directors could become criminally liable for certain insolvency related actions, such as (i) embezzling social security contributions; (ii) committing tax evasion, (iii) committing special bankruptcy offences such as embezzling assets of the company, not maintaining proper records or favoring certain creditors; and (iv) fraud by entering into new business transactions knowingly that the company cannot perform.
Also, in a restructuring, directors of German subsidiaries of a restructured group need to carefully assess the sustainability of the refinancing based upon realistic business and financial projections. If the refinancing is not sustainable, i.e., cannot be reasonably expected to be serviced and refinanced or repaid at maturity, the directors of the subsidiary must not grant any upstream or cross-stream security.
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