Insolvency as a strategic option
Restructuring under insolvency protection by self-administration as part of insolvency proceedings is not new and has been an option in Germany since the insolvency law was reformed in 1999. However, the new law that took effect on 01 March 2012 under the name ESUG simplifies the available options for this type restructuring significantly.
By filing for insolvency, the debtor company places itself under the protection of insolvency law or into provisional self-administration. Thus, unlike the old law, the new law immediately places the company under (provisional) self- administration. An insolvency administrator is no longer necessary in these proceedings; that role is taken over initially by a provisional trustee. Unlike insolvency administrators under the previous law, provisional trustees have only control and monitoring functions. The insolvent debtor is thus its own insolvency administrator (debtor-in-possession) from the very beginning of the proceedings. That is, figuratively speaking, the debtor sits on the coach’s bench, while the trustee sits in the stands. Because the debtor lacks sufficient legal and business knowledge to implement the insolvency, it will need to be guided through the proceedings by an expert who is accountable for the success of the proceedings. The new law also gives creditors a much stronger influence on the course of the proceedings; however, their involvement is in turn significantly influenced by the debtor in self- administration. Both the management and the company are given the opportunity to structure the proceedings with the input of creditors in a way that is by and large legally watertight, and they can also influence the selection of the trustee, even in opposition to the competent court’s opinion as long as the provisional creditors’ committee agrees unanimously.
Building blocks of ESUG
Essentially the new law is based on three building blocks:
- considerably strengthening creditor influence,
- optimising the insolvency proceedings and structuring them in a more risk-free way and
- significantly strengthening self-administration.
Like traditional insolvency proceedings, restructuring under insolvency protection by self-administration begins with filing an insolvency application. The competent insolvency court will first examine whether there is the required reasonable expectation that the proceedings can be carried out successfully. A competent consultant can predict this with great certainty and expertly prepare the proceedings so that success is virtually assured, or if failure is foreseeable, he
will not even initiate the proceedings. However, this requires that the consultant has sufficient time to prepare and has comprehensive knowledge of all causes of the specific crisis. Only if the company communicates fully with the consultant is the success of the insolvency proceedings largely ensured and only then can these proceedings be initiated at almost no risk at all.
Insolvency plan governs debt reduction
Upon the opening of the insolvency proceedings, an insolvency plan is drawn up. This plan sets forth the final settlement of the company’s liabilities and is submitted to the creditors for approval. Secured creditors are often satisfied in the amount of their collateral security by having them continue to make loans available to the company against the existing collateral. Unsecured creditors lose their interests completely (e. g., secondary creditors such as mezzanine capital lender) or receive only a pro rata share (other unsecured creditors) of their unsecured claims, which is normally paid to these creditors within about two years after the conclusion of the insolvency proceedings. These unsecured creditors waive the entire remainder of their claims as part of the insolvency plan submitted.
In the course of the proceeding’s new liabilities, e.g., tax liabilities or the insolvency benefit of the Federal Employment Agency will be incurred, and for these, too, these creditors will receive only a pro rata share. The pro rata shares are generally between 5 and 30 percent. In general, this is much more than an insolvency administrator can obtain in standard insolvency proceedings. However, even low pro rata shares for unsecured creditors do not necessarily lead to a rejection of the insolvency plan because what matters to creditors is usually not how high a pro rata share for their claims they can receive in the proceedings; rather, what matters to them is that the company continues to exist as a going concern. Thus, for the Federal Employment Agency a high pro rata share is not relevant; what matters to it is avoiding having to pay unemployment benefits and keeping as many jobs as possible. Likewise, the employees are more interested in keeping their jobs than in getting a high pro rata share. And what matters most to suppliers is keeping their sales channels and not having to find new customers. The widespread view held by insolvency administrators that they must achieve the highest possible pro rata shares to ensure the best possible satisfaction of creditors conforms neither to the actual intention of the legislature nor to the wishes of most creditors. If insolvency proceedings are conducted as standard insolvency proceedings, the administrator will generally receive substantial compensation for preparing and implementing the plan, which, in turn, reduces the pro rata share. What matters is what the creditors want. There- fore, the creditors are thus asked to vote on the insolvency plan. Low pro rata shares for creditors ensure the company’s future liquidity because the more funds flow to the creditors, the less is available for the company to ensure its future liquidity.
The proceedings are intended to ensure the company as a going concern
The self-administered insolvency plan is intended to enable the company to continue as a going concern. The status of the shareholders remains unaffected. The company is neither liquidated nor sold to a third party, e. g., by means of an asset deal. A capital increase through a third party acquiring shares is possible but must be approved and supported by the existing shareholders. So-called debt equity swaps in which liabilities are converted into equity play hardly a role at all in practice, at least not for medium-sized companies. Creditors’ waivers strengthen equity by considerably reducing liabilities while assets (cash, receivables, inventories) are increased through the inflow of normal revenues at significantly lower costs due to the state insolvency benefits and unpaid old liabilities. The vote on the insolvency plan marks the end of the proceedings. If the creditors approve the plan with the necessary majorities – which is virtually always the case – the court will conclude the insolvency proceedings shortly thereafter (ca. two to four weeks), and insolvency is thus ended. Despite the proceedings being over, the company then still has up to two years, and in exceptional cases significantly more time than that, to implement the plan and earn the funds to pay the pro rata shares owed to unsecured creditors. Due to the effects of the proceedings new loans are usually not necessary.
Operational restructuring is essential
In addition to the restructuring of the balance sheet’s liabilties side, operational restructuring must also be tackled right away and often already at beginning of the proceedings. Only if the operational restructuring is successfully ensured for the long term can the company be effectively and sustainably restructured. Costs must be reduced, processes improved and new markets opened up; here, too, insolvency offers significant relief. Often social compensation plans cannot be financed outside of insolvency proceedings. With a self-administered insolvency plan the necessary funds are generated, and at the same time the social plan costs are reduced, independent of employees’ years of service, to a maximum of two and a half months’ salary. The maximum notice period for terminating employees is three months, regardless of how long an employee has been with the company. Insolvent debtors in self-administration can terminate continuing obligations, such as long-running tenancy or lease contracts, with a notice period of three months. However, termination on the part of the landlord or lessor is excluded as long as the insolvent debtor fulfils its obligations under the respective tenancy agreement. These options give the debtor-in-possession more ways to overcome the crisis at hand, something that would be unthinkable outside of the insolvency proceedings. Whether or not these options will be used will be decided by the previous management and not by an insolvency administrator.
New provisions on group insolvency
In March 2017, the German Bundestag enacted a new law to facilitate the handling of group insolvencies, which takes effect in April 2018. Under that law, all self-administration proceedings relating to a single group are to be consolidated and heard by a single insolvency court – which was not the case in the past. The consolidated self-administration proceedings are intended to safeguard the economic unity of the group and the added value it generates. They facilitate the overall restructuring of the group by preserving the added value generated and the existing jobs. The legislature here has expressed its desire to strengthen and facilitate restructuring through self-administration proceedings even for corporate groups. The aforementioned amendments finally establish the “second chance” concept in Germany, a concept that has been practiced in the USA for decades, and offers ways to make restructuring of corporate groups easier as well. However, these ways can only be utilised if restructuring experts prepare companies in advance for such an “orderly” insolvency by self-administration and guide them through the proceedings because many relevant decisions under insolvency law that have with significant effects on the restructuring process must already be made in this time period.