The Law of Insolvency and Security Interests

R. Nacke

1Introduction

Section 1 of the German Insolvency Act defines the comprehensive goal of the insolvency procedure as the satisfaction of all the claims of a debtor’s creditors jointly, by either realizing the assets of the debtor and dividing the proceeds or by reaching a divergent arrangement, whereby the business continues to exist.

Responsibility for the achievement of the goal is first and foremost the insolvency court and the insolvency administrator appointed by the court. In addition, there is often a Committee of creditors (Gläubigerausschuss) appointed.

How and under which legal conditions the mentioned institutions pursue the objectives defined under Section 1 of the Insolvency Act is the subject of this article. Sections II–IV describe the normal insolvency procedure, Section V describes a special insolvency plan procedure (equivalent to composition proceedings), and Section VI outlines the provision concerning the discharge of remaining indebtedness. This provision allows natural persons who have been declared bankrupt to be released from their remaining liabilities, if they agree for a definite time period to assign a substantial part of their future wages or salary to creditors. Section VII contains a brief description of the legal situation in cases where the debtor has property not only in Germany but in other countries as well.

2Steps Leading to the Institution of Insolvency Proceedings/Security Interests

2.1Steps Leading to Insolvency Proceedings

Insolvency proceedings may be instituted against the property of a natural or legal person through the granting of a court order issued in response to a petition filed either by one or more creditors or by the debtor himself.

As a rule, the pre-requisites for such a court order instituting insolvency proceedings include: (1) current insolvency (inability to pay one’s debts) or (2) if the debtor

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applies for insolvency also impending insolvency (the expected lack of liquid resources necessary for paying one’s debts). In the case of legal persons, the court may also grant an order initiating insolvency proceedings in the case of (3) excessive indebtedness. Excessive indebtedness exists if the liabilities of the business exceed the value of its assets. This excessive indebtedness is not shown by the normal financial statement. Rather, the determination is made with the help of the so-called “Überschuldungsbilanz” (excessive indebtedness balance). The basis of this special financial statement may, however, be the normal commercial balance sheet. The primary difference between the commercial balance sheet and the excessive indebtedness financial statement is that, in the latter, it is very important to properly reflect the true value of the business’s assets and liabilities. The assets are valued with their real value, which often deviates from their book value. Therefore, in preparing the excessive indebtedness financial statement, a decision must be made whether property shall be valued according to its liquidation value or according to the “going concern” principle. Which method is used depends on whether a business analysis indicates a positive or a negative prognosis. If the business is not able to continue in existence, then the liquidation value will be used. Otherwise, the “going concern” method of valuation should be employed.

The manager of a legal person has a difficult task because he is required by law to file a bankruptcy petition as soon as the business is insolvent or has excessive indebtedness. Whether a business is insolvent is difficult to ascertain because this prerequisite is not fulfilled with only temporary lack of means to pay the company’s debts. In order to meet the legal obligation concerning over-indebtedness, the managing director must, as a practical matter, begin to prepare an excessive indebtedness balance on a monthly basis as soon as the business finds itself in a financially critical phase. If the manager of the business fails to file a bankruptcy petition when required, he often is held liable for civil damages.

Prior to the official institution of insolvency proceedings, the appropriate Local Court decides whether the petition for the institution of bankruptcy proceedings shall be initially accepted. Venue is not only determined by the official domicile (registered office) of the business, but also according to where the business conducts its economic activities. Therefore, efforts of a debtor to influence the choice of judicial forum by relocating the business’s registered office or domicile are generally ineffective.

If the petition for the institution of insolvency proceedings is initially accepted, the Local Court will issue an order prohibiting the creditors from pursuing execution or enforcement actions in moveable assets, and will appoint a provisional insolvency administrator. Frequently, the debtor will be prohibited from managing his property. Such management rights will be transferred to the provisional administrator.

The provisional insolvency administrator has the following duties:

●To protect and preserve the property of the debtor

●To carry on the business for the time being unless the court has ordered its closure

●To determine if the assets of the debtor are sufficient to cover the costs of the insolvency proceedings

2.2Security Interests

In particular, this last duty means that the provisional insolvency administrator must determine if the unencumbered assets are sufficient to cover his own expenses as well as his compensation. Still, an uncountable number of applications for the institution of insolvency proceedings are denied, and the basis for this denial is an insufficient amount of unencumbered assets. The reason that debtors often possess so few unencumbered assets is the extensive use of security interests in Germany. Hardly anywhere in the world do such far-reaching and commonly used possibilities exist for the supplier to secure the payment of an unpaid purchase price.

As a first step, the supplier does retain ownership rights in the delivered product. In addition, it is common for the supplier to secure in advance a security interest in the products that are to be produced with the help of the delivered product. Further, suppliers typically require the debtor to assign to the supplier all accounts receivables which result either from the sale of the supplied product or from the sale of the product which the debtor has produced with such product (extended reservation of title). According to the standard business terms often added to contracts, the supplier further does not lose his security rights with the payment of the purchase price of the respective products. Rather, such rights are extinguished only at the point when all claims against the buyer have been satisfied or when the value of the supplier’s security greatly exceeds the value of his underlying claims.

Similar to the supplier, the bank which has provided financing also secures its loan by obtaining a transfer of ownership rights in business assets or assignment of the debtor’s accounts receivables.

Unlike in most countries, the creation of security interests in personal property neither requires certification by a notary nor registration. Rather, sellers and buyers or banks and debtors create such interests through contracts which incorporate standard business terms. Notarization as well as registration is only required in order to obtain security in real property through a land charge or mortgage. Although standard business terms are sufficient, they should be drafted with care, because otherwise the intended effect can easily be missed (see III.B.).

The creditor who holds one of the above referenced security interests in principle has in some cases the right to demand surrender of his property from the insolvency administrator (screening, e.g., in case of reservation of title). However, the court may decree that the insolvency administrator is entitled to reject such a demand in order to continue the business in cases where the respective item is of significant relevance for the continuation of the business. In any event, the insolvency administrator is obliged to satisfy a secured creditor’s claim before the satisfaction of other creditors’ claims (preferential treatment).

In case of goods delivered to the debtor under reservation of title, the administrator can return the goods for the seller or can keep the products for fulfillment of the purchase contract to continue with the business. In this case, he must pay the full purchase price to the seller (see below IV.E).

In case of preferential treatment, the insolvency administrator satisfies such preferred creditors claims either out of the resulting proceeds of his sale of the secured

property or out of the accounts receivables associated with such property which he collects. Above all the latter becomes practicable if the debtor, in case of an extended reservation of title supra second break has sold the supplied product or if he has processed and then sold the result of the processing. The administrator in such cases will collect the purchase prices from the customers of the debtor and pay the outcome to the creditors after deducting 9% fee for his efforts.

2.3Negative Result of the Preliminary Investigation

When the insolvency administrator to a large extent finds such secured goods in the above described ways, hardly any value is left over for distribution to the remaining creditors or to cover the costs of the insolvency proceeding. One provision which helps to ensure that at least some value exists, however, is the requirement that 9% of realization proceeds from property obtained through the efforts of the insolvency administrator must be allocated to the insolvent’s estate.

If the provisional insolvency administrator determines that the debtor does not possess sufficient unencumbered property to cover the costs of the proceedings, he will recommend to the court that it deny the petition for the institution of bankruptcy, unless a creditor exists who is willing to provide an advance to cover the foreseeable costs. A creditor will only consider making such a payment if the insolvency administrator, given his economic expertise and his understanding of the debtor’s circumstances, is in a position to at least recover and pay to the creditor a portion of the claim which such creditor stands to lose.

If the petition for institution of bankruptcy proceedings is denied and execution becomes possible, a creditor may attempt to achieve payment of his claim by way of a separate execution action. However, in conjunction with denying the petition to initiate bankruptcy, the court in the case of a bankrupt legal person will order it struck from the commercial register with the result that such business no longer exists.

3Order of Events in the Insolvency Proceedings

3.1Institution of the Proceedings

If the court, based on the opinion of the provisional insolvency administrator, determines that the debtor has sufficient assets for the institution of bankruptcy proceedings, then it shall issue an order initiating such proceedings. The court appoints an insolvency administrator. If the debtor himself wishes to handle the further proceedings, the court will appoint him, if it comes to the conclusion that this has no adverse effect on the proceedings. The court in this case must appoint a person whose role it is to supervise the debtor’s transactions.

At the same time, all creditors are given a certain amount of time to present their claims to the insolvency administrator and reveal all of their security interests and rights in the property of the debtor. All persons with claims are required to seek relief only from the insolvency administrator instead of the debtor (see IV.B.).

In addition, the fact that bankruptcy proceedings have been instituted is publicized in the Internet (http://www.insolvenzbekanntmachungen.de).

3.2Collection of Assets by the Administrator

As previously mentioned, determining the assets is one of the duties of the insolvency administrator. For this purpose he can alienate the entire company by means of asset deals which could possibly bring the proceeding to a fast end. However, he also can proceed with the business operation himself, or he can cease operations and primarily concentrate to assert the debtors claims against customers, shareholders and managing directors and to wind-up the debtor.

With regard to limited liability companies (GmbH + AG as well as GmbH & Co. KG) he shall at first check whether the nominal capital has been fully paid in, whether loans granted to the company by shareholders have been re-paid to shareholders within the last year prior to the filing of the petition for the institution of insolvency proceedings or whether some creditors have received preferential treatment before others by payments during the past few months prior to the opening of the insolvency proceedings (also the house bank, e.g., by customer payments into an account showing a negative balance), etc. All this leads to claims of the insolvency estate, and the administrator will, in the first instance, assert those claims extra-judicially and, if necessary, enforce the claims by court action. This explains why insolvency proceedings in most of the cases take years.

3.3Announcement of Claims, Surrender of Property

Typically, creditors file their claims through use of a special form which the court provides. Although a creditor can personally handle the filing of a claim, most creditors secure an attorney to represent them in the announcement of their claim. In this way, the creditor ensures that he has an attorney who is familiar with the issues in case the insolvency administrator fails to recognize the claim(s), and it becomes necessary for the creditor to take legal steps to enforce such recognition. In spite of the denial of the claim through the insolvency administrator, an action for allowance of the claim is not necessary if the creditor already has an executory title (e.g., a judgment). If the debtor still contests the claim, he and not the creditor has to institute legal proceedings.

Attorney representation is also advisable for those creditors with security interests in the debtor’s property. Such a security interest can arise, for example, when the creditor delivers property under a reservation of title or provided credit under

the condition that he be granted a lien in the debtor’s property (see II.B.). If a creditor’s claim is secured, it is not only necessary to correctly announce one’s claim, but care must also be taken to ensure that the property which is owned by the creditor and not the debtor is surrendered by the insolvency administrator. Despite such security, voluntary delivery of the creditor’s property is not always forthcoming. It can fairly be said that the insolvency administrator is interested in saving as much of such property as he can for all the creditors, thereby achieving the largest distributive share for each creditor as possible. The insolvency administrator who accomplishes this not only develops a good reputation, but can also command a higher compensation for his services rendered in the proceedings. Thus, the creditor’s demand for recognition of his security right is quite often met with arguments by the insolvency administrator against the legal effectiveness of such right, rather than with a easily obtained recognition.

3.4Committee of Inspection and Creditors’ Meetings

In addition to the insolvency administrator, the court often appoints a Committee of Inspection (Gläubigerausschuss) consisting of representatives of creditor groups (i.e., creditors with claims of relatively greater value, creditors with claims of lower value, employees, etc.). The Committee of Inspection supports and oversees the actions of the insolvency administrator.

In addition, the creditors as a whole may decide important issues in a creditor’s meeting to which all creditors are invited (Gläubigerversammlung). Such decisions include discharge of the insolvency administrator, the appointment of his replacement, the closure of the business or its continued operation.

3.5Distribution of Property to Creditors and Conclusion of the Proceedings

When the insolvency administrator has essentially brought the insolvency proceedings to an end, he presents the court with a recommended list of the amounts that each creditor shall receive. Upon receipt of the court’s approval, the property of the debtor is distributed. Following this distribution, the court declares the proceedings to be concluded.

To the extent claims of creditors have not been satisfied, and assuming the debtor has any remaining property or income, creditors can file an execution or enforcement action against the debtor in an attempt to recover their claim. However, such execution or enforcement actions are not possible if the debtor has been granted a discharge of all his remaining liabilities (see I above and VI below). From a legal standpoint, creditors can (and assuming their claims are not barred by the

statute of limitations) always pursue their unsatisfied claims against a legal person because legal persons are not entitled to a discharge of remaining liability. All claims which were recognized in the course of the bankruptcy proceeding remain enforceable for 30 years against any future property acquired by a legal entity. However, from a practical standpoint the possibility of property acquisition by a bankrupt company is not very large, since, as the result of the insolvency proceedings, the company has been struck from the commercial register and, therefore, is no longer permitted to operate as a business.

4Effect of the Institution of Insolvency Proceedings

4.1Legal Actions

The institution of insolvency proceedings results in a suspension of all lawsuits which have been brought by or against the debtor. In the insolvency administrator’s discretion, however; such actions can be pursued by the insolvency administrator. In addition, if the action involves certain rights of the creditor, such as a claim for the debtor’s surrender of secured property, the creditor also is entitled to continue the lawsuit.

4.2Enforcement/Execution

No individual creditor may execute upon the debtors property during the course of the proceedings. This does not apply to execution actions undertaken based on certain types of liability claims, which arose due to acts or omissions of the insolvency administrator.

4.3Offsets

Creditors may not offset their claims against the debtor’s claims during the insolvency proceedings, unless the creditor would have been able to do so prior to the institution of such proceedings. This means, for example, that a creditor is not permitted to obtain satisfaction of his claims against the debtor by purchasing goods from the insolvency administrator and then off-setting his claim against the purchase price he had to pay to the insolvency administrator. The offset ban also prevents a debtor of the insolvent business from buying up the claims of the insolvent business’s creditors in order to offset them against the insolvent business’s claims against him.

4.4Contesting the Debtor’s Prior Transactions

Often creditors deal with the debtor in order to secure property in satisfaction of their claims prior to the institution of the insolvency proceedings. This can occur, for example, through the debtor’s gift of money or property to individual creditors, through the debtor’s satisfaction of the claims of individual creditors, or through the debtor’s grant of security to individual creditors.

The law grants the insolvency administrator the right to contest such legal transactions i.e., the right to demand the return of such money or other property or rights therein. While the laws regarding such contests by the insolvency administrator are quite complicated, it can be said that all steps taken by the debtor for the benefit of a creditor will be critically examined if such steps took place within the 3 month period prior to the filing of the petition for the institution of insolvency proceedings. Such pre-insolvency petition transactions are suspect, even if the creditor is not given exceptional preferential treatment, but only receives what he is entitled to under his existing contract with the debtor. Moreover, even the receipt of security or a satisfaction of a creditor’s claim pursuant to the outcome of regular judicial proceedings is subject to contest by the insolvency administrator.

The administrator further can hold the managing director(s) liable for such payments.

Of particular importance in this context is the re-payment of a loan by the insolvent GmbH or GmbH & Co. KG to shareholders. In case such re-payment was effected within the year prior to the filing of the petition for the institution of insolvency proceedings, the administrator may demand respective refund (prospective legal status from June 2008 onwards).

4.5Delivery of Goods Contracts

The insolvency administrator is not obligated to secure the complete performance of contracts, which, at the time of the institution of insolvency proceedings, have not yet been completely performed by the debtor or the other party. Rather, he has a choice whether or not to demand performance by the contract partner. If the insolvency administrator determines to demand full performance, he must first ensure that the debtor’s obligations under the contract are performed by paying the full purchase price. If the insolvency administrator decides to forego fulfillment of a contract, then the contract partner may only demand damages, and in so doing, such contract partner’s claim shall be treated like those of a general creditor of the bankrupt person, i.e., such contract party receives (partial) payment only if all the other creditors also receive at least a partial satisfaction of their claims.

The contract party has the right to a timely decision by the insolvency administrator regarding whether or not his contract shall be fully carried out. If the insolvency administrator does not reach a prompt decision in this regard, he loses his

right to demand performance of the contract. An exception exists if the contract partner has sold property to the debtor under a reservation of title to such property (see II.B.). In this case, a longer decision-making period is afforded to the insolvency administrator (Section 107 II of the Insolvency Act). This exception enables the administrator to use that property, at least until he has met a decision whether or not to continue the debtor’s business.

4.6Leases

If the debtor has leased immovable property, then such leases remain in effect after the institution of bankruptcy proceedings. If the debtor has leased space himself, the insolvency administrator has the right to terminate said lease. In so doing, he is entitled to take advantage of the shortest notice of termination period allowed by law.

4.7Employment Contracts

The earnings of employees for the last 3 months prior to the institution of the insolvency proceedings are guaranteed to be paid, because the law grants all employees the right to payment of these earnings from the government employment office, in the event of their employer’s insolvency.

According to Section 113 of the Insolvency Act, the insolvency administrator may discharge an employee upon giving a 3 month notice of termination. This is true even if the contractual or normal termination notice period provided by law is longer. This has practical significance primarily in the case of employees who have worked for the insolvent business for a long time, because such employees are often entitled to a much longer notice of termination. Termination of employees under the Insolvency Act are subject to challenge before the Labor Court just like any other termination. The termination can be challenged on the basis that it is not justified in light of the fact that the business is to be continued in operation. As a rule such a complaint has a chance of success only if the debtor employs more than ten persons. Only then are the provisions of the “Kündigungsschutzgesetz” (Termination Protection Act) applicable. (Note: See chapter “Aspects of German Labor Law”).

Despite the applicability of the Termination Protection Act, the insolvency administrator can reduce the number of employees in order to reorganize the business, provided that he is able to convince the Labor Court that the termination of a certain number of employment contracts is absolutely necessary and that such terminations are fair. This latter condition can be shown to have been met by evidence that the insolvency administrator has taken the employees’ length of service, age and support obligations into consideration in determining which employees to terminate.

5The Insolvency Plan

A special variant on the outcome of the insolvency proceedings is the establishment of an insolvency plan. This plan, which can be presented by the debtor or by the insolvency administrator, enables the insolvency proceedings to be handled in more flexible ways. The parties can resolve a procedure which differs fundamentally from the insolvency proceedings described under Sects. 2–4 of this chapter.

While the usual outcome of insolvency proceedings is liquidation of the business, the adoption of an insolvency plan can result in the business being transferred to a third party or the business being continued in operation or continued in operation in a reorganized form rather than being liquidated.

An insolvency plan must be presented in a writing and contain a description of the stage reached in the insolvency proceedings, the measures which remain to be taken, the treatment of the creditors, etc.

The court can reject the insolvency plan under certain conditions, for example, if the debtor has presented a plan, which is obviously not feasible. If the court does not reject the plan, then it is presented to the creditors for their approval. For this purpose, the creditors with the most similar financial interests are grouped together. The insolvency plan is then deemed accepted by the creditors if the following two conditions are met: (1) a majority of all creditors in each group agree to the plan and (2) the creditors in each group who have approved the plan represent a majority of the claims in such group (according to amount).

It is further deemed to be accepted if the majorities have not been reached, even though the plan was reasonable for the group rejecting the plan (prohibition of obstruction).

If the plan is accepted, then its content determines whether claims shall be forgiven or deferred, or whether property of the debtor shall be sold etc. In other words, the insolvency plan determines how the insolvency proceedings shall be carried out.

6Discharge of Remaining Debt

In Germany the usual limitation period for the claims (i.e., period after which existing claims are barred) is 3 years, unless an executory title for the claim is existing.

In such case the limitation period is 30 years. However, a debtor has the possibility of achieving a discharge of his liabilities if he undergoes a certain procedure and thereafter can show that in the 6 years following the beginning of the insolvency proceedings, he tried his best to fulfill his obligations vis-à-vis his creditors.

As implied in the above sentence, a debtor is entitled to such a discharge only if he has been the subject of a bankruptcy proceeding which has been finalized. Upon the debtor’s application for discharge, the court releases the debtor from his remaining liabilities on the condition that he complies with certain duties, including:

●That he be reasonably gainfully employed or at least has made a good faith effort to secure gainful employment

●That to the extent not urgently required for his support or the support of his family, he makes half of all assets which he acquires through inheritance, the lottery, or earnings available to his creditors

●That he provides notice of all changes of his address

7International Insolvency Procedures

It is now common practice that foreign companies keep up branch offices in Germany and that German companies keep up branch offices abroad. If such company becomes insolvent, the question of which law is applicable to property abroad.

Germany, like the entire European Union, has decided to recognize insolvency proceedings instituted abroad if – according to German law – the foreign court is competent for the proceedings. Regarded as competent for the proceedings according to German law is the court where the debtor’s centre of business activities is located.

On the other hand, German courts apply German law in insolvency proceedings in Germany to the debtor’s assets situated abroad.

However, there are a number of exceptions to the above principles.

It is possible to open separate insolvency proceedings against the German company’s property abroad or against a foreign company’s property situated in Germany. In such a case, the law of the country in which the separate proceedings are filed is applicable.

Moreover, German law applies in cases regarding security interests on property created under German law. The creditor to whom a security interest was created according to German law, may trust that his position will not be less favourable than it would be the case at German insolvency proceedings (Section 351 German Insolvency Law). Furthermore, according to the aforementioned rule, German law generally applies to immovable property. In this regard, the foreign insolvency administrator does not have more options than those provided by German law.