German Portfolio Companies in Distress – Avoiding Liability Pitfalls for Sponsors

The shareholder is typically management’s first point of contact for financial assistance, and German (insolvency) law is notoriously prone to trigger liability where a rescue attempt has failed.

Absent any pre-agreed commitments under the shareholders’ agreement or articles of association, shareholders are not responsible to expand their exposure and provide fresh money or other forms of financial assistance.

In a multi-shareholder structure, individual shareholders must not use their voting rights to veto a required and promising rescue attempt that has the support of the majority shareholders. In practical terms, this in particular means that once balance-sheet equity has turned zero or negative, minority shareholders can be forced out unless they buy back into the equity by contributing fresh money. If called for by the circumstances, it can also be justifiable to offer existing shareholders less than their pro rata share of the new equity, or no new equity at all.

In StaRUG restructuring proceedings, shareholders can be forced out against their will by the lenders. A controversial line of lower-court decisions suggests that StaRUG proceedings over private companies cannot be commenced without shareholder approval. It is unclear if the German Federal Court would uphold this requirement for shareholder approval. It is also conceivable that a middle route may emerge; eg, that no shareholder approval is required if the shareholders are out of the money and have refused to contribute to a going-concern solution.

As long as no insolvency proceedings have been opened, shareholders stay in control and retain their power to replace and issue binding instructions to management. This includes the decision to “cut the lifeline” and, for example, instruct the removal of individual subsidiaries from the group’s cash pool, even if this inevitably pushes the subsidiary into insolvency (and as long as this does not come with a value extraction, see immediately). The right to issue instructions is limited by management’s mandatory statutory duties. In particular, management cannot be instructed to:

A “deep” subordination of shareholder loans is a typical early measure to fix a company’s balance sheet. While claims under shareholder loans (and economically equivalent claims) are for the most part automatically subordinated in a German insolvency, such loans still need to be factored into the balance-sheet solvency test, unless a deep subordination has been agreed. Deep subordination essentially means that interest and principal are only payable from future annual surpluses, a liquidity surplus, or other free assets which remain after full satisfaction of all other creditors and as long as not causing the debtor’s insolvency.

The German Federal Court has stipulated detailed requirements as to the wording of such deep subordination clauses which must be strictly observed in order to achieve the desired effect.

Comfort letters are often requested by auditors of technically over-indebted companies to enable the issuance of an unqualified audit opinion. The intention to endow the company with financial resources can be communicated on a non-binding (“soft” comfort letter) or on a binding basis (“hard” comfort letter). From a shareholder perspective, it may often be preferable to provide a soft comfort letter to retain optionality, and soft comfort letters are typically also sufficient for audit purposes as long as there are no specific reasons to call the company’s solvency into question.

For the distressed scenario, the German Federal Court in 2021 held that a soft comfort letter alone is typically not sufficient to support a positive going-concern prognosis and thus remedy balance-sheet insolvency. According to the German Federal Court, a soft comfort letter as such is no sufficient evidence that the shareholder will contribute the required funds on a more-likely-than-not basis, as would be necessary to uphold a positive going-concern prognosis. Issuing a comfort letter thus requires careful balancing of the shareholder’s versus the company’s interests and tailored wording that provides the necessary support to the company without exposing the shareholder to more liability than intended.

A German peculiarity is its “lender liability” regime under which new money providers can be held liable for other creditors’ losses if the new credit is deemed to have delayed an inevitable insolvency for selfish reasons. Lender liability risk can be mitigated by relying on an expert opinion certifying that the new credit was ex ante required and sufficient to achieve a sustainable restructuring.

It is unclear to what extent this regime, and thus the need to obtain a restructuring opinion, also applies to fresh shareholder money. Typically, there should be good reasons to argue that no restructuring opinion is required to protect the shareholder because shareholder funding is always subordinated in a German insolvency and providing fresh money can thus be regarded as evidence that the shareholder had no intention to harm creditors. However, where exceptional circumstances imply that fresh shareholder money improves the shareholder’s position in a subsequent insolvency (eg, because the fresh money is aimed at enabling affiliate transactions benefiting the shareholder), it may be worth considering obtaining a restructuring opinion as downside protection.