Boom To Bust: Investor Risks When a German Portfolio Company Faces Insolvency
Germany is a bellwether for international economic robustness, but the first half of the year saw the number of German companies filing for insolvency proceedings rise by a hefty 20.5% compared to the first half of 2022 (according to Destatis). This is the largest percentage jump in more than two decades.”
No wonder that investors such as private equity or venture capital funds which have (indirectly) acquired shares in a portfolio company in Germany may be nervous. Under German law, investors using a typical acquisition structure face the risk of the total loss of their equity investment during insolvency proceedings of a portfolio company, as the proceeds from the sale of any assets (unless otherwise stipulated by an insolvency plan) are entirely allocated to the priority satisfaction of creditors.
This risk is well known and the flip side of the profit opportunities of investments. Less well known might be the fact that under German law, investors (as direct or indirect shareholders) may be exposed to additional risks in a portfolio company’s insolvency, which may exceed the original investment.
The following risks apply to portfolio companies incorporated as German limited liability company (Gesellschaft mit beschränkter Haftung – “GmbH”) or German stock corporation (Aktiengesellschaft – “AG”) and German law.
- Obligations to file for insolvency proceedings
A company’s management (not its shareholders, except in narrow exceptions) is obliged to file for insolvency proceedings upon the occurrence of over-indebtedness or illiquidity of a portfolio company as well as the various related liability risks under civil and criminal law in case of a violation thereof.
Individuals managing the investor’s investment are generally only exposed to personal liability risks in relation to the portfolio company’s insolvency event if they have assumed a management position at the entity. However, investment managers of the investor may also be exposed to a liability risk due to filing obligations as de facto managing directors (who are not duly appointed as managing directors) under certain circumstances.
- Liability for a portfolio company’s debt
Investors’ risk of liability (as shareholder) for the portfolio company’s liabilities is usually capped at the amount of the (pro rata) share capital participation, due to the liability privilege that these legal forms grant. There are, however, exceptions to that liability privilege, the most important being by actions of the investors which damage the company and lead to the insolvency of the company. Investors might think that this risk is only remote but if considering actions such as mergers or fire asset sales may severely damage a company, the risk becomes more imminent.
- Breaches of capital maintenance regulations
Investors might be liable for payments or any other benefits they have received from the portfolio company’s assets in violation of German statutory capital maintenance rules. With respect to such payments, they may be debtors of a claim for reimbursement of the portfolio company (later asserted by the insolvency administrator). Liability risks for investors result, inter alia, from the fact that such reimbursement claims may not only be asserted against the direct shareholder, but in various circumstances third parties (e.g. sister companies) who are equivalent to direct shareholders in terms of liability may also be liable for reimbursement. Therefore, an investor’s leeway for circumventing the liability risks of such payments is considerably limited.
- Shareholder financing delaying insolvency
If investors (as shareholders) grant debt or equity capital to a financially distressed portfolio company to save the investment, they can be held liable for damages to third party creditors due to immoral intentional damage by delaying insolvency under certain circumstances. In this respect, the principles of lenders liability for delaying insolvency might also apply to shareholder financing.
Such liability can arise in relation to shareholder financing if a shareholder delays the timely filing for insolvency proceedings for selfish reasons, intends to gain an individual special advantage by delaying the insolvency, this is to be qualified as immoral and third parties therefore engage in transactions with the company, which they would not otherwise have entered into, and thus suffer damage.
- Subordination of claims from shareholder loans
If investors have granted shareholder loans to a portfolio company, they are exposed to the risk that, in the event of the portfolio company’s insolvency, their outstanding claims for repayment of these shareholder loans are, as a general rule under the German Insolvency Code, subordinated to insolvency creditors and certain other subordinated creditors in insolvency proceedings of the portfolio company and will therefore usually not be satisfied (subject to exceptions). This risk becomes particularly relevant for investors if they grant loans to the portfolio company to avoid or eliminate the occurrence of mandatory reasons to file for insolvency proceedings in order to save their investment.
- Insolvency claw-back risks
Correlating with investors’ risks that their claims under shareholder loans are subordinated in a portfolio company’s insolvency proceedings, investors’ may be exposed to the risk that security or satisfaction received in respect of these claims may be subject to claw-back claims under the German Insolvency Code. Such claw-back risk may arise regarding securities or satisfactions received prior to the commencement of the insolvency proceedings of a portfolio company within certain hardening periods. As a result of a successful assertion of a respective claw-back claim by an insolvency administrator, securities or satisfactions received must be returned to the portfolio company’s insolvency estate.
Further risks of claw-back claims may arise for investors in case of a portfolio company’s insolvency, for instance, regarding an attempted transfer of material assets by portfolio company to the investor or affiliated companies of the investor prior to the insolvency proceedings.
Some of the investors’ risks in connection with the insolvency event of a portfolio company are rather remote and will probably only materialise in exceptional cases. However, practically relevant risks for investors in the insolvency event of a portfolio company may arise for:
- reimbursement obligations for payments or other benefits received from the portfolio company’s assets in breach of capital maintenance provisions;
- the subordination of claims arising from shareholder loans in the portfolio company’s insolvency proceedings; and
- risks of claw-back claims regarding, inter alia, collateral or satisfaction received from the portfolio company regarding claims under shareholder loans or a pre-insolvency transfer of material assets of the portfolio company to the investor or affiliated companies.
Peter Memminger is a Partner and Jonas Schwarz is Counsel at King & Spalding in Frankfurt
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