Directors’ liability risk in Germany – Part 1

Introduction

The scrutiny jurisdictions apply to directors’ management of a distressed company differ vastly. This applies equally to directors’ obligations to take measures to restructure the company as well as to file for bankruptcy under certain conditions. Whether - and to what extent - directors are permitted to continue to trade on behalf of a company after an insolvency event is also viewed differently by jurisdiction. Even among the member states of the European Union, which aim for an increasing harmonisation of their individual insolvency and restructuring laws, the rules company directors must adhere to in distressed situations remain inconsistent.

Looking at the various legal frameworks governing directors’ liability, it is fair to say that German law provides one of the strictest and most ominous set of rules on directors’ liability. For directors of companies with their centre of main interest (COMI) in Germany, violations of these rules can result in criminal prosecution and unlimited personal liability.

In the context of group-wide restructurings where only individual subsidiaries have their COMI in Germany, the directors of the German entities typically seek higher levels of comfort when assessing the likelihood of a successful restructuring and securing future financing. The strict German rules on directors’ liability are often regarded as a bottle neck which the directors of cross-border groups with operations in Germany must overcome.

In the first part of this three-part article, we provide a general overview of the duties and highlight key liability risks for directors of companies in financial distress.

 

Background

The directors of a company are generally obliged to protect the economic interests of the company for the benefit of its shareholders. However, once the company becomes insolvent, it no longer possesses sufficient assets to satisfy its creditors – absolutely (over-indebtedness) or within a specific timeframe (illiquidity). This inherently defective state disqualifies the company from partaking in economic life and marks the onset of its exit from the market. In insolvency, the shareholders’ claims, be it equity or loans, are subordinated in relation to other creditors’ claims. As such, shareholders cannot recover their investment unless all other creditors have been paid in full.

This principle justifies that creditors’ interests completely replace the shareholders’ stake in the company in an insolvency scenario. Henceforth, the pari passu principle provides that all creditors within the same class are entitled to equal treatment in respect of their claims. The directors’ primary duty then is to preserve the company’s estate in order not to further deplete the assets. Herein lies the reason why policymakers have established rules on director’s liability. These rules aim to prevent directors of companies in distress from actions which may disadvantage the companies’ creditors.

 

A duty to restructure?

German law emphasises that creditors’ interests can overtake shareholders’ interests even before a company becomes insolvent. Pursuant to Sec. 1 of the German Act on the Stabilisation and Restructuring Framework for Businesses (StaRUG), directors are obligated to consistently oversee any developments that may jeopardize the company's solvency, implement suitable countermeasures, and promptly inform supervisory bodies of such developments. This illustrates that once a company is in financial difficulties, the creditors' interests become most relevant and gradually shift away from the shareholders. 

Under German law, a company is deemed to be in financial difficulties if its directors cannot sincerely and plausibly conclude a predominant probability that within the next 24 months the company will be able to meet its liabilities as they fall due. In this event, the directors are permitted – but not required – to make use of the StaRUG restructuring framework or to file for insolvency proceedings based on imminent illiquidity (drohende Zahlungsunfähigkeit).

The requirement to “implement suitable countermeasures” is understood by some commentators as a strict duty to restructure. This view may put it too high, as suitable countermeasures could, for instance, merely entail a request to shareholders to provide additional capital or parental guarantees. In any case, failure to fulfil the duties in Sec. 1 StaRUG may result in legal repercussions, including personal liability for damages and potential disqualification from directorships. This ensures that directors maintain vigilance and proactive crisis management to safeguard the company's stability and therefore the interests of shareholders and creditors. Therefore, directors would be well advised to, as a minimum, establish 24-month liquidity monitoring which allows for adequate tracking of the company’s forecasted financial situation and the underlying assumptions upon which it is based.

 

Duty to file for insolvency

German law provides that filing for insolvency is mandatory upon the occurrence of specific circumstances. The failure of directors to file for insolvency with the relevant insolvency court within the legal time limits is a criminal offense, which can lead to hefty monetary fines and even imprisonment. In addition, a delayed or omitted insolvency application can lead to personal liability for the directors in respect of payments made by the company after the insolvency event.

As stated above, imminent illiquidity (Sec. 18 German Insolvency Code, InsO) does not establish a duty to file for insolvency, but merely a right to do so. This is intended to enable companies to make use of the procedural tools provided by the InsO at an early stage of financial distress to facilitate a successful restructuring.

In turn, a duty to file for insolvency is triggered upon the occurrence of illiquidity or over-indebtedness. Illiquidity (Zahlungsunfähigkeit, Sec. 17 InsO) generally means that a company is unable to pay its liabilities that are due at any given time and, within a maximum of three weeks, fails to obtain the funds necessary to restore its ability to pay its outstanding liabilities, including those which have become due within the three-week period. A company is over-indebted (Überschuldung, Sec. 19 InsO) when its liabilities exceed its assets, unless it is predominantly probable (i.e. more than a 50% probability) that the company does not become illiquid within the next 12 months.

Upon the occurrence of illiquidity, directors must file for insolvency immediately and certainly within a maximum of three weeks. In the event of over-indebtedness, the maximum period to submit an insolvency application is six weeks. However, these periods may only be fully utilized under certain, very limited circumstances, if the directors take measures to prepare an insolvency application or to permanently eliminate insolvency.