Directors’ liability risk in Germany – Part 2

In part 1 of this article, we provided a brief overview of the general risks and duties of directors of German-based companies in a situation of financial distress. In this part 2, we will take a closer look at certain transaction types in the context of trading after an insolvency event.

Limitations on trading after an insolvency event

Upon the occurrence of an insolvency event, the directors are obliged to protect the company’s assets from dissipation. Consequently, directors are generally prohibited from disbursing funds from the company's estate following insolvency, which severely limits the company’s ability to continue to trade. However, the immediate and absolute cessation of all payments may not always be in the best interest of the creditors. Especially when the management considers to strategically utilize the insolvency proceedings to facilitate a sale of the business or part of it, a debt-to-equity swap or any other solution, which entails to (temporarily) uphold operations, cessation of all trading could lead to a collapse of the business, rendering any efforts to restructure to be futile from the onset. This risk can be particularly high where, for example, management ceases to pay utilities like electricity and water, employee wages, or critical suppliers.

Therefore, after an insolvency event has been triggered, directors must simultaneously safeguard creditors’ interests in preserving the company’s assets while ensuring the operations of the company are continued to the extent necessary to enable a potential restructuring, which should also be in creditors’ interests.

This principle is reflected in Sec. 15b InsO, which provides for a strict limitation of the payments which can still be made by the company after it has become insolvent. The term "payment" is to be interpreted broadly and is not limited to cash payments. This means that almost any outflow of assets from the company's estate is within the scope of the rule. Any payments made in contravention of this rule must be personally reimbursed by the directors. An exception from the general prohibition to make any payments after the occurrence of illiquidity or over-indebtedness is made for so-called "privileged" payments. The liability risks which follow from making non-privileged payments include unlimited liability and insolvency administrators often vehemently pursue the assertion of such claims against directors.

Privileged or not privileged, that is the question

Whether or not a specific payment is privileged and therefore can be executed by the directors without risk of having to reimburse that payment, is not always clear.

Sec. 15b InsO provides that the general prohibition of payments only applies to those not “consistent with the due care of a prudent and conscientious manager”. This rather vague description hardly serves as clear guidance to directors as to which payments are within the exception and which are not. In turn, by broadly referencing the unwritten but universally acknowledged code of conduct for prudent and conscientious managers, German lawmakers recognise that crisis situations are as complex as trading. The privileged treatment of a payment therefore remains open to interpretation and subject to an assessment of the circumstances of the specific situation, similar to the business judgement principle under fair weather conditions.

To provide further guidance, Sec. 15b InsO establishes an assumption that payments made in the ordinary course of business are, generally, privileged if they are objectively necessary for the purpose of upholding the company’s operations. Such payments may include payment of wages and salaries, rent or lease payments, payments for gas, water, or electricity, telecommunication bills, premiums for essential or legally mandatory insurances, and purchasing of essential goods. Nevertheless, it is important to note that every payment must be scrutinized to ascertain whether or not it is actually required for business operations. Directors would be well advised to seek professional advice when assessing whether a payment can be made. In addition, the rationale for making a specific payment at a particular time should be duly documented.

The privileged status of certain payments is always subject to the condition that the directors take parallel measures either to eliminate the insolvency risk or to prepare an insolvency application. Accordingly, in the event of a delay in filing for insolvency, i.e. after the deadline for filing for insolvency has passed, all payments are generally deemed to be incompliant with the due care and diligence of a prudent and conscientious businessperson.

Examples for special risks related to certain transaction types

First let us consider a few examples for transactions leading to common pitfalls that directors must be aware of in order to avoid liability:

• Direct debits: Since direct debits also constitute a "payment" within the meaning of Sec. 15b InsO, all direct debit / SEPA mandates should be revoked as a precautionary measure so that the directors can decide for themselves in individual cases whether a (privileged) payment is made or a (prohibited) payment is not made.
• Incoming payments on negative accounts: Perhaps counterintuitively, even received payments can be a relevant “payment” within the meaning of Sec. 15b InsO, if the payments are made to a bank account with a negative balance as the incoming funds are effectively used to repay a credit line to the account-keeping bank. It can be advisable to make sure that all payments received by the company are sent to a non-overdrawn non-pledged account to avoid liability risks.
• Payment obligations under tax law: German tax law provides that directors may, under certain circumstances, be liable for the unpaid tax obligations of the company. After insolvency has occurred and if the directors are not late in their duty to file an insolvency application, this liability risk is eliminated by Sec. 15b InsO. The preservation of the assets of the company in the interests of its creditors takes precedence vis-à-vis the interest of the tax authorities to collect and directors cannot be held liable for unpaid taxes.
• Social security contributions: Similarly to the non-payment of tax obligations, the non-payment of social security contributions on behalf of employees results in personal liability risks for directors. This may even lead to criminal prosecution. Hence, regardless of whether or not directors pay the contributions, they face potential liability risks, which constitutes a severe conflict of duties. However, contrary to tax obligations, Sec. 15 InsO does not provide an exemption that allows directors to withhold social security contributions without having to fear liability. Therefore, their payment would – in most cases – be considered as privileged under insolvency law.

These examples illustrate how directors must proceed with caution when making payments on behalf of a distressed in the timely context of a crisis situation.

Legal consequences and scope of liability

Any violation of the directors’ duty to file for insolvency within the relevant time periods after an insolvency event can lead to criminal prosecution. This may result in monetary fines or imprisonment for up to three years.

The non-payment of employees’ contributions to the relevant social security providers may also lead to criminal prosecution of directors, which may result in monetary fines or imprisonment for up to five years.

The exact legal consequences of prohibited, i.e. non-privileged, payments were controversial before the introduction of Sec. 15b InsO in 2021. The German Federal Court of Justice (Bundesgerichtshof) previously assumed an obligation to compensate each individual payment after the occurrence of an insolvency trigger, insofar as the company was not directly compensated. While nowadays the law still stipulates that directors are obliged to reimburse the relevant payments, they are granted the opportunity to prove that the creditors of the company have actually suffered a loss which is less than the aggregated individual payments made from the company’s estate after the insolvency event. This typically requires for the directors to prove that any compensatory consideration for certain payments is still available in the company's assets and can be realised for the benefit of the creditors. The directors’ obligation to reimburse the payments may then be limited to the remaining losses suffered by the creditors.