1 – Corporate law & finance –BL M – No. 2 – September 25, 2014

Closed for business, but not for paying up: German courts have ruled that capital maintenance provisions in upstream guarantees do not apply to German limited liability companies undergoing insolvency proceedings.

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Quo vadis capital maintenance? Courts set aside limitation language for upstream guarantees in insolvency By Dr. Birgit Friedl and Dr. Marcus Geiss

he Higher District Court of Frank- in situations when insolvency proceed- the managing directors of German limited of upstream guarantees or collateral to furt recently upheld a ruling ings have been opened over the assets liability companies in financing transac- the detriment of financing banks. This is of the District Court of Darm- of a German limited liability company. tions in which German subsidiaries grant due to one of the peculiarities of German Tstadt restricting the scope of protection upstream collateral for shareholder debt. corporate law and its strong emphasis against capital impairment accorded While the decision has not yet become ful- on the principle of capital maintenance to German limited liability companies ly effective as further remedies are still be- The principle of capital maintenance (Kapitalerhaltung) pursuant to Sections (GmbHs): The courts argued that the ing pursued by the guarantor in the case, 30 and 31 of the German Limited Li- prohibition to repay registered share the ruling will likely impact negotiations In financing transactions it has long been ability Companies Act. These provisions capital to shareholders does not apply between financing banks, borrowers and customary to restrict the enforcement prohibit the repayment of registered –> 2 – Corporate law & finance –BL M – No. 2 – September 25, 2014

share capital by the respective GmbH the financing banks and the borrowing to its shareholders. As the amount of parent shareholders, on the one hand, registered share capital is recorded collide with the legal obligations of the When the same old way isn’t enough in the publicly accessible commercial management of the German subsidiar- register, creditors of German GmbHs ies, on the other hand, who are regularly creativity is required. can in principle rely on the fact that being asked to support the parent loan any GmbH will, based on a balance by providing upstream guarantees and/ sheet assessment, have assets to cover or other forms of upstream securities such registered share capital figures like global assignments, pledges or or, if assets have been used up in the real estate securities. The fact that the course of an entity’s business activi- subsidiary might be asked to repay or ties, they at least have not been repaid secure the parent’s debt directly vis- or upstreamed to shareholders. à-vis the bank when the parent itself defaults on its repayment obligations >> is structurally the economic equivalent The German principle of of upstreaming funds to the parent, ­capital maintenance can lead who then repays the bank. This can to frictions, particularly in also result in a prohibited repayment the context of larger inter­ of the registered share capital. In order national financings to mitigate the risk of personal liability, German management therefore has << to insist on certain contractual safe- guards, so-called limitation language, In order to sanction any undue repay- in German security agreements before ment of share capital, the managing granting any form of upstream security. directors of German corporations In essence, this language provides that face personal liability when they any future enforcement of upstream effect or authorize the repayment guarantees or security is restricted to Gibson, Dunn & Crutcher LLP of registered share capital in contra- those assets that can be used without Hofgarten Palais, Marstallstrasse 11 vention of these strict principles. infringing against due maintenance Munich 80539, Tel. +49 89 189 330 of the registered share capital fig- [email protected] In particular in the context of larger in- ure. In addition, such clauses often ternational financings, these principles include the specifics of how the free can lead to frictions. The interests of assets available for enforcement –> www.gibsondunn.com 3 – Corporate law & finance –BL M – No. 2 – September 25, 2014

are calculated and which balance sheet the guarantor’s insolvency, both courts This interpretation is reinforced by ing they did not deal with in rem or other position can be disregarded, particularly approached the issue by determining the courts’ additional auxiliary argu- genuine upstream securities, it is notable in cases in which the securing German the purpose of such limitation language ment that the registered share capital that the reasons of the courts appear subsidiary directly benefits from the first. Rather than basing their analysis is regularly used up in insolvency, any- to be deliberately abstract and broad loan granted to the parent. From the predominantly on the interests of the way. Therefore, the protective layer for enough to cover any type of upstream bank’s perspective, such limitation company’s creditors at large in preserv- creditors accorded by the principle of collateral. The effect of this judgment language may considerably reduce the ing the registered share capital figure capital maintenance no longer exists. is even more far-reaching when applied value of the guarantee or collateral. as a liability fund for all creditors, the to genuine upstream securities such as courts held that the main purpose of >> global assignments or land charges. Such The ruling such limitation language is to protect The court’s reasoning appears in rem securities give the beneficiary the managing director against the risk to be deliberately abstract and bank a secured priority claim and right The District Court of Darmstadt (Land­ of personal liability inherent in grant- broad enough to cover any to preferred satisfaction in insolvency. gericht Darmstadt, AZ 16 O 195/12) and, ing security for a debt of the parent and ­type of upstream collateral If they are indeed untouched by the on appeal, the Higher District Court of shareholder. The courts then decided limitation language in insolvency, this Frankfurt (Oberlandesgericht Frankfurt am that this protective purpose no longer << would result in a situation in which the Main, AZ 24 U 80/13) have recently become applies in insolvency proceedings be- lending banks will be entitled to enforce the first German courts to deal with the cause at this stage the managing direc- This decision means that the scope of and satisfy their claims without any effects and effectiveness of such limitation tors have already been replaced by the the assets available to the bank for satis- regard to capital maintenance rules in language clauses. In this particular case, insolvency administrator. In other words, faction of its claims is—from a legal per- preference to other third-party creditors. the borrower defaulted under the loan the limitation language served its initial spective—more extensive in insolvency and the bank in turn proceeded against purpose of protecting the managing than it was while the guarantor was still Practical implications for lenders and the subsidiary under an upstream guaran- directors of the guarantor for as long as trading. While guarantees in insolvency grantors of subsidiary security tee that contained limitation language to they were in office. As soon as they are only give the banks an unsecured claim protect the registered share capital of the replaced due to the initiation of insol- that has no structural priority over other Until further guidance by future court guarantor. The specific question the courts vency, the courts concluded, the limita- third-party creditors and is settled from decisions or by the Federal Supreme were faced with was whether such limita- tion language is no longer necessary to the regular insolvency quota alongside Court (if this decision is successfully tion language still applied and protected protect them. It thus no longer applies other third-party creditors, outside revisited on further appeal), it can be the registered share capital against the in insolvency. The bank’s claim for the insolvency, the claim under the guaran- expected that banks will revise the word- bank’s enforcement claims even after both guaranteed sum is no longer limited to tee would be restricted to the amount ing of the limitation language they are the borrowing parent and the guarantee- free assets only but now covers all of the by which the net assets of the GmbH willing to accept from borrowers or their ing subsidiary had fallen into insolvency. debtor’s assets (including those previ- exceed the registered share capital. subsidiaries in such a way as to expressly ously required and blocked to cover the state that the limitations under capital When dealing with the effectiveness sum of the registered share capital un- While the facts of the decided case only maintenance rules only apply and limit of limitation language at the stage of der a balance-sheet-based assessment). concerned an upstream guarantee, mean- the pre-insolvency enforcement by the –> 4 – Corporate law & finance –BL M – No. 2 – September 25, 2014

lenders, but exclude their applicability From a bank’s perspective, the court’s the broad applicability the courts have Dr. Birgit Friedl, in insolvency both for guarantees and view will be a very welcome one. For seemed to have given them. Without go- Attorney-at-Law, Gibson, Dunn & Crutcher LLP, all other types of upstream security. years, banks have reluctantly accepted ing into the finer details, it is, for instance, Munich limitation language as an inevitable, not true that managing directors are The courts further ruled that the limita- but bothersome restriction necessary generally replaced in insolvency proceed- [email protected] tion language also does not apply as to allow managing directors to safely ings. There are insolvency proceedings long as the subsidiary has received any enter into upstream securities. On the where the management stays in charge Dr. Marcus Geiss, unrepaid loan from the parent rather other hand, they have always argued that of the debtor during insolvency, for Attorney-at-Law, Gibson, Dunn & Crutcher LLP, than just and specifically (part of) the such language often bites hardest in the example in protective shields proceed- Munich bank loan in question because such loans very scenario for which such security is ings (Schutzschirmverfahren) and own serve as compensation for the granting granted, the financial breakdown of the administration proceedings (Eigenverwal­ [email protected] of securities. In the case at hand, the borrowing shareholder that leaves the tung). It is debatable whether the court’s borrower-shareholder and the guarantee- lending bank looking for alternative pay- reasoning justifies that the limitation www.gibsondunn.com ing subsidiary were engaged in extensive ers. If the decision of the Higher District language would also automatically cease intercompany lending. The shareholder Court of Frankfurt becomes unappeal- to apply in such proceedings. Similarly, had initially passed on a tranche of the able, this argument at least no longer ap- the argument that the registered share specific bank loan to the guarantor. In the plies once such financial distress reaches capital is regularly used up in insolvency intervening years, however, the subsidiary the stage at which the guarantor/security anyway, thus removing most of the had likely repaid this specific tranche to grantor itself has entered insolvency purpose of the limitation language, is the shareholder but reborrowed unre- because banks are then freed from the not always and automatically sound lated funds under a cash-pool system. shackles of capital maintenance and the if insolvency proceedings are initiated In practical terms, this will either result corresponding limitation language. not based on over-indebtedness but in a further qualitative narrowing of the rather purely due to illiquidity where scope of applicability for the limitation For managing directors, the decision significant illiquid assets may exist from language as many groups of under- means that the scope of the limita- a balance-sheet perspective. As such, takings will operate downstream loans tion language may need to be revised it will be interesting to see how this in the context of cash-pool systems even in future negotiations to reflect the judgment will affect future negotia- if the secured loan as such is reserved key conclusions of the judgment. tions between lenders and borrowers exclusively for the parent-borrower in this sensitive area between general level and not on-lent, or will result in Outlook German corporate law and international the borrower having to reformulate the financing law and legal principles. <– limitation language in the negotiations The legal community as such will be left with banks to only exempt specifically to assess whether some of the more gen- on-lent funds from the limitation. eral points in the judgment really have