Pitfalls of Distressed Lending

MAYER BROWN ROWE & MAW GAEDERTZ

At a glanceInsolvency Law

General Granting of New Loans When a company in a distressed situation asks for an extension of Granting a new loan to an unprofitable company does not give its loans or even for new loans, the banks are faced with a dilemma: rise to concerns as long as the company is not in a financial crisis. in the event they deny such a request, the debtor very often files A company is deemed to be in a financial crisis when it is unable an application to initiate insolvency proceedings. In such case, the to pay its debts when they fall due (Zahlungsunfähigkeit) or loans already granted by the bank, or at least the loans which are when the assets of the company do not cover its liabilities (Über- not completely secured, will likely not be repaid entirely. If the bank schuldung). However, there is a gray area. Therefore, a bank should decides to support the company, there are certain risks. These legal bear in mind the risks described herein as soon as the inability risks materialize if the granting of a new loan or the extension of to pay due debts or over-indebtedness becomes apparent or is an old loan in a distressed situation of the debtor violates bonos threatening. mores (gute Sitten). The two main risks are the following: Under certain circumstances the loan and/or security agreement If the bank grants a new loan to a company in a financial crisis, could constitute a violation of bonos mores and, therefore, be one must clearly distinguish between permitted restructuring null and void pursuant to Section 138 of the German Civil Code. loans (Sanierungskredit) as well as permitted bridge loans (Über- As a consequence, the bank would become an unsecured in- brückungskredit) on the one hand, and loans delaying the insolvency solvency creditor. proceedings (Insolvenzverschleppung) and constituting a violation Additionally, the bank could be liable vis-à-vis third party of bonos mores on the other hand. creditors of the distressed company if the extension of a loan or the granting of a new loan is deemed to constitute an act 1. Restructuring Loan by which the bank willfully and in violation of bonos mores In the event of a company’s financial crisis, the bank is generally harms other creditors of the distressed company (Section 826 free to grant new loans. However, it is often difficult to distinguish of the German Civil Code). between permitted restructuring loans (zulässige Sanierungs- kredite) and loans delaying the insolvency proceedings (Insolvenz- Below, we focus on two alternatives: the bank decides to remain verschleppung) constituting a violation of bonos mores. In this passive or agrees to grant a new loan. regard, the following is decisive: The bank delays the insolvency proceedings (Insolvenzver- Remaining Passive schleppung) and violates bonos mores if it tries to postpone the In the following, the term “remaining passive” (Stillhalten) includes insolvency of the customer by an injection of capital that is (i) the waiver of or failure to execute statutory or contractual ter- insufficient for a reorganization but sufficient to obtain advan- mination rights, (ii) the maintenance of a credit line which had tages through the prolonged economic life of the debtor. This been granted for an unlimited period of time and (iii) the extension is especially true if former (unsecured) loans are (or should be) of loans. repaid in this period or if the bank allows third parties to be mislead with regard to the debtor’s creditworthiness (Insolvenz- As a general rule, in the event of a company’s financial crisis the verschleppung). bank is not obligated to terminate the granted loan, which It was in fact the bank’s aim to support the company in a restruc- would force the company to file an application to initiate insolvency turing process (Sanierungskredit). proceedings. However, in some cases, the bank may violate bonos mores, if it, for example, a. Selfish or Unselfish Loan? requests additional securities for insufficiently secured loans, For the avoidance of doubt, a violation of bonos mores is only exercises considerable influence on the company’s management assumed if the bank acts selfishly. Therefore, the granting of loans resulting in a disempowerment of the latter, or must always be judged from the point of view of selfishness or induces third parties to conclude contracts with the company. unselfishness, respectively.

© Mayer, Brown, Rowe & Maw LLP March 2007 When the granting of a loan is unselfish, there are no grounds b. Solution: Recapitalization Audit for assuming a delay of an insolvency proceeding which would The bank does not act contrary to bonos mores when, after having violate bonos mores. Loans are undoubtedly granted unselfishly performed a recapitalization audit (Sanierungsprüfung), it has if the bank does not have “additional” advantages from the new justifiable reasons to believe that the financial crisis of the company loan (except from interest for, and repayment of, the new loan), can be solved. It is no longer absolutely necessary that the audit for example, because the new loan is not secured by the assets is undertaken by an independent third party, e.g. an auditor, but of the company and the bank does not already have existing it is very common and advisable to involve third party auditors. claims against the company. The objective of such recapitalization audit is to examine (i) the plausibility of a company’s recapitalization and finance plan, (ii) Granting a loan is considered to be selfish when the bank itself the reasons for the financial crisis and (iii) possible ways to over- does not believe that the company’s financial crisis can be over- come it. The relevant point in time for such a plausibility check is come and only grants the loan to secure its own advantages to the time at which the loan is granted. The violation of bonos mores the disadvantage of other creditors. The bank acts selfishly if the through new loans does not depend on the success or failure of loan granted is not sufficient to rescue the company but only delays the recapitalization. However, the bank should monitor the im- its financial deterioration. The granting of such a loan could appear plementation of the recapitalization plan. reasonable to the bank if, for example, other creditors such as suppliers or contractors will improve the bank’s securities by advance 2. Bridge Loan performance, including the supply of raw materials or parts Recapitalization loans (Sanierungskredit) have to be distinguished which have been previously assigned by way of security to the from bridge loans (Überbrückungskredit). Bridge loans serve solely bank in advance, or by advance work on real estates encumbered to provide liquidity during the period of analyzing the company with a land charge. and the drafting of a reorganization and finance plan. As a general rule, the granting of a bridge loan does not constitute a violation of bonos mores because the bank is entitled to grant new loans for as long as such examination usually takes. The granting of a bridge loan should be linked to the commissioning of an expert to analyze the company, the drafting of a restructuring and finance plan and only to a corresponding time limit.

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Dr. Rainer Markfort Frankfurt/Main: Mayer, Brown, Rowe & Maw LLP T: +49 (0)30 20 61 30 90, [email protected] Bockenheimer Landstrasse 98-100, 60323 Frankfurt/Main Dr. Joachim J. Modlich Tel.: +49 (0)69 79 41 0, Fax: +49 (0)69 79 41 100 T: +49 (0)221 57 71 122, [email protected] Mayer, Brown, Rowe & Maw LLP Memoranda provide comments on Dr. Marco Wilhelm new developments and issues of interest to our clients and friends. T: +49 (0)69 79 41 2091, [email protected] These memoranda do not purport to provide comprehensive coverage Dr. Jörg Wulfken of the subject matter and are not intended to provide legal advice. T: +49 (0)69 79 41 1291, [email protected] Readers should seek specific legal advice before taking any action with regard to the matter covered.

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