Increased liability for managing directors – bow wave theory rejected by court

Introduction
Illiquidity
Bow wave theory
Decision
Consequences for practice

Introduction

German regulations obliging managing directors to monitor the liquidity of a company during crisis situations are typically rather strict and give rise to the risk of personal liability in cases of non-compliance. Legislation requires company management to file for insolvency proceedings without undue delay in the case of illiquidity or over-indebtedness. Continued trading where the company is considered to be materially insolvent can have serious consequences for managing directors and leave them exposed to considerable damage claims. Therefore, in the context of a financial crisis or restructuring process, it is crucial that managing directors closely monitor the financial situation of the company on a daily basis. The Federal Court of Justice has now further specified the conditions under which a company is considered to be illiquid within the meaning of the Insolvency Code.

Illiquidity

According to the Insolvency Code, 'illiquidity' is a debtor's inability to meet payment obligations when they fall due. It is generally indicated by the fact that the debtor has ceased to make payments. Illiquidity might not be considered where there is only a temporary delay in payments – for example, in cases where the state of illiquidity does not exceed a period of three weeks or in which the liquidity gap is below 10%.

A liquidity status and liquidity balance based on objective facts will form the basis of thorough liquidity planning and liquidity management. On its assets side, the liquidity balance must show the funds currently available to the debtor (Assets I), as well as the assets that can be liquidated or funds that will be made available within the next three weeks (Assets II). Additionally, it should be demonstrated by appropriate (precautionary) documentation that claims contained in Assets II are both valuable and enforceable. On the liabilities side, the balance must show the current liabilities of the debtor which have been called on by the creditors (Liabilities I). Until now, the Federal Court of Justice had remained silent on the question of whether, in addition to these liabilities, the management would also be obliged to include the liabilities of the debtor which come into existence within the three weeks following the date of the liquidity balance (Liabilities II). In the absence of clear guidance from the courts, it was heavily debated among German practitioners whether Liabilities II should be included in the liquidity status, as their inclusion would trigger the mandatory insolvency filing obligations earlier. For managing directors navigating their companies through crisis situations, the inclusion of future liabilities was viewed as the more conservative and secure approach. As such, managing directors typically seek to reduce the risk of personal liability to the highest extent possible.

Bow wave theory

Where managing directors capitalise on this flaw, they cannot be considered to have taken a conservative approach. These debtors would have found themselves in a situation where only the current amount of debt is taken into account when measuring liquidity, and not the so-called 'bow wave' of liabilities which the debtor would soon have to settle. In rare cases, debtors may even be inclined to build up a bow wave of debt and push such a wave ahead without considering themselves illiquid. Such an approach is often considered by insolvency practitioners to be an attempt to delay the mandatory insolvency filing, although jurisprudence did not necessarily support their case. The legal requirements have now been set out by the Federal Court of Justice, which finally brings an end to the bow wave theory.

Decision

The Federal Court of Justice has held that Liabilities II must be included in the liquidity status. In this case, the insolvency administrator of a GmbH (a limited liability company) sued the managing director for damages in relation to payments made from the account of the debtor in the months leading up to the company's insolvency filing. The insolvency administrator argued that the insolvency debtor had been materially insolvent for several weeks before it had actually filed for insolvency. As evidence, the insolvency administrator submitted a liquidity status based on the company's accounts at that time.

The Federal Court of Justice stated that in addition to liabilities, which are due on the date of the liquidity status (Liabilities I), such a liquidity status must also consider the liabilities that will fall due and be demanded within three weeks as of the date of the liquidity status (Liabilities II). It determined that the Insolvency Code seeks to achieve an early opening of proceedings. This goal would be undermined if Liabilities II were not taken into account; thereby allowing a debtor to postpone the deficit. Such a system was found to be unsustainable. The inclusion of Liabilities II was considered to be consistent only with the use of Assets II. In addition, disregarding Liabilities II was held to be contrary to the economic principles of valuation. The court has further held that the defendant cannot object to the accounts provided by the insolvency administrator on the basis that their own accounts were not properly managed during the crisis period.

Consequences for practice

The bow wave theory has been an area of controversy for a long time. The Federal Court of Justice has now removed uncertainty for managing directors and has defined a clear rule in this regard. For managing directors and restructuring consultants this means that the tools used to monitor the liquidity of a debtor must not only reflect the prospect of meeting at least 90% of the existing liabilities, but also the ability to serve the debts becoming due and payable in the relevant three-week period. In cases where planning does not cover Liabilities II, the managing directors may be exposed to the risk of incurring personal liability for continued trading in a crisis situation. Correspondingly, consultants may also find themselves exposed to a liability risk when preparing an insufficient plan.

For further information on this topic please contact Cristina Weidner or Stefan Sax at Clifford Chance LLP by telephone (+49 69 7199 01) or email (cristina.weidner@cliffordchance.com or stefan.sax@cliffordchance.com). The Clifford Chance website can be accessed at www.cliffordchance.com.