Pre-Packaged Insolvencies on the Rise in Germany? Evaluating the German ESUG

In 2012, German insolvency law has been substantially reformed by the so-called ESUG reform act (i.e., Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen).  The German parliament intended to make the German Insolvency Act (Insolvenzordnung) more attractive and competitive compared to foreign insolvency law regimes - like the U.S. and UK regimes.  It strengthened the role of creditors, implemented new and streamlined pre-existing restructuring tools within the German Insolvency Act.
 
The German legislator wanted to counter a trend pre-ESUG for debtors to strongly consider, and in some cases implement, a shift of the debtor company's centre of main interest (the so-called COMI) abroad in order to benefit from foreign insolvency legislation.  Notably, substantial improvements were made to the insolvency plan proceedings as well as the Chapter 11-like self-administration proceedings.  Nearly two years onwards, we present a preliminary evaluation, focusing on large-cap and mid-cap restructurings.
 
An important result of the ESUG is a thorough change to German insolvency law 'culture'.  The last two years have much advanced a shift to a forward-looking restructuring-based approach to large German corporate insolvencies, turning away from the liquidation-based approach that was pre-eminent for decades.  Focusing on large-cap and mid-cap restructurings, debtor- and creditor-side counsel have never had so many efficient potential restructuring tools and options at their disposal.
 
Enabling Proactive Restructuring Strategies by Companies in Distress
 
The ESUG introduced a new kind of preliminary insolvency proceeding that is very attractive to distressed companies, the so-called protective shield proceedings (Schutzschirmverfahren).  Under certain legal conditions, debtors can file for protective shield proceedings with the insolvency court, which then puts a quasi-moratorium in place for up to three months under which enforcement of any claims against a company is prohibited.
 
Crucially, management can generally stay in place and is supported and monitored by a preliminary custodian.  During this period, management can work out a restructuring plan which can then shortly thereafter be put up for a vote of the creditors in subsequent self-administration and insolvency plan proceedings.  Thus, debtors are also able to make use of pre-packaged insolvency plans (pre-packs) to enable a corporate reorganisation or restructuring.
 
We consider the protective shield proceeding to be a very viable and attractive tool especially for large-cap companies, with several prominent cases having taken place in just the past year.
 
Loan-to-own Strategies for Creditors
 
On the creditor side, private equity investors and hedge funds have found that loan-to-own strategies have been easier to implement than before.  Given the changes to the insolvency plan proceedings by the ESUG, loan-to-own investors now have another viable and efficient option at their disposal - in addition to the pre-existing possibility of share pledge enforcements.
 
By acquiring syndicated loans at a discount once debtors are in distress, loan-to-own investors are now able to use a combination of pre-planned insolvency plan proceedings and self-administration proceedings more efficiently and reliably than before to replace an existing shareholder in a short period of time. 
 
Simplification of Debt-to-equity Swaps
 
One of the main goals of the ESUG was to simplify corporate measures and in particular to make debt-to-equity-swaps more attractive for creditors.  Pursuant to the newly introduced Section 225a (4) German Insolvency Act, third parties may not terminate/withdraw from agreements with insolvent companies, if corporate measures such as debt-to-equity swaps are implemented by way of an insolvency plan.  Thus, creditors are incentivized to improve the company’s balance sheet as in their role as a new shareholder they may rely on the continuation of existing business relationships. 
 
Further, protective shield proceedings simplify the set-up of a pre-pack, including e.g.  a debt-to-equity swap, prior to the opening of insolvency proceedings.  The three months’ quasi-moratorium provides companies in distress with sufficient time to prepare pre-packs together with their main creditors and the preliminary custodian.  Finally, a pre-pack often allows the insolvency proceedings to be terminated within a period of several weeks after they have been opened.
 
Financial Restructuring by InsolvencyPlans
 
Under an insolvency plan the company’s creditors are placed into different classes of creditors.  Each class has to comprise participants with the same legal rights and similar economic interests (e.g. secured creditors, unsecured creditors or employees).  The approval of a plan (besides formal court approval) requires majority approval of creditors in terms of number and value.  However, German insolvency law provides for a cram-down mechanism if a majority of the classes votes in favour.  A rejecting class will be deemed to have accepted the insolvency plan under certain statutory conditions.
 
The financial restructuring of a company in distress under an insolvency plan is mainly achieved by distributing a specific quota to each class of creditors.  Once this quota has been distributed to creditors who filed their claims, their remaining debt is released. 
 
Together with a simplification of debt-to-equity swaps insolvency plans have become a very attractive tool which may be utilised to financially fine-tune a company and streamline its corporate structure in the course of insolvency proceedings and to leave those creditors behind which may have hindered the company’s success in the past. 
 
Pre-packs - The Road Ahead
 
ESUG has proven a success.  As intended, it has enabled both creditors and debtors to more efficiently and reliably use German insolvency law to further their legitimate interests.
 
Given the advantages of a pre-pack for creditors as well as debtors, respectively, in distressed situations, we fully expect pre-packs to take on an even more prominent position in German restructurings in the future.  For large-cap and mid-cap restructurings, this will be accompanied with a general trend towards self-administration proceedings instead of mainly court-driven regular insolvency proceedings with a court-appointed insolvency administrator.
 
Frank Grell, partner in Latham & Watkins‘ Hamburg office, chairs the German Restructuring and Insolvency Practice.  His practice focuses on insolvency and restructuring, including corporate reorganisations, financial and operational restructurings and out-of-court and in-court representation of creditors of distressed companies and investors in such companies.
 
Dr. Daniel Splittgerber and Dr. Hendrik Hauke are both associates in the Hamburg office of Latham & Watkins LLP and members of the firm’s Finance Department.  They represent national and international banks, private equity investors and strategic investors in complex financial and operational restructurings and financings in particular with regard to M&A deals.
 
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