Insolvency structuring options in the M&A context

In view of the current economic developments, the number of insolvency proceedings is expected to increase all around the world. Also in M&A context, it is expected that the number of companies in imminent danger of insolvency will be growing. The topic of insolvency is gaining importance for existing engagements and ongoing acquisitions.

Insolvency proceedings are regarded as a restructuring instrument and offer numerous structuring options. Insolvency proceedings under self administration open up particularly abundant structuring options. A major advantage of Insolvency proceedings under self administration compared to classic insolvency proceedings is that an insolvency supervisor is appointed. He acts as the supervisory body under insolvency law. Unlike the insolvency administrator, his tasks are basically only of a supervisory nature and he does not conduct any operational business for the company. In addition, insolvency proceedings under self administration offer the advantage that the power of administration and disposition remains within the company. Accordingly, the corporate boards of a company continue to represent it towards third parties and retain sovereignty over all financial and strategic decisions.

In order to benefit from insolvency proceedings under self administration, a corresponding application must be filed, which must be accompanied by a self administration plan. If the plan is complete and consistent, the court orders provisional self administration. The second phase after successful adjudication of self administration involves the "opened proceedings", followed by the "continuation phase" after the proceedings are closed (see Figure). 

In the phase of "opened proceedings", the insolvency plan is submitted to the court. The plan determines, among other things, the handling of the proceedings, the distribution and realisation of the insolvency estate, and the rates for the settlement of creditors' claims. According to the law, the rights of participants are categorised into groups. The rights within the groups must be uniform. In order to adopt the insolvency plan, a majority of people (majority of the creditors) and a majority relating to the sum of claims (sum-of-claims-based majority) are required. The insolvency plan may interfere with the rights of the parties compulsorily covered by the plan even against their will.

Restructuring instruments under self administration

Insolvency proceedings under self administration offer a variety of restructuring instruments, e.g. due to the fact that insolvency claims that arose before insolvency proceedings were opened are, as a rule, initially not fulfilled. In the opened proceedings, unsecured insolvency claims are to be satisfied only proportionally. This leads to a tax-privileged debt relief in the event of reorganisation.

Another instrument is available for selected types of contracts, such as lease agreements, and involves a prohibition of termination in the case of payment defaults in the period prior to filing for insolvency. Furthermore, during opened proceedings, lease agreements can be terminated with a maximum notice period of three months. Other long-term obligations can be terminated immediately by unilateral declaration or may end by virtue of law.

Furthermore, wages and salaries may not be paid for a maximum of three months during opened proceedings. Insolvency allowances, which are paid to the employees upon opening of insolvency proceedings, can be pre-financed.

The opening of insolvency proceedings also enables an effective reduction in the number of employees, as employment contracts can also be terminated upon maximally three months’ notice and any claims of employees to severance pay are, as a rule, capped at a maximum of 2.5 months' salary.

Impact on the financial statements

The described restructuring instruments also offer structuring options with regard to the balance sheet, the income statement, and the cash flow statement. With regard to the balance sheet, insolvency proceedings under self administration can lead to an improvement in the balance sheet ratios, as previous burdens such as pensions and provisions can be cut off and the balance sheet can be adjusted by reversing value adjustments. In addition, the restructuring profit arising from a debt relief leads to the strengthening of equity.

The special termination rights for employment contracts, lease agreements and other long-term obligations give rise to further structuring options that can improve the operating result.

Finally, insolvency proceedings under self administration create more room for structuring measures thanks to improved liquidity. Improved liquidity can result from the fact that initially no insolvency claims have to be paid, interest on insolvency claims is subordinated, insolvency allowances are paid, and direct debits from the period before filing for insolvency can be revoked.

Participation of an investor in insolvency proceedings

Investors may participate in insolvency proceedings in form of an asset or share deal.

In an asset deal, part or all of the debtor's assets are transferred to a new legal entity that continues the business operations. Prior to the takeover, a purchase price must be paid to the insolvency administrator for the assets taken over. In an asset deal, the acquirer takes over only certain contracts, if approved by the contractual partner, and, thus, only selected warranty obligations. However, it should be noted that according to § 613a of the German Civil Code (BGB) all employment relationships are transferred to the acquirer. Possible terminations can be carried out according to the "acquirer concept", under which the seller serves the notice of termination on instruction of the acquirer before the asset deal is carried out.

Alternatively, the insolvency plan may also stipulate the transfer of shares in the form of a share deal. A purchase price does not necessarily have to be paid as part of the share deal itself. However, the amount determined in the insolvency plan must be paid after the takeover. For the purpose of transferring shares, a creditor group consisting of the shareholders must be formed. Any lack of consent by this group of creditors may also be substituted. Under the share deal, the necessary declarations given by the existing shareholders are deemed valid. Moreover, the former shareholders have de facto no claim for compensation. In addition, third parties cannot derive any rights from the transfer of the shares. If the share deal is specified in the insolvency plan, the employment relationships will continue with the existing legal entity. Before that occurs, however, terminations are possible. The acquirer takes over all existing contracts and thus also the warranty obligations. However, the insolvency plan contains rules for handling claims arisen before the proceedings.

As a rule, the implementation of a share deal requires extensive advice. However, due to the effects of insolvency law and the structuring options in the insolvency plan, a due diligence examination is only necessary to a limited extent. Advantages of a share deal that should be mentioned include detailed structuring options and the guarantee of full contract assumption.. In addition, from the point of view of an investor, participation in the insolvency plan through a share deal requires a lower investment volume and may have a smaller impact on liquidity. The asset deal, on the other hand, is more popular and can therefore be implemented more quickly. Depending on a given case, the advantages and disadvantages of the possible forms of participation should be carefully analysed and weighed up.