Subordinated creditors in German insolvency plan proceedings—Vae Victis?
By Dr. Christopher Wolff and Dr. Christian Mock
Paul Hastings (Europe) LLP, Frankfurt am Main
I t is the very nature of subordinated claims that they are treated less favorably than senior claims in an insolvency proceeding. However, foreign investors in particular may be unpleasantly surprised when learning their legal situation in German insolvency plan proceedings. The 2013 reform of the German Insolvency Code (Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen, or ESUG) resulted in stronger rights for secured creditors and the management of insolvent companies under the German Insolvency Code (“Code”) while subordinated creditors have been disenfranchised and are now regularly cut off from legal remedies. Consequently, subordinated (bond) creditors are often entirely wiped out without efficient remedies to appeal such decisions as was the case in Pfleiderer and IVG Immobilien. The reason is that the Code allows for a full waiver of subordinated claims in insolvency plan proceedings. Investors should be aware of these risks before making an investment in subordinated debt. The following summary is intended to give investors a better understanding of the legal position associated with subordinated debt.
Senior, mezzanine and junior creditors in German insolvency proceedings
Market participants in Germany are influenced by English terminology and frequently use the terms senior, mezzanine and junior debt when describing the relative rank of priority of their claims. However, it should be noted that the Code does not recognize these terms and that they have to be “translated” into German statutory law. In a technical sense, the Code solely recognizes two groups of insolvency creditors: ordinary insolvency creditors pursuant to § 38 of the Code and subordinated creditors pursuant to § 39 of the Code. Pursuant to the Code, secured creditors like secured bank-loan lenders become ordinary insolvency creditors if the enforcement proceeds out of the collateral are not sufficient to pay back their claims. The Code defines this group as creditors with the right to separate satisfaction (Absonderungsberechtigte Gläubiger). Based on this distinction, secured creditors often wear two hats in insolvency plan proceedings: one of a secured creditor (to the extent that the insolvency plan changes the rights of the secured creditors) and one of an unsecured ordinary insolvency creditor (to the extent that realization of collateral is not sufficient). Coming back to the abovementioned priority of debt (senior, mezzanine and junior debt), it is, of course, possible under German law to contractually agree on this kind of distinction. As a consequence, it is a common market practice that facility and intercreditor agreements governed by German law also contractually provide for these or comparable creditor groups and respective waterfall provisions. However, every investor should be well aware that contractual waterfall provisions are not fully in line with the statutory concept provided by the Code. This being said, contractual provisions may supersede the Code concept inter partes, but German law principally and solely recognizes creditors as ordinary insolvency creditors and subordinated creditors.
Being or becoming a subordinated creditor pursuant to § 39 of the Code
The most frequent reasons for a creditor qualifying as a subordinated creditor pursuant to § 39 of the Code are (a) explicit agreements according to which the creditor agrees to the subordination of his or her claims concerning the respective borrower, and (b) circumstances in which a creditor is deemed to be a quasi-shareholder or “equitable/shareholder subordination.” Here, we will focus only on the first group. A contractual subordination of claims in the sense of § 39 subsection 2 of the Code requires an explicit agreement between the creditor and the debtor. To the extent that bilateral credit or bond documentation contains a subordination clause in case of an insolvency proceeding, the Code provides a rebuttable presumption that the subordinated creditor ranks junior to ordinary insolvency creditors as well as to the subordinated debt as mentioned in § 39 subsection 1 No. 1 through No. 5 of the Code. This includes, but is not limited to: (a) interest and penalties for late payment accruing on the claims of the ordinary insolvency creditors from the opening of the insolvency proceedings, (b) costs incurred by individual insolvency creditors due to their participation in the proceedings and (c) even claims for restitution of a loan replacing equity capital or claims resulting from legal transactions corresponding in economic terms to such a loan. In this respect, it is noteworthy that typical LMA-based intercreditor agreements, which are concluded solely between certain groups of creditors who agree on different layers of debt, are generally not sufficient to trigger a technical subordination of junior creditors in insolvency proceedings in the sense of § 39 subsection 2 of the Code as long as a respective provision clearly lays out the concept that the subordination shall only apply among the creditors themselves and shall not apply for the benefit of the debtor (for example, via a contract to the benefit of a third party).
Legal consequences of § 39 of the Code in insolvency proceedings
Based on a general decision of the German legislator, subordinated creditors have only limited rights and protections under the Code. The reason is that subordinated creditors shall not be in a position to block or hinder insolvency proceedings in which not even the ordinary insolvency creditors get repaid in full.
Accordingly, subordinated creditors only have the right to:
(a) attend the creditors’ meeting,
(b) request information provided in the creditors’ meeting and
(c) access the court file of the proceedings.
As a consequence, subordinated creditors do not have the right to:
(a) file proof of claim in the insolvency proceeding (unless specifically permitted to do so by the insolvency court),
(b) request that the insolvency court convene a creditors’ meeting,
(c) vote at the creditors’ meeting,
(d) request that the insolvency court reverse a decision by the creditors’ meeting and
(e) be represented in the (preliminary) creditors’ committees.
In insolvency plan proceedings, the Code contains a provision (§ 225 subsection 1) according to which subordinated claims are fully waived under a plan unless the plan specifically provides for a distribution for subordinated claims (see below under lit. 4 and 6). Based on this waiver, no class of subordinated claims is even formed under the insolvency plan. And without being grouped into a class, subordinated creditors do not get to vote on the plan. In other words, the law provides a mechanism which deprives subordinated creditors of all their claims without having a say or legal remedies (for example, by rendering evidence that the company actually has a higher value than asserted by either the management or higher ranking creditor groups).
Influence of shareholders vs. subordinated creditors in German insolvency plan proceedings
Two of the major changes resulting from the Code’s insolvency reform were the introduction of the possibility to cram down on existing shareholders and as a result transfer old or new equity in the company to implement corporate changes at the insolvent entity (§ 225a InsO). This includes, but is not limited to, debt-to-equity swaps. Most noteworthy, the Code’s provision dealing with the rights of the shareholders is the exact opposite of the provision dealing with the rights of subordinated creditors. While § 225 subsection 1 contains an assumption that all subordinated debt is waived (to the extent not otherwise provided for in the plan), § 225a subsection 1 implies that shareholder rights shall remain unaffected by the insolvency plan unless otherwise outlined in the plan. Therefore, it is legally possible that ordinary creditors take a hit on their claims and subordinated creditors lose everything while the shareholders, the most junior class in the capital structure, remain unaffected and thus become the primary beneficiaries of the restructuring process implemented by the insolvency plan. This already shows a statutory discrimination of subordinated creditors in comparison with shareholders that is surprising since—as a general principle—even subordinated debt should (being the nature of debt) always rank ahead of equity. However, the Code does not recognize this concept because subordinated debt is treated equally as equity or in some provisions even worse. § 245 subsection 2 No. 2 of the Code gives a prominent example for the fact that subordinated creditors and shareholders are treated equally while other examples show that shareholders clearly have more rights than subordinated creditors:
(a) § 238a of the Code provides for a voting right of the shareholders to the extent that the insolvency plan impairs their rights who need to be crammed down in case of a dissenting vote of such group, § 245 of the Code; The subordinated creditors are principally not granted a voting right even if they lose 100% of their claims.
(b) The cramdown provision in § 245 subsection 3 of the Code provides special protection for shareholders with respect to their reasonable participation in the economic value of the insolvent company. The Code does principally not contain a similar provision for the benefit of subordinated creditors.
The background for granting shareholders the aforementioned rights is that a debate has taken place about the potential infringement of Art. 14 of the German Constitution that addresses property and expropriation. However, this debate has solely taken place in connection with shareholders while it is not apparent why subordinated creditors are less worthy of protection—especially in the light of Art. 3 of the German Constitution that addresses equality before the law.
Legal remedies of subordinated creditors in insolvency plan proceedings
§ 245 of the Code solely permits the cramdown of a dissenting class of creditors, if:
(a) the dissenting class is treated in a manner no worse than in a liquidation scenario,
(b) no other creditors receive economic value that exceeds the amount of their claims,
(c) neither equity nor creditors that are junior to the dissenting class receive economic value and (d) the majority of the voting classes vote to approve the plan.
While these prerequisites provide a certain protection for a group of creditors in insolvency plan proceedings, it is important to note that this protection only applies to classes that actually vote to reject the plan, namely to a group of creditors who have been granted voting rights. In other words, if no voting class is formed, the protections granted by § 245 would not apply. As noted above, under the InsO, subordinated creditors whose claims are waived under a plan are not entitled to vote on the plan. Accordingly, the cramdown protection generally does not apply while it does apply to the shareholders who are subject to the plan according to § 245 subsection 3 InsO. In addition, a further major goal of the Code’s reform was to make insolvency proceedings more effective and thus faster. Hence, potential legal remedies by participants in the proceedings were further reduced. Principally, § 6 subsection 1 of the Code states that decisions of the insolvency court are only subject to an appellate remedy in cases where the Code explicitly provides for an immediate appeal (sofortige Beschwerde) or so-called numerus clausus of legal remedies. Such an individual right is set forth in § 253 InsO. After court confirmation of the insolvency plan, a creditor (including a subordinated creditor), may file an immediate appeal of the confirmation order. However, such an immediate appeal is permitted only if the creditor:
(a) objected to the plan prior to the voting deadline,
(b) voted against the plan,
(c) demonstrates that the plan provides the creditor with treatment significantly inferior to what that creditor would receive in a liquidation scenario and that the funds set aside pursuant to § 251 subsection 3 of the Code are insufficient to compensate the creditor for such inferior treatment and
(d) files an appeal within two weeks of plan confirmation.
For a subordinated creditor, it is almost impossible to meet these prerequisites, especially the test regarding the liquidation scenario. First of all, subordinated creditors need to render evidence that they would receive a quota on their claim in a liquidation scenario. In other words, they have to provide evidence that all senior creditors (namely claims against the insolvent estate or Masseforderungen) as well as ordinary insolvency claims would get repaid in full in case of an insolvency. However, this is very rarely the case since insolvent companies are usually over-indebted, meaning their assets do not cover their existing payment obligations. Secondly, the applicant must demonstrate that the situation is “significantly” inferior, thus even increasing the obstacles for a successful appeal and making it a blunt sword for subordinated creditors.
Potential avenues of escape for subordinated creditors
In light of the above, the question arises what remedies a subordinated creditor has to evade the doom of being entirely wiped out in insolvency plan proceedings. First, the subordinated creditor should challenge the reason for subordination to rank as an ordinary insolvency creditor. This will, of course, only be possible in a few, exceptional cases (for example, by arguing that the subordination clause is invalid). To the extent that the legal qualification as a subordinated creditor cannot be disputed, there are two important provisions in the Code that have significant impact on the role of subordinated creditors:
(a) § 174 subsection 3 sent. 1 and
(b) the exception of § 225 subsection 1
In the Code, § 174 subsection 3 sent. 1 enables the insolvency court to issue a request to subordinated creditors to file a proof of claim. Following this request, subordinated creditors have increased rights since they have, among other things, the right to (a) vote in the insolvency plan proceedings and (b) form a group under the plan and receive the benefit of the cramdown protection. However, the Code does not define the circumstances under which the insolvency court should issue a respective request to the subordinated creditors. The competent judge has to make an economic assessment whether there are enough assets in order to fully pay the claims against the insolvent estate and the ordinary insolvency creditors and whether excess assets will be available to at least partly satisfy subordinated creditors. Experience has shown that judges are not inclined to dig deep into these highly complex economic questions. In this context, the following should be considered: Insolvency proceedings are often opened not only due to illiquidity, but also due to over-indebtedness (in other words, the assets of the insolvent company are not sufficient to cover its ordinary debt). In order to assess the situation of over-indebtedness, the judge rarely makes his or her own independent decision, but usually relies on one or more valuations provided either by the debtor (and its advisors) itself (in case of debtor-inpossession proceedings) and/or the insolvency administrator/trustee.
All aforementioned parties are usually not incentivized to push through higher valuations for the assets of the company that might put them in a situation where there is a discrepancy of the assessed (higher) value and the actually realized (lower) proceeds. Moreover, the automatic waiver of subordinated debt is a very handsome tool for both the debtor and his or her ordinary creditors since it increases the value of the company and reduces the number of recipients of proceeds at the same time. Once insolvency proceedings (based on these valuations) are opened, it is more or less impossible to show that sufficient assets are available to also satisfy subordinated creditors since (a) the judge would have to admit that his or her initial decision was not correct, and (b) German insolvency law does not recognize the concept of a “battle of valuations.” Therefore, the likelihood that a request according to § 174 subsection 3 sent. 1 of the Code based on an independent decision of the insolvency court is rather remote. The more likely scenario is that the insolvency administrator or the trustee (in case of debtor-in-possession proceedings) informs the insolvency court of the possibility for a distribution (like in the German Lehman Bank case), and the insolvency court issues the request on this information. Hence, § 174 subsection 3 sent. 1 of the Code does not provide a real angle for subordinated creditors. >> The German Insolvency Code does very little to support the legal position of subordinated creditors << In the Code, § 174 subsection 3 sent. 1 again comes into play via the exception of § 225 subsection 1 Code to the extent that the authors of the insolvency plan envision an independent group of subordinated creditors. If the insolvency plan foresees a special provision for subordinated creditors, for example, for tax reasons, the prerequisite for such a group formation is again the request of the insolvency court to the subordinated creditors to file a proof of claim. In such a scenario, it is again either the insolvent company (in case of debtor-in-possession proceedings) or the insolvency administrator who makes the respective request to the insolvency court. This being said, the subordinated creditors themselves again are not independently in a position to facilitate such a request, but need the support of either the insolvency company, the insolvency administrator or other groups of creditors. It may be the case that such support can be secured, for example, in cases in which subordinated creditors are willing to invest new funds in the insolvent company. In principal, however, ordinary creditors or the insolvent company itself are not incentivized to support the subordinated creditors. This is due to the fact that either proceeds would have to be shared or a debt burden would remain, which would otherwise be fully waived. As such, the avenues of escape are extremely narrow if at all existent.
Summary and outlook
The above has shown that the Code in its current version not only does very little to support the legal position of subordinated creditors, but makes the life of such creditors extremely cumbersome. A direct comparison with shareholders shows structural disadvantages that can hardly be justified. While criticism in this respect was already voiced directly after the implementation of the 2013 reform, the legislator should immediately (de lege ferenda) implement safeguards for the benefit of subordinated creditors to abolish the currently existing disadvantages and to ensure the necessary fundamental rights. Otherwise, the German marketplace runs the risk of subordinated (bond) debt no longer being available as a refinancing instrument. Investors will not be silently led to the slaughter.