Identifying Further Restructuring Risks in Germany – Federal Court of Justice Clarifies Liability for Continuing the Business of an Insolvent Company

The Financial Crisis, a difficult market situation and a tense liquidity status have led to remarkable difficulties for mid-sized businesses within the past years. Strategic and financial investors have and continue to utilize these circumstances to acquire interesting distressed companies for comparatively moderate purchase prices.

In order to benefit from these circumstances, investors need to understand how to avoid or minimize the risks of liability related to such acquisitions.

The statutory liability for existing obligations of the acquired business is one of the main risks for the purchaser who continues the business. Although established German case law provides for an exemption from this liability in cases that involve an acquisition of an insolvent business from the insolvency administrator, the timing of the transaction, which might lead to a factual continuance of the business before the initiation of insolvency proceedings, is the determinant of liability risks for the purchaser.

Liability Associated With Continuing the Business

Under German commercial law, anyone who carries on the commercial business under the previously existing trade-name acquired by a legal transaction or contract is generally responsible for all obligations incurred by the former owner during the course of the business (Sec. 25 para. 1 German Commercial Code). Pursuant to German case law, such liability will generally exist regardless of how the successor took over the continuing business activities (e.g. by contract, gift or factual take-over). The fact of continuing the business is the operative test.

However, according to case law established by the German Federal Court of Justice, this liability shall not apply in situations where the insolvency administrator sells all or substantially all of a company’s business after the initiation of insolvency proceedings. The reason for this exemption is that no reasonable buyer would be willing to acquire and continue the business, if the buyer were held liable for the existing liabilities of the company that are associated with the use of its former trade name.

Decision of the German Federal Court of Justice

In a recent decision, dated October 23, 2013 (doc. no. VIII ZR 423/12), the German Federal Court of Justice decided a case which pertained to the question of assumed liability, and it used this case to develop its consistent case law.

The plaintiff was an Italian seller of electrical heating who entered into a purchase agreement with a German limited liability company (GmbH) that became insolvent and was deleted from the commercial register after the termination of the insolvency proceedings. After the insolvency proceedings had concluded, the plaintiff demanded payment of the remaining purchase price from the former managing director, who had continued the business during the insolvency proceedings by using the predominant element of the trade-name of the debtor.

Contrary to the previous court instances which rejected the claim, the Federal Court of Justice found that the plaintiff had a payment claim based on a liability pursuant to Sec. 25 German Commercial Code.

The court of appeal had held that Sec. 25 para. 1 German Commercial Code is not applicable because the defendant commenced operations after the insolvency proceedings were initiated. The court argued that according to the case law of the Federal Court of Justice, the application of Sec. 25 para. 1 German Commercial Code would be contrary to the duty of the insolvency administrator to liquidate the assets of the debtor in order to obtain the highest possible proceeds for the benefit of the creditors. The goal – best possible liquidation – would in most cases be unreachable if the value of the assets were reduced by the fact that the purchaser would bear the danger of future direct claims from the insolvency creditors and the insolvency administrator would only be able to liquidate the assets by not selling a “going concern” but selling individual assets or groups of assets, which usually yield a lower purchase price.

The Federal Court of Justice set this decision aside.

In its judgment, the Federal Court confirmed that, in accordance with the specific circumstances of insolvency proceedings mentioned above, Sec. 25 para. 1 German Commercial Code has to be interpreted restrictively and does not apply if the insolvency administrator liquidates the insolvency estate by selling the entire business or a relevant part to a third party.

However, the Federal Court ruled – by confirming previous case law – that these peculiarities of insolvency proceedings would not apply to continuing the business of an insolvent company outside of insolvency proceedings. For example, if a business is acquired from a preliminary insolvency administrator but no insolvency proceedings follow, the application of Sec. 25 para. 1 German Commercial Code is not excluded. The same applies in cases in which the company was acquired after the initiation of such proceedings had been declined for insufficiency of assets or when the business of a later insolvent company were continued by a third party before the insolvency proceedings had been opened.

The Federal Court of Justice held that the specific circumstances which require a narrow interpretation of Sec. 25 para. 1 German Commercial Code do not apply when the business of an insolvent company is merely factually continued by a third party, but the continuance of the business is not caused or executed through a purchase from the insolvency administrator. In that case, there is neither a conflict with the administrator’s obligation to best possible liquidation nor the risk of an unequal treatment of the creditors.

Consequences and Recommendations

Although it is unusual for a business to continue outside insolvency proceedings on a purely factual basis, the decision clarifying the application of Sec. 25 para. 1 German Commercial Code highlights the risks for a purchaser or any person or entity who continues the business of insolvent companies:

  • In particular, the danger exists when the purchaser takes over the company factually before the initiation of the insolvency proceedings or when the initiation will later be declined for insufficiency of assets. Insolvency creditors then may demand their insolvency claims, which do not lapse after termination of the insolvency proceedings, from the person/purchaser continuing the business.
  • As negotiations for purchase of the company/business are often started after the application for initiation of insolvency proceedings but before the initiation of the insolvency proceedings, the purchaser has to make sure that no relevant binding commitments or decisions are made during the negotiations that could lead to a factual situation that can be considered as continuing the business.
  • The person/purchaser continuing the business can avoid liability for existing obligations by changing the trade-name or, in a case of opened insolvency proceedings, by an agreement with the insolvency administrator that excludes the liability that has to be registered with the commercial register.
  • Any purchaser of a German distressed company/business should ensure that comprehensive legal advice is obtained with respect to structuring, timing and executing the transaction in order to minimize any liability risks.