Directors’ liability during a crisis: payment restrictions, the obligation to file for insolvency and personal risks

Grounds for insolvency and deadlines for filing an application: insolvency, imminent insolvency and over-indebtedness

The Insolvency Code distinguishes between three key stages of crisis. In principle, only insolvency and over-indebtedness trigger a mandatory obligation for the management of a limited liability company (GmbH) or other company required to file for insolvency to do so. Imminent insolvency, on the other hand, opens up options for action before the obligation arises.

Insolvency under section 17 of the Insolvency Code (InsO)

Insolvency exists where the company is unable to meet its due payment obligations. A suspension of payments is a strong legal indicator. In practice, this status is assessed on the basis of the company’s financial position as at a specific date and its short-term liquidity planning. On the one hand, there are the available free cash resources and credit facilities that are securely available in the short term. On the other hand, there are the liabilities that are due and for which serious demands for payment have been made, as well as the expected inflows and outflows during the relevant period.

According to case law, a liquidity shortfall of ten per cent or more that cannot be resolved within three weeks is generally a significant indication of insolvency. Even a smaller shortfall may indicate insolvency if it is likely to widen or cannot be closed in the short term. Conversely, mere hope of future payments is not sufficient. Funding commitments, shareholder contributions or deferrals must be sufficiently specific and legally sound.

Typical warning signs include repeated failed direct debits, arrears in wages, taxes or social security contributions, and the persistent exceeding of credit limits. Other warning signs include delivery suspensions or demands for payment in advance, enforcement proceedings and account seizures, as well as the systematic selection of individual creditors because it is no longer possible to pay them all. Failed financing negotiations and the ongoing postponement of due payments are also among the serious warning signs.

The managing director must not rely solely on the account balance. The decisive factor is the totality of obligations due and the liquidity actually available.

Impending insolvency under section 18 of the Insolvency Code (InsO)

Imminent insolvency exists where the company is not expected to be able to meet its existing payment obligations when they fall due. The law generally assumes a forecast period of 24 months. In principle, this does not trigger a mandatory obligation to file for insolvency. However, the company may file for insolvency itself and, under certain conditions, make use of the instruments provided for in the StaRUG.

It is precisely at this stage that genuine options for restructuring often remain available, such as out-of-court refinancing, shareholder contributions or the sale of assets or parts of the business. Other options to be considered include operational restructuring, the adjustment of financing terms and debt restructuring mediation.

Further steps available include the restructuring plan under the StaRUG and the preparation of self-administration or an insolvency plan. The managing director should not treat impending insolvency as a mere deviation from the plan. It is the point at which measures can still be prepared with greater scope for action.

Over-indebtedness within the meaning of section 19 of the Insolvency Act (InsO)

Over-indebtedness within the meaning of the provision exists where the assets no longer cover the existing liabilities, unless the continuation of the business over the next twelve months is, in the circumstances, highly probable. The assessment is therefore carried out in two steps:

Is there a positive going concern prognosis for the next twelve months? If not: do the assets, when assessed under insolvency law, cover the liabilities?

An abstract hope of restructuring is not sufficient for the going-concern prognosis. A coherent financial plan based on verifiable assumptions is required. This includes, in particular, integrated planning of income, assets and liquidity, robust revenue and margin assumptions, as well as financing commitments or realistic refinancing measures. Due repayments, covenants and taxes, planned restructuring measures, as well as scenario and sensitivity analyses, must also be taken into account.

The plan must be updated on an ongoing basis. If a key source of financing is lost or the business deteriorates significantly, a previously positive going concern forecast may lose its basis.

Time limit under section 15a of the Insolvency Act (InsO)

In the event of insolvency, the application for insolvency must be filed without culpable delay, at the latest within three weeks. In the event of over-indebtedness, the maximum time limit is six weeks. These time limits are not fixed restructuring periods. They may only be utilised in full provided that concrete measures exist with a realistic prospect of completely eliminating the cause of insolvency within the time limit. If restructuring is futile or if financing cannot be secured in time, the application must be filed earlier.

The calculation of the time limit begins with the objective occurrence of the cause of insolvency, not with the managing director’s possible later realisation of it. Lack of knowledge may exclude or mitigate fault, but only provides protection if the managing director has fulfilled its monitoring and audit duties.

Who must file the application?

In the case of a GmbH, the obligation generally falls on every member of the management board. An internal division of responsibilities does not fully absolve them of liability. Even a managing director without responsibility for finance must respond to warning signs, request information and, in case of doubt, arrange for a specialist audit. In the case of joint management, the status review, restructuring measures and deadlines should be dealt with and documented jointly. A managing director must not simply assume that a co-managing director or the group headquarters will submit the application in good time.

Payments after the company has become insolvent: What is still permitted under section 15b of the Insolvency Code (InsO)

Once insolvency or over-indebtedness has occurred, directors who are required to file for insolvency may, in principle, no longer make any payments on behalf of the company. Section 15b of the Insolvency Code (InsO) imposes a personal liability to pay compensation if payments are not consistent with the diligence expected of a prudent and conscientious director.

The term ‘payment’ is broad. It covers not only bank transfers, cash payments and direct debits, but also set-offs and offsetting of claims. In addition, the assignment or collection of claims on debtor accounts, the transfer of assets and the provision of security may also be covered. Equally critical are payments to shareholders or affiliated companies, as well as direct debit authorisations and automated payment processes.

The decisive factor is whether the transaction reduces the assets available to creditors or whether it results in the receipt of a valuable consideration that directly preserves the estate.

Payments within the application period

Within the statutory filing period, payments are generally deemed to be consistent with the required standard of care, provided they serve to maintain business operations and so long as serious measures are being taken to permanently remedy the cause of insolvency. This does not constitute a blanket authorisation of normal business operations. Each payment must fit within the specific restructuring and liquidity plan.

Typically, wages for essential staff, energy costs, rent and supplies necessary for operations, as well as payments to safeguard critical IT or production systems, may be eligible. In addition, costs relating to qualified restructuring and insolvency advice, insurance premiums for material risks, and expenditure designed to prevent greater immediate damage may, where appropriate, be permitted.

The more uncertain the restructuring and the closer the deadline for filing the application approaches, the stricter the scrutiny.

Payments after the application deadline

If the application deadline has passed or there is no longer any realistic prospect of remedying the grounds for insolvency, payments are only considered to have been made with due care in very limited exceptional cases. The focus shifts to protecting the body of creditors and ensuring the proceedings are properly prepared. Continuing business operations without a sound plan can multiply liability. A managing director should therefore not attempt to buy time by continuing to pay individual creditors selectively.

Cash Transactions and Consideration

Not every payment results in an economic loss to the estate. If the company immediately receives consideration of equivalent value that is of use to the creditors, this may be relevant to the assessment of liability. However, consideration that benefits only the shareholder, a group company or a business model that is no longer viable is not automatically sufficient. Payments that no longer have any realisable value after the opening of proceedings may also be problematic.

Wages, taxes and social security

There are competing obligations and personal risks, particularly in relation to wages, payroll tax and social security contributions. Failure to pay employees’ share of social security contributions may give rise to criminal liability. Tax obligations may lead to personal liability. At the same time, however, such payments may be problematic under section 15b of the Insolvency Act (InsO).

There is therefore no simple order of priority based on the principle that certain creditors must always be paid first. The specific legal situation, the relevant date and the planned filing of the petition must be professionally coordinated at short notice.

Payments to shareholders

Payments to shareholders or related parties are particularly critical. These include the repayment of shareholder loans, distributions and management fees. Equally critical are withdrawals from a cash pool, purchase price or settlement payments, and the provision of security in favour of the parent company. In addition to Section 15b of the Insolvency Code (InsO), capital maintenance rules, insolvency avoidance actions and fiduciary duties under company law may also come into play.

Scope of liability and documentation

A claim under section 15b of the Insolvency Code (InsO) may cover a large number of individual payments. Where business operations are continuing, the risk can quickly add up to substantial sums. Managing directors should therefore establish a payment authorisation system from the outset of a serious crisis. It is advisable to maintain a central liquidity overview, updated daily or several times a week, to flag payments that are sensitive under insolvency law, and to implement a dual-signature authorisation process. It has also proved effective to provide a brief justification for significant payments, to link them to the restructuring or going-concern plan, and to retain supporting documents and the basis for decision-making. A retrospective, blanket statement that the payment was necessary for business operations is significantly less compelling than a timely, documented decision.

This should be accompanied by ongoing consultation with restructuring and insolvency advisers.

Liability pitfalls within a group, in cash pooling and in relation to instructions from the parent company

In group structures, crises rarely occur in isolation. Liquidity is often managed centrally, financing arrangements are interlinked across the group, and decisions are dictated by the parent company. Nevertheless, the German managing director remains responsible for its own company.

Instructions do not automatically relieve liability

Shareholders may, in principle, issue instructions to the management of a GmbH. However, this does not override mandatory obligations under insolvency law. An instruction not to file for insolvency despite the company having reached the point of insolvency, or to transfer liquidity to the parent company, does not protect the managing director.

In the case of unlawful instructions or those that threaten the company’s survival, the managing director must object, document the decision and, if necessary, seek independent advice. In extreme cases, resignation from office may also be considered. However, this does not retroactively exempt the managing director from obligations that have already arisen and must not take place at an inopportune time if it would render the company unable to act.

Cash pooling

In a cash pool, the subsidiary’s surplus funds are regularly transferred to a central account. Liquidity requirements are met through repayments or intra-group credit facilities.

In a crisis, the following questions arise in particular:

• Is the claim for repayment against the pool manager a valid one? 
  
• Can the subsidiary actually access liquidity at any time?
  
• Are there any set-off or termination rights? Is the parent company itself in crisis?
  
• Are new transfers being made despite an apparent risk? I
  
• Is the financing legally documented and in line with arm’s-length principles?
  

A payment into the cash pool may reduce the estate if the claim for repayment is not of equivalent value or is not realisable. Automated sweep mechanisms should therefore not be allowed to continue unchecked at the first signs of a crisis.

Intra-group loans and collateral

New loans from the parent company can stabilise a crisis. However, they must be bindingly committed to in good time, disbursable and taken into account in liquidity planning. Non-binding letters of support or general letters of comfort are often insufficient, depending on their terms.

Conversely, repayments to the parent company or collateral for group liabilities may increase liability.

In addition to section 15b of the Insolvency Code (InsO), particular attention must be paid to the capital maintenance rules under sections 30 and 31 of the Limited Liability Companies Act (GmbHG), equity substitution and subordination rules, as well as the right to challenge transactions in insolvency proceedings. Added to this are third-party security arrangements, cash pool agreements, and tax and transfer pricing implications.

Foreign parent company

Where there is a foreign parent company, additional practical risks arise. German insolvency law is often underestimated at group headquarters; reporting is delayed or follows a different system; and liquidity is assessed at group level rather than on a company-by-company basis. Furthermore, decision-making powers are often unclear, local managing directors receive conflicting instructions, and documents or approvals are not readily available at short notice in an emergency.

The German managing director therefore needs to carry out his own liquidity and status assessment. A positive group cash flow does not eliminate the German subsidiary’s insolvency if it does not have legally secured access to the funds.

Multiple managing directors and division of responsibilities

A division of responsibilities can help to structure tasks, but it does not remove overall responsibility. The finance director must monitor the situation on an operational basis. The other managing directors must ensure they are regularly briefed, take warning signs seriously and seek clarification where anything is unclear.

During a crisis, mutual obligations regarding information and oversight increase. In particular, it must be clarified which figures were available and which questions were asked. Furthermore, it must be clarified which measures were decided upon and who was responsible for implementing them. It must also be clarified when the situation will be reviewed again.

D&O insurance

A D&O policy may cover defence costs and certain liability claims. Whether claims under Section 15b of the Insolvency Code (InsO) are covered depends on the specific terms and conditions of the policy and the case law relating to the claim in question. Exclusions for wilful breaches of duty, late reporting or known circumstances may be relevant. The insurer should be informed at an early stage and in accordance with the reporting obligations. However, the policy does not replace either the status review or the timely filing of an insolvency petition.

Action checklist for the first few weeks of the crisis

A crisis calls for a structured process. The following sequence helps to combine operational recovery with personal protection.

1. Ensure transparency regarding liquidity

This involves drawing up a daily or weekly liquidity overview, establishing a liquidity plan covering at least 13 weeks, and fully recording all liabilities due. It is equally important to review credit lines and their actual availability, to weight incoming payments according to their probability of occurrence, and to calculate scenarios for a decline in turnover and payment delays.

2. Conduct a technical assessment of insolvency status

The parties involved should prepare a financial status report in accordance with section 17 of the Insolvency Code (InsO). They should then distinguish between payment difficulties and insolvency. Furthermore, they should review the going concern forecast for twelve months. Following this, they should determine the status of over-indebtedness in the absence of a positive forecast. They should also record the effective date and deadlines in writing and update the status immediately in the event of significant changes.

3. Set up a crisis management structure

The parties involved should appoint a small decision-making team and establish clear reporting lines. Furthermore, they should hold daily or regular crisis meetings and keep the shareholders and supervisory bodies appropriately informed. External restructuring, tax and insolvency advisers must be coordinated, and D&O insurers and, where applicable, credit insurers must be informed.

4. Monitor payments

Automatic payment runs must be reviewed; cash pool sweeps must be suspended where necessary, and significant payments must be justified on a case-by-case basis. Payments to shareholders and affiliated companies warrant particular scrutiny. The consideration and impact on the insolvency estate must be documented, and payroll, tax and social security obligations must be managed in a coordinated manner.

5. Realistically assess restructuring options

The parties involved must reach a binding agreement on shareholder financing. Thereafter, deferrals and standstill agreements should be negotiated, and other operational measures quantified and scheduled. In addition, StaRUG instruments should always be kept in mind in the event of imminent insolvency; or, if proceedings become necessary, preparations should be made for self-administration, a protective shield or an insolvency plan.

6. Preparing the application decision

Once the competent insolvency court has been identified – and, where applicable, initial informal contact has been made – the necessary documents and lists of creditors must be prepared. At the same time, matters relating to employees and social security must be coordinated, followed by planning communication with banks, customers and suppliers. This must be done before the application is submitted in the correct form and in full.

7. Document your own position

Good documentation is essential. The basis for decisions, differing opinions and objections to unlawful instructions must be documented promptly and in a traceable manner. The same applies to seeking expert advice. Emails, planning documents and approvals must be archived in full and in an organised manner.

Restructuring before insolvency

The greatest scope for action usually exists before the company reaches the point of insolvency. Section 1 of the StaRUG therefore obliges managing directors to continuously monitor for early signs of crisis. Any suitable system must be proportionate to the size and complexity of the company, but should at the very least track liquidity trends, profit and loss, the order book and breaches of covenants. In addition, customer and supplier concentration, legal disputes and compliance risks, as well as financing maturities, must be monitored. Furthermore, operational developments that threaten the company’s continued existence must be identified. If action is only taken once wages remain unpaid or bank accounts are seized, the scope for manoeuvre is often already severely restricted.