If the business partner is insolvent

Exclusion and separation: the crucial difference

The German Insolvency Code distinguishes between whether an item forms part of the estate at all. Anyone with a right that excludes the asset from the estate may claim its exclusion, i.e. demand its return. This is typically the case with an asset that is merely in the debtor’s possession, such as tools provided by the debtor or goods still owned by the supplier. In the case of exclusion under German law, the asset forms part of the insolvency estate (it is already owned by the debtor), but a creditor has a security interest in it, such as a lien or a security interest in the property. Upon separation, the creditor does not receive the item itself, but rather preferential satisfaction from the proceeds of its realisation, after deduction of the costs of determination and realisation.

In practice, the first question to be answered is that of classification. A supplier entitled to separation is in a significantly better position than a creditor who is registered only for a share of the distribution. It is therefore worth examining every outstanding item at the outset: am I still the owner, do I have a security interest, or am I a simple creditor? This classification has a direct impact on the distribution ratio. Those entitled to separation generally receive their asset or its value in full; those entitled to exclusion receive the proceeds after deduction of costs; whilst ordinary insolvency creditors are limited to the general distribution ratio. The economic differences between these positions can be considerable.

The systematic distinction between right of separation and right to be excluded from the distribution is common in the insolvency laws of many countries. Although the outcomes under the relevant national law need not necessarily be identical to those under German law, it is always worth checking as quickly as possible whether a creditor is entitled to any privileges, and if so, which ones. 

Retention of title and the administrator’s right of choice

German law has a sophisticated and systematic approach to the concept of retention of title:

A simple retention of title, for example, means that the seller retains ownership of the goods delivered until the purchase price has been paid in full. If the buyer becomes insolvent and the goods are still in the buyer’s possession, the supplier remains the owner. However, the seller cannot simply demand the return of the goods, because where a contract has not yet been fully performed by either party, the insolvency administrator has a right of choice: he may demand performance and pay the purchase price, or refuse performance and demand the return of the goods. The supplier is not obliged to wait indefinitely for the insolvency administrator’s decision. He may request that the insolvency administrator make a decision. Many national legal systems recognise and understand the simple retention of title. However, the formal requirements they impose for proving it may be stricter than those laid down by German law. It is therefore important to ensure that the retention of title is properly documented in good time – i.e. at the time the contract is concluded – and, where applicable, in accordance with the relevant foreign law. In most cases, simply noting a ‘retention of title’ on an invoice is not sufficient. We will deal separately with how the retention of title can be established even before a crisis, particularly in international trade.

German law recognises further forms of retention of title. For instance, extended retention of title additionally covers the case of resale. In this case, the buyer’s claim against their customer is assigned to the supplier in advance. The extended retention of title, for example, secures further claims. Under German law, creditors who can prove such retentions of title generally enjoy a right of separation in insolvency proceedings with regard to the surrogate asset, i.e. the proceeds or the assigned claim. However, if the insolvency proceedings are taking place abroad, these specific forms of retention of title may prove ineffective, for example because they are not recognised under the relevant national law. 

A group retention of title, which maintains ownership until the claims of affiliated group companies have been settled, is, on the other hand, already invalid under German law.

Ongoing contracts: What happens to performance and consideration

In the case of reciprocal contracts which have not been fully performed by either party at the time of the opening of insolvency proceedings, the German Insolvency Code grants the insolvency administrator the right to choose. He decides whether to perform the contract (and thus pay the full consideration from the insolvency estate) or to refuse to perform it. If the administrator refuses, the contracting party may only lodge their claim for non-performance as an insolvency claim. For the supplier, this means that services rendered but not paid for prior to the commencement of insolvency proceedings generally constitute ordinary insolvency claims. If, on the other hand, the insolvency administrator chooses to perform an ongoing contract, any claims arising after the commencement of insolvency proceedings become liabilities of the estate, which must be settled as a matter of priority from the estate. This may make continued supply economically viable, but only with a clear statement from the insolvency administrator. This systematic approach is common in comparative law, meaning that other countries also recognise it. Nevertheless, in the event of the insolvency of a foreign business partner, it cannot automatically be assumed that the insolvency administrator has the sole authority to make such decisions. The debtor’s domestic insolvency legislation may provide for different rules and formalities regarding the continuation of business operations; these must be checked before making further deliveries. 

The opposite applies to the customer. If the supplier is insolvent and the customer has paid in advance without having received the goods, the customer bears the full risk that the insolvency administrator will refuse to release the goods. Claims for repayment by the customer are, under German law, insolvency claims. Anyone reliant on ongoing supplies should therefore clarify at an early stage with the German insolvency administrator whether, and under what conditions, further supplies will be made. If the supplier is based abroad and the insolvency proceedings are not being conducted under German law, the customer may find themselves dealing with an insolvency administrator who is reluctant to make decisions and is legally restricted in the decisions they can take. In such cases, it is advisable for the customer to seek clarification as soon as possible regarding the scope of decision-making powers held by the foreign insolvency administrator. 

Challenging insolvency transactions: When payments are reclaimed

One risk is often underestimated in practice: the insolvency administrator may challenge legal acts that disadvantage the remaining creditors. In particular, the insolvency administrator may reclaim payments that have already been received. So, anyone who receives payment for an outstanding invoice at the last minute whilst their business partner is in financial difficulty is not automatically protected against a claim for repayment.

The insolvency laws of various countries recognise several grounds for challenging transactions. Typically, transactions that can be challenged include, amongst others, security or payments received by a creditor whilst aware of the debtor’s insolvency or an application for the opening of insolvency proceedings, as well as benefits received by a creditor to which they were not entitled in that form or at that time. Another typical ground covers legal acts which the debtor carried out with the intention of disadvantaging their creditors, provided the other party was aware of this intention.

The time limits for avoidance are linked to the date of the legal act prior to the application for the opening of insolvency proceedings and vary depending on the specific grounds. These time limits can vary considerably, depending on which national insolvency code applies. Under the German Insolvency Code, for example, the grounds for avoidance generally cover only a few months prior to the petition. This may be regulated differently in other countries. Anyone receiving payments from a financially troubled partner should document the chronological context and their level of knowledge regarding the crisis.

Not every payment is voidable. An exchange of performance in which the performance and consideration are exchanged directly and on an equivalent basis – a so-called cash transaction – is, for example, largely protected under German law. In practice, this means that anyone working with a financially distressed partner during a crisis should ensure prompt, step-by-step settlement and scrutinise any unusual forms of security or advance payments, as these in particular may be subject to clawback claims at a later date.

Immediate action: The first few days are crucial

As soon as news of the partner’s crisis emerges, action should be taken in a structured manner and without delay. Firstly, the contractual situation must be reviewed: Which deliveries are outstanding, which payments have been made, and what security interests exist in relation to which items? All documentation relating to retention of title, security agreements and items provided must be collated.

Claims for separation of assets (in Germany, against the insolvency administrator) must then be asserted. Claims for separation of assets, for example in respect of tools or goods subject to retention of title, must be lodged and the return of the assets demanded. Rights of set-off against the proceeds or assigned claims must be disclosed (in some countries, these can only be asserted in conjunction with the filing of the claim). From now on, further deliveries may only be made following a clear declaration from the administrator, to ensure that advance payments do not merely become insolvency claims. 

Finally, the claim itself must be filed within the prescribed time limit, together with supporting documents and an explicit indication of any priority rights or security interests. In Germany, claims are filed with the insolvency administrator, whose appointment and address are set out in the opening order and the public notice. The basis and amount of the claim must be stated. Security interests must be expressly identified. Whilst it is possible to lodge a claim after the deadline has passed, this may incur additional costs and jeopardise its inclusion in interim distributions. Particular caution is required where insolvency proceedings are taking place abroad, as the filing process may be subject to different rules (the filing authority may, for example, be the court) and failure to meet the deadline may result in the loss of the claim. It is therefore of considerable importance to review the relevant legal situation promptly. 

Last but not least: in Germany, the deadline for filing a claim is set out in the order opening the proceedings. In other countries, however, it may be implicit in the law and run out tacitly. Those who swiftly ascertain the relevant legal situation and promptly take the appropriate steps required by it will secure a stronger position. 

Customer and supplier: different levels of influence

The creditor’s position in the debtor’s insolvency proceedings varies depending on the creditor’s role in the business relationship. 

The supplier relies primarily on retention of title and the separation of goods still in the debtor’s possession, as well as on the separation of proceeds and assigned claims. Their most important lever is robust contractual protection, which must be agreed upon before the crisis and documented in a watertight manner. For deliveries abroad, one must rely on safeguards and formal requirements that will remain effective in the event of insolvency. 

The customer of an insolvent supplier takes a different approach. Their primary objective is to receive supplies or to obtain repayment. Anyone who relies on the continuation of supplies should negotiate early with the insolvency administrator regarding the fulfilment of current contracts. Services paid for in advance but not delivered give rise to insolvency claims, provided there is no security in place. 

In both situations, preparation is key. Those who are familiar with their contracts, have agreed security rights in good time, can provide sound evidence and adhere to the procedural deadlines will minimise the damage. Those who only seek to mitigate their partner’s crisis once the order commencing insolvency proceedings has been issued will have already missed many opportunities.