Upstream guarantees and German capital maintenance rules

The gist of the ruling The Federal Court of Justice (Bundesgerichtshof) recently held: If (i) a shareholder takes out a loan, (ii) his/her company furnishes collateral for such loan, and (iii) at the point in time the collateral is granted this instance (a) creates or increases an adverse balance sheet situation (ie the net equity turns into the negative or, in case it already was negative, it deteriorates further) and in addition (b) it is (to an adequate degree of probability) certain that the shareholder will not be able to repay the loan, then granting of the collateral by the company constitutes a prohibited payment within the meaning of section 30 paragraph 1 sentence 1 of the German Limited Liability Companies Act (GmbHG) - in other words: in such case granting the collateral violates mandatory German capital maintenance rules. This holding, and in particular the pertinent simplifications (also) resulting therefrom, are probably not apparent to everyone, at least not straightaway. In this note, we will therefore expose the core of the ruling and give an overview of its practical implications for managing directors of limited liability companies (GmbH) under German law:

German capital maintenance laws and their relevance for the creation of in rem collateral

Let us first have a look at the statutory obligation to maintain the minimum share capital as specified for German limited liability companies:

1. It is prohibited to pay out the assets required for the maintenance of the nominal share capital to the shareholders of a limited liability company, ie as a general rule a minimum stock of assets equivalent to the nominal share capital of a GmbH “always has to be at disposition of the company”.

2. Whether in a specific situation an amount of cash (or assets, etc.) may or may not be paid out to a shareholder is calculated on the basis of a balance sheet test: Payouts to shareholders are prohibited if (as they are made) the amount of the nominal share capital is not (or no longer) covered by the company’s assets. If and to the extent, in turn, there are (still) enough assets backing the nominal capital, payments to shareholders are permissible (from a capital maintenance perspective, there may be other hurdles to observe such as minimum retention of profit provision in the articles of association).

3. Thus, the nominal share capital constitutes the financial payout limitation for a German limited liability company. However, this payout restriction in not applicable to payments covered by a fully recoverable compensation or repayment claim of the company against its shareholder. In such case the payments made by a company to its shareholder will not be deemed a prohibited payment.

4. Whether the compensation or repayment can be deemed “fully recoverable” depends on whether or not a write-off is likely or not, which is to be assed in accordance with reasonable commercial standards from an ex-ante perspective.

5. The consequence of infringing upon the principles of capital maintenance (for a shareholder) is that the receiving shareholder will be required to reimburse the company for all payments received. For the managing director participating in such unlawful payments personal civil and criminal law liability may be triggered.

The relevant point in time is the one in which the collateral is granted

The question whether a payout is prohibited (ie infringes upon the obligation to maintain the share capital) is exclusively decided upon the point in time in which the collateral is granted - this is the gist of the court’s new holding.

One of the main arguments is that, from the point in time of the creation onwards, the other creditors will no longer have access to these (or this part of the) company’s assets (anyway). They will not be able to prevent a recovery in favor of the holder of the collateral upon maturity. According to the Federal Court of Justice, the fact that, generally, the creation of the collateral does not directly affect the trade balance does not conflict with this view. Instead, the “balance sheet approach” as explained above means taking an economic perspective. According to the Federal Court of Justice, a payout will not only occur if a recovery of the security is impending.

We have already stated above that the nominal share capital will not conflict with a payout to the shareholders if the payments are covered by a fully recoverable compensation or repayment claim (against the shareholders). With a security in rem having been furnished, this claim to compensation or repayment (whose full recoverability is decisive) is the company’s claim against its shareholders to be indemnified from the recovery of the security upon loan maturity. And, according to the Federal Court of Justice, this, ie the assessment of the full recoverability of this claim to repayment, depends on the point in time of the collateral being furnished. In short, this means that at the end of the day it is important whether the shareholder will be able to repay the loan - such question to be answered at the point in time the collateral is granted.

A later deterioration in the shareholder’s assets position will, according to the court, be irrelevant for the payout assessment. This also applies to the recovery of the collateral.

Practical implications

A managing director of a GmbH will therefore fulfill his/her obligations if he/she checks at the point in time of the creation of collateral whether the company’s indemnification claim against its shareholder(s) is fully recoverable. It is only then that he/she may agree to furnishing the collateral and the only way he/she can exclude an infringement of the capital maintenance principles (which, as already mentioned, would entail severe consequences under civil and criminal law for him/her).

However, the ruling by the Federal Court of Justice also yields that a managing director must ascertain without a doubt that the hurdles put in place by the Federal Court of Justice are actually cleared in each specific case when collateral is granted. In this regard, it is often difficult to ascertain the full recoverability of the repayment claim. This applies especially to managing directors of subsidiaries in a larger group. They often lack the information that is required to assess the parent company’s liquidity and/or balance sheet situation. Overall, the ruling by the Federal Court of Justice is likely to induce managing directors to entrust external auditors with the assessment in this respect in order to guard against the jeopardy of personal liability.

Limitation language

It is also debatable how the ruling will affect the limitation language in financing agreements. These are clauses determining that collateral may not be recovered where such recovery would cause or increase an adverse balance. Lenders are now arguing that such limitations will no longer be necessary, as the point in time of recovering the security will not (no longer) be the deciding factor - according to latest case law as presented herein. However, the lenders and particularly the liable managing directors can argue against this by saying that a "limitation language" will continue to be necessary, as the ruling by the Federal Court of Justice discussed in this article refers to in rem collateral only. Personal guarantees for example are clearly outside the explicit scope and wording of this new holding of the court. In addition, it is essential that the managing directors’ general liability is not ignored: They are measured by the due care of a prudent businessman, who, for good reasons, can be expected to agree a "limitation language" that covers both the point in time of creating and of recovering collateral.