20. May 2020

The acquisition of a business from a seller threatened with insolvency involves a high risk for the buyer: In the event of a subsequent insolvency of the seller, the buyer is threatened with a total loss of his investment if the insolvency administrator successfully contests the transaction. The legislator has minimised this risk – albeit possibly unintentionally.

In the worst case, what appears to be a bargain at first glance can turn into a nightmare. A company run into financial difficulties has to disinvest from a subsidiary or a part of a business to generate liquidity. The pressure on the seller’s side is often high in such situations, resulting in a low purchase price. If a deal is reached, both sides are satisfied: The seller has solved his liquidity problem, the buyer has bought at a favourable price. However, if the inflow of liquidity is not sufficient to permanently overcome the seller’s crisis, the buyer is at risk of losing his entire investment.

If the seller has to file for insolvency following the sale, the insolvency administrator may under certain circumstances contest the business acquisition. The legal consequences of a successful contestation are dramatic for the buyer. He has to transfer the acquired company back to the insolvency administrator – in an asset deal the individual assets and, in a share deal the shares – while his claim to repayment of the purchase price is merely an insolvency claim. He then only receives an often low insolvency rate after the insolvency proceedings have been completed, which thus often many years later.

I. Requirements for a contest of debtor’s transactions

In case of doubt, the conditions for a successful contest of debtor’s transactions in insolvency proceedings are quickly met in the current situation. According to section 129 of the German Insolvency Statute [InsO], the basic condition for any contest of debtor’s transactions in insolvency proceedings is, first of all, a transaction which disadvantages creditors, whereby a indirect disadvantage is usually sufficient. An impairment of creditors’ prospects of satisfaction is necessary, in particular by a reduction in the assets of the insolvency debtor. An at least indirect disadvantage for creditors is usually assumed even if the seller initially receives an appropriate purchase price, but this is then spent and is therefore no longer available to the creditors. In the “normal case” of a contest of debtor’s transactions in insolvency proceedings, the so-called congruent cover pursuant to section 130 InsO, the seller must also have been insolvent at the time of the sale and the purchaser must at least have been aware of circumstances which necessarily indicate such insolvency. If the seller is insolvent, the buyer will regularly become aware of this in the course of the due diligence that he usually carries out, so that a contest of the business acquisition in the insolvency proceedings has good prospects of success if the insolvency application is filed within three months after the completion of the business acquisition.

II. Protective mechanisms against a contest of debtor’s transactions

In practice, various mechanisms have been developed to reduce the risk of a contest of debtor’s transactions in insolvency proceedings in a distressed M&A deal prior to the seller’s insolvency. The safest and only practicable solution is the so-called cash transaction in the sense of section 142 InsO. Such a cash transaction which is protected against contesting [“anfechtungsprivilegiertes Bargeschäft”] is given if buyer and seller directly exchange equivalent services. In the case of a business acquisition, the close temporal connection between the payment of the purchase price and the full transfer of business is the only decisive factor. According to case law, the time lag may not exceed 30 days. Ideally, however, the transaction is executed on a step by step basis. At the same time, the requirement of a complete exchange of services means that rules which have become customary in the meantime, such as guarantee retentions or earn-outs must be waived. All subsequent payments lead to the fact that the purchase price has not yet been paid in full, so that there is no direct exchange of services. Finally, the purchase price paid must represent an equivalent consideration in order to be able to consider the transaction as a cash transaction. This can be demonstrated in the course of an auction process by the fact that a higher purchase price could not be achieved. Alternatively, this can also be proven by a fairness opinion.

Other possible protective mechanisms are not practicable. On the one hand, the buyer could waive or severely limit a due diligence in order to avoid becoming aware of circumstances that would necessarily imply an insolvency. A buyer will regularly not agree to this because he does not want to “buy a pig in a poke”. On the other hand, it is often recommended to first establish a right conferring prospective entitlement [Anwartschaftsrecht] which cannot be contested during insolvency and to complete the business acquisition by paying the purchase price only after the expiry of the deadline for contesting the transaction. However, this approach is unlikely to be considered, especially in crisis situations, because the seller is dependent on fast liquidity inflows. In the meantime, there is also case law which classifies such a construction as an intentional circumvention of a contestation and therefore allows a contest of debtor’s transactions in insolvency proceedings due to a transaction made with the intention to disadvantage creditors according to section 133 InsO.

As an interim result, it should be noted that protection of the buyer in the case of a business acquisition that prefigures a seller’s insolvency is basically only possible if the transaction is structured as a cash transaction.

III. New regulations as a result of the COVID 19 Pandemic

With the “Act on the Temporary Suspension of the Obligation to File for Insolvency and on the Limitation of executive body liability in the Event of Insolvency caused by the COVID 19 Pandemic” (COVID 19 Insolvency Suspension Act – COVInsAG), the legislator primarily regulated that for a suspension period initially limited until 30 September 2020, debtors are not required to file for insolvency if the factual insolvency is based on the consequences of the spread of the COVID 19 Pandemic and there are prospects of eliminating the insolvency. According to section 4 COVInsAG, the Federal Ministry of Justice can extend the suspension period once until 31 March 2021. In addition, section 2 para. 1 no. 4 COVInsAG stipulates that congruent cover provided during the suspension period cannot be contested in subsequent insolvency proceedings unless the contractual partner was aware that the debtor’s restructuring and financing efforts were not suitable for eliminating the insolvency that had occurred. Therefore, if the contractual partner of the insolvency debtor during the suspension period, receives exactly what he was able to claim, precisely at the agreed time, it is almost impossible contesting the transaction. The grounds of the Law do not indicate whether this provision should also apply to business acquisitions. The only indication here is that there is a need for protection against the contesting of transactions, e.g. for contractual partners of long-term commitments such as landlords and lessors, but also suppliers (Bundestag printed paper 19/18110, p. 24). It further states: “If such contractual partners, in the event that the restructuring efforts of the enterprise in crisis fail and insolvency proceedings are subsequently opened, had to fear having to repay received payments as a result of a contest of debtor’s transactions, they would be inclined to terminate the contractual relationship as fast as possible, which, in turn, would frustrate the restructuring efforts.

This reasoning can easily be transferred to a business acquisition. It is true that this is obviously not a long-term commitment or a supply relationship. However, these case groups are only mentioned as examples in the grounds of the law. If one also considers the overriding objective of the COVInsAG, it becomes clear that the protection against the contesting of transactions must also apply to business acquisitions. This consists in “enabling and facilitating the continuation of enterprises that have become insolvent or got into economic difficulties as a result of the COVID 19 Pandemic” (Bundestag printed paper. 19/18110, p. 17). According to this, it is expressly intended to support restructuring efforts. Accordingly, and for consistency, pursuant to section 2 para. 1 no. 4 COVInsAG congruent transactions can only be contested in subsequent insolvency proceedings if the contractual partner was aware that the debtor’s restructuring and financing efforts were not suitable for eliminating an insolvency that had occurred.

The foregoing is illustrated by the following example: A bank requires a company to take certain measures to compensate for a loss of liquidity caused by the COVID 19 Pandemic in order to continue to suspend covenants. For example, if these measures consist of divesting certain business areas or selling a subsidiary, it becomes clear that the sale is intended to reorganize and continue the seller’s company. A sale for the purpose of restructuring is therefore clearly within the scope of the legislative objective of not torpedoing these restructuring efforts through a risk of contestation. If a prospective buyer were to fear the dramatic consequences of a contest of debtor’s transactions in insolvency proceedings in the event that restructuring efforts fail and a subsequent insolvency of the seller occurs, the prospects for the seller to generate liquidity through a sale would be considerably reduced. The restructuring efforts would thus be frustrated from the outset. This is exactly what COVInsAG wants to prevent.

IV. Conclusion

Even if it cannot be inferred from the grounds of the Law to the COVInsAG whether the legislator also wanted to privilege a business acquisition that prefigures a seller’s insolvency with regard to the contest of debtor’s transactions, there is strong evidence for the fact that the exclusion of the contest of debtor’s transactions according to section 2 para. 1 no. 4 COVInsAG also applies to such transactions. Anything else would undermine the declared overriding objective of the legislator. Nevertheless, one must be aware that this question is breaking new legal ground. It cannot be predicted with certainty whether, in the event of a dispute, a court will later decide in the same way. The buyer who acquires a business from a seller threatened by insolvency is therefore strongly recommended to structure the transaction as a cash transaction if possible. If its requirements are not met, the buyer can additionally invoke the protection of section 2 para. 1 no. 4 COVInsAG. He must therefore also ensure that the requirements for congruent cover are met, i.e. that the exchange of the services takes place exactly as agreed. Any deviation can lead to the fact that the protection against the contesting of transactions provided for in the COVInsAG does not apply and therefore, may increase the buyer’s risk of a total loss of his investment. If the buyer considers this fact, his situation will improve significantly. In addition to the cash transaction, he can present another strong argument to an insolvency administrator.

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Johannes Landry, Partner
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