Riding or breaking the wave

It has been three years since the pandemic began to tighten its grip on the global economy, marking the onset of an unsparing sequence of disruptions that left certain global markets in shambles. Economists, legislators, journalists and restructuring professionals alike seemed to have engaged in fierce competition over the 'Nostradamus of the year'—trophy, proclaiming week after week the imminent arrival of the infamous "insolvency wave"—which never happened in Germany. Even though the warning 'this time it's different!' seems to have lost its potency entirely, a recent uptick in German insolvency filings indicates that it very well may be different this time. While the fact that none of the sombre prophecies have materialized sooner is likely to be equally attributed to the profound legislative countermeasures on one hand and the self-regulating capacities of the markets on the other, lawmakers in Berlin have left nothing to chance. Germany ramped up its crisis legislation once again before heading into the winter months with a large question mark over central Europe's energy dilemma and with lingering distress in supply chains and the skilled labour market. The result is another patchwork solution bill with—as German tradition commands—a rather cumbersome title: "Sanierungs- und insolvenzrechtliches Krisenfolgenabmilderungsgesetz" (SanInsKG), which is of course merely the short form of " Gesetz zur vorübergehenden Anpassung sanierungs- und insolvenzrechtlicher Vorschriften zur Abmilderung von Krisenfolgen"¹, which replaces its predecessor with an even more melodious name, the "Gesetz zur vorübergehenden Aussetzung der Insolvenzantragspflicht und zur Begrenzung der Organhaftung bei einer durch die COVID-19-Pandemie bedingten Insolvenz"² or for short: "COVID-19-Insolvenzaussetzungsgesetz" (COVInsAG). Let that sink in.

While the COVInsAG—which primarily implemented a partial suspension of directors' duties to file for insolvency—was widely considered to be an appropriate reaction to the initial impact of the COVID-19 pandemic, the recently enacted SanInsKG received mixed reactions among restructuring professionals. We take a closer look at these new regulations and assess whether they will materially assist companies that are facing the potential of a global recession.

Core of the new legislation

The SanInsKG did not come as a brand new bill, but rather in form of various changes to the existing COVInsAG—along with a name change. The name change was merely a reflection of the fact that the original title no longer appropriately depicted the legislators' current reasoning and intent behind the provisions. Unlike its predecessor, the SanInsKG does not include another suspension of the duty to file for insolvency when a company becomes illiquid (zahlungsunfähig) or over-indebted (überschuldet). Rather, the new SanInsKG choses a different approach in order to counteract the noticeable increase³ in insolvency filings with the German local courts (Amtsgerichte), which serve as dedicated courts for insolvency and restructuring proceedings.

For the period from 9 November 2022 until 31 December 2023, the SanInsKG modifies the dedicated time frames for financial forecasts required in connection with the commencement of proceedings under the German Insolvency Code (Insolvenzordnung—InsO) and the German Restructuring Act (Stabilisierungs- und Restrukturierungsgesetz—StaRUG). The modifications come in the form of significant shortenings of relevant forecast periods and thus reflect the rather limited capacities currently of managers and directors to reliably make assumptions relating to the financial prospects of their businesses. The shorter forecast periods enable companies to focus their outlook on what they can—to an extent—plausibly predict. While uncertainty is the inherent flaw of any forecast, lawmakers acknowledge that this holds true all the more in times of exploding energy prices, currency devaluation and impaired supply chains.

Specifically, the modifications to the forecast periods made by the SanInsKG are as follows:

• The length of the period for the going-concern forecast as part of the over-indebtedness test is shortened from 12 months to only 4 months
• The forecast period for a positive finance (cash flow) plan required for a petition to enter into debtor-in-possession insolvency proceedings (Eigenverwaltungsplanung) is shortened from 6 months to 4 months
• The forecast period for a positive finance (cash flow) plan required for a petition for a moratorium under the StaRUG (Restrukturierungsplanung) is shortened from 6 months to 4 months

On top of that, the SanInsKG grants businesses, which have already entered over-indebtedness, more time to coordinate their restructuring efforts:

• In the event of over-indebtedness, the period within which directors must file for insolvency is extended from 6 weeks to 8 weeks

As a consequence, companies are given an additional two weeks in which they can—theoretically—engage and align with their stakeholders and advisors to adequately approach the situation or find other solutions to resolve the over-indebtedness.

It is noteworthy however that in the event of illiquidity (Zahlungsunfähigkeit)—the other and by far most prominent reason for insolvency under German law—things remain as they were. Likewise, the parameters under which to conduct the liquidity forecast within the test for imminent illiquidity (drohende Zahlungsunfähigkeit) remain untouched by the SanInsKG. Imminent illiquidity does not trigger a duty to file for insolvency. However, it allows companies to optionally file for either insolvency proceedings, preferably in debtor-in-possession proceedings, or utilize the tools of the StaRUG restructuring framework at their earliest convenience. A concept that has proven to be a key factor for preventive, effective refinancings and reorganisations.

Over-indebtedness: A never ending story

Years of declining borrowing costs led to increased borrowings and often heavy over-leveraging, thus leaving many companies in a constant state of balance sheet over-indebtedness, where the value of their assets at liquidation valuation do not cover their liabilities. From the perspective of German insolvency law, this already checks one of the two boxes of the over-indebtedness test according to Sec. 19 InsO and—at least in theory—has one foot out the door on the way to the insolvency court. However, the second box to be checked is the absence of a positive going-concern forecast (Fortführungsprognose), which in practice features a cash flow-based prognosis of the probability of a company becoming illiquid within the next 24 months. Hence, insolvency under the premise of over-indebtedness requires balance sheet over-indebtedness and a negative going-concern forecast.

While restructuring lawyers and researchers may insist to the contrary, auditors and financial advisors have acknowledged for years that—at least in practice—there is no material distinction between the going-concern forecast within the scope of the over-indebtedness test and the liquidity forecast within the test for imminent illiquidity. Take it from the German Institute of Auditors (IDW) and its 'Gold Standard' IDW S 11 principles: The planning methodology is identical.⁴ On a side note, certified auditors must use—and other advisors and consultants broadly and willingly opt to use—the IDW S 11, as the principles specified therein have proven over many years to be practical and are constantly updated to reflect the most recent financial learning on this matter. Using "S 11" is playing the safe card for a company's management and board.

Meanwhile, even the legislator has discerned, that in times when virtually all businesses are balance sheet over-indebted, imminent illiquidity (Sec. 18) and over-indebtedness (Sec. 19 InsO) have become indistinguishable, and therefore grounding decisions based on purported differences between these two symptoms are impractical for business operators as well as insolvency professionals. The expectations were high when the draft bill for the further development of German insolvency and restructuring law (SanInsFOG⁵) was launched in late 2020. Apart from the implementation of the StaRUG framework, many restructuring professionals anticipated that it would entail the eventual abolishment of over-indebtedness as a mandatory ground for insolvency filing.

All the greater was the disenchantment, when it turned out that the over-indebtedness test remained in place. From 2021, the formerly identical⁶ prognosis periods for the going-concern forecast and the illiquidity forecast have been dissected. The illiquidity forecast must cover the coming 24 months, whereas the going-concern forecast must generally span only the coming 12 months—not considering the SanInsKG modifications. This legislative masterpiece, however, cannot change the fact that, after all, a petition to file for insolvency solely based on over-indebtedness remains a mythical creature: often spoken about, never seen by anyone. With remarkable consistency, years of ex-post evaluations by insolvency administrators and insolvency forensic experts have yielded the result that—even when the debtor bases its insolvency filing on over-indebtedness—there are virtually no cases of over-indebtedness without the concurrent presence of illiquidity as well.

The softening of over-indebtedness alone as a trigger for insolvency filing is unlikely to break the wave

Can we conclude from this that over-indebtedness is, in fact, irrelevant for anything but serving the intents and purposes of insolvency administrators when pursuing claw back claims? Well, the answer to that question shall be left to everyone's own verdict. As for the time being, over-indebtedness is here to stay. However, as restructuring practitioners, we do have to pose the question whether or not the shortening of the prognosis period of a mandatory ground for an insolvency filing, which in practice is a mere shadow of the mighty juridical theory it adheres to, can actually provide a benefit for businesses in peril.

The majority of market participants affected by the current crisis catalysts – the production industry, supply chain dependents and energy intensive businesses—face urgent liquidity shortages; hence, insolvency by illiquidity (Sec. 17 InsO) by far is the more imminent threat. The illiquidity test requires that based on a rolling 13-week liquidity forecast, a company is not able to fulfil its outstanding liabilities within the following three weeks. The SanInsKG does not provide any relief in that regard. In contrast to the government's response to the COVID-Pandemic, large scale direct or state backed financial aids are not part of the current governmental strategy. However, small and medium sized enterprises may at least benefit from the so-called "Gaspreisbremse", a mechanism to implement price caps for natural gas under certain circumstances.

Where businesses struggle to maintain the necessary liquidity to operate, four months seems like an awful long time to present a reliable financial forecast. The law generally expects business leaders to monitor projected cash-flows for the next 24 months at all times.⁷ A requirement rarely complied with. Even if businesses identify liquidity deficits some months down the road—with no feasible plan to remedy those—they are scarcely inclined to take a walk to the insolvency court right away and claim over-indebtedness due to the lack of a negative going-concern prognosis. At that point, directors and shareholders frequently begin to evaluate options to make a continuation of business at least 'predominantly probable' (see Sec. 18 para. 2 InsO). The virtual lack of insolvency petitions based on over-indebtedness not only indicates this observation to be true, but suggests that these efforts are, in most instances, carried above and beyond the threshold of six weeks, after which an insolvency petition must be filed in the event of over-indebtedness outside of the scope of the SanInsKG. When considering that this phenomenon has been observed for years, even outside of times of universal recession, it should dawn on us that it certainly will not change now, due only to the further shortening of the prognosis period. In other words, if the average director refuses to file for insolvency due to over-indebtedness in spite of civil and criminal liability risks under normal circumstances, the shortened prognosis period of the SanInsKG won't convince them otherwise.

Taking the sole perspective of the 'average director' of any small or medium sized business might seem like a gross oversimplification in order to make this argument, and it may also disregard the many business leaders that are very aware of the risks associated with a failure to file for insolvency in due course. Point taken. However, when speaking about the lawmakers' aim to prevent the much proclaimed 'wave of insolvencies' and to mitigate the consequences of crisis factors on the national economy, these diligent business leaders are not exactly the reference group by which to cast a verdict on the quality of the legislation. It is self-evident that—fortunately—a large fraction of businesses are becoming increasingly sensitized to restructuring and distress prevention related issues and—again, fortunately—we can observe a widespread professionalization of crisis management in businesses. But there is a whole other argument to be made in this regard: businesses possessing sufficient capacity and awareness to engage into early stage, preventive restructuring measures will likely not find themselves in a situation where the shortening of the prognosis period for over-indebtedness serves their ability to avoid insolvency. Those businesses frequently work with cash-flow projections much longer than four months and are far more prone to utilize the various in- and out-of-court restructuring tools available to them. Namely the tools under the StaRUG framework, e.g. a court ordered moratorium (Stabilisierungsanordnung) or the implementation of a restructuring plan, or the tools made available by the InsO, e.g. debtor-in-possession insolvency proceedings (Eigenverwaltung), potentially in connection with an insolvency plan (Insolvenzplan). All of these tools can be utilized at a sufficiently early stage, in particular, when the business is imminently illiquid (Sec. 18 InsO), and thus as soon as an argument can be made that, within the next 24 months, the continuation of the business is not 'predominantly probable'. As a result, the reasoning behind softening the over-indebtedness test becomes even less convincing.

Can we expect some benefits from the remaining SanInsKG provisions?

In light of their negligible value, the shortening of the prognosis period provides for businesses in distress and the effects of the extension of the period by which directors must file for insolvency from six weeks to eight weeks are equally underwhelming. As no significant increase in insolvency petitions based solely on over-indebtedness is to be expected, directors now have been granted an extension of a deadline, which most did not have much concern for to begin with. Besides, whether 'unpredictable developments' actually provides a sound reasoning to further prolong the period in which to file for insolvency is doubtful to say the least.

In spite of all that, from the perspective of restructuring advisors, the shorter prognosis period for over-indebtedness must not be disregarded. Over-indebtedness, irrespective of the criticism, remains hard, positive law. Consequently, when advising companies in distress, the shortened prognosis period is an essential parameter in the assessment of the going-concern prognosis, as it can provide comfort in regard to more distant liquidity threats. Notwithstanding the SanInsKG provisions, the prognosis period in fact may remain longer for other purposes, in particular in order to obtain an unqualified audit opinion for financial statements. In that regard the management is still required to prove that the company will remain liquid for at least twelve months from the date of the audit opinion.

The provisions to shorten the prognosis period for the finance (cash flow) plans required, for either a petition to enter into debtor-in-possession insolvency proceedings or for a moratorium under the StaRUG from six months to four months, may turn out to be rather helpful. When applying for the aforementioned restructuring tools, the respective forecasts have to be submitted directly to the relevant restructuring or insolvency court. Hence, the finance plans indeed must be comprehensible and sufficiently reliable in order to convince the court to approve the proposed restructuring instrument. As mentioned above, four months can already be shockingly long. Consequently, a forecast spanning six months would likely require the debtor to come up with pages of unsubstantiated prose grounded on bold assumptions. By shortening the prognosis period, the courts are at least spared the dubious pleasure of reading through lengthy and inherently subjective predictions of future events. If this helps a few businesses to successfully enter into fruitful restructuring proceedings, we should consider this a victory.

Conclusion

Whatever height the wave of insolvencies may reach, just like every wave, it may eventually break or fade before it meets the shoreline. In either case, the recent amendments to the German crisis legislation alone are unlikely to serve as an effective breakwater, but rather as balm to the troubled minds of legislators concerned in the face of an unforeseeable general crisis. The facts are that whether or not a business manages to 'ride the wave', and thus proceed to thrive long after the waters have settled, will largely depend on three factors. The ability to rethink and adapt an existing business model, the confidence to approach shareholders and financial backers at the earliest possible stage and the foresight to partner with competent advisors to help navigate through these rough waters. No legislation can meaningfully accomplish that.