Restoring companies from crisis to confidence

Every recovery process has its pros and cons. In emergency situations, it is crucial to first weigh up all the options.

In a recent post on the Die Unternehmervertrauten platform, FalkenSteg partner Wolfram Lenzen sheds light on the advantages and disadvantages of recovery proceedings as a means of resolving business crises.

If a company enters a profitability and liquidity crisis, a range of recovery options are available. Under German law, a distinction can be drawn between out-of-court recoveries and recoveries within the scope of insolvency proceedings. Since recoveries often require a fresh capital injection, it may be possible to recruit an investor, either as part of a share deal or an asset deal.

Out-of-court recovery
Out-of-court recoveries are often initiated at the urging of bank lenders. These banks are required by in-house protocol to obtain a recovery report (Sanierungsgutachten) when supporting a distressed company’s recovery efforts. Such reports must meet the requirements set by Germany’s highest court (IDW S6/BGH standard) and will involve an independent third party examining whether appropriate recovery measures will be able to restore the business’ competitiveness and profitability, which in turn will indicate its overall recoverability. Especially in the case of SMEs, an out-of-court recovery process is only worth pursuing if the company’s shareholders have the confidence of significant creditors. If non-shareholding directors do not command trust or there are doubts as to their suitability for carrying out the recovery process, they may be replaced or joined by an experienced chief restructuring officer (CRO). To prevent liability risks for directors and board members with an out-of-court recovery, constant monitoring is needed to ensure there is no legal obligation to file for insolvency at any point during the recovery efforts.

A significant advantage of pursuing an out-of-court recovery process is that it is better shielded from publicity than a recovery during insolvency proceedings. Plus, when effectively implemented, an out-of-court recovery generally incurs less expense. One of the disadvantages is that an out-of-court recovery attempt must include all creditors. The significant creditors will hold an extremely strong hand in the event of an out-of-court recovery. If a creditor is uncompromising, it is rarely possible to change their mind.

However, the biggest drawback is that highly effective recovery methods available as part of a recovery during insolvency proceedings are not applicable during out-of-court recoveries. This means that it must be possible to fund the measures constituting the recovery action plan. If that is not the case, there is still the option of a recovery during insolvency proceedings or a company sale.

Recovery during insolvency proceedings
If insolvency filing is mandatory under law (insolvency as per Section 17 or overindebtedness as per Section 19 InsO, the German Insolvency Statute), the only remaining option is a recovery during insolvency proceedings. In the event of impending insolvency, with the company unable to make payments when due (Section 18(1) InsO), there is a right to apply for proceedings. This means that a recovery during insolvency proceedings remains available as an option, even if the business has not yet actually become insolvent.

The process of recovery during insolvency proceedings offers a variety of benefits, including the three-month period for compensation for wages lost due to insolvency, which protects the company’s liquidity, as well as the limitation of employees’ notice period to a maximum of three months and possible compromises regarding staff severance claims. Disadvantageous contracts can be unilaterally dissolved and uncooperative individual creditors can be controlled.

On the other hand, recoveries during insolvency proceedings generate publicity and must follow a clear legal framework. Another downside of this method is that insolvency proceedings are also associated with a loss of influence for shareholders, directors and board members. Under certain conditions, this can be confronted via a debtor-in-possession management process (Eigenverwaltungsverfahren), a self-administration approach in which the company’s directors retain executive control.

Recovery via company sale
It is possible to recruit an investor while a business recovery is ongoing, whether in an out-of-court process or during insolvency proceedings. In either case, this may take the form of a share deal or an asset deal. A share deal can be done during insolvency proceedings via an insolvency plan solution (preserving the legal entity).

Bringing an investor on board also benefits the company’s owners by providing a source of fresh capital. If they are a strategic investor, a complete or partial acquisition of the business may also strengthen the crisis-stricken company’s strategic positioning. Engaging an investor is also a sensible course of action whenever the significant creditors have lost confidence in the existing shareholders, as the sale will typically limit or eliminate the influence of existing shareholders. In addition, sales processes are often used for both out-of-court recoveries and during insolvency proceedings to provide a composition option with the aim of ensuring creditor satisfaction.

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