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Andreas Lehmann of Squire Patton Boggs LLP looks at a recent German case which clarifies the German illiquidity or cashflow test and the so-called bow-wave theory.
What is the German test for insolvency?
Under German law, there are strict legal obligations for the managing directors of an insolvent company to file for insolvency. Failure to comply exposes a managing director to civil and criminal liability. It is therefore important for managing directors to know how to test whether their company is insolvent. One of the legal reasons for insolvency is illiquidity and the second senate of the German Federal Civil Court (BGH) has, in a decision dated 19 December 2017 (II ZR 88/16), clarified a question regarding the illiquidity test.
Pursuant to Section 17 para. (1) of the German Insolvency Code, a company is illiquid if it is not able to pay its liabilities when due. In 2005, the ninth senate of the Federal Civil Court decided (BGH IX ZR 123/04) that a liquidity gap which is not significant and only temporary does not constitute illiquidity but is only a payment delay (Zahlungsstockung) which does not trigger insolvency. The BGH set the threshold for ‘significance’ at 10% of the total obligations due and limited the timeline to cure a liquidity gap to no more than three weeks. According to the BGH, if a liquidity gap can be reduced within a three week period to less than 10% of all due payments, it is generally assumed that the company is not illiquid but only has a payment delay—unless it is foreseeable that the liquidity gap will in the near future increase above 10%. Where the liquidity gap is at least 10%, it is generally assumed that the company is illiquid, unless it is virtually certain that the liquidity gap can be reduced to nearly zero and creditors can reasonably be expected to accept a payment delay.
How is illiquidity calculated?
The 2005 decision of the BGH based the illiquidity test on the ratio between (i) the sum of the existing liquidity (‘liquidity 1’) and the liquidity which is forecast can be raised within the next three weeks (‘liquidity 2’) and (ii) the total amount of the liabilities due (and requested for payment) at the respective date. There was a question as to whether ‘new’ liabilities arising during the three-week period can be disregarded in the calculation. Lower courts and several legal scholars and commentaries advocated that only the liabilities due at the date the liquidity test is calculated (‘liability 1’) need to be taken into account and that ‘new’ liabilities becoming due during the three-week period (‘liability 2’) can be disregarded. This method of calculation was named the ‘bow wave theory’ (‘Bugwellentheorie’), because it allowed a company to push ahead a significant level of due liabilities (like the bow of a ship), the only requirement being that working capital generated within the next three weeks would be sufficient to reduce those liabilities to below 10%.
What guidance has been given by the German courts?
The bow wave theory was widely criticized. Critics requested that illiquidity should be calculated by deter-mining the ratio between (i) the sum of liquidity 1 and liquidity 2, and (ii) the sum of liability 1 and liability 2. In its decision of 19 December 2017, the BGH followed the critics and rejected the bow wave theory, having reviewed the legislation, the intention of the law and economic principles, citing in particular the relevant standard of the Institute of Public Auditors in Germany.
This decision of the BGH finally provides clarity and guidance for managing directors on the calculation of the illiquidity test. Restructuring professionals and managing directors may have hoped for another decision, because the effect of the bow wave theory was to give more leeway and resulted in illiquidity at a later point in time, allowing breathing space to attempt a restructuring of the business. On the other hand, insolvency administrators will welcome this decision as it will make it easier for them to pursue liability claims. It remains to be seen whether the end of the bow wave theory will be the beginning of a wave of liability claims.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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