Restructuring Lessons from the Covid Pandemic: Bail-Out vs. Market Approach

Abstract

Bail-out, bail-in, or restructuring? In this article, we argue that restructuring has its rightful place in macro crises, such as the Covid pandemic. A policy that primarily focuses on insolvency avoidance and bail-outs is misled as it creates unwanted risk incentives, distorts market selection and resource allocation, and reduces beneficial transformative pressure. As a crisis typically goes hand in hand with new and fundamental developments, the changing environment should be met by competitive innovation. Bail-outs which tend to preserve the status-quo may be justified as part of a comprehensive emergency strategy and to overcome temporary market dysfunction. Such a response strategy, however should always be designed in concert with restructuring options. We propose amendments to the German insolvency and restructuring laws to address the shortcomings of restructuring/insolvency uncovered during the Covid pandemic. The goal is to improve the restructuring/insolvency regime so that it can better deal with the specific challenges of macro crises.

1 Introduction

1.1 German Crisis Resolution: Insolvency Avoidance Policy and Bail-Outs

Bail-out, bail-in, or restructuring?¹ During the financial crisis of 2007–09, and more recently and widespread during the Covid pandemic of 2020/21, the German government’s response was clearly in favor of bail-out. For the present energy crisis, it is currently debated how this question should be answered.

Paradoxically, the German corporate insolvency/restructuring policy during times of crisis, favoring bail-out and emergency adjustments to insolvency law, which together factually suspend the widespread application of insolvency law, stands in stark contrast to the approach taken in dealing with distressed businesses in ordinary times. In ordinary times, German insolvency laws are a constant threat to directors facing potentially ruinous liability and criminal sanctions for having avoided or delayed insolvency filings.

During recent crises, emergency adjustments to the insolvency regime were introduced and massive bail-out programs rolled out so as to make insolvency the rare exception, an option only for truly desperate cases. This ‘bail-out approach’ stands in contrast to the efforts to rework insolvency and restructuring laws to incentivize debtors to initiate procedures for an early going-concern restructuring. Measures taken during the Covid pandemic exemplify this insolvency avoidance policy approach.

The dominance of the ‘bail-out approach’ raises the question as to whether insolvency and restructuring procedures can handle macro shocks, or as to whether their area of use is practically limited to the idiosyncratic financial distress of individual companies. Certainly, the first time that a particular external or sector-specific shock hits unexpectedly, a governmental bail-out program may be a good choice if the restructuring regime is not yet prepared to deal with the challenges of such a crisis. The second time a similar or comparable shock hits, however, there is barely an excuse not to be prepared.

The experience after the financial crisis has shown that restructuring and structured creditor bail-in can work better with diligent preparation. The international response to the financial crisis of 2007–09 has been focused on tackling the central issue that the mere prospect of receiving a state bail-out creates risky incentives for financial institutions to follow a ‘too big to fail’ strategy.² A series of EU legislative measures in the financial crisis aftermath, however, such as the Bank Recovery and Resolution Directive (BRRD) of 2014, implemented in the German Restructuring and Resolution Act (SAG), and supplemented by the Single Resolution Mechanism Regulation (SRMR), paved the way for a harmonized bank resolution regime. It allows a number of emergency measures, such as business transfer or bail-in actions by the ECB or national regulators, to take place in a quick and market-sensitive manner. Since its implementation, there have been several examples of successful applications.³ In recent times large-scale situations have arisen also outside the financial sector where a restructuring was successfully achieved by creditor bail-in combined with a market-focused approach under suitable restructuring laws.⁴

1.2 Structure

Against this background, we argue that restructuring/insolvency laws, if properly reformed, are an indispensable tool even in complex crisis scenarios caused by macro shocks. These laws should prompt the stakeholders of companies with private sector financing to overcome financial distress primarily by attempting to identify and implement privately negotiated solutions. Government-funded bail-out programs should be limited to bridging temporary market dysfunction.

In this light, we test our hypothesis that the ‘market approach’ with a crisis-ready insolvency and restructuring regime is likely to produce superior results to the recently predominant ‘bail-out approach’. As a starting point to our analysis, we take a look at the emergency measures of the Covid pandemic in Sect. 2.1 and during the energy crisis in Sect. 2.2. In Sect. 3, we explore the limits of insolvency law in crisis situations which are considered to be too big or too widespread to handle with market-tested insolvency and restructuring regimes. In Sect. 4, we build on our problem analysis in Sect. 3 and ask the question what role a reformed insolvency/restructuring law could play in future macro crises, i.e., whether shortcomings of insolvency/restructuring law identified in Sect. 3 can be addressed by an improved framework. We propose some reform provisions for the German insolvency and restructuring regime in Sect. 4.

2 The Covid Experience – Repeating Measures in 2022?

During the Covid pandemic, the number of insolvency filings dropped to a historically low level despite a public health crisis, government-ordered business closures, and curfews.⁵ The policy approach to avoid widespread insolvencies (and the risk of mass layoffs) was based on two pillars: (1) emergency adjustments and exceptions to the German insolvency regime; and (2) bail-out and state-sponsored business relief programs. These national measures were seconded by a continuously loose monetary policy of the ECB, aimed at keeping the capital markets open during the crisis, with historically low interest rates for lenders. Eventually, the implementation of the EU Restructuring Directive was accelerated to give distressed businesses a non-insolvency option to deleverage their Covid-plagued balance sheets. We will first look into the Covid response (Sect. 2.1) and subsequently discuss certain similarities with the response to the 2022 energy crisis (Sect. 2.2).

2.1 The Covid Response

A key provision of the German Covid insolvency-relief law (COVInsAG) to which other provisions were linked was the suspension of the director’s obligation to file for insolvency. Under German law, the directors of a corporate debtor with limited liability⁶ are obliged to file for insolvency in cases where the debtor either is unable to pay⁷ its debts or becomes over-indebted.⁸ Practically, the latter is a solvency projection by management showing that the company is – more likely than not – able to meet all its payment obligations at any time when they become due during a certain period defined by law. At the time of the Covid pandemic, the projection needed to cover the subsequent 18–24 months; in 2021, this period was reduced to twelve months.

As the pandemic evolved, German laws were repeatedly adjusted: from 1 March until 30 September 2020, the obligation to file for insolvency was suspended altogether.⁹ From 1 October 2020 until 31 December 2021, the filing obligation was suspended only for over-indebted debtors. From 1 January 2021 until 30 April 2021, the suspension was linked to applications under the government-sponsored support programs,¹⁰ which arguably created an incentive to apply for bail-out funds. Additionally, public creditors such as tax authorities and social security insurances, which are normally responsible for a large portion of involuntary insolvency filings of small enterprises, did not strictly pursue involuntary insolvency filings against debtors which defaulted on existing payment obligations.¹¹ The suspension of filing duties has been used before to limit the number of formal insolvencies to a volume considered ‘manageable’, especially during floods and heavy rains, e.g., in 2002, 2013, 2016 and 2021.¹² We will review more recent changes that have taken place as a reaction to the energy crisis in 2022 in Sect. 2.2 below.

Once a company was eligible for suspension of the filing obligation under the Covid insolvency regime,¹³ the debtor benefitted from a series of further alleviations, i.e.:

• (1)
  

  The director’s personal liability, which typically requires reimbursement of any payment made following the debtor’s inability to pay debts or its over-indebtedness,¹⁴ was suspended so that directors did not risk their personal insolvency in consequence of the firm’s eventual insolvency (and their delayed filing).¹⁵

• (2)
  

  New financing extended to a debtor that was affected by slow or no business due to public health regulation and lock-down measures was privileged.¹⁶ Regularly applicable claw-back provisions or liability risks to the detriment of new money lenders were suspended.¹⁷

The second important legislative reform was the implementation of the German restructuring procedure (StaRUG) well ahead of the implementation deadline imposed under the European Directive on Preventive Restructuring Frameworks (PRD). The first governmental draft was surprisingly restructuring-friendly, which may have been the result of the pandemic as a practical example that financial distress may be caused by factors other than mismanagement outside of the directors’ control.¹⁸ The proclaimed goal was to provide debtors with an efficient regime to unburden themselves from unbearable liabilities upon exiting the Covid pandemic. The restructuring regime was to offer such opportunity outside formal insolvency and thus protect the reputation of debtors in an early stage of distress while they could still bind dissenting creditors to a restructuring plan. The restructuring procedure has so far not been used widely as a tool to deleverage in the aftermath of the Covid pandemic. It plays a role, however, as a bargaining chip in out-of-restructuring negotiations.

Apart from these legislative measures, the enormous bail-out and state-sponsored business relief programs were, in our understanding, a major driver behind the historically low numbers of insolvency filings. The various bail-out programs together accounted for several hundred billion euros. These numbers do not include the ECB’s purchase programs.

• 
  

  Non-refundable direct public grants under various different government programs (Überbrückungshilfe I, II, III, IV, V, November- und Dezemberhilfe, etc.) have accounted for approximately 75 billion euros since 2020.¹⁹ These grants, which were not limited to specific sectors particularly affected by the Covid pandemic (e.g., hospitality and entertainment), ensured additional operational liquidity for companies. They were typically calculated as a function of key financial reference data of the pre-pandemic year 2019 related to the pandemic-related decline in revenue²⁰ and/or in relation to fixed costs unfunded because of a decline in revenue.²¹

• 
  

  Wide-range furlough schemes allowed employers to keep their employees despite lack of employment opportunities without mass lay-offs. At peak times, the salaries of up to 6 million employees, representing about 13.5% of the German workforce of approximately 45 million employees, were covered by state funding. The total costs of unemployment support and furlough subsidies accounted for approximately 60 billion euros per year in 2020 and 2021, which is double the pre-pandemic amount. Approximately 42 billion euros were spent on pandemic-related furlough subsidies in both years (compared to 157 million euros in 2019).²²

• 
  

  Next to non-refundable subsidies, the state-owned German development bank (KfW) co-sponsored loans at favorable conditions in a volume of approximately 60 billion euros. Additionally, the federal stability fund (Wirtschaftsstabilisierungsfond, WSF) provided financial support through hybrid or equity instruments, in particular to large-cap businesses such as Lufthansa and TUI, in a volume of approximately 10 billion euros. Government guarantees in a volume of at least 7 billion euros were advanced to businesses to enable outside financing by the federal government and in cooperation with state governments.²³ Further credit was advanced in the form of tax postponements totaling a volume of approximately 93 billion euros until June 2021.²⁴

The European Commission contributed its part to the German Covid bail-out, importantly by relaxing the rules and restrictions for Member States’ aid programs under the Temporary Framework.²⁵ The ECB’s Pandemic Emergency Purchase Program amounted to approximately 1.85 trillion euros.²⁶

2.2 Measures in Response to the Energy Crisis

While it is too early to assess the governmental energy-crisis response program, which is a current political and legislative process, we shall highlight certain similarities with the governmental approach to limit insolvency applications and grant public crisis funds:

• 
  

  The COVInsAG has recently been transformed into a law that may (permanently) be applied to macro crises, as of now as a reaction to the energy crisis, continuing its predecessor’s path under the new title ‘Temporary Restructuring and Insolvency Law Adjustments for Crisis Mitigation’ (Sanierungs- und insolvenzrechtliches Krisenfolgenabmildungsgesetz, SanInsKG).²⁷ Again, the pressure of mandatory insolvency filings is relieved. The projection period for directors’ solvency testing as part of the ‘over-indebtedness’ test as formal qualification for insolvency is reduced from twelve to four months until 31 December 2023.²⁸ Once the test turns negative, i.e., a debtor is found to be over-indebted, directors have eight instead of six weeks to turn to the insolvency court.²⁹

• 
  

  The government provides (i) direct grants to individuals, especially from low-income households, to support them during times of rising energy costs and to stimulate the economy, and (ii) direct grants especially for energy-intensive companies under two so-called relief packages (Entlastungspaket I, II), amounting to a volume of approximately 30 billion euros so far, with a third relief package (Entlastungspaket III) with a volume of 65 billion euros to follow.³⁰ The German government, moreover, announced a protective shield to reduce the negative economic impact of the energy crisis.³¹ For the protective shield, the German parliament approved 200 billion for financing measures to be provided by the federal stability fund.³² The federal stability fund is to use such funds for investments into key energy businesses/gas importers and other businesses which are in trouble because of the energy crisis, as well as for programs to limit gas and electricity prices.³³

• 
  

  The German parliament extended the authorization for the government, until mid-2023, to lower and relax the requirements for furlough schemes.³⁴ It is not yet clear to what extent the government will eventually make use of its authorization and assume a substantive portion of employees’ salaries, reducing the risk of mass lay-offs.

• 
  

  The government is ready to bail out and stabilize large energy companies to guarantee energy supply. Uniper is certainly the most prominent bail-out, with a volume that reached almost 30 billion euros in debt and equity investment by the end of September 2022 in a government take-over of the company,³⁵ with the government signaling additional funds that could amount to a total bail-out of up to 60 billion euros.³⁶

• 
  

  In preparation for bail-outs, stabilization and eventual government take-over of systemically relevant energy companies, the government has been empowered to transfer control of key energy suppliers to a designated trustee so as to properly structure bail-out and stabilization measures.³⁷ This move was motivated, among others, by the case of Germania Gazprom GmbH, an energy supplier that was affected by sanctions imposed as a reaction to the Russian aggression against Ukraine.

While the crisis resolution strategy is still in the making, at least the early signals seem to imply that the government is following a similar pattern as during the Covid crisis: the primary goal is to prevent insolvencies or comprehensive financial restructurings by a combination of substantive bail-out programs and relaxed insolvency filing duties.

3 Does Insolvency Law Still Matter?

The above-described Covid crisis response raised – for restructuring lawyers – the question of why insolvency and restructuring laws as well as out-of-court restructuring solutions matter, or should matter, for overcoming a widespread crisis such as the Covid pandemic. Are bail-out measures the better crisis resolution tool? We shall analyze this question by considering the temptations of these types of crisis (3.1) and discussing the impact and costs of a bail-out (only) approach (3.2).

3.1 The Temptation to Bail Out: Two Kinds of Crises

Let’s first recall the purpose of insolvency laws and other restructuring tools: insolvency law serves various functions, notably preserving and maximizing the value of the insolvent estate³⁸ and promoting an efficient allocation of resources from a macro perspective. The latter goal is achieved by clearing the market of inefficient businesses and thus releasing otherwise bound resources that could be better deployed elsewhere.³⁹ Collective voting on a restructuring arrangement under pre-insolvency restructuring tools, such as the StaRUG, or within formal insolvency proceedings, such as the insolvency plan, aims at reducing the cost of agreement among the stakeholders when certain rescue measures are supported by a statutorily defined majority of interested parties. Such majority-approved measures are deemed to be in the overall interests of the stakeholders, justifying reasons for legally imposing them on the dissenters. Due to their targeted and speedy nature, established pre-insolvency or pre-packed arrangements can avoid certain direct and indirect costs of traditional insolvency procedures.

The goals of insolvency and restructuring laws must be tested against the backdrop of the issues to be solved. Hence, we will ask whether during times of crisis it may be justified to limit their application. We should therefore look into the issue to be resolved, i.e., the type of crisis a corporation is facing; we can distinguish two kinds of crises in response to which the government has shown a strong temptation to bail out troubled debtors: one type of crisis that otherwise results in insolvencies of businesses that are ‘too big to fail’ (A.), and another type in insolvencies that are ‘too widespread to handle’ (B.).

3.1.1 Too Big to Fail –Knock-On Effects Beyond the Debtor

The first type of crisis involves a potential chain reaction that must be contained before it unfolds. The crisis would start with the insolvency of a debtor or a few debtors that are too big (in numbers of employees, economic capacity, etc.), too connected or too relevant to fail.

In such a crisis, the failure of a key player, a ‘fallen angel’ with a previously high reputation, can destroy trust in other comparable debtors and be the starting signal for a run on assets. This concern prevailed especially during the financial crisis of 2007–09. It was feared that the insolvency of financial institutions would cause a credit crunch so that business opportunities could not be developed, i.e., it was assumed that financial institutions were not only too relevant but also too connected to fail. One piece in the chain falling would make others follow. Hence, the insolvency of the Lehman Brothers investment bank on 15 September 2008 prompted the G7 governments to pledge, in October 2008, that no further insolvency in the financial sector would happen.⁴⁰

Similarly, the insolvency of a debtor that is a major regional employer may cause a regional chain reaction because unemployment leads to a drop in spending capacity so that the regional market, e.g., for services, shrinks. Another type of cluster or network effect may emerge if major or key players on whom entire supply chains depend, collapse. If, for instance, a key raw material producer goes out of business, the businesses which depend on such materials for their production may have to limit production, while the insolvency of an end producer may cause distress, fire sales, and over-supply of raw or production parts. The so-called ‘knock-on’ effect is comparable to the chain reaction as projected for a financial crisis, the difference being that it starts in the real economy and not the financial sector. However, a crisis that begins in the real economy may, eventually, spill over to the banking system, leading to a rising volume of non-performing loans.

During the Covid pandemic, the rescue of Lufthansa and TUI followed such ‘too big to fail’ logic.⁴¹ The recent bail-out of the troubled central gas distributor Uniper, which could no longer bridge the immense delta amount of purchase costs for gas on the market to meet its supply commitments towards more than 100 local energy providers and large corporates,⁴² also follows this logic. The government decided to step in to prevent the negative impact insolvency would have had on the next level, i.e., on private and industry customers of gas distributors.⁴³ The insolvency of major energy or gas suppliers could have critical network effects if they caused (regional) black-outs or supply disruptions, forcing dependent businesses to stop operating.

3.1.2 ‘Too Widespread to Handle’ –Multitude of Contemporaneous Triggers

A second type of crisis is exemplified by the Covid crisis. Widespread distress and economic turmoil will affect SMEs as well as large-cap companies. Differently from a crisis with insolvencies that are ‘too big’ to handle, the primary concern is not that a few large debtors fail but that insolvencies emerge across a range of industries and business sectors, affecting the smallest and the largest debtors at the same period of time. Debtors would stop trading because they are forced to do so by governmental order. Especially those debtors with few financial reserves would very soon be in trouble, with income running out.

Such widespread distress entails various challenges: these may simply be the direct costs involved with formal processes and a scarcity of resources, such as qualified advisors, administrators and court personnel, to support value-preserving restructuring solutions. In this environment, it becomes even harder – adding to higher indirect costs – to distinguish valuable and non-valuable businesses from one another. Not only will there be a lack of time and resources for robust business valuation, it will also be challenging to sort out the (temporary) factor of externalities as a cause for financial/economic distress, such as government-ordered curfews in the pandemic and high energy prices caused by the Russian aggression in Ukraine. In such a situation, temporary financial distress may not serve as a reliable market test to reconsider asset allocation, but as an ‘over-inclusive’ signal that no longer allows for proper differentiation between valuable and non-valuable businesses. Importantly, finding a better deployment of resources is difficult if the market is flooded with assets from distressed businesses leading to deflated prices. What is more, there may not be a better use for such assets at all if economic distress is triggered by outside factors not intrinsic to the affected business. Lastly, the smaller the size of an affected business, the more expensive a private restructuring process relative to the size of the capital structure. This may result in a lack of proper private engagement and of new credit sources.⁴⁴

3.2 The Benefits and Costs of a ‘Bail-Out (Only)’ Approach

The expected negative wider impact on the economy in each of the two above scenarios bears the temptation of bail-out as the immediate policy response. Decision-makers may be tempted to regard a company’s financial distress as a risk for the public benefits that company provides to society. Public benefits, or positive external effects of private business for society, are essential to an economy based on private entrepreneurship. These positive external effects of private business activity for society may be, for example, stable employment and income conditions for the company’s workers, infrastructure for daily public life or supply of goods and services required for the wider well-being. Protecting these public goods by upholding a company’s solvency with public funding is certainly an important and legitimate factor when weighing the correct policy response.⁴⁵ However, equally important are considerations regarding the limits of a bail-out program as well as the distortion of the market mechanism. A bail-out program will always face the tough policy choice of how to ‘rightly’ define eligibility criteria and package size in a situation of high public attention. For the subsequent roll-out, the question arises how to efficiently distribute the resources available under the public funding program. Such programs and their application tend to be ‘over-inclusive’ since detailed guidelines and exhaustive application procedures may, by definition, defy the purpose of a quick and effective emergency response. At the same time, any public emergency funding is typically having an impact on the market for credit and on credit risk. The availability, or even already the expectation of obtaining public funds may critically distort the selection mechanism of viable and non-viable businesses in the market. If debtors receive (untargeted) bail-outs and creditors can expect debtors to be bailed out there is little incentive for private initiatives to restructure, reorganize and invest. Correspondingly, there is limited transformative pressure for businesses. Eventually, the signaling effect is distorted because information as to the creditworthiness and value of a company will be diluted by widespread bail-out funds received.⁴⁶

A lack of transformative pressure is especially worrying during a macro crisis because every crisis brings about structural changes. The Covid pandemic, for instance, changed work routines. Remote and hybrid working became new standard formats. Business travel was often replaced by video calls. The development from on-site to online shopping was accelerated; department stores have come under pressure to justify their market position.⁴⁷ While certain developments will be temporary or some features (partly) rolled back, many developments are here to stay. The downsides for society caused by untargeted bail-outs may surface with delay. They often feature more subtle and less immediately relatable drawbacks to the bail-out approach if bail-outs eliminate pressure and incentive for shareholders, creditors and business partners to work towards a value-maximizing business strategy and transformation in times of crisis. Not only will the allocation of resources be distorted for economically distressed businesses, but employees may also delay their search for alternative employment opportunities which could be more promising in the long run. While an in-depth analysis of benefits and costs of bail-outs goes beyond the scope of this article, it is obvious that the ‘bail-out (only)’ approach is likely to be very costly for society. Not least under consideration is the fact that the availability of public bail-out funding is not unlimited, it comes with long-term costs for an economy and can result in government forgoing more productive deployments of public funds.

4 Can Restructuring Laws Be Trusted to Handle Widespread Crises?

If the ‘bail-out (only)’ approach is inherently flawed, the question arises if insolvency and restructuring laws should play the leading role in a widespread crisis instead. We seek to challenge the approach of a bail-out superiority that – according to our impression – has dominated crisis policy during the Covid period. We will defend the market approach where private renegotiation backed by restructuring and insolvency laws is the primary tool to overcome the financial distress of a private company. Restructuring and insolvency laws should empower the stakeholders to come to beneficial decisions and implement them in a reliable and timely fashion. This is particularly true in major restructuring situations where the direct restructuring costs are lower in relation to the total capital structure. We will evaluate what changes of the German restructuring and insolvency laws we consider necessary to better tackle macro crises in the future – possibly and where needed in concert with limited and targeted bail-out programs.

In Sect. 4.1, we argue that certain adjustments are a template for permanent reforms in order to give out-of-court solutions a more predictable and creditor-friendly framework. In this context, we argue against a criminal sanction for mere time-delayed insolvency filings. In Sect. 4.2, we propose to strengthen the framework for new money for a distressed company. Both proposals are intended to bolster out-of-court solutions in times of financial distress, even in uncertain business circumstances. In Sect. 4.3, we argue that the scope of application of the newly introduced restructuring regime should be broadened in order to serve as an actual pre-insolvency regime. In Sect. 4.4, we turn to the challenge of group restructurings in an international context. Each section relates to the specific challenges of macro crises as identified in Sect. 3. Eventually, we discuss informal arrangements to overcome macro crises in Sect. 4.5.

4.1 Ad Hoc Filing Suspension as a Template for Permanent Reforms

The repeated ‘gut reaction’ of politicians to suspend the insolvency filing duty may imply a certain uninformed skepticism among the German law-makers about traditional insolvency law being able to cope with macro shocks. This skepticism is short-sighted: the repeated suspension and amendment of insolvency filing duties, in our view, reveal structural weaknesses of German insolvency law, which should better be addressed permanently, the assumption being that projections about companies’ going concern are necessarily imprecise in an uncertain business environment.

First, the mandatory German insolvency filing duty should be limited to cash-flow insolvency (s. 17 InsO). The duty to file for over-indebtedness (s. 19 InsO) should be abolished. Ascertaining whether assets exceed liabilities may be a good indicator of a common pool problem in bankruptcy theory. However, it is neither strictly applied in Germany, nor can it be regarded as a ‘health indicator’ for a business in a macro crisis. A balance sheet test, especially during a macro crisis, is an over-inclusive signal of distress when temporary market dysfunction leads to low asset values. Anyway, also the current German approach lets the ‘going concern prognosis’ trump the rather imprecise balance sheet deficit test. The testing period for the prognosis was already reduced over the past years from about 24 to 12 months. The recent push to reduce it to as low as four months undermines the legitimate purpose – if any – of the provision. Even if the reduction is only temporary, it documents that section 19 InsO is ill-conceived as an entry test for formal insolvency proceedings in a macro crisis, and it has no clear advantage in ‘normal times’ either.

Second, the criminal sanction for a delayed filing should be abolished consistently under German law.⁴⁸ The more exceptions are made from the filing obligation, and the more debtors are bailed out, the less a criminally sanctioned filing obligation can be justified. Other countries, such as the United States, which pride themselves with an efficient insolvency regime, do not threaten directors with a prison sentence for unduly deferring insolvency proceedings. A regime primarily based on private incentives has the advantage that directors who should be expected to hold superior (insider) information about the debtor’s financial and economic condition have an interest to act sufficiently early in the best interest of creditors. Where criminal sanctions are regarded to be in the public interest, their trigger should not be a mere function of time-assessing a delayed insolvency commencement in hindsight. Fraudulent and in particular damaging actions of directors committed at a stage of (imminent) insolvency are already sanctioned by other criminal provisions.⁴⁹

Third, a wrongful trading liability of the directors should be introduced with fiduciary duties towards the creditors. A wrongful trading rule that allows directors to flexibly adjust to different – in a macro crisis often structurally new – situations and justify their decision in the best interest of creditors would better fit a modern restructuring law.⁵⁰ Such a rule could pick up an established element of projection as is currently part of the ‘going concern prognosis’ assessment under section 19 InsO, combined with a safe harbor provision. The proposed rule could read as follows:

Once the debtor is more likely than not to become unable to pay its debts when they fall due, the directors are liable for damages suffered by creditors, unless they could reasonably expect to continue trading in the best interest of the company and its creditors. The projection period for this assessment will be 3 months, unless a shorter projection period is more appropriate in any given situation.

Such a provision would be intended to incorporate a shift of fiduciary duties into German insolvency laws. The shift of fiduciary duties aligns the corporate interest with the shifting economic incentives of company shareholders/managers when moving deeper into a financial crisis.⁵¹ To date, German directors remain instruction-bound towards shareholders in closed corporations and liable towards their interest in closed and public corporations regardless of whether the shareholders’ interest is ‘out of the money’. A duty towards creditors exists arguably only under a general interpretation of German corporate law to establish a risk management/early warning mechanism for the prevention of damages to the company and thus indirectly to creditors as the company’s (potential) beneficial owners in distress.⁵² Directors of closed corporations⁵³– and according to certain views also of public corporations⁵⁴ – risk personal liability towards shareholders if they apply for formal restructuring tools. A flexible/gradual shift of fiduciary duties towards creditors in the vicinity of insolvency as envisaged in the government draft of the StaRUG⁵⁵ leaves directors with more flexibility to consider value-maximizing decisions. The enactment of an express duty was proposed but taken out of the bill, leaving this topic open for ad hoc interpretation and advice. Imposing a duty on directors to actively seek solutions for upcoming financial distress expectedly paves the way for active corporate rescue with professional players. A forecast period of three months seems appropriate because this period corresponds with the liquidity forecast of 13 weeks which is regularly performed by SMEs and large corporations, i.e., thus following an established market practice.⁵⁶

In a macro crisis, such an approach may require a series of companies to start looking after the interests of a wider stakeholder group, ultimately fostering negotiations in the surrounding business network for long-term benefits. The proposed rule also leaves flexibility not to rush to the insolvency courts during unpredictable times but to actively seek a solution and organize a proper process with the creditors. Any decision would have to be based on reasonable expectations, which require the assessment by a prudent and conscientious director based on diligently gathered information. A director may justify the decision not to enter insolvency during a macro crisis and instead continue trading based on the reasonable expectation that financial distress becomes a less reliable indicator for the company to enter formal insolvency, and that insolvency can yield suboptimal results because of an oversupply of distressed assets. With the burden of proof for damages caused by continued trading outside insolvency on the creditors’ or insolvency administrator’s side, as is currently the case only for associations and foundations under German law,⁵⁷ the uncertainty of a crisis factually strengthens the directors’ position to defend themselves against liability claims. Discharge from liability will become easier for the directors if they can show that continuous trading was assumed to be reasonably in the best interest of the company and creditors, especially if they did so in close consultation and agreement with the company’s creditors. In contrast thereto, the current liability regime under s. 15b InsO allows to establish claims on a mere reduction of assets requiring directors to prove a lower damage to the creditors; this puts directors in a challenging position when seeking to defend against heavy liability claims by an administrator. The here proposed rule does not require ad hoc emergency legislative adjustments to the wide liability regime of s. 15b InsO but can be applied appropriately also in widespread emergency situations.

4.2 Lowering the Burden for Out-of-Court Rescue Financing

The suspension/tightening of a lender’s liability, claw-back provisions, and shareholder subordination during the Covid pandemic under § 2 COVInsAG was intended to unleash potential for credit in times of crisis.⁵⁸ It is worthwhile to consider whether the lender liability risk, i.e., the lender’s risk of being liable to other creditors in a subsequent insolvency, is not too high a barrier for early restructurings. Especially for debtors in financial distress, creditors facing the risk of claw-back and subordination is a heavy burden, even in the absence of an uncapped liability risk. During times that are not predictable and involve significant uncertainties, it is important to unburden lenders from this risk that comes in addition to the default risk. Such an approach would be in line with the Covid response laws⁵⁹ and remove a presently unjustified disadvantage of private rescue funds compared to public crisis funds which are privileged by an exemption from such lenders’ liability.⁶⁰ It seems difficult to justify that private lenders who provide funding or runway for a business rescue with limited upside should be in a worse position than a shareholder shielded by limited liability.

While the requirements for successfully pursuing a lender liability claim are high, and lender liability is only very seldom invoked,⁶¹ the question of lender liability often dominates private restructuring negotiations. As a justification, lenders typically require the debtor to commission the preparation of accounting reports according to the IDW S6 or S11 standard, which is a time- and resource-intensive process. Especially during a macro crisis, it is even questionable whether such reports – including those prepared with the highest skill and expertise – are sufficiently conclusive to evidence a hardly predictable business recovery over a number of years. In this light it seems recommendable to specify, if not abolish altogether, the rather vague general concept of lender liability. It should generally be outside the scope of creditors’ duties and liability to actively monitor the debtor following closing of the financial restructuring.⁶² The creditors each have a proprietary interest to monitor the debtor and – failing to do so – they may suffer a loss on their investment. Liability towards other creditors for lack of monitoring is a heavy burden for lenders in distress, not least since the duties and limits are vaguely defined compared to the statutory governance regime of limited companies. The monitoring problem should be better dealt with through more refined accounting rules and ongoing disclosure obligations to provide the market with sufficient information as to creditworthiness and counterparty risk.

Moreover, a formally codified exemption for claw-back of new financing in distress could be an accelerator for financing during a macro crisis. The German restructuring law provides an explicit exemption for transactions which are executed as part of the court-sanctioned restructuring plan, including for new financing.⁶³ In this spirit, a rule applicable also to out-of-court restructuring situations should be established to encourage lending in distressed situations, especially during a macro crisis. The rule should trigger a statutory presumption that a creditor’s lending as part of a comprehensive restructuring concept did not harm other creditors. This would exempt creditors from claw-back because any claw-back under German law essentially requires a disadvantage to creditors. Such a rule could read as follows:

New financing shall be deemed in the legitimate interest of the debtor and its creditors in financial distress if it was provided as part of a comprehensive restructuring concept that offered a reasonable prospect of achieving a sustainable restructuring.

Because shareholders are often an important source of financing, it is worth considering whether this privilege should also extend to shareholder loans and be understood as an exemption from shareholder subordination in insolvency.⁶⁴

Further, it is to be discussed whether such rescue loans may be granted with super senior status; businesses in macro crises often suffer from a lack of liquidity. Encouraging debtor-in-possession (DIP) financing can provide a privately funded alternative to government-sponsored bail-outs. Should the DIP financier be granted priority status, possibly also super priority on collateral already pledged to other creditors? As (super-)priority financing not only dilutes the creditor’s claim but also puts a new superior layer of debt on top of existing liabilities, it would be important to implement suitable safeguards, e.g., require court review and adequate protection for affected liens. This is especially true if (super-)priority should be extended to restructuring situations (under StaRUG) outside formal insolvency proceedings.⁶⁵

4.3 Making Room for the Restructuring Plan

While the restructuring procedure itself provides a useful tool to bind dissenting creditors to a restructuring plan, it has certain shortcomings that should be corrected to make the restructuring procedure macro-crisis-ready.⁶⁶ First of all, the German law-maker has followed a traditional approach in working with rather inflexible entry (and exit) routes to the restructuring procedure.⁶⁷ As creditors are protected by procedural safeguards, such as approval requirements, appeal rights, and minority protection, one must question whether the debtor should not be given the opportunity to make use of the procedure in its own assessment.⁶⁸ The entry to the restructuring procedure is further limited by the practical requirement that directors risk personal liability if they make use of restructuring instruments without shareholders’ approval.⁶⁹ Directors are basically sitting on the fence between liability risks towards shareholders and creditors when making a decision on the voluntary use of restructuring or insolvency tools. The wrongful trading rule proposed under Sect. 4.1 above would address this problem.

What further limits the use of the restructuring procedure is the unbalanced restriction on financial creditors (and other, typically minor, open trade liabilities). The StaRUG procedure lacks the option to modify claims from executory contracts insofar as the contractual obligations have not already been performed by one party, i.e., resulting in accrued liability for past performance.⁷⁰ This privilege regarding a certain type of claims as contrasted to financial obligations makes the restructuring procedure unfit to cope with the challenges of a macro crisis. The privilege also leads to unjustified results: a company that acquired a property with credit and pledged the same property to its creditor can avail itself of the benefits of the StaRUG. That company, however, could reduce its payment obligations only under a formal insolvency procedure if it rented the property instead.

As discussed in Sect. 3.2, every crisis brings structural changes that require operative adjustments. Debtors will therefore have to cut off or restructure contracts for supplies no longer needed or terminate leases for unused office and retail space. If financial creditors have to carry the burden of uneconomic contracts, they will have little incentive to accept a haircut to sponsor the debtor’s landlords and suppliers. Formal insolvency proceedings, however, allow for the rejection of executory contracts and the early termination of leases, but do so at higher than needed (direct and) indirect costs. It is conceivable that an energy crisis has lasting effects that require transformative business decisions. Opening the pre-insolvency regime to modify executory contracts or reject contracts should thus be an urgent reform project for making the restructuring law fit for future crises.⁷¹ Judicial oversight should be applied so as to prevent misuse.

4.4 Efficient Restructuring of International Groups

Restructuring and insolvency laws are usually calibrated to address single-entity financial distress. Currently, the German restructuring and insolvency procedure only allows the plan to affect certain rights in collateral provided by connected parties for adequate compensation.⁷² A macro crisis, however, carries a particularly high risk that distress will spread amongst corporate groups due to organizational, operational and financial interconnections and thus requires restructuring of several group entities.⁷³ A group-wide approach can be achieved by coordination of single-entity plans that are approved conditional upon each other’s approval. Hold-out and dilemma problems remain in this context.

It would be more efficient and predictable to resolve distress across a group of intertwined companies at once in an integrated restructuring plan voted upon by creditors of all group companies in a similarly integrated voting procedure. A single group plan should provide for a cram-down mechanism applicable across different legal entities.

Successful restructurings such as that of the Croatian food conglomerate Agrokor in 2017–19 (now: Fortenova) are a showcase of the viability of the integrated group approach. We think that such group restructuring law should be available also at the pre-insolvency level as required by the PRD, outside formal insolvency proceedings, as part of further harmonization across the European Union. The cornerstone of such law to secure coordination benefits for a swift restructuring would be a single group plan with cross-class cram-down rules which stretches across the entire group and allows for the modification of debt, equity, and collateral rights of all or selected group entities. The plan certainly would have to account for structural subordination or contractual de facto subordination as imposed, for instance, by limitation language so as to mirror the distribution waterfall outside formal insolvency/restructuring, i.e., the plan would have to honor pre-insolvency/restructuring contractual rights and positions. These characteristics can be factored into an entity priority calculation which allocates available value across the group to the legally entitled stakeholders. Importantly, those parties affected must still be able to oppose the plan based on a best-interest or no-worse-off test so as to secure that the restructuring surplus is distributed fairly.⁷⁴

4.5 Bail-Out: Preference for Indirect Government Incentives for Negotiated Restructuring Solutions

During a macro crisis neither debtors nor creditors should typically have an incentive to start an insolvency procedure upon the first sign of trouble. On the contrary, a number of soft restructurings implemented during the pandemic show that so-called ‘amend & extend’ transactions, i.e., prolongations of existing credit, possibly under amended terms, were a dominant strategy,⁷⁵ which often allowed debtors to take out additional loans to bolster liquidity.

The government should thus focus on hybrids of bail-out and bail-in, which are meant to foster out-of-court solutions between creditors and debtors. The government could incentivize debt forgiveness and new financing during times of crisis. Creditors could be granted tax exemptions and privileges for income from new financing and generous tax deductions for debt reductions. Such privileges may be applied if creditors and the debtor legitimately pursue the restructuring to overcome the debtor’s financial crisis.⁷⁶ The risk of over-incentive and misuse should on balance be lower than outright governmental payments. The application of tax benefits/exemptions can be policed as part of the ordinary taxation procedure.

Eventually, the government as well as private initiatives of lenders may encourage burden-sharing amongst creditors by rewarding cooperation and punishing free riding, thus creating soft pressure for out-of-court restructurings. The London Approach is often cited as a positive example of such cooperation for out-of-court initiatives.⁷⁷

5 Conclusion: Bail-out vs. Insolvency Reform?

Can a reformed restructuring law make bail-outs as crisis solution mechanism obsolete? Bail-outs will probably continue to play a role in macro crises. There will often be a good reason to provide subsidies to those who are severely affected by an external shock, such as a natural catastrophe, or who have to carry a particular burden during a crisis, e.g., because of governmental curfews or for the greater public good, such as the public health interests during the recent Covid pandemic. Possibly, there is more research to be done on the network effects of macro crises and the role that financial restructuring can play to strike the right balance. We do not intend to argue that restructuring is always the best possible fit to overcome a crisis. However, we advocate the idea that restructuring and insolvency laws, if properly adjusted to the specific challenges of distressed cases previously assumed to be ‘too big’ or ‘too widespread’ to handle, should have their rightful place as a primary governance tool also in a macro crisis.

Germany’s insolvency and restructuring laws have gone through a number of reforms in recent years, including by implementation of the PRD, but with slow innovation in practice. The recent Covid ad hoc measures have uncovered structural shortcomings in German insolvency law that should inspire permanent reforms, such as a flexible wrongful trading rule to replace rigid filing duties enforced with similarly inflexible liability. The continuous application of the statutory framework should remain the default also in an unprecedented crisis situation. The predictable application of the statutory framework – in this case insolvency/restructuring laws – without ad hoc adjustments ensures effectiveness of contractually agreed positions within the general civil law regime because debtors and creditors will eventually adjust their behavior to their expectation of how the law will be applied. The better private stakeholders can address financial distress under restructuring – and, if needed, insolvency – laws, the more bail-out programs can be scaled back and largely limited to, for example, guarantees and loans or indirect tax incentives made available after diligent evaluation of applications on a case-by-case basis rather than as non-refundable and untargeted subsidies. When debtors and creditors as well as other stakeholders within the business network have both an incentive and a stable framework to take up negotiations, in- and out-of-court restructurings can have a transformative effect. They assist the development of new and resilient business structures that adequately adapt to a changing environment as affected by the crisis, thus facilitating an efficient (re)allocation of assets. Debtors and creditors are in the best position to evaluate and decide the way forward in a crisis. Government bail-out may have its legitimate role where these basic mechanics of a market economy find their limits.