“The impact of German capital maintenance rules on acquisition finance requires particular attention”

Leaders League: Who is most concerned by the German capital maintenance rule?

Arnold Büssemaker. Acquirers who contemplate (partially) financing the acquisition of a group of companies, should pay particular attention in the preparation and execution of their transaction, if any of the target group’s companies are organized as a German limited liability company (GmbH), a German stock corporation (AG) or as a German limited partnership which does not have a general partner who is a natural person, e.g. as GmbH & Co. KG.

These types of German companies are subject to the capital maintenance rule, which restricts their ability to make payments or provide collateral to the benefit of their shareholder or their shareholder’s affiliates.

Please note that the capital maintenance rule also requires compliance when including these types of German companies in a group-wide cash-pooling.

What is the purpose and the nature of this rule?

German limited liability companies are under a statutory obligation to maintain their registered share capital (Stammkapital). This also applies – with a few deviations – to German GmbH & Co. KGs and AGs. This capital maintenance rule complements the statutory requirement that, when establishing a GmbH as a legal entity with assets and liabilities separate from those of its shareholders, the shareholders are required to contribute assets to the GmbH in an amount equal to the (future) GmbH’s registered share capital.

The essence of the capital maintenance rule is: A German GmbH can employ all its assets to pursue its business purposes, but it is prohibited from distributing its assets to its shareholders to the extent the respective distribution amount is required to be retained for the maintenance of its registered share capital.

The amount of assets available for distribution to the shareholders is determined by means of a balance-sheet test: In a first step, the total amount of assets is reduced by deducting the total amount of liabilities and provisions. Assets required to service these debt items are protected from distribution to shareholders. In a second step, any remaining amount of assets is further reduced by deducting the nominal amount of the GmbH’s registered share capital. The remainder can be distributed to the GmbH’s shareholders (absent any retention of profit provisions in the company’s articles of association).

Can a GmbH structure a payment or a service to its shareholder in such a way as to avoid the requirement to apply the capital maintenance test?

Yes, the distribution restriction does not apply where the GmbH makes payments or delivers services to its shareholder in consideration of a fully recoverable compensation or repayment claim by the company against its shareholder. The ratio legis of this exemption is: Where the asset distributed to the shareholder is – in the balance sheet - replaced by a fully recoverable compensation or repayment claim, the transaction is accounted for as a mere asset swap, which does not at all reduce the GmbH’s assets. Whether the compensation or repayment claim can be deemed “fully recoverable” is to be assessed in accordance with reasonable commercial standards under German GAAP from an ex-ante perspective.

How are violations of the capital maintenance rule sanctioned and can the GmbH and its shareholders agree on deviations?

Distributing a GmbH’s assets in violation of the capital maintenance rule has grave consequences: In addition to the receiving shareholder, the GmbH’s managing directors are personally liable for restitution; and the GmbH is under a statutory prohibition to waive any such restitution claims.

Why does the capital maintenance rule matter in acquisition finance transactions?

It is common practice for lenders to require the acquirer (by means of conditions subsequent to be fulfilled upon consummation of the acquisition) to cause the target and its material subsidiaries to provide guarantees and collateral in rem to secure the acquisition finance loan granted to the acquirer.

When granting such collateral for the benefit of the acquirer, management of companies organized as a GmbH (or AG or GmbH & Co. KG) is under a legal duty to comply with the capital maintenance rule. The grantor’s management, which will usually attempt to meet the exemption for a fully recoverable compensation claim, will be faced with the following practical questions: First, which is the legally relevant point in time for the determination whether the GmbH has a compensation claim that is fully recoverable: The moment when we grant the collateral? Or the moment when the collateral is realized / enforced? Second, do we have the information required to make this determination?

On the first question, the German Supreme Court (Bundesgerichtshof) ruled in 2017 that the grantor of a collateral in rem (e.g. pledge, security assignment, land-charge) needs to determine compliance with the capital maintenance rule at the time of the granting of the collateral. It is at this time that the compensation claim needs to be viewed as fully recoverable; a later deterioration of the recoverability is irrelevant for this determination. In practical terms this means that management of the grantor of collateral needs to form a view on the basis of a prognosis – at the point in time the collateral is granted – whether or not the shareholder will likely be able to repay the loan. However, the court’s decision is not applicable to the granting of collateral that is not in rem. Therefore, it remains to be seen whether the German Supreme Court will take the same view in relation to the granting of personal collateral, such as a guarantee or an assumption of debt.

On the second question, the German Supreme Court has not provided any guidance yet. It is therefore uncertain what amount of information and what degree of probability will be sufficient for the prognosis whether the shareholder will be able to repay the acquisition loan.

For these reasons, management of each grantor of collateral organized as a GmbH, a GmbH & Co. KG or an AG will require – prior to granting the collateral required from them – time to prepare their decision and possibly to obtain professional advice.

What is the best-practice approach to complying with the capital maintenance rule?

Prior to the German Supreme Court’s decision in 2017, it was best practice – accepted by most lenders – to limit the lender’s ability to realize the collateral if such realization caused a violation of the capital maintenance rule by inserting so-called limitation language in the collateral documentation. Typical limitation language allocates the burden of proof that the lender is actually limited in the realization of the collateral on the grantor of collateral.

From a lender’s perspective, limitation language risks to significantly reduce the value of a collateral for the lender exactly at the time when he most needs to rely on it.

Therefore, lenders widely welcomed the 2017 decision of the German Supreme Court. And some lenders started to reject limitation language in relation to collateral in rem arguing that the court had decided that management needed to perform its balance sheet analysis prior to granting the collateral and not at the (later) time of its realization.

Nevertheless, management of a grantor of collateral is still well advised to insist on limitation language even in relation to collateral in rem: First, the German Supreme Court has not yet provided guidance as to when exactly a compensation claim can be viewed as fully recoverable. Second, limitation language protects management from the risk that its prognosis regarding the recoverability of the compensation claim may – after a future realization of the collateral – be found flawed or insufficiently documented.

In addition, and in particular where a lender rejects limitation language, management should request the shareholder to provide it with all information relevant to assess the shareholder’s ability to repay the acquisition loan at maturity. Management should cautiously assess the information and document its decision-making process. Further, management should require the shareholder to provide it with regular updates of this information going forward. Though a future deterioration of the shareholder’s ability to repay the acquisition loan would not (retroactively) cause the granting of the collateral to violate the capital maintenance rule, management is under a legal duty to continue monitoring the shareholder’s creditworthiness and to properly react to its deterioration.

Accordingly, acquirers of corporate groups with subsidiaries organized as German GmbH, GmbH & Co. KG or AG should - when negotiating the terms of the acquisition loan - anticipate that the management of these German subsidiaries will need to comply with these statutory requirements when entering into the respective collateral documentation post-closing of the acquisition.

Interview with

Arnold Büssemaker

Corporate Finance and Restructuring Attorney

HEUKING KÜHN LÜER WOJTEK