The Acquisition and Leveraged Finance Review: Germany
Acquisition finance in Germany has traditionally been dominated by loan agreements with German or Germany-based international banks, often in club deals. The spectrum has broadened and by and large all kind of financings available in the London market can be accessed in the German market as well. A large part of leveraged loans are still structured as club deals, especially in the small and mid-cap market segment, but unitranche and super senior financings are increasing in number and volume. For higher-volume credit, typically term loan Bs (TLBs) and high-yield bonds combined with bank revolvers are used.
The Loan Market Association (LMA) standard documents have established themselves as the dominant documentation standard in Germany for syndicated loan facilities. The LMA published two German law precedents, for investment-grade borrowers and for real estate financing. At the lower volume end of transactions, LMA-based but shortened documentation prevails. Where only German banks and borrowers are involved, the documentation is often set out in the German language.
Regulatory and tax matters
i Licensing requirements
In contrast to other jurisdictions (e.g., England), commercial lending in Germany generally requires a banking licence. Under the German Banking Act (KWG), lending is a regulated banking activity if it is performed on a commercial basis or to an extent that requires commercial business operations. The commercial-basis test is usually met if the lending is to be conducted for a certain period of time and with the intention to generate profits. Consequently, this requirement is usually met (long) before commercial business operations are required. In practice, the latter criterion is, therefore, of little relevance. It is noteworthy that, according to the administrative practice of the German Federal Supervisory Authority (BaFin), there is no de minimis exemption for lending activities, and the licence requirement under the KWG applies irrespective of whether or not loans are extended to consumers or corporate borrowers.
In principle, a licence under the KWG is only required for banking activities conducted in Germany if the lender has its registered seat or a permanent establishment in Germany. A licence might also be required for foreign lenders who actively address the German market by repeatedly offering loans to individuals or legal entities situated in Germany. However, under the 'reverse solicitation' exemption, which is based on an established administrative practice of BaFin, no licence is required for loans made by foreign lenders to borrowers in situated Germany if permitted under the relevant foreign jurisdiction and the respective lending transaction has not been solicited by the lender but was provided solely upon the initiative and request of the borrower. The assessment of this criterion is highly fact-driven and requires an overall assessment of all circumstances of the individual case at hand.
For an activity to qualify as 'lending' under the KWG, a person or entity must grant loans or enter into contractual obligations to grant loans. Hence, the acquisition of a loan that has already been disbursed in full and where the purchaser is under no obligation to extend any (further) credit does not qualify as 'lending' pursuant to the KWG. The mere administration of the acquired loan by the purchaser in accordance with the loan agreement does also not require a licence under the KWG. Therefore, the acquisition of fully disbursed term loans does not generally require a banking licence in respect of the purchaser. There are two important exceptions to this rule. First, a novation, prolongation or any other material amendment of an existing loan is treated by BaFin as an extension of credit. As a consequence, a purchaser of fully disbursed term loans who does not have a banking licence for lending transactions must not enter into the aforementioned amendments or transactions in respect of the acquired loans. This, of course, limits the available options should the acquired loans, for example, need to be restructured. Second, the acquisition must not be conducted on an ongoing or revolving basis. The ongoing acquisition of loans (or other receivables) on the basis of a master agreement would require a banking licence for factoring transactions under the KWG. In addition to that, where the purchaser of loans also takes over the role of facility or security agent, the exercise of such role may require a licence pursuant to the German Payment Services Oversight Act (ZAG).
In contrast to the general rule that the extension of loans on a commercial basis requires a banking licence, no licence is required for commercial lending by certain alternative investment funds (AIFs) and their managers (AIFMs) since 2016. This statutory exemption is widely used by credit funds that originate loans in and to Germany. The exemption applies to German AIFs and AIFMs, which in turn are regulated by the German Capital Investment Act (KAGB), EU-AIF and AIFM, which are subject to the rules and regulations implementing the Alternative Investment Fund Managers Directive (AIFMD). Among other prerequisites, the loan origination must form part of the collective portfolio management of the AIF and AIFM. AIFs and AIFMs from outside the EU may only benefit from this exemption if they have successfully completed the notification procedure with BaFin for the marketing and distribution of the fund in Germany. A notification procedure for the marketing and distribution of the fund only to professional investors does not suffice for the purposes of this exemption under the KWG.
ii Taxes and fees
Interest payments under loan agreements are subject to German corporation tax if the lender is tax-resident in Germany, which, together with the solidarity surcharge, amounts to 15.825 per cent. In addition, trade tax imposed and rate set by municipalities applies (roughly between 7 and 18 per cent).
While Germany charges a withholding tax on specific capital investments, interest on loan agreements is generally not subject to withholding tax. Certain exemptions apply, for example, for certain hybrid loans (i.e., loans with an interest rate linked to the borrower's profits or liquidity). Furthermore, in the case of non-German lenders, the German tax authorities could impose a withholding tax obligation on the borrower if the interest is subject to German limited tax liability (e.g., in the case of a non-German lender if the loan is secured by German real estate). Specific attention is, therefore, required in phrasing tax gross-up and indemnity clauses.
Interest expenses are generally tax deductible in Germany. Certain exemptions apply, such as the interest barrier rule,2 which limits the tax deductibility of interest expenses in excess of the interest income to 30 per cent of the tax EBITDA of the relevant taxpayer (subject to certain exemptions), and the add-back provisions under the German Trade Tax Act. To achieve deductibility of interest expense of the acquiring entity taking out the financing against operating income of the target in a leveraged buyout, a tax group is usually implemented between both entities by way of a profit and loss transfer agreement. For the purposes of corporation and trade tax, the operating profit may then be set off with the interest expenses. The problem can be further mitigated by a debt pushdown, bringing part of the interest-incurring debt to the same level as the operating profit.
While loans are by default VAT exempt, lenders may opt to charge VAT on interest payments. As it might be unclear whether the borrower is entitled to a corresponding VAT credit (in the absence of which the VAT paid to the lender would be a definite cost item), such an option is typically excluded from VAT gross-up in loan agreements.
There are no stamp duties payable in Germany. There are notarisation and registration fees in connection with share pledges over limited liability companies and land charges. Notarisation of share pledges may trigger notarisation fees – the registration or assignment of land charges in the land register and the submission to immediate enforcement trigger registration and notarisation fees, respectively. Fees depend on the value of the collateral asset.
With respect to the US Foreign Account Tax Compliance Act (FATCA), it is not required for German lenders to enter into FATCA agreements. Instead, they are obliged to make certain reports. Nevertheless, it is typical for LMA-based documentation to include FATCA wording, usually based on the LMA wording, for allocating FATCA risks to lenders.
It is typical for facility agreements to contain representations and undertakings regarding compliance with domestic, EU, UN and US sanctions. As many German banks have US branches or subsidiaries, these provisions can also be found in facilities agreements governed by German law or made for German club deals. Compliance with these sanctions, specifically with US economic and trade sanctions that have extraterritorial reach and are administered and enforced by the US Office of Foreign Assets Control (OFAC), is, however, problematic. German and EU blocking laws prohibit participation in foreign boycott measures (i.e., sanctions that are not UN, EU or German).
EU regulation (EC) 2271/963 and the German Foreign Trade Ordinance4 prohibit entities located in the EU or Germany, respectively, from complying with sanctions that are not recognised by Germany or the EU (these are most notably OFAC-administered sanctions). Compliance with UN, EU and German sanctions is unproblematic, and the relevant representations and undertakings are phrased accordingly.
German borrowers and guarantors typically request carveouts from sanction covenants to avoid having to comply with sanctions not recognised by the EU, the UN or Germany. German banks also require that they be carved out so that the representations and undertakings are not given to them. An alternative to carveouts is to enter into a side letter providing for full sanction compliance (including OFAC) but which is only signed by non-German borrowers, guarantors and lenders. Awareness for the need of such carveouts for German but also for other European borrowers, guarantors or lenders has been increasing in recent times, and occasionally carveouts extending to European members of a borrower group or non-German European banks can be seen.
Security and guarantees
i Types of security and guarantees
In contrast to some common law jurisdictions like England,5 there is no 'all-asset' type of security instrument available in Germany. Rather, security has to be taken over each asset class individually by separate security documents. Generally speaking, security can be granted over almost all kinds of assets, but some are more burdensome and costly than others. Due diligence is, therefore, required to establish what kind of assets are available and whether taking security over them is appropriate from a cost and benefit perspective.
Typical German security instruments for a financing comprise the following:
|Asset type||Form of security instrument||Comments|
|Shares||Pledge||GmbH shares can only be pledged by notarial deed incurring notarial fees.|
|Bank accounts||Pledge||Requires notice to account bank. Restrictions on payments or transfers can be imposed by lender.|
|Receivables (including trade receivables, intercompany and insurance receivables)||Assignment by way of security||Usually (undisclosed) assignment; disclosure only in enforcement scenario.|
|Movable property (including machinery and inventory)||Transfer of title by way of security||The asset concerned must be clearly identified, either by transferring every item in a certain location or by revolving delivery of asset lists.|
|Intellectual property||Pledge or assignment of title by way of security||Registration is not compulsory but recommended. Enforcement of the pledge takes place by public auction.|
|Real estate||Land charges or mortgages||The land charge is preferred to a mortgage because it creates abstract security and can be reused. Both security interests are typically notarised and require registration in the land register incurring notarial and land register fees.|
There are no restrictions on granting security over real estate to foreign lenders; however, this might have adverse tax consequences.6 The grant of security over real estate and shares in a GmbH, namely a German limited liability company, requires notarisation, which will involve the payment of notarisation fees. In addition, security over real estate requires registration in the land register, which will involve registration fees. The notarisation and registration fees are determined by statute and can be substantial.
In addition to in rem security, it is common that the material members of the borrower group grant guarantees for all loans outstanding under the relevant facility agreement.7
ii Accessory or non-accessory nature of security
German law security interests are either accessory or non-accessory in nature. Accessory security interests are linked to and share the fate of the secured claim. Thus, they do not come into existence without a valid secured claim and cease to exist, by operation of law, as soon as the relevant secured claim is extinguished. A creditor cannot benefit from accessory security unless it is also the holder of the secured claims. As a consequence, accessory security interests will be automatically transferred together with the underlying secured claim and cannot be separately transferred. Non-accessory security interests, on the other hand, are independent of the secured claim. They are more flexible from the perspective of the secured creditor. Non-accessory security interests need to be re-transferred or reassigned to the relevant security provider and do not automatically lapse upon extinguishment of the underlying secured claim. Mortgages and pledges are accessory security interests, whereas assignments and transfers for security purposes as well as land charges belong to the group of non-accessory security interests. Owing to their nature; there are different requirements for the creation, enforcement, release and transfer of accessory security versus non-accessory security that need to be observed.
iii Security agent and parallel debt
Non-accessory security is not linked to the holding of a claim and thus can be held by a person other than the creditor of the secured claims. Holding and administering of non-accessory security by security agents acting for the lenders is, therefore, straightforward. The holder of an accessory security, on the other hand, has to be the holder of the secured claim. A security agent is, however, not a creditor of the loans under a facilities agreement made by the lenders. To allow the lenders to benefit from an accessory security, the security agent will commonly be granted a parallel debt obligation by the borrowers and guarantors in the amount of and payable at the same time as the debt under the finance documents. This artificially created obligation will then be secured by the accessory security. Any payment on the debt under the finance documents will simultaneously discharge the corresponding parallel debt and vice versa. The parallel debt is usually established in the intercreditor agreement or security agency agreement but can also be created by the facilities agreement or a separate document.
While parallel debt is widely used to secure financings, the legal concept of creating parallel debt obligations in syndicated lending has not yet been tested before a German court. To mitigate the risk of the parallel debt being held invalid and thus the accessory security being unenforceable, it is common to grant security directly to the lenders in addition to the security agent.
iv Transfer of security and amendment of finance documents
Under German law, a transfer of secured claims will not automatically result in the transfer of all types of German security and, in some cases, can result in the automatic extinguishment of that security. Similarly, certain amendments to facility agreements may affect the validity of German guarantees and security.
Non-accessory security is usually granted to a security agent and remains unaffected in the event of a loan participation being transferred to a new lender, whether by way of assignment or novation. But where a lender was directly granted an accessory security and assigns his or her loan participation, the security interest will pass to the new lender by statute. This similarly applies where the lender's participation in the loan is transferred by way of assumption of contract. However, if the loan participation is transferred by way of novation (as is often the case under English law facility agreements), whereby the original loan claims are extinguished and then re-established in the new creditor, the accessory security interest will be extinguished.
To avoid any security to extinguish upon transfer of a loan participation, two remedies are used in German lending practice. Most commonly, the security agent is granted a parallel debt which is secured by the accessory security as explained above in Section III.iii. Alternatively, a 'future pledgee' concept is included in the pledge agreement. Thereby, the security agent accepts the accessory security as representative for any future, yet unknown, secured party. The future secured party ratifies the granting of accessory security once it accedes to the finance documents at the time it acquires a loan participation. Under German law, it is also recommended not to use novation for loan transfers but only assignments or assumptions of contracts.
Further, amendments, term extensions or fee and interest increases must be structured in a way to ensure that guarantees and security are extended to the amended or increased obligations. There is certain doubt as to what extent security grantors and guarantors are able to secure future unforeseeable debt. To mitigate this risk, it is market practice to confirm or redo German law security and expressly extend the security to the amended or increased secured obligations. Non-accessory security will be confirmed by confirmation agreements. For accessory security such as pledges, new junior ranking security will be granted (known as 'supplemental pledges'). The latter might result in significant notarial fees in relation to share pledges over a GmbH.
v Enforcement of security interests
The enforcement of security interests depends on the type of security and the specific asset class over which security has been taken.
To enforce accessory security in the form of pledges, the underlying secured obligation has to become due and payable.8 The pledge is unenforceable as long as only certain covenants or undertakings have been breached but the loans have not been accelerated or other payment claims have become due. Pledges over rights (such as bank accounts or IP) theoretically require that the secured party obtains an enforceable instrument.9 This requirement is, however, mostly waived in security agreements. The enforcement procedures are stipulated by statute and typically require public auction10 unless the assets have a value determined at a stock exchange or other predetermined market price.11 Pledges over receivables or bank accounts give the secured party the right to collect the secured claim from the third-party debtor or bank.12
There are no requirements by statute for the enforcement of non-accessory security (except for security over real estate). The parties are generally free to agree on the requirements and the procedure of enforcement. The collateral is typically sold or auctioned subject to the enforcement procedures agreed upon in the security documents.
Enforcement of real estate security (i.e., land charges or mortgages) will be carried out by the lender in accordance with the German Foreclosure Act (ZVG) by way of a forced auction (compulsory sale) of the property. An application for foreclosure requires filing an original enforceable instrument. To avoid court proceedings at the time of enforcement, the enforceable instrument is obtained when the real estate security is granted by way of a submission by the landowner to immediate foreclosure in the notarial land charge deed. In addition, a land charge or mortgage must be terminated before enforcement with a notice of six months, causing significant delay in the enforcement procedures.13
Irrespective of the statutory requirements, security agreements usually contain additional preconditions for the enforcement of security, which can differ across the types of security. Typically, the borrower must be in payment default or a declared default must have occurred. Furthermore, the lender must give notice of enforcement to the grantor of the security before starting enforcement procedures.
vi Most relevant limitations on granting security interest
German courts regard guarantees on first demand (viz. on mere assertion of a claim or production of a document) as potentially dangerous for the guarantor. Pursuant to case law,14 guarantees on first demand granted by individuals or companies inexperienced in international trade or finance are invalid. The same applies to guarantees on first demand that are contained in general terms and conditions.
German law security arrangements are deemed void if the total security taken is far in excess of the secured obligations at the time the security arrangements are entered into (initial over-collateralisation). Initial over-collateralisation is generally held to occur if at the time of entering into the security agreement it is certain that in the event of a foreclosure there will be an obvious imbalance between the realisable value of the collateral and the secured claims. There is no clear case law guidance on thresholds, but invalidity of the security is often assumed when the realisable value of the collateral exceeds the cover threshold (which is generally held to be 150 per cent of the nominal amount of the secured claims) by more than 200 per cent (i.e., the realisable value would be in excess of 300 per cent of the nominal value of the secured claims). Because of the relatively high thresholds, initial over-collateralisation is rarely an issue, but should always be considered when structuring security packages for loan financings.
The ratio of the value of security to secured debt can also change during the life of a loan; for example, because of scheduled repayments. Again, this can result in over-collateralisation. However, in contrast to initial over-collateralisation, such subsequent over-collateralisation does not result in the security being void. Rather, if the estimated value of security subsequently exceeds certain thresholds, the grantor of the security can request its release to the extent necessary for lowering the value of the security below that threshold. The applicable threshold depends on the type of collateral. For assets whose realisable value is (quite) certain, as with account pledges, it is assumed that this value can indeed be realised in the event of an enforcement of the security. Therefore, only a 10 per cent surcharge is permissible, or, in other words, the value of security shall not exceed 110 per cent of the value of the secured obligations. Where the realisable value of the collateral is uncertain, as, for example, with security over movables, that threshold is raised to 150 per cent. Generally, however, these rules have been carved out by judgments of the Federal Supreme Court and can be subject to change as well as to their exact application to the facts of each individual case.
Capital maintenance rules and financial assistance
A German limited company (GmbH)15 or a German stock corporation (AG) may provide security for its own debt and that of its subsidiaries without limitation. However, under capital maintenance rules, debt of a German limited liability company's direct or indirect shareholders and their affiliates can only be secured up to the amount of equity that a shareholder would be entitled to draw from the company.16 Thus, assets sufficient to cover the debt of all other creditors have to remain in the company. The effect of the relevant limitation language is that all other creditors rank prior to financial creditors benefitting from upstream security. Pursuant to capital maintenance rules, a stock corporation cannot grant any benefits to its shareholders or any of their affiliates except for the payment of dividends from annual profits.17 This does not apply if a domination or a profit-and-loss-transfer agreement has been entered into between a limited liability company or stock corporation as security grantor and its shareholder or if the security grantor has a fully valuable compensation claim against that shareholder.18
A breach of capital maintenance rules does usually not render the security or guarantee invalid, but the shareholder receiving the benefit and the management granting the security would become liable to the company or corporation for any loss caused. Therefore, it is common to include limitation language into security agreements entered into by German entities with limited liability, capping any enforcement of security against them at the permissible amount, subject to certain exceptions.19 In addition, German stock corporations are strictly prohibited from providing financial assistance. Apart from directly financing the acquisition of its own shares, this also comprises any indirect assistance by way of upstream security and guarantees in respect of acquisition debt.20
A debt push is often employed to overcome the restrictions to upstream guarantees and security (see above) and the resulting 'structural subordination' of creditors of acquisition debt. A debt pushdown is implemented by way of assumption of contract by the relevant target company. The extent to which a pushdown of acquisition debt can be implemented is also subject to corporate law requirements and needs to be analysed in detail in the light of the balance sheet situation and the tax affairs of the relevant group.
Destructive interference, bonos mores and inducement of breach of contracts
In addition to capital maintenance rules, the German Federal Supreme Court has developed the concept of 'destructive interference'. This means a situation where a shareholder deprives an entity of the liquidity necessary for it to meet its liabilities.21 This concept may be applied by courts with respect to the granting of guarantees or security by a German entity for securing debt of its shareholder.
Furthermore, the Federal Supreme Court has ruled that the beneficiary of a transaction effecting a repayment of the stated share capital of a GmbH could become personally liable under exceptional circumstances. This can be the case if, for example, a creditor taking security were to act with the intention of detrimentally influencing the position of the other creditors of the debtor in violation of the legal principle of bonos mores.22 This intention can be deemed to be present if the beneficiary of the transaction was aware of circumstances indicating that the grantor of the guarantee or collateral was close to financial collapse.
Finally, a security agreement may be void because of tortious inducement of breach of contract if a creditor knew about the distressed financial situation of the debtor and anticipated that the debtor will only be able to grant security by disregarding the vital interests of its other business partners.
vii Clawback rights in insolvency proceedings
Under the German Insolvency Code, the insolvency administrator (or in the case of debtor-in-possession proceedings, the custodian) may challenge transactions, performances or other acts that are deemed detrimental to insolvency creditors and that were effected prior to the opening of formal insolvency proceedings during applicable hardening periods. If successfully challenged, any benefit derived from the challenged transaction must be returned to the insolvency estate.
Any transaction (which includes the granting of a guarantee, the provision of security and the payment of debt) detrimental to the creditors of an insolvent entity may be challenged in the following most relevant situations.
Congruent coverage (Section 130 Insolvency Code)
Transactions providing the creditor with security or satisfaction for its claims if:
- the relevant transaction was entered into within three months prior to the filing for insolvency, the debtor, at the time of the transaction, had already been illiquid and the creditor had positive knowledge thereof; or
- the relevant transaction was entered into after the filing for insolvency and, at the time of the transaction, the creditor had positive knowledge of the debtor's illiquidity or of the fact that an application for the opening of insolvency proceedings had previously been filed.
Incongruent coverage (Section 131 Insolvency Code)
Transactions providing the creditor with security or satisfaction for its claims to which the creditor was not entitled at that time or not in that manner are subject to clawback if:
- the relevant transaction was entered into during the last month preceding the filing for insolvency or thereafter;
- the relevant transaction was entered into during the second or third month prior to the filing for insolvency and the debtor, at the time of the transaction, was already illiquid; or
- the relevant transaction was entered into during the second or third month prior to the filing for insolvency and the creditor, at the time of the transaction, had positive knowledge that the transaction was detrimental to the insolvency creditors.
Transaction without consideration (Section 134 Insolvency Code)
Transactions without (adequate) consideration (e.g., where a debtor grants security for a third-party debt, which might be regarded as having been granted gratuitously), if granted within four years prior to the filing for insolvency.
Wilful damage (Section 133 Insolvency Code)
Transactions providing the creditor with security or satisfaction for its claims within the four years prior to the filing for insolvency or thereafter if the debtor acted in bad faith with the intention to harm its creditors and the creditor receiving the security or satisfaction was aware of the debtor's intention (such knowledge being assumed or indicated under certain circumstances).23
An important option to avoid clawback risks for security or guarantees in a financing transaction is to structure of security and guarantees as 'cash transactions'. A transaction is considered a cash transaction if the debtor receives a consideration of equal value in return for and concurrently with its own performance (e.g., the debtor grants security for a new loan within a short period of time after disbursement of the funds).
Priority of claims
i Ranking of claims and security
Under German law, all claims, whether secured or unsecured, have the same ranking unless subordinated by contract or statute. The most common method of ranking is a contractual subordination by way of a subordination or intercreditor agreement between the various creditor classes and the borrowers. Structural subordination is also employed specifically in larger volume deals with multilayer financing structures. Contractual and structural subordination are often combined. Documentation is typically based on LMA standards with shorter versions for lower mid-cap deals.
Whether security can be created in first, second or further ranking depends on the type of security. Accessory security such as pledges can be created for different creditors with different ranks. Non-accessory security such as receivables assignments can only be granted to one secured party and thus only as first ranking security. It will usually be made to the security agent with an intercreditor agreement providing for a ranking among the secured parties. For layered financings, which would typically also have layered security packages (e.g., senior and mezzanine), pledges over shares, bank accounts and release estate can be granted separately for each creditor class. Common practice in Germany nowadays is to pool security with one security agent and to set up one intercreditor agreement for all layers of creditors and debt. Parties rely on the contractual agreement in the intercreditor agreement with regard to ranking and waterfall.
For debt increases and term extensions, it is common practice in Germany to confirm non-accessory security and grant junior ranking accessory security (supplemental pledges, see Section III.iv) to ensure that the increased or extended debt is covered.
ii Impact of the German insolvency regime on secured creditors
All creditors, whether secured or unsecured, need to participate in the insolvency proceedings. Secured creditors are generally not entitled to enforce any security interest outside the insolvency proceedings but have certain preferential rights in the insolvency proceedings. Depending on the type of security, the right to enforce such security is either vested in the secured creditor or the insolvency administrator. It may be vested in the secured creditor if he or she has a preferential right to enforcement or a right to separation. Regarding preferential rights, the insolvency administrator generally has the right to realise any movable assets in the debtor's possession that are subject to security, as well as to collect any claims that are subject to security assignment agreements. If the enforcement right is vested in the insolvency administrator, the enforcement proceeds, less certain contributory charges (usually up to 9 per cent of the gross enforcement proceeds), are disbursed to the party secured by the security interests. With the remaining enforcement proceeds and any unencumbered assets of the debtor, the insolvency administrator satisfies all creditors (whether secured or unsecured) rateably.
iii Equitable subordination of shareholder loans
Claims for repayment of shareholder loans are subordinated in a German company's insolvency and treated as if the loan amount was contributed as equity.24 Prior to an insolvency, a shareholder loan can be repaid at any time with basically no restrictions. However, repayments of shareholder loans, whether due or not, within one year prior to filing for insolvency can be challenged by the insolvency administrator and would need to be paid back to the insolvency estate.25 Exceptions apply for loans granted by shareholders who (1) do not participate in the management of the company and do not hold more than 10 per cent of the capital of the company or (2) have acquired the shares to rescue the company in a financial crisis.26
As the rules on equitable subordination only apply in an insolvency of a borrower, a borrower may make payments on a shareholder loan prior to its insolvency (subject to hardening periods of one year). Thus, in financing structures it is common for shareholders to agree with the lenders that shareholder loans are contractually subordinated and that (except for interest in certain cases) no payments will be made on the shareholder loans as long as the debt financing remains outstanding.
Pursuant to case law,27 even third-party lenders may be treated as shareholders in exceptional circumstances and thus become subordinated. This is the case if they have influence over the borrower to the extent that they take over its day-to-day management. It is disputed whether the tight covenants as contained in template LMA documentation limit the corporate and commercial flexibility of borrowers to an extent that the loan is subordinated. Representations and undertakings should, therefore, provide borrowers with sufficient flexibility to manage their day-to-day business. German obligors are sometimes carved out from specific covenants. However, such covenants will apply indirectly to them via information undertakings to the lenders, which then have the option of cancellation for good cause.
i Choice of governing law
Generally, courts in Germany will uphold the choice of foreign law as governing loan agreements. The application of foreign law to agreements governed by the Rome I Regulation28 will only then not be upheld of in the event of a conflict with public policy or overriding mandatory provisions of German or foreign law.29 A choice of law regarding non-contractual obligations is subject to the provisions of the Rome II Regulation30 which imposes similar restrictions. Under the conflict of law rules of Germany and the European Union, the lex rei sitae principle applies to all rights in rem, and German law may under those provisions also be applied to security interests over non-physical assets such as receivables governed by German law. Security over German collateral is, therefore, generally subject to German law.
ii Choice of venue
A choice of venue is possible under German and European law subject to certain limitations. However, an agreement on a place of venue could be blocked by provisions of German law and the Brussels I Regulation,31 determining exclusive venues for certain matters (e.g., disputes concerning the ownership of immovable property, employment contracts, the existence of a company or the validity of registrations in public registers).
iii Enforcement of foreign judgments
The requirements for enforcement of foreign judgments depend on the country of the ruling court. Enforcement of judgments of courts of member states of the European Union of the European Economic Area are subject to the provisions of the Brussels I Regulation or the Lugano Convention,32 respectively, which are largely the same. Judgments of such countries will be recognised and are enforceable in Germany without separate declaration of enforceability by a German court. Judgments from other countries require a declaration of enforceability by a German court, and their recognition is subject to the German Code of Civil Procedure,33 which requires, inter alia, that the country of origin of the judgment would recognise and enforce German judgments on generally equivalent conditions (reciprocity).
Acquisitions of public companies
Public companies are usually organised as stock corporation, partnership limited by shares or European company (societas Europaea). These entities are subject to the Stock Corporation Act or the Regulation on European Companies.34 Transactions in the capital markets are regulated by the Securities Trading Act (WpHG).
The takeover of listed public companies in Germany is regulated by the Takeover Act (WpÜG). The Act and supplemental guidelines set out the rules for the consideration, the content of the offer and the offer procedure.
According to German law, a person obtaining direct or indirect control over a listed company has to submit a mandatory offer for the acquisition of all shares in the target company. Control is assumed if 30 per cent or more of the voting rights are acquired by a person. Voting shares of subsidiaries and persons acting in concert can be attributed to the person making the acquisition under certain conditions. An enforcement of security over shares in a listed public company may also trigger a mandatory offer for the acquirer and needs to be considered when structuring security packages. There is no obligation to make a mandatory offer if control over the target company was reached by way of a voluntary takeover offer. Exemptions from a mandatory offer may be granted by BaFin. The takeover offer must stipulate a consideration at a certain minimum price as regulated in an ordinance (the higher of the average share trading price of the past three months and the highest price paid by the bidder during the past six months).35
Voluntary offers generally follow the same rules as mandatory public offers. The bidder may freely set the purchase price unless the offer may lead to acquiring control in the target.
A mandatory or voluntary offer may not be made subject to financing. The bidder has to have financing agreements in place ensuring payment assuming that all shares are tendered.36 The bidder has to specify in the offer how its financing is ensured. The financing arrangements must provide the bidder with certain funds that are definitely available if and when the offer closes.37 For considerations in cash, a written confirmation has to be provided by an independent securities services provider (a 'financing confirmation') that the bidder has taken all necessary measures to ensure that the funds required are available for the complete fulfilment of the offer at the time the consideration becomes due.
All shareholders have to be treated equally in an offer. The offer may be made conditional in certain respects. For example, essential antitrust conditions are accepted by the authorities. The conditions have to be objective, and the offeree has to be able to make an informed decision on the basis of the information provided. A valid condition may be that shares in excess of a minimum threshold are acquired. In practice, takeovers are often conditional on the acquisition of at least 75 per cent of the voting shares, enabling the bidder to reorganise the target group. Once the bidder has announced its decision to make a takeover offer, it is obligated to execute the further offering procedure. The offer may only expire if conditions relating to it are not fulfilled.
The year in review
Throughout 2019 and until the beginning of 2020, the German financing market was still in full swing and financings continued to remain available on the same loose documentary conditions as for the previous years. The party on M&A transactions and supporting financings was abruptly stopped when – because of the covid-19 pandemic – Germany went into lockdown mode in March of 2020. Lenders became cautious and ongoing transactions were postponed, cancelled or commercially tightened, setting the scene for a challenging year.
In light of the fast and severe economy downturn, the German legislator reacted quickly and – economic consequences caused by the ongoing pandemic in mind – modified the German insolvency regime to avoid the collapse of companies with going concern: rules governing the obligation to file for insolvency were adjusted and restrictions for new financings were attenuated in order for struggling companies to meet liquidity needs, providing a measurable relief to companies and allowing them to adapt to the pandemic economical environment.
In addition, the German government rolled out or extended several state-supported loan programs to covid-affected businesses. These subsidised loans were mainly made available via state-owned bank KfW. Two programs were predominantly used for companies with a leveraged financings in place. First, the existing entrepreneurial loan programme was extended to cover covid-19-affected businesses by the KfW providing back-to-back loans to the banks with the banks passing the funds through to the borrower, with KfW bearing 80 per cent of the credit risk. Second, the new and more complex programme for direct participation in syndicated financing facilities was designed to support larger companies with new syndicated loan facilities or an additional tranche in existing syndicated loan facilities.
Throughout 2020, it was a major task for all market participants to adjust to the changing environment and especially the changing practice guidelines issued by KfW for its loan programmes, even impacting current documentation processes, resulting in lengthy negotiations and complex documentation. Most of the discussion points in the programmes were settled in the months since their introduction and the market developed a general understanding and practice for documentation and structural aspects.
One of the major challenges for existing leveraged financings was the impact of the covid-19 pandemic on borrowers' EBITDA as the figure went down considerably, in particular in industries depending on travel, leisure and public life in general. This pushed net leverage, the most common financial covenant in acquisition financing, often significantly above the set financial covenant requiring covenant waivers and re-sets. In many cases, a liquidity covenant was added for a certain time period in which an existing leverage covenant was suspended.
Further, in connection with diving EBITDA due to the pandemic, borrowers and sponsors tested the possibilities of EBITDA adjustments in loan agreements. Some tried to make COVID-19-related adjustments, which was met with scrutiny by lenders. The interpretation and scope of financial definitions and EBITDA adjustments thus became a point of intense discussion.
While deals were abandoned or delayed in the first half of 2020, new M&A transactions and accompanying financings seem to be back on track in the third and fourth quarter of 2020. While pricing has initially been adjusted upwards, it has largely come down to almost pre-crisis levels. Documentary terms remain accommodating and borrower-friendly, specifically for stronger sponsors. Liquidity is still aplenty and needs to be deployed, resulting in a significant competition of many lenders for fewer deals.
Discussions as to what extent exceptional effects resulting from the covid-19 pandemic can be normalised in EBITDA will continue. With market practice far from being settled, it remains to be seen how future finance documentation will address disruptive events like a global pandemic.
Given current activity levels, one can be slightly optimistic for the remainder of the year 2020 and 2021. Despite the significant impact covid-19 had on the German economy so far, it shows early signs of recovery that began to translate into an increasing amount of new money deals. Yet the pandemic is ongoing and seems to be resurging in autumn. The economic recovery from the hit of the lockdown in the first six months of the year remains patchy and new pandemic-related restrictions may again depress the economy and new deals.
1 Thomas Ingenhoven is a partner and Odilo Wallner is an associate at Milbank LLP.
2 Note that the German Federal Fiscal Court considers the interest barrier rule unconstitutional and has referred the case to the German Federal Constitutional Court.
3 Article 5 of EU regulation (EC) 2271/96 of the European Council of 22 November 1996, protecting against the effects of the extraterritorial application of legislation adopted by a third country, and actions based thereon or resulting therefrom.
4 According to Section 7 of the German Foreign Trade Ordinance, German-based persons (e.g., borrowers, guarantors) may not give declarations to enter into or comply with a trade boycott unless the trade boycott is in accordance with sanctions imposed by the UN, the EU or Germany. It is further unlawful for anyone (Germany-based or not) to request a Germany-based person to adhere to trade boycotts that are in accordance with sanctions imposed by the UN, the EU or Germany. Violation may result in a fine of up to €500,000 or, under specific circumstances, criminal liability.
5 All-asset security in England and Wales is typically taken by way of a floating charge.
6 See Section II.ii.
7 See Section III.v.
8 Section 1228, paragraph 2 of the German Civil Code.
9 Section 1277 of the German Civil Code.
10 Section 1235 of the German Civil Code.
11 Section 1221 of the German Civil Code.
12 Section 1282 of the German Civil Code.
13 Section 1193 of the German Civil Code.
14 See, for instance, BGH, decision dated 23 January 1997, IX ZR 297/95.
15 This includes partnerships that include a GmbH as a general partner.
16 Section 30 of the German Limited Liability Companies Act.
17 Section 57 of the German Stock Corporations Act (AktG).
18 Section 57 of the German Stock Corporations Act (AktG), Section 30 of the German Limited Liability Companies Act (GmbHG). See Heidinger, Kommentar zum Gesetz betreffend die Gesellschaften mit beschränkter Haftung (GmbH-Gesetz), 3rd Edition, Section 30, No. 89, for further details.
19 German limitation languages usually contain certain carve outs and adjustments that deviate from the enforceable level stipulated by law, but that shall ensure that the management of the company granting security complies with its obligations under the Finance Documents as it would otherwise become personally liable under capital maintenance laws.
20 Section 71a of the German Stock Corporations Act (AktG).
21 BGH, decision dated 16 July 2007, II ZR 3/04.
22 BGH, decision dated 16 March 1995, IX ZR 72/94; BGH, decision dated 12 March 1998, IX ZR 74/95.
23 The previous hardening period was 10 years, which has been reduced by the insolvency clawback reform, which became effective on 5 April 2017.
24 Section 39(1), No. 5 of the German Insolvency Code.
25 Section 135(1), No. 2 of the German Insolvency Code.
26 Section 39(4)–(5) of the German Insolvency Code.
27 BGH, decision dated 13 July 1992, II ZR 251/91.
28 Article 3 of Regulation (EC) No. 593/2008 of the European Parliament and of the Council on the law applicable to contractual obligations.
29 Article 9 of Regulation (EC) No. 593/2008.
30 Regulation (EC) No. 864/2007 of the European Parliament and of the Council on the law applicable to non-contractual obligations.
31 Regulation (EU) No. 1215/2012 of the European Parliament and of the Council on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters.
32 Convention on jurisdiction and recognition and enforcement of judgments in civil and commercial matters dated 30 October 2007.
33 Section 328 of the German Code of Civil Procedure.
34 Aktiengesetz (AktG) and Regulation (EC) No. 2157/2001 of the European Parliament and of the Council on the statute for a European company (SE).
35 Takeover Act Offer Ordinance (WpÜG-AngebotsVO).
36 Section 13 of the German Securities Acquisition and Takeover Act.
37 Conditions are only permitted to a very limited extent. For more detail, see Baums, Thoma, WpÜG – Kommentar zum Wertpapiererwerbs- und Übernahmegesetz, 8th delivery, Section 13, No. 191.