Payment for advance performance (mostly) prohibited as of factual insolvency

Once again, the Bundesgerichtshof (German Federal Court of Justice - FCJ) has tightened restrictions on payments made after factual insolvency (Insolvenzreife) – especially if the contractual counterparty has provided (unsecured) advance performance.

 

In its judgment dated 27 October 2020 – II ZR 355/18 – the Second Civil Panel of the FCJ has once again stated its position on an issue that is vital to assessing a managing director’s personal liability for payments made after factual insolvency in breach of the prohibition found in the previous version of section 64, first sentence, Limited Liability Companies Act (which has now been added almost word for word to the German Insolvency Code as section 15b(1)). The FCJ has decided whether and under what prerequisites payments towards goods and/or services provided by a contractual counterparty as advance performance can result in the personal liability of a managing director under the previous version of section 64, first sentence, Limited Liability Companies Act. The implication of this decision for the members of the management board of a company that is factually insolvent (i.e. unable to pay its debts when due (illiquid) and/or over-indebted) is that, in order to minimise liability risks, before paying an invoice issued by a supplier or service provider, they must determine whether or not the contractual counterparty has already provided performance (under retention of title). Conversely, for contractual counterparties of companies in distress, this judgment means that they must insist on payment in advance to best reduce their risk of a default on their claims.

I. Context of the decision

1. Managing director liable for payments made after a limited liability company (Gesellschaft mit beschränkter Haftung – GmbH) is factually insolvent

Until 31 December 2020, managing directors were obliged to reimburse the company they represented for payments they performed from the company’s assets after the company became illiquid or over-indebted (factually insolvent) under the previous version of section 64, first sentence, German Limited Liability Companies Act (GmbH-Gesetz – GmbHG).

The term “payment” was to be broadly interpreted within the meaning of this provision. It covered all outflows of the company’s assets. This included, was not limited to, not only disbursements from an account with a positive balance (credit-side account) but also acceptance of payments into a bank account with a negative balance (debit-side account). In the latter case, the transfer of the funds into the debit-side bank account resulted in repayment of a liability towards the bank, which meant that, from a commercial point of view, these payments were to be treated as payments to the bank. The only exception to this payment prohibition was for payments that were consistent with the care of a prudent businessman. According to the case law of the Second Civil Panel of the FCJ, this exception applied to only a few payments.

Provisions analogous to the abovementioned provision applied to the management board (and supervisory board) of a stock corporation under the previous version of section 92(2) German Stock Corporation Act (Aktiengesellschaftsgesetz – AktG) and to the managing director of a limited partnership with a limited liability company as general partner (GmbH & Co. KG) under the previous version of section 130a German Commercial Code (Handelsgesetzbuch – HGB). However, not only the previous version of section 64 Limited Liability Companies Act but also the analogous liability provisions applicable to stock corporations and limited partnerships with a limited liability company as general partner were recently repealed with the passage of the German Act on Updating Restructuring and Insolvency Law (Gesetz zur Fortentwicklung des Sanierungs- und Insolvenzrechts – SanInsFoG) dated 22 December 2020, most of the provisions of which entered into effect on 1 January 2021, and replaced by a new liability provision in the German Insolvency Code (section 15b). The intention of the previous liability provisions under corporate law that provided for an obligation on the part of companies’ governing instances to provide reimbursement of payments ordered after factual insolvency has been preserved in section 15b German Insolvency Code.

Even if the repeal of the liability provisions previously found in company law and their replacement by section 15b Insolvency Code transferred the competence to adjudicate liability actions against corporate governing instances of insolvent companies from the Second Civil Senate of the FCJ (competent for company law) to the Ninth Civil Senate of the FCJ (competent for insolvency law), it is probably not to be expected (in the absence of contrary indications) that the previous case law of the Second Civil Senate of the FCJ has lost its relevance, but rather that this case law will continue to be an important aid in determining what payments are permissible or not after factual insolvency.

2. Case law of the Second Civil Panel of the FCJ on the (im-)permissibility of payments after factual insolvency

In recent years, the Second Civil Senate of the FCJ has continuously tightened the requirements for permissibility of payments made after factual insolvency occurs, in particular since its decision dated 4 July 2017 - II ZR 319/15. In that decision, the FCJ stated that the assessment under insolvency law of the cash transaction privilege found in section 142 Insolvency Code is not to be applicable (even by analogy) to the assessment of the permissibility of payments in the context of the previous version of section 64 first sentence, Limited Liability Companies Act. As the FCJ clarified in its decision, this is the reason why, under the previous version of section 64 first sentence, Limited Liability Companies Act, managing directors are subject to increased risk of liability once factual insolvency occurs, including for salary payments to the company’s employees, even if the work received in return for the payments had been done recently and still fell in the three-month cash transaction period according to section 142(2) second sentence Insolvency Code. Despite the fact that many criticisms of this decision appear in the literature (for example the Munich Commentary on the Act on Limited Liability Companies(MüKo)/Müller , 3^rd ed. 2018, section 64 para. 149-50 with additional notes) it was recently noted that the Second Civil Senate of the FCJ intends to stand by its strict policy in assessing the permissibility of payments after factual insolvency occurs (see for example FCJ, decision dated 24 September 2019 - II ZR 248/17).

II. Essential content of the FCJ decision dated 27 October 2020

A new judgment by the FCJ dated 27 October 2020 (case no. II ZR 355/18) has been added to this case law. In it, the FCJ was called upon to decide on a case in which, after a limited liability company had become factually insolvent, its managing director ordered payments to be made from bank accounts with a positive balance to its creditors that had provided advance performance, i.e. had already delivered their goods or provided their services to the company.

The FCJ decided that a contractual counterparty’s advance performance is in principle not suitable to compensate for the decrease in the limited liability company’s assets associated with the subsequent payment. Thus, in the opinion of the FCJ, such payments are always relevant to liability. The FCJ states that such cases do not constitute a mere exchange of assets that balance each other out, resulting in a neutral effect, because the counter-performance before the payment had already been incorporated into the company’s assets before the payment was made (FCJ as above; para. 12). The FCJ takes the position that payments from the assets of a factually insolvent company can thus – as a general principle – never be deemed as suitable compensation for any advance performance by the recipient of the payment (with release from liability) (FCJ as above; para. 44).

This means that the FCJ considers the chronological sequence of performance and counter-performance generally relevant to the assessment of the permissibility of a payment after factual insolvency according to the previous version of section 64 Limited Liability Company Act and section 15b Insolvency Code. Only when the factually insolvent limited liability company provides advance performance and its contractual counterparty’s counter-performance follows shortly thereafter is adequate compensation deemed given as regards assets (and release from liability) for the decrease in the company’s assets caused by the payment. This applies in any case if the counter-performance has at least the same (liquidation) value as the payment when it flows into the company’s assets. This constitutes a mere exchange of assets that has a neutral effect on the company’s assets and thus no relevance for the managing director’s liability according to the previous version of section 64, first sentence, Limited Liability Companies Act (and now section 15b Insolvency Code).

However, if the limited liability company’s contractual counterparty provides advance performance, the FCJ deems this an increase in the assets of the company. In the opinion of the FCJ, the advance performance that has already been received cannot be deemed adequate compensation in terms of assets for the decrease in the company’s assets caused by the subsequent payment made by the company’s managing director for this advance performance. But the FCJ states that the previous version of section 64, first sentence, Limited Liability Companies Act serves precisely to retain or replenish the company’s allocable assets. Thus, according to the FCJ, once factual insolvency has occurred, a managing director must refrain from making any payments towards any goods and services already received by way of advance performance. In other words, a managing director must leave these goods/services uncompensated in order to avoid personal liability risks under the previous version of section 64, first sentence, Limited Liability Companies Act. However, the FCJ has expressly left unanswered the question as to whether this assessment also applies to an exchange of performance implemented concurrently in the context of which the managing director precisely does not have the option of securing the performance of the contractual counterparty for the insolvency assets without providing performance himself/herself (FCJ as above, para. 47).

Nevertheless, the FCJ permits an exception to the general liability relevance of payments made by a limited liability company that is factually insolvent for advance performance if the goods supplied in advance were delivered under retention of title, with the result that the payment served only to extinguish the contractual counterparty’s title retention, and the ownership of the goods was transferred to the factually insolvent company. This is because, as the FCJ explains, only after the payment is made, the transfer of ownership precipitated by the payment results in the possibility of recovering the value of the goods received and thus in their addition to the company’s assets (FCJ as above, para. 49 onward).

III. Practical tips and outlook

As a general rule, providing advance performance should be avoided to the greatest extent possible in order to prevent one’s own claims from becoming unrecoverable if the contractual counterparty is or becomes insolvent and thus cannot pay the claims. The abovementioned FCJ decision dated 27 October 2020 – II ZR 355/18 – confirms this principle once again.

In the light of the abovementioned case law, however, it is now more than ever advisable for contractual counterparties of distressed companies to demand payment in advance before beginning to provide performance. This applies in any case to service providers and suppliers that are not secured by retention of title. Otherwise, the risk of an unrecoverable claim is particularly high if the contractual counterparty accepts the performance and is or becomes illiquid or over-indebted. In such a case, a managing director’s “hands are tied” by liability law, i.e. as a rule, he/she cannot make any further payments towards the goods or services already received on pain of personal liability.

An exception is only possible for suppliers that deliver goods under retention of title. Thus, they considerably lower the risk that the managing director of the contractual counterparty is prevented by liability law from paying for the goods. This applies in any case if the delivered performance has a (liquidation) value at the time of performance that corresponds in value to at least the amount of the payment owed. If there are doubts in this context (for example if objets d’art or perishables are delivered under retention of title), the supplier should still demand advance payment even if retention of title has been agreed.

To summarise, the FCJ decision dated 27 October 2020 once again emphasises how important it is from the perspective of insolvency law to agree on retention of title to delivered goods and to insist on sufficient advance payment before providing performance.

From the perspective of the managing director of a distressed company, it is advisable, before paying invoiced amounts to contractual counterparties, to examine closely whether the counter-performance owed by the contractual counterparty has already been received. If it has, payment of these amounts can only be considered if the invoices refer to goods delivered with retention of title or if the payment for the performance that has already been received is absolutely necessary to maintain business operations, the time period of three or, in some cases, six weeks to file for insolvency under section 15a(1) second sentence Insolvency Code has not expired and at the same time steps have been taken to cure the insolvency in the long term or to prepare an insolvency application with the care of a prudent and conscientious executive manager. Managing directors should make a credible record of the fulfilment of all of these prerequisites at the latest when each payment is made in order to reduce personal liability risks in case the limited liability company is subsequently subject to insolvency proceedings.

The legislator’s most recent modifications to legal liability for prohibited payments made after factual insolvency in the form of the Act on Updating Restructuring and Insolvency Law (SanInsFoG) and the new conditions for liability under section 15b Insolvency Code have not changed these liability relationships in the slightest.