Taking Security in Distressed Loan Restructurings – Update from the Federal Supreme Court in relation to Voidness of Security, Claw-Back and Lender Liability
With the judgment XI ZR 305/14 of 12 April 2016, the Federal Supreme Court has clarified the conditions for the voidness of security created in proximity of the grantor's/borrower's insolvency. Further, it has taken the opportunity to summarise its views on questions of lender liability and claw-back of security. Such aspects are of relevance to lenders who grant or restructure loans in instances of a borrower's financial distress (in particular where new security is taken).
In a situation where a borrower enters into financial distress, lenders must act with particular diligence and attention when deciding whether or not - and if so, how - to grant further credit, to restructure or reschedule the financial indebtedness and/or to take further security.
With regard to credit institutions, the reason for such increased duty of diligence and attention is that a bank is normally the main creditor and, as opposed to other creditors, normally has the contractual strength to obtain in-depth information about its borrower's financial situation. Further, it has also the capabilities to properly evaluate such information. Third party contractors of the borrower, who do not have such contractual power and know-how, might rely on the bank's decision to further extend credit to the borrower and therefore be induced to also enter into further contractual relationships with the borrower, to supply further goods and services to it and to grant further trade credit to it. For these reasons, case law and literature identify increased duties of diligence and care on the part of the lenders vis-à-vis both their borrowers and third parties in situations of borrowers' distress. The same duties also apply to lenders who are not banks but are in a similar position (debt funds, transferees of loans, and issuers of securitisations).
Due to the above, the lender's decision regarding the loan and the security in the borrower's distress means passing between Scylla and Charybdis. On the one side of the strait, the lender faces the risk of incurring liability for the frustration of a turn-around (Sanierungsvereitelung) if it (unjustifiably) accelerates the loan or does not further extend it; on the other side of the strait, if the lender further extends credit to the borrower and takes additional security, it incurs various other risks such as in particular risks of (i) lender liability in vis-à-vis the borrower and/or third parties, and (ii) the claw-back of payments and security.
With the judgment XI ZR 305/14 of 12 April 2016, the Federal Supreme Court has elaborated on such principles. In addition, the above judgment has clarified details of an aspect relatively rarely considered in restructurings, which is the voidness of the security pursuant to Section 138 of the German Civil Code (legal transaction contrary to public policy – sittenwidriges Rechtsgeschäft).
II. THE CASE
The subject matter of the judgment was a situation which can be summarised as follows:
In October 2007 the lender (a local credit institution) had granted a loan to the borrower which was subsequently extended and increased on various occasions. At the end of the financial year 2007/2008 the borrower entered into distress. In November 2009 an auditor's going concern opinion (Fortführungsprognose) was issued for the annual years 2010 /2011 and 2011/2012 confirming that, under certain assumptions and under the condition that certain measures would be implemented, the going concern prognosis was positive.
By means of security agreements dated July 2010 and March 2011, the borrower created a security transfer of chattels (Sicherungsübereignung) in favour of the lender. After such security transfer of title, by another agreement dated April 2011 (presumably on the basis of an authorisation by the lender/secured party under the security document) the borrower sold and transferred title to the assets to a third party (the claimant). The payment was used to reduce the outstanding financial indebtedness. Shortly after such sale and purchase of assets, the lender enforced the security transfer.
Following the opening of an insolvency proceeding over the borrower's assets and the lender's enforcement of the security, the claimant asserted that the security transfer in favour of the lender was void pursuant to Section 138 of the Civil Code because such security was created in a situation where the borrower/security grantor was already on the brink of insolvency and, therefore, the claimant claimed title to the transferred assets. The High Court of Düsseldorf had allowed the claim and declared that the creation of the security was void pursuant to Section 138 of the German Civil Code, holding that:
(a) the borrower/grantor was considered by all parties as being in distress. In particular, the new credit granted in 2010 was denominated by the lender as "restructuring credit" ("Sanierungskredit") which, the High Court held, implied that the borrower's/grantor's financial conditions did not need to be specifically evaluated (i.e. the financial distress could be assumed); and (b) the lender/secured party had not sufficiently evaluated the prospects of recovery at the time the security was created, as the actual going concern opinion was not sufficient for such purpose.
III. THE JUDGMENT
The Federal Supreme Court overruled the High Court judgment as follows:
Pursuing own interests, including by taking additional security, is lawful as a matter of principle. The legal actions of granting credit or taking security may be void pursuant to Sections 138 and 826 of the German Civil Code only if they are completed under certain peculiar circumstances, in particular if the loan and/or the security interests:
(a) oppress the borrower/security grantor (Knebelung);
(b) constitute or are part of a fraudulent delay of bankruptcy (Insolvenzverschleppung); or
(c) deceive other creditors.
Fraudulent delay of bankruptcy can be realised, for example, if a lender postpones the inevitable insolvency of its borrower by extending further credit which does not have any reasonable prospect of turning the borrower around but merely serves the purpose of delaying its breakdown. In that regard, lender liability can arise if other creditors are misled by the lender about the borrower's creditworthiness and the lender is (or ought to be) aware of such effect.
Deceit of other creditors can be realised, for example, if the borrower/grantor charges or transfers almost its entire assets to or in favour of the lender, and if such transaction is entered into in circumstances which are able to and serve the purpose of deceiving other creditors and inducing them to grant further credit to the borrower.
It is also worth noting the following (which was not mentioned by the Federal Supreme Court): the majority view in case law and literature is that oppression of the borrower/security grantor (Knebelung) is realised if the lender restricts the borrower/security grantor to such an extent that no material independent commercial activity is possible and/or no material free assets remain.
However, the Federal Supreme Court highlighted that the above circumstances are only indications, and that the voidness of a legal act of granting credit or taking security can and must be evaluated on the basis of all circumstances of the case, in particular (i) the conditions under which the agreement was entered into, (ii) the effects of the agreement, (iii) the subjective purpose pursued and (iv) the underlying motivations.
For this reason, the Federal Supreme Court clarified that an external going concern prognosis (Forführungsprognose) alone is no sufficient factor for determining whether or not any such legal act is void.
Further, the Federal Supreme Court pointed out that the interests of the borrower's other creditors are in the first place protected by the statutory insolvency claw-back provisions. Only where the challenged legal acts present specific aspects beyond the defeating of other creditors can voidness pursuant to Section 138 of the German Civil Code apply.
Another aspect highlighted by the Federal Supreme Court is that the relevant point in time for the question of the voidness of security pursuant to Section 138 of the German Civil Code is the time of the obligational arrangement (schuldrechtlicher Sicherungsvertrag) and not the time of the conveyance (Erfüllungs-/Verfügungsgeschäft).
The Federal Supreme Court corrected the High Court's view regarding the ascertainment of the borrower's financial conditions, clarifying that the fact that all parties considered the borrower as being in distress does not exonerate the court from analysing the borrower's/grantor's financial conditions on the date on which it created the security. Instead, repeating a principle established in the judgment of 9 July 1953, BGHZ 10, 228, the Federal Supreme Court stated that "the security transfer agreements […] are void pursuant to Section 138 para.1 of the Civil Code if the bank grants a loan to a borrower which is on the brink of insolvency (konkursreif) for the purposes of a restructuring (Sanierung), if it causes that third parties potentially suffer damage for being deceived about the borrower's creditworthiness and if prior to granting the credit the bank has not ascertained the prospects of success of the restructuring by way of an in-depth and objective analysis by an economic expert.
The Federal Supreme Court has provided further clarifications regarding the conditions under which the creation of security in instances of a borrower's distress may be void pursuant to Sections 138 and 826 of the German Civil Code. Further, it has clarified the relationship between claw-back and voidness of security pursuant to Sections 138 and 826 of the German Civil Code. This increases legal certainty for lenders. An uncertainty arises from the fact that the Federal Supreme Court, when referring to questions of the voidness of security, highlighted the necessity to ascertain "the prospects of recovery by way of an in-depth and objective analysis by an economic expert". This could be read in the sense that external advice, in particular a going concern opinion pursuant to the Standard for Restructuring Concepts No. 6 of the Institute of Chartered Accountants (IDW S6), is in any case necessary for the purposes of the credit decision in case of the borrower's financial distress. Such conclusion, however, is not justified, as (i) providing an external going concern opinion might not be feasible for reasons of timing and costs in the concrete circumstances of the case and (ii) it is broadly accepted that a credit institution's own appraisal of the borrower's financial conditions is in most cases sufficient for the purposes of the credit decision, as a credit institution normally has sufficient capabilities for making such determination alone. However, residual doubts remain in this respect.
V. CONCLUSIONS FOR LEGAL PRACTICE
The following conclusions can be traced from the above judgment for the purposes of legal practice:
(a) When granting further credit, restructuring or rescheduling the financial indebtedness and/or taking further security in circumstances of a borrower's distress, lenders must comprehensively evaluate the borrower's financial conditions and prospects of recovery. They may not rely on an auditor's going concern opinion alone. The evaluation should be internally documented in detail.
(b) The in-depth evaluation described in item (a), above, provided that it identifies reasonable prospects of the borrower's recovery, is necessary, but is also sufficient for excluding possibilities of challenging the loan and/or security on the basis of Section 138 and 826 of the German Civil Code. In this respect, the judgment gives lenders comfort and certainty.
(c) The reference to the "in-depth and objective analysis by an economic expert" causes some uncertainty which, in turn, might give lenders an additional argument for insisting on external going concern opinions (in particular pursuant to the Standard for Restructuring Concepts No. 6 of the Institute of Chartered Accountants (IDW S6)) for the purposes of supporting their credit decisions regarding borrowers in distress.