Pre-pack sales add to the German restructuring toolbox

Pre-pack sales add to the German restructuring toolbox

By Lorenz Scholtis (Norton Rose Fulbright) and Tanushree Ajmera (Norton Rose Fulbright)

A pre-pack procedure provides for the negotiation of the sale of a financially distressed entity, as a going concern, prior to the commencement of the insolvency proceedings through which it is executed. The concept is widely used in the UK in the course of an administration.

German insolvency law allows for a pre-pack sale to be executed by way of a protective shield procedure (Schutzschirmverfahren). The protective shield allows for the debtor in possession to pre-negotiate an insolvency plan with its creditors, which outlines restructuring and other measures to be taken to stabilise operations. However, while such insolvency plan may entail a sale of the company or its assets, its ambit can reach far beyond that. In spite of some practitioners marketing the protective shield as "German pre-pack", its limitations over a true form of the pre-pack concept lie in the requirement to execute a sale by way of a rather lengthy, formalised insolvency plan.

Best practice for German pre-packs

In principle, German law allows for the execution of pre-pack sales outside of an insolvency plan – even without providing a dedicated procedure. The German insolvency proceeding by default entails a two-phased approach:

• Phase 1: The preliminary insolvency proceedings, which immediately follow the application and entail the appointment of a preliminary insolvency administrator (or preliminary trustee in case of debtor-in-possession proceedings). The preliminary insolvency administrator assesses the status quo and decides whether to liquidate or to restructure the business (or sell it respectively).
• Phase 2: The (final) insolvency proceedings, which sees the appointment of the preliminary insolvency administrator as (final) insolvency administrator, who then legally takes over the entity and proceeds to execute the approach decided upon.

Phase 1 is often used for the preparation of a sales process, which is then executed immediately following the opening of the insolvency proceedings.

The EU Draft Directive: An attempt at harmonizing insolvency laws

On December 7, 2022, the European Commission published its proposal for a directive harmonizing certain aspects of the insolvency law (the draft directive). As the domestic insolvency laws of the EU member states differ extensively, this can translate into serious information collection costs for investors, e.g. when assessing enforcement or claw-back risks for potential investments in foreign jurisdictions. The draft directive attempts to establish predictability in the outcome of insolvency proceedings through minimum harmonization in targeted areas of core non-bank insolvency law.

The draft directive is part of the further development of the Capital Markets Union (CMU) and presents the third puzzle piece in an attempt to harmonise insolvency and restructuring laws after the Directive 2019/1023 on preventive restructuring frameworks (Restructuring Directive) and the Regulation 2015/848 on insolvency proceedings (European Insolvency Regulation, EIR).

In an attempt to maximise the recovery values of insolvent estates, enhance efficiency in proceedings, and ensure fair distribution of creditor recoveries, the draft directive proposes harmonization in these key aspects: (i) obligations of directors to file for insolvency proceedings; (ii) introduction of pre-pack proceedings; (iii) a minimum set of harmonisation rules for claw-back actions and asset tracing; (iv) creation of an insolvency regime for small and micro-enterprises; and (v) greater transparency and rules on creditor committees and ranking of claims.

A Dive into the Details – the Pre-Pack Procedure

Article 19 of the draft directive obliges member states to include two phases in the pre-pack process:

a)    Preparatory phase: Commences with the appointment of a monitor who documents and prepares the sales process. To ensure the process is competitive, fair, transparent and up to the market standards, the monitor: (i) invites parties to participate in the sales process, (ii) enables due diligence by the interested purchases, and (iii) obtains offers and recommends one which is in the best interest of creditors.

b)    Liquidation phase: Commences the approval and execution of the pre-negotiates sale and the distribution of the sales proceeds to the creditors.

Member States may diverge from this approach by implementing a pre-pack sale by way of public auction in liquidation phase. In this alternative to a privately organized sale, the offer recommended by the monitor is used as a "stalking horse bid." In the event the auction results in a better bid, the "stalking horse bidder," among other inducements, is reimbursed for the expenses incurred or offered a break-up fee. If the sale takes place by way of a public auction, the high standards regarding competitiveness, fairness, transparency and adhesion to market standards are no longer mandatory for the monitor.

The pre-pack sale must be authorised by the court. The purpose is to align the draft directive with the rights of employees in the event and insolvency proceeding result in a transfer of undertaking as per Article 5(1) of Directive 2001/23/EC). The impairment of employee rights has been an issue in relation to pre-pack proceedings in the Netherlands before.

Goodbye “German Pre-Pack”?

Like the draft directive pre-pack procedure, under a German 'protective shield' the power of disposal assets may remain with the debtor in the proceedings, carried out as debtor-in-possession (Eigenverwaltung). The draft directive provides for the appointment of a monitor for supervisory purposes. Again, this is an element well known to German insolvency law.

The draft directive's pre-pack model nevertheless provides for a few key advantages over the status quo of pre-pack implementation in Germany:

• no requirement for the forming of creditor classes or formal voting processes;
• transfer of the executory contracts to the purchases that are needed for business continuity - regardless of the counterparty's consent;
• creation of an overall favourable environment for execution If the debtor is insolvent or likely to become insolvent, a stay may be brought on individual enforcement actions during preparatory phase;
• Necessary interim financing is permitted and so is credit bidding. Pursuant to the latter, creditors can offer their secured claims as consideration for the purchase of collateralised assets. The proceeding condition to offset claims as consideration is that the secured claims must hold a value much lower than the market value of the business.
• The pre-pack proposed by the draft directive is much more transaction-specific than the protective shield. Its advantage over the widely used approach of pre-negotiating a sale in preliminary insolvency proceeding would be that the new pre-pack can be conducted without the need of an insolvency petition and therefore confidentially.

Firm conclusions on the true value of a specific pre-pack proceeding must be reserved until the new directive has passed EU legislative process and German lawmakers have implemented it. But there is certainly an argument that every addition to the legal toolbox at hand for businesses in peril will be useful. In Germany, the draft directive will likely improve the existing restructuring regime to offer the distressed debtors with the benefit of a clear additional option.

* This article was originally published by Norton Rose Fulbright.