Best practice: How to protect the seller in M&A transactions
By Dr. Steffen Schniepp and Dr. Christian Hensel
When it comes to the financing of companies, shareholder loans are of outstanding importance whether for mid-tier companies, (inter)national groups or venture capital or private equity investors. When companies financed by shareholder loans are sold the seller does not usually wish to continue his financial engagement. By the same token, the purchaser regularly wishes to end any kind of financial dependence between the target company and the seller. Taking account of these interests, share purchase agreements have, up until now, usually provided for the sale and assignment of shareholder loans together with the shares in the target company. Since 2013, there has been a great discussion about whether or not this approach can remain standard procedure.
According to s. 135 ss. 1 no. 2 German Insolvency Act (Insolvenzordnung – InsO) any payments on shareholder loans (principle amount and interest) can be contested by the insolvency administrator if insolvency proceedings are opened over the assets of the company within one year after payment. In 2013, the German Federal Court of Justice (Bundes-gerichtshof, or BGH) decided that if a shareholder loan is assigned and repaid after assignment not only the assignee but also the assignor is liable (as joint and several debtor) for restitution pursuant to s. 135 ss. 1 no. 2 InsO. That effectively means that the assignor has to repay funds it has never received. Clearly, the underlying case demonstrated strong signs of collusion. However, the BGH emphasized that collusion was not proven and not required to order the assignor to repay the full amount of the shareholder loan.
There are grounds for rejecting this judgment. It is, for instance, doubtful whether s. 135 ss. 1 no. 2 InsO provides a basis for a claim against the assignor although the assignor never received a payment. Quite the contrary: s. 143 ss. 1 InsO expressly states that assets received by virtue of the contested transaction have to be returned, meaning that someone who did not receive anything cannot be obliged to return it. It is also questionable whether the insolvency administrator should benefit from a duplication of debtors just because the shareholder loan was assigned, or even multiplication of debtors, in the event of several assignments of the same loan.
Furthermore, there are grounds to argue that this judgment should not apply to the transfer of shareholder loans in M&A transactions. In contrast to the case decided by the BGH, the assignment of shareholder loans is, in M&A constellations, a mere annex to the sale and transfer of shares. The seller loses its position as shareholder and, in consequence, his responsibility for the fate of the company (Finanzierungsfolgenverantwortung).
Nevertheless, as long as there is no deviating judgment by the BGH, the seller is well advised to insist on contractual protection against repayment claims asserted by a potential insolvency administrator.
Protecting the seller
The M&A practice has, in essence, found two ways of shielding the seller from claims pursuant to s. 135 ss. 1 no. 2 InsO. One option is to sell the shareholder loan but to include clauses in the sale and purchase agreement dealing with potential claims by the insolvency administrator. The other option is not to sell the loan and instead provide for an economically equivalent solution.
Clauses shielding the seller from risks
If option one is chosen, there are several ways to protect the seller: (a) a binding letter of comfort by the purchaser, (b) an indemnity against claims by a potential insolvency administrator and (c) an obligation by the purchaser not to collect the shareholder loan for (at least) one year after closing. As outlined as follows, these solutions feature different advantages and disadvantages.
A binding letter of comfort avoids (as long as the purchaser is solvent, see below) the insolvency of the target company and, hence, any risk of contestation pursuant to s. 135 ss. 1 no. 2 InsO. However, the purchaser will not usually be prepared to agree to such wide-ranging obligations.
The indemnity is more precise. It provides the assignor with a recourse claim against the purchaser only if and to the extent the insolvency administrator actually brings claims against the assignor. If the indemnity is secured and drafted in a way that suits the sellers and the purchasers needs, for example with regard to caps and time-limitations, then the indemnity is usually a good solution to the question at hand. It is often used in practice.
However, once in a while a purchaser objects to the indemnity because it bears the risk of paying twice for the same loan: initially at closing when paying the purchase price for the loan and later, after a potential contestation, when the indemnity is invoked. The seller’s argument that this will happen only if the target company falls insolvent within the rather short period of one year after closing and at a time when the company is under the sole control of the purchaser is sometimes countered. Some purchasers fear that the insolvency could be triggered by risks already set by the seller in the past that surface only after closing and without sufficient coverage by seller’s guarantees.
In such situations, the obligation not to collect the loan for at least one year after closing can provide a way out. BGH-jurisdiction clearly indicates that a collection later than one year after closing excludes the risk of contestation pursuant to s. 135 ss. 1 no. 2 InsO towards the seller. At the same time, as long as the shareholder loan is not repaid, the purchaser does not run into danger of paying twice.
As a result, the secured indemnity will regularly constitute the preferred solution. Only in certain cases will the parties choose a comfort letter or a non-collection obligation.
An alternative approach
If the second option is chosen, the parties have decided against an assignment of the loan and terminate the loan prior to closing.
One possibility to achieve this aim is by repaying the loan at closing. While the repayment can be structured in different ways, the only really promising method is the direct payment of the amount of the shareholder loan by the purchaser to the seller at closing immediately after the shares have transferred to the purchaser, this repayment qualifying in between the purchaser and the company as contribution to the free capital reserves of the company and in between the purchaser and the seller as repayment of the loan. However, given that, from a civil law perspective, even in this situation wherein the company makes a payment to the seller, there remains a certain residual risk of contestation.
Therefore, it seems advisable to refrain from repaying the loan. Rather, before the share transfer takes effect, the seller should contribute the loan to the free capital reserves of the company immediately at closing. As a consequence, the loan lapses by way of confusion of rights (Konfusion). At the same time, the share purchase price increases because the financial debt that is to be discounted from the share purchase price according to the usual cash-free / debt-free formulas is reduced. The contribution therefore regularly constitutes an economically neutral and rather elegant possibility to eliminate the risk of contestation. The only material downside: the contribution is, generally speaking, tax-neutral only if the contributed loan is fully recoverable (werthaltig).
It is open to discussion whether the BGH-jurisdiction regarding the contestation of payments on assigned shareholder loans also applies to assignments in the course of M&A transactions. As is often the case, legal certainty will be achieved only once this question has been finally answered by court judgment. Until then, the seller will have to contractually protect himself against potential risks. The rule of thumb is: if the shareholder loan is fully recoverable the seller should contribute the loan to the capital reserves of the target company at closing in exchange for an accordingly increased share purchase price. If the shareholder loan is not fully recoverable the seller should seek protection by a secured indemnity or at least a secured obligation of the purchaser not to collect the loan within one year after closing.