May 2006

Corporate Update (Germany)

Distressed debt: Gaining control of companies in crisis

In 2004 more than 39,000 business enterprises in Germany were subject to insolvency proceedings. This means that the number of insolvencies has more than quadrupled as compared to 1991. A growing market thus beckons for financial investors specialising in cases of capital reorganisation. The objective of such investors is to gain control over a business enterprise requiring capital reorganisation to safeguard it against insolvency through a capital restructuring and by the implementation of a reorganisation plan.
In comparison to the traditional LBO market, this path entails a considerably greater risk. It is initially marked by complex negotiations with creditor banks, employees' representatives, suppliers, customers and management. In the event that the balance sheet is encumbered by unsecured pension liabilities, the Pension Security Association (Pensionssicherungsverein) is to be included in the reorganisation discussions as a guarantee fund. It is not uncommon for labour-market policy interests to result in the participation of public institutions. Depending on the financial situation of the business enterprise, these negotiations are subject to intense time constraints. The gaining of control and thus the possibility of implementing a reorganisation strategy without delay is effected if an investor, subject to individual provisions of the articles of association, holds at least 75 per cent of the voting capital of the company. Otherwise, there is a risk that shareholders' resolutions and reconstruction measures will be defeated by blocking minorities. In addition to the gaining of direct control, the discharge of distressed debt (notleidendes Fremdkapital) by means of a "debt-equity swap" is also increasingly playing a key role in the market. In that respect, various forms of outside capital are taken into consideration: ordinary claims under loans, bonds or even mezzanine capital. The latter may, depending on its structure, be deemed to be equity capital for balance sheet purposes but does not bring with it any of the rights of shareholders. An alternative approach is to await insolvency proceedings and to acquire owners' shareholdings or portions of the business enterprise from authorised insolvency administrators only after the commencement of insolvency proceedings. Following their commencement, the insolvency administrator is in a strong position, albeit also subject to the supervision of the insolvency court and, in the case of certain measures, the consent of the creditors' meeting or the creditors' committee. The primary task, which falls to the insolvency administrator, is to satisfy creditors by the continuation or liquidation of the business enterprise, with the continuation of the business enterprise being less prevalent in practice.

Debt-equity swap
The conversion of debt claims against the target company into equity capital is effected in the course of a capital increase through contributions in kind (Sachkapitalerhhung) in the form of the investor's claims. The capital increase requires a shareholders' resolution and entry into the Commercial Register to be valid. Such capital increase, as a rule, is preceded by a capital writedown by a simplified capital reduction. The capital writedown can prevent a deficit on the balance sheet and renders the equitable distribution of the capital interests between former shareholders and the investor possible. For the purpose of shareholder and creditor protection, capital increases through contributions in kind (Sachkapitalerhhungen) are subject to special requirements compared to cash capital increases. In the case of the conversion of distressed debt into equity capital, the statutory pre-emption right of the previous shareholders as well as the value of the claims to be contributed prove, in that respect, to be problematical.

Exclusion of pre-emption rights

In the event that existing shareholders do not waive the exercise of their statutory pre-emption rights in view of the company being in crisis, their pre-emption rights must be excluded within the framework of the resolution on the capital increase. Where the articles of association of the company do not provide for any other majority requirements, the shareholders' resolutions on a capital

Brussels Dubai Frankfurt London Madrid Milan Munich New Delhi New York Paris Singapore Tokyo

increase together with the exclusion of the pre-emption right may be passed by a majority of at least 75 per cent of the share capital represented. In the case of a public limited company (Aktiengesellschaft - AG), in addition an absolute majority of those entitled to vote must support the resolution. It may be relevant that, pursuant to established case law of the highest courts, minority shareholders, on account of their fiduciary duty to the other shareholders, are prohibited from preventing a sensible reconstruction sought by the majority.

cover the requisite capital requirements by third party loans on conditions usual in the market. However, these provisions on shareholder loans to thinly capitalised companies have no application where the holding of the investor, or multiple investors whose shares are required to be aggregated as they are acting in concert, is less than 10 per cent in a GmbH or 25 per cent in an AG. Similarly, the rules do not apply in the case of the first-time acquisition of company shares for the purpose of reorganising the company.

Value of distressed debt

The debt-equity swap within the framework of the increase of the share capital of the AG requires a valuation of the contribution be conducted by an auditor appointed by the court. This valuation for the increase of the share capital of a private limited company (Gesellschaft mit beschrnkter Haftung - GmbH) is, admittedly, not required in principle. The competent Commercial Register may, however, reject the registration of the increase in share capital if the value of the contribution in kind falls below the lowest issue price of the shares to be issued. Determination of the value of distressed debt may prove to be difficult in the case of companies in crisis. If the value of the claim is set too high, the investor bringing capital into the company is in danger of incurring an obligation to make an additional contribution in the form of a cash payment of the outstanding difference. In the case of a GmbH, the co-shareholders will have an accessory liability for this amount. Furthermore, resolutions on increases in capital are, in such case, subject to challenge. In the event that the investor is interested in a capital interest held by the company in a subsidiary, an exchange of that interest for the waiver of distressed debt is a possible approach. As within the framework of a capital increase, the question of the value of the claim is also essential here, as a sale of the capital interest by the company at an undervalue may be challenged in the event of subsequent insolvency.

Special case: debt securities

Bonds which are issued by foreign financing subsidiaries of domestic companies are subject to the agreed law. This can be general German civil law or, as is common practice, English or even US law. In accordance with general German civil law, any change to the terms and conditions requires, in principle, the consent of all of the creditors. This does not apply where the German Bond Act (Schuldverschreibungsgesetz - SchVG) is applicable. The SchVG applies, in principle, to all bonds issued by issuers whose registered office is in Germany (excluding regional or local authorities). The SchVG enables changes to certain terms and conditions by way of resolutions passed by a majority of votes in a creditors' committee to be binding on all bondholders where the change serves to avert a default in payments or insolvency. Resolutions in the creditors' committee are passed with a majority of 75 per cent of the votes cast and at least 50 per cent of the nominal value of the bonds currently outstanding. The SchVG permits the appointment of a creditors' representative and his commissioning with the safeguarding of joint rights of the bondholders. By a resolution passed by a majority of votes, the following can be provided for outside of an insolvency plan for a limited period of up to three years: reduction of the interest coupon; deferral or the waiver of interest; deferral of the principal claim; or non-exercising or the waiver of current or future rights to terminate.

Shareholder loans to thinly capitalised companies

If the investor extends a loan to the crisis-ridden company, there is the danger that, in accordance with the provisions on shareholder loans to thinly capitalised companies, his claims under the loan will be subordinated. In that respect, a company is deemed to be in crisis at a time in which a shareholder in its capacity as a conscientious businessman (ordentlicher Kaufmann) on behalf of the company would raise equity capital, because, for instance, it is unable to

An alteration of the principal claim is only feasible within the framework of an insolvency plan. The SchVG does not permit any further amendments to the terms and conditions by a majority resolution. Undue preference (Begnstigung) given to individual creditors is prohibited. The SchVG dates back to 1899 and is in need of reform. Granting the creditors' committee full authorisation to

change any terms and conditions is currently under consideration. The time schedule of a possible reform is, however, wide open.

Reporting requirements and mandatory offer

Depending on the corporate structure, shareholders are subject to various reporting requirements to the company and, if applicable, also to the Federal Financial Supervisory Authority (Bundesanstalt fr Finanzdienstleistungsaufsicht - BaFin) in the event of certain participation thresholds being exceeded. A violation of reporting requirements may result in a forfeiture of voting rights and thus to the blocking of reorganisation measures. A special provision applies to companies whose shares are admitted to trading on an organised market within the meaning of the German Securities Acquisition and Takeover Act (Wertpapiererwerbs- und bernahmegesetz - WpG). Here, any shareholder who acquires at least 30 per cent of the voting rights in the company is required to submit a takeover offer to the remaining shareholders for the shares held by them (mandatory offer). In that respect, one should take into account that complex, and, in individual cases, contentious allocation provisions (Zurechnungsregelungen) play a key role within the framework of, in particular, shareholders acting in concert. The BaFin may, however, upon application, grant an exemption from the duty to submit an offer if obtaining control occurs in connection with the reorganisation of the company.

assessment of value in the case of contribution processes (date of evaluation); and ramifications of subordination agreements on the balance sheet for tax purposes (Steuerbilanz) of the financed company.

Conclusion
The admission of investors enables companies in need of reorganisation to find a way out of the crisis. On account of the positive stimulus of external investment and an entrepreneurial assumption of responsibility in connection therewith, creditors, customers, suppliers and employees will have more confidence in the economic performance and the continued existence of the business enterprise. The previous shareholders are thus afforded the opportunity to prevent the loss of their investment. For investors, a successful investment in companies in need of restructuring ultimately offers the prospect of attractive returns. In view of the nature of interests involved and the general economic environment, investments in companies in need of reorganisation and thus the acquisition of distressed debt is set to increase substantially.

Contacts - Frankfurt:
Dr. Nikolaus von Jacobs T: +49 (0)69 97 11 26 E: nikolaus.vonjacobs@ashurst.com Dr. Ingo Scholz T: +49 (0)69 97 11 26 E: ingo.scholz@ashurst.com Andreas Vogel T: +49 (0)69 97 11 26 E: andreas.vogel@ashurst.com

Tax aspects
Of the multitude of tax aspects in connection with the gaining of control of companies in crisis, only the following aspects are mentioned: taking into account the provisions in respect of thin capitalisation rules; in the case of the waiver of non-recoverable claims (nicht werthaltige Forderungen) and their contribution (debt-equity swap): taxable extraordinary revenue of the company (recapitalisation gains). On the basis of a letter from the Ministry of Finance, a deferral and abatement of taxes is conceivable; being at risk of loss-carry-forwards in the case of the waiver of non-recoverable claims or their contribution (due to lapse of the factual conditions required for the utilisation of loss-carry-forwards); being at risk of loss-carry-forwards in the case of the gaining of control (due to lapse of the group relationship required for the utilisation of loss-carryforwards);

Contacts - London:
Dr. David von Saucken T: +44 (0)20 7638 1111 E: david.vonsaucken@ashurst.com Matt McDonald T: +44 (0)20 7638 1111 E: matt.mcdonald@ashurst.com Dr. Dietmar Schulz T: +44 (0)20 7638 1111 E: dietmar.schulz@ashurst.com

Brussels Avenue Louise 489 1050 Brussels Belgium Tel +32 (0)2 626 1900 Fax +32 (0)2 626 1901 Dubai Level 42 Emirates Towers Sheikh Zayed Road PO Box 119974 Dubai United Arab Emirates Tel +971 (0)4 319 7530 Fax +971 (0)4 319 7474 Frankfurt Oberlindau 54-56 60323 Frankfurt am Main Germany Tel +49 (0)69 97 11 26 Fax +49 (0)69 97 20 52 20 London Broadwalk House 5 Appold Street London EC2A 2HA UK Tel +44 (0)20 7638 1111 Fax +44 (0)20 7638 1112 Madrid Alcal, 44 28014 Madrid Spain Tel +34 91 364 9800 Fax +34 91 364 9801/02 Milan Via Sant'Orsola, 3 20123 Milan Italy Tel +39 02 85 42 31 Fax +39 02 85 42 34 44

Munich Prinzregentenstrae 18 80538 Munich Germany Tel +49 (0)89 244 421 100 Fax +49 (0)89 244 421 101 New Delhi Liaison Office 6 Aurangzeb Road, D-1 New Delhi 110011 India Tel +91 11 2301 4054 Fax +91 11 2301 4089 New York 712 Fifth Avenue New York, NY 10019 USA Tel +1 212 245 4540 Fax +1 212 245 4335 Paris 22, rue de Marignan 75008 Paris France Tel +33 (0)1 53 53 53 53 Fax +33 (0)1 53 53 53 54 Singapore 6 Battery Road #15-08 Singapore 049909 Tel +65 6221 2214 Fax +65 6221 5484 Tokyo Shiroyama Trust Tower, 30th Floor 4-3-1 Toranomon Minato-Ku Tokyo 105-6030 Japan Tel +81 3 5405 6200 Fax +81 3 5405 6222

This update is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specific issues or transactions. For more information please contact us at Oberlindau 54-56 60323 Frankfurt am Main Germany Tel +49 (0)69 97 11 26 Fax +49 (0)69 97 20 52 20 or Prinzregentenstrae 18 80538 Mnchen Germany Tel +49 (0)89 244 421 100 Fax +49 (0)89 244 421 101 www.ashurst.com 2005 Ashurst Ref:DTP/4124 May 06