Germany's Business Judgement Rule not applicable to insolvency administrators

Europe

In a recent decision, the German Federal Supreme Court addressed the applicability of the Business Judgement Rule to insolvency administrators in Germany and rejected the applicability of the rule in the specific case that was argued before it.

The Business Judgement Rule is a legal principle derived from Anglo-American law, which gives a company's management the necessary room for manoeuvring in order to make entrepreneurial decisions that reflect economic risks. Provisional insolvency administrators mandated to oversee the continuation of operations for insolvent companies have traditionally claimed to apply this rule in Germany, which was rejected by the recent federal high court decision.

Business Judgement Rule: where is it regulated, what does it mean?

Managing directors must make business decisions every day and, in times of crisis, under time pressure and with enormous economic consequences for the company. At the same time, managing directors in Germany are subject to a strict liability standard: they must act with the diligence of a prudent businessman. There is a lower objective standard, which prevents  a managing director from claiming he lacks the necessary knowledge and skills to fulfil certain managing director duties. In short, a lack of competence does not exonerate a managing director. At the same time, special individual abilities intensify the standard of care applicable to a managing director.

But it is also clear that some business decisions fail to achieve a desired result. If anticipated increases in turnover and earnings or other corporate goals are not achieved, the question of management liability quickly arises under German law.

Unfavourable burden of proof in liability proceedings

In Germany, the burden of proof in liability proceedings is unfavourable for managing directors. In principle, it is the general responsibility of the plaintiff to present and prove all facts favourable to him in a given claim. In German liability proceedings against a former or current managing director, however, the company only need present and prove that damage has occurred and this damage is based on the conduct of the managing director. These two points are usually not a particularly high standard to meet.

On the other hand, it is up to a managing director to demonstrate and prove that he did not act in breach of his duties, that any breach was without culpa or that the damage would have occurred even if the managing director had acted without error.

In order to grant a managing director the necessary leeway against these strict liability risks, the "Business Judgement Rule" was developed in Anglo-American law. At the beginning of the 21st century, this principle was increasingly applied in Germany as well with case law initially applying this legal principle to the management boards of public limited companies, and then later to the managing directors of German private limited companies.

Ultimately, this legal principle was anchored in the German Stock Corporation Act in 2005, where it continues to apply to managing directors of German private limited liability companies. Further to this, Article 93 (1) sentence 2 of the German Stock Corporation Act states: "There is no breach of duty if the member of the Board of Management could reasonably assume, when making a business decision, that he was acting in the best interests of the Company on the basis of appropriate information."

Exclusion of liability of the management possible

The scope and requirements of the Business Judgement Rule were succinctly outlined, excluding the liability of management under certain conditions. The rule, however, applied only to a business decision (i.e. not the fulfilment of legal obligations to act, such as the obligation to pay taxes under current tax law), which represented a genuine choice based on commercial considerations.

Furthermore, the director must reasonably believe that he is acting for the benefit of the company (i.e. not for his own benefit) and on the basis of appropriate information. This last point is crucial since the careful preparation and execution of the decision-making process on a well-informed factual basis represents the core of the Business Judgement Rule.

Only if an entrepreneurial decision is based on a solid factual foundation and the manager then takes a bona fide decision, which objectively serves the welfare of the company, is the manager released from liability for the lack of success (i.e. for any damage incurred). In this way, he has acted within the scope of his entrepreneurial freedom of decision and thus not in breach of his duty. Consequently, he is not liable for damage incurred to the company.

Document decisions and the decision-making process

Every managing director in Germany is advised to document the basis for decisions and the decision-making process as completely, carefully, continuously and comprehensibly as possible for later evaluation by third parties, at least in the case of significant business decisions.

Such documentation may become a business practice elsewhere in the EU since the Business Judgement Rule is spreading in continental Europe, recently adopted by the Polish Ministry of National Property (Ministerstwo Aktywów Państwowych, MAP) under Minister Jacek Sasin in the reform proposal for a new group law in Poland, which represents the first codification of the Business Judgement Rule in Polish law.

Not applicable in insolvency

If a managing director of a German private limited company or a German joint stock corporation files an application for the opening of insolvency proceedings, a provisional insolvency administrator is usually appointed. The administrator's task is to secure the company’s assets, ensure that the company's operations actively continue and examine whether the conditions for the opening of insolvency proceedings are met (in particular determining whether the available assets are sufficient to cover the costs of the proceedings). Its powers depend on the decision of the insolvency court in each individual case, and whether a "strong" or (as is usually the case) a "weak" insolvency administrator has been appointed.

The "strong" insolvency administrator takes the place of the previous management, and serves like a "substitute managing director" with the powers of disposal and company management transferred to him. A "weak" insolvency administrator operates alongside the previous management and must consent to management decisions. As a rule, a "weak" insolvency administrator is appointed first with a "strong" administrator installed and the previous management dismissed if it turns out that the creditors' interests are endangered by the continued operation of the original management.

Continuation of operations should be the rule

In principle, the temporary insolvency administrator is required to continue operations since it is the creditors at the first report meeting who must decide on any closure of the insolvent business. In order not to anticipate this decision, the debtor’s operations should normally be continued, unless continuation is not in the interest of the creditors as a whole (e.g. because the business is not viable). The management and the "weak" provisional administrator work together on the continuation of the business, with management decisions formally taken by the management. The involvement of the provisional administrator is limited to the act of approval, which in fact has a major influence on all decisions.

If the creditors decide to continue the business in the first report meeting after the opening of insolvency proceedings (e.g. for the purpose of a sale by an asset deal), the business will also continue in the opened insolvency proceedings. However, the opening of the insolvency proceedings could result in a change of ownership. In this case, the power of administration and disposal of the company’s assets are transferred by virtue of law from the management to the insolvency administrator who must take all decisions under his sole responsibility from the opening of insolvency proceedings. The insolvency administrator thus becomes the de facto company manager.

In this way, the insolvency administrator (and provisional insolvency administrator to a degree) is in a similar situation to the managing director. Since he must make business decisions on a regular basis, it is obvious to grant the insolvency administrator the same entrepreneurial leeway as management. Consequently, in the past it was often argued in German legal literature that the Business Judgement Rule should also be applied to the insolvency administrator in the continuation of operations during the insolvency.

Business Judgement Rule not applicable to insolvency administrators in Germany

The German Federal Supreme Court (Bundesgerichtshof) in its capacity as the highest German civil court put a stop to this view in its landmark decision of 12 March 2020 (file number IX ZR 125/17). The court is of the opinion that the benchmark for all entrepreneurial decisions of the insolvency administrator in the context of the continuation of operations is the insolvency purpose (i.e. the goal of "the best possible joint satisfaction of the insolvency creditors as well as the procedural goal jointly decided by the creditors" in "the liquidation of the company, sale or insolvency plan - as a means of achieving the purpose").

Furthermore, the court states that "the discretionary scope to which the insolvency administrator is entitled in business decisions ... is exceeded if the measure is no longer justifiable from an ex ante perspective in view of the costs, expenses and risks associated with it in regard to the duty of the insolvency administrator to secure and preserve the assets." As a consequence, the Business Judgement Rule is not applicable to the insolvency administrator in the continuation of operations in the insolvency, but rather the insolvency administrator is liable according to the standard of § 60 InsO without being able to invoke § 93 (1) sentence 2 AktG.

Similarities and differences: further development remains to be seen

The Business Judgement Rule can also be applied in the area of insolvency administration. The Federal Supreme Court also admits the obvious parallels between management and the insolvency administrator in the continuation of operations. Both bodies must make entrepreneurial decisions, manage third party assets and become active for the benefit of third parties. In both cases, there is a very similar liability regime. In addition, the liability basis applicable to the insolvency administrator (§ 60 (1) InsO) is based on the liability standard applicable to the management of AGs and GmbHs, because according to § 60 (1) sentence 2 InsO the insolvency administrator (similar to the manager of an AG or GmbH) must also "vouch for the diligence of a prudent and conscientious insolvency administrator".

Nevertheless, the Federal Supreme Court ruled not to grant the insolvency administrator the protective shield and safe haven of the Business Judgement Rule. Instead, the court places the special features of insolvency law and the purpose of insolvency in the foreground. At the same time, the court also makes it clear that the insolvency administrator, like the managing director, is not liable for the success of his entrepreneurial actions under certain circumstances.

In this respect, the court states: "The insolvency administrator is not liable for wrong business decisions, which can only be objectively determined ex post." It would have been justifiable if the Business Judgement Rule had also been extended to the insolvency administrator and the adjustments to the insolvency law, and the clearly necessary purpose of the insolvency had been achieved by replacing the "well-being of the company" with the purpose of the insolvency (i.e. the equal satisfaction of all creditors within the framework of the insolvency law).

Understood in this way, the Business Judgement Rule would have led to similar if not identical results in the case decided by the Federal Supreme Court, and at the same time it would have created a certain parallelism in liability before and after the insolvency of a German company before and after commencing insolvency proceedings.

Differences between company manager and insolvency administrator

On the other hand, there are certainly differences between a company manager and an insolvency administrator. The position of trustee and administrator of other people's assets is ultimately more pronounced in the case of an insolvency administrator than in the case of a company manager. This is already evident from the choice of the respective person. If the company owners do this outside the insolvency, the insolvency court (i.e. not those bearing the economic consequences of the decision) usually appoints the (provisional) insolvency administrator. Therefore, the insolvency administrator has a function similar to that of an office.

The motives behind this decision can differ. This can be exemplified by the decision on a settlement in a legal dispute. "Soft" factors, such as a quick resolution of the dispute in order to bundle forces for future tasks, to come to terms with the past or to avoid internal unrest, have real economic value for a company manager outside of insolvency, which must be taken into account in the decision-making process. These motives can only persuade the insolvency administrator to reach a quick settlement if it translates into "cash" (i.e. if they bring financial benefit to the creditors).

The same applies to strategic considerations, such as the acquisition or sale of companies or the establishment of business relationships with selected partners. Here the scope for decision-making outside insolvency is much greater, whereas an insolvency administrator must make his decisions strictly according to pure financial results.

Applicability of the Business Judgement Rule remains open to discussion

The differences identified may justify different treatment. However, the following does not apply: "Karlsruhe locuta - causa finita". On the contrary, the discussion about the extension of the Business Judgement Rule to insolvency administrators should remain open now even though the Federal Supreme Court has for the first time taken a position in this dispute.

For more information on this ruling and the application of the Business Judgement Rule in Germany, contact your regular CMS partner or local CMS experts:

Dr. Igor Stenzel, Niklas Lütcke.