ARTidLE:~·. . - " ..~ ,..;'

Germany's Special Resolution Regime for Failing Banks

Dr Martin Prager, Attorney. and Dr Christoph Keller, Attorney. PLUTA Rechtsanwalte, Munich, Germany

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I. Introduction

Banks, in their capacity as financial intermediaries,act at the very centre of modern economies, Theirpotential insolvency should therefore be consideredunique. Indeed a barn,'s insolvency may affect thestability of the economy as a whole, thus creating vastexternalities. The financial crisis of 2008-9 and theinsolvency of Lehman Brothers are prime examplesof this destabilising effect. Both events have demon­strated the shortcomings of corporate insolvencyregimes in relation to the insolvency of ban1ts. Thisresults from the fact that corporate insolvency re­gimes are built upon principles that do not fully takeinto account the distinctive features behind a bank'sinsolvency. I Firstly, there is a difference in objectives.Corporate insolvency law seeks to achieve equal ('paripassu') treatment of creditors and maximisation of theassets of the debtor in the interest of general credi­tors. By contrast, the main aim in bank insolvency[Jroceedings is the protection of tbe underlying finan­cial system. Other important considerations includeprompt payment to depositors and minimising coststo deposit insurance funds. Secolldly, creditors canbe more active in general insolvency proceedings ascompared to bank insolvency proceedings. While inthe former, creditors can initiate the proceedings andact indiVidually or collectively through creditor com­mittees, in the latter, the power to commence and,to a certain extent, govern the proceedings typicallylies with the regulator.1 Tilirdly, the general triggersusually associated with corporate insolvencies maybe considered inappropriate for balli,s. In this regard,definitions of insolvency vacillate between cash-flow

('commercial') and balance-sheet ('absolute') criteria.In relation to banks, however, the widely held viewis that insolvency proceedings should commence atan earlier stage since, by the time a bank has alreadydefaulted on any deposit liabilities, it will probably betoo late for an orderly resolution. On the other hand,the balance sheet may not provide an accurate pictureof the true depth of the acclilllUlated losses since loanportfolios tend to deteriorate rapidly in bad times.3

German parliament has learned these lessons dur­ing the financial crisis. On 1 January 2011, after twoyears of drafting work, the Restructuring Act 20111

(the l\ct') came into force. Along with amendments tothe German Banking Act, 5 the Act establishes a specialresolution regime for banks in distress with a view notonly to protecting the stability of the financial system/'but also enhancing public confidence in the stability ofthe financial system while protecting depositors.

II. Germany's special resolution regime

I. Overview

Both the Act and the German Banking Act providespecific provisions as to Germany's new special resolu­tion regime for failing banks. While the Act establishestwo stabilisation (or rescue) procedures, the GermanBallidng Act provides for a supervisory procedure, inwhich Germany's regulator BaFil1 7 may order a partialasset transfer onto a bridge banle The new regimeapplies to banks within the meaning of § 1(1) of theGerman Banking Act.8 More specilically, the Act ap­plies to institutions that have permission to carryon

R.M. Lastra, 'Northern Rock, UK bank Insolvency and cross-border bank lusolvency' (2009) 9 Journol of Bonking Regulation 165, 171 et seq.;M. ObermiiUer and K. Kuder, 'Die Entwicklung del' Gesetzgebung zuBaokinsolvenzen' ZlnsO 2010. p. 2016, 2017.

2 Lastra. supra note 1: ObermiHler/Kuder, supra note 1. p. 2019.3 C. HadjiemannuU, 'Bank Resolution Policy and the Organization 01 Bank Insolvency Proceedings: Critical Dilemmas', in David G. Mayes and

Liuksila, Aarou (eds.), Who Paysfol' Bonk Insolvency? (Loodon: Palgrave MacMillan, 2004).4 RcslruklurlcrungsoescL: - KrcdRt:orgG.5 KrecUtwcsenocsc/z - KWG.6 On the dillicully of dellning the term financial stabiliiy, see H. Davies and D. Green, Bonkino anllw Fulurc- The Ftrll 0/111 Rise of Central Banking

(Princeton University Press, Princeton and Oxford, 2010) pp. 54-59.7 HUfI(!csmls/.olt.jlir FI/llIllzdlcnst.lclsl.llngsoujsidlL Further infurmation is available at <www.bafin.de>.B A translation of the German Banking Act is available at <www.iuscomp.urg/gla/statutes/KWG.blm#l>.

Martin Prager and Christoph Keller

the regulated activities set forth in § 1(1) No 1-12 ofthe German Banking Act.~ The Act does not applyto insurance companies. With regard to the balefulrole played by some insurance companies during thefinancial crisis, the ambit of the regime is open to criti­cism for being too narrow. The Act applies to domesticbanks only, i.e. banks with their statutory seat locatedin Gerlllany.lO It does not apply to branches of eitherEEA, or other foreign incorporated, banks. Lastly, noneof the procedures require cash flow or balance sheetinsolvency. Rather, their commencement standards ~'etied to the minimum capital and liquidity ratios derivedfrom the Basel Accords as transformed into domesticlaw by the German Banking Act. Although Germany'snew special resolution regime cannot therefore rightlybe viewed as genuine insolvency law, I I one should beaware that these commencement standards will in factcomprise cash flow and balance sheet insolvency asparticularly intense forms of [mancial distress.

2. Stabilisation procedures

a) Sanierungsverfahren

As soon as a bank is no longer compliant with themininmm capital or liquidity requirements of the Ger­man Banking Act, it is eligible for what has been namedSanierungsverjahren. The Sanierungsveljahren is set forthin ~§ 2-6 of the Act and it is a voluntary non-publicprocedure available to any banle irrespective of its sys­temic relevance.1l This procedure is similar to a CVA ora Scheme of Arrangement under ss. 895-901 of theCompanies Act 2006 in that it is a multilateral agree­ment between the creditors, the distressed bank and its

shareholders with the aim of preserving the bank as agoing concern. The Sanienll1gsveljahren is conductedunder the supervision of the Court13 and it shall notinterfere with third parties' rights and interests. H

The SanierulIgsveljahrell is triggered by a notice fromthe bank to BaFi/! where the banIe notifies that it is nolonger compliant with the minimum capital or liquid­ity requirements under § 10 and § 11 of the GermanBanIcing Act. 1s Along with the notice. the banIe shallsubmit a draft reorganisation arrangement and pro­pose a reorganisation advisor. J6 If BaFin determinesthat the bank is no longer compliant with the mininmI11capital or liquidity requirements and that such distressmay successfully be remedied by way of the proposedarrangement, it shall immediately apply to the HigherRegional Court (Oberlandesgericllt) of Frankfurt/MYfor commencement of a SanierungsverfalJren. If thecourt is satisfied that the proposed arrangement is not'evidently unsuitable' (a test comparable to the feasibil­ity test in a chapter 11 proceeding), it will grant anorder allowing the Sanierungsverjallren to proceed andappoint a reorganisation advisor to that effect. Tllisrather complicated procedure - notice, application,court order - is the result of the legislator's desire tocombine private initiative with both early regulatoryparticipation and court supervision.

The reorganisation advisor has the most importantrole in the Sanierungsverfahren. The reorganisation ad­visor implements the reorganisation arrangement andmay, inter alia, investigate the bank's business conduct,inspect the banIe's records, take part in board meetings,and give instructions to the bank's management. lij Thereorganisation advisor is entitled to remunerationJ9

and shall be liable for acts and omissions negligentlycommitted in exercise of their office.20 Lastly, they are

9 Namely the acceptance of funds from others as deposits or of other repayable funds from the public unless the claim to repaymeut is securitisedin the form of bearer or order debt certiflcates. the granting of loans. the purchase of bills of exchange aud cheques. the purchase and sale ofllnanclalinsll"uments in the credit institution's own name for the account of others, the safe custody and administration of securities for theaccount of others, the business specified in section 1 of the Act on Investment Companies tGcsctz libcr KopitalonloycgescDschoflO/l). the incurrenceof Lhe obligation to acquire claims in respecl of loans prior to their maturity, the asswnption of guarantees and other warranties on behalf ofothers. the execution of cashless payment and clearing operations, the purchase of financial instruments at the c.redit institution's own risk forplacing in the market or the assumption of equivalent guarantees. the issuance of prepaid cards for payment purposes, unle:;s the card issuer isalso the service provider and hence the recipient of the payment made using the card. and the creal ion and administrdtion of unils of paymentin computer networks.

10 § 1( 1) of the Act. On the international application of the Act. sec below fir.11 S. Schelo. 'Neue Restruhurierungsregeln fiir Banken' NJW 2011, p. 186, 188. This may be regarded as a notable difference from the U.K.

Banking Act 2009, which does in fact establish both a new genuine bank Insulvency procedure and a new bank admlnistratlun procedure.12 Schelo. supra nute 11, p. 186 el seq.13 § 3(1), § 4(2). § 5 and § (,(2) of the Act.14 § 2(2) of the Act.15 § 2(l) of the Act.16 § 2(2) of the Act. The reorganisation advisor may be an employee of the bank or a member of the bank's managcmcnt board, § 3(3) of the

Act. Both BoFill and the Court may deviate from the bank's proposal if the)' think the pruposed advisor may not to bc the right pcrson (§ 2(3)and § 3(1), respectively).

17 § 2(3) of the Act and Schelo. SLll'l"O note 11. p. 186 et seq.18 § 4( 1) of the Act.19 § 4(4) of the Act.20 § 4(3) of the Act.

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Germany's Special Resolution Regime fOI" Failing Banks

to notify the Court on the successful completion of theSanierungsvelfahren. 21

The reorganisation arrangement may allow for anyappropriate or adequate measure that remedies a bank'sdistress. Some notable examples include dischargeor deferment of the banIe's debts, new loans. capitalincreases and/or reductions and debt equity swaps. Asmentioned above, the reorganisation arrangementshallnot interfere with third parties' rights and interests.There is. however, one important exception to that rule.The reorganisation arrangement may stipulate thatnewly granted loans shall enjoy priority in subsequentinsolvency proceedings, if such proceedings are com­menced within three years after the court has orderedthe SanierwlgsvcljiIhrell to commence.22 The rationaleof this rule is that, in its absence, the bank would havedifficulty obtaining new financing if potential lenderscarried the risk of ranking pari passu with unsecuredcreditors in subsequent insolvency proceedings. Thisexception is truly remarkable. given that the Germancorporate insolvency law is, in general. not cognisantof priority rules. The percentage of such priority fund­ing shall, however, not exceed ten percent of the banksown funds. Unsecured creditors may appeal against thepriority status on the grounds that the commencementstandards for a SilIlienmgsvcl:fiillren were not met orthat the 10% threshold was exceeded.23

b) Reorganisationsverfahren

If the bank considers a Sanienll1gsvelfahrcn futile, or U' itfails. a Reorganisationsvelfahren, under §§ 7_2324 of theAct, may be commenced. The Reorganisationsverfahrenis modelled after the German Insolvenzplanvclfahren:Germany's closest equivalent to Chapter 11 of the U.S.Bankruptcy Code. It is a voluntary public procedureconducted by a court-appointed practitioner (not nec­essarily an IF) under the supervision of the Court.

According to § 7(1) and (2) of the Act, the Reorga­nisationsvcljahren is triggered by a notice to BaFin thatindicates that the existence of the bank is endangeredand that this, in turn. endangers the stability of theIinancial system. A bank's existence shall be deemed

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endangered if its capital or liquidity has fallen below oris likely to fall below the minimum capital and liquidityrequirements as set forth in § 10 and § 11 of the Ger­man Banking Act by 90% or more.2; The stability of thefinancial system is deemed endangered if the bank'sdislTess is likely to detrimentally allect other marketparticipants in the financial sector, the financial mar­kets or public confidence in the proper functioning ofthe financial markets.26 Hence, § 7 of the Act does notonly provide for the commencement standards of theReorganlsationsveljahren, but it also confines its scopeto banks of systemic relevance. Along with the noticeunder § 7 of the Act. the bank shall submit a dral't reor­ganisation plan and propose a reorganisation advisor.

If BaPin is satisfied that the requirements set forthin § 7 of the Act are met, it may apply to the HigherRegional Court (Oberlandesgericht) of Franldtirt/M. fora Reorganisationsvelfallren to be commenced. 'rhe courtshall hear Deutsche Bundesbank before making a deter­minationY While there is no moratorium in the strictsense of the word. once the bank has notified BaFin anyprior agreement with the bank may not be terminateduntil the end of the following day.28 This provision.which shall apply, inter alia, to close-ollt netting,29 isthought to facilitate reorganisation since it preventscreditors trom withdrawing assets in the form of con­tractual claims. However, the established period of tinleis clearly too short to achieve this goal: a banle cannotpossibly be restructured in one day. 30

At the heart of the Reoryanisationsvel:{aiIren lies thereorganisation plan submitted by the bank. Unlike thereorganisation arrangement under § 2 of the Act, thereorganisation plan is not a multilateral agreement.Rather, it is a bundle of reorganisation measures votedon by the creditors and the shareholders of the dis­tressed bank. It does not require unanimous consentbut. broadly speaking. a majority vote: thereby allow­ing lor the interference with the rights and interests ofdissenting creditors' and shareholders.3 ! Class forma­tion is mandatory.32 Court approval is required. TheReorganisationsverjiIhren is distinct from a traditionalInsolvcnzplanvelfahren in two respects: (i) creditor'sappeals will be limited to a minimum so as to render

21 § 6(3) of the Act.12 § 2(2) of the Act.23 § 3(2) of the Act.24 In addition. the provisions on the SOllirrulIgsvel!altrell shall apply according to § 7(5) of the Act.25 § 48b(l) of the German Banking Act.26 § 48b(2) of the German Banking Act.27 § 7(4) of the Act.28 § 13 of the Act.29 Schelo. supra nole 11. p. 189; Lorenz. 'Der Regierungsenlwurf eines Geselzes me Reslrukturlerung und geordnelen Abwlcklung von Kredit-

Instllulen- Uberbllck und erste E1nordnung' NZG 2010. p. 1046. 1050.30 Schelo. supra note 11, p. 189.31 § 8(3), 9-12 of the Act.32 § 8(2) of the Act.

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Martin Prager and Chl-istoph Keller

obstructive behaviour less likely, and (ii) shareholderswill be allowed to participate in the procedure, therebyensuring their consent when the reorganisation is latervoted upon in the shareholder's general meeting.

If the creditors so vote, the reorganisation plan maydischarge or defer the bank's debts, may provide fornew loans, capital increases and/or reductions, or debtequity swaps.33 Since debt equity swaps dilute the hold­ings of the bank's existing shareholders, the bank shallgrant appropriate financial compensation. Accordingto parliament, the value of the compensation shall"bedetermined ou the basis of a going coucern valuationof the bank.34 Finally, the plan may also stipulate thatpart or all of the banle's assets shall be transferred toa suitable third party purchaser with sufficient marketconfidence.];

3. Asset transfer order

If rescue proves untenable, a supervisory proceduremodeled after U.S. conservatorship will take place. Un­der § 48a-§ 48s of the German Banking Act, BaFin hasthe power to transfer the systemically relevant parts ofthe distressed bank to a transitional bridge bank,3b Aswith the Reorganisationsver!alJren, the supervisory pro­cedure requires that the banle's existence and financialstability be endangered. In addition, the asset transferis only permissible if there are no other equally effectivebut less severe means to remedy the distress. In thesecircumstances, BaFin shall take into account factorssuch as the bank's existing funding profile, the sourcesof additional capital or liquidity open to it (such as n'omother group companies and the market) and the mar­kets in which it is seeking to access those funds (takinginto account factors such as its credit rating and pastattempts to raise capital). BaFin may also afford thebanl, the opportunity to submit its own recovery plan.

If a partial asset transfer is ordered, the bridge banlcwill assume some of the bank's failed deposits and otherliabilities as well as acquiring some of its assets. It willonly eJloist for a limited time and it will be used by theregulator as a transition bank until it can transfer theassets and liabilities of the failed bank to a healthy in­stitution. In order to facilitate the transfer, contractual

termination rights are suspended. 37 Through the mech­anism of a partial asset transfer, BaFin has the abilItyto 'split' a failing bank; that is, to transfer only part ofthe bank's business (such as its deposit book) to a pur­chaser or bridge bank at a suitable price, while leavingmore troublesome assets (such as collateralised debtobligations or similar securities) with the 'rump' bank.to be sold or run off by means of an usual corporateinsolvency proceeding.

4. Reorganisation fund

A separate act38 introduces a restructuring fundadministered by the German Federal Authority for Fi­nancial Market Stabilisation. 3Y The EUR 70 billion fundwill be financed by way of a banl, levy and shall serveto support failing banks. The fund has been criticisedfor being too small and becoming available too late,as it will talce a couple of years before it will reach itsintended size:1O

III. EC cross-border insolvency

Both of the aforementioned stabilisation proceduresas well as the asset transfer order under § 48a of theGerman Banking Act should fall within the purview ofDirective 2001/24/EC of the European Parliament andof the Council of 4 April 2001 on the Reorganisationand Winding-up of Credit Institutions (the 'Directive').Art. 2, seventh indent, of the Directive will cover theseprocedures since 'reorganisation measures' includemeasures which are intended to preserve or restorethe financial situation of a credit institution and whichcould affect third parties' pre-existing rights, includingmeaSUl-es that involve possible suspension of payments,suspension of enforcement measm-es or reduction ofclaims. Where foreign law does not permit the assettransfer order to become effective, the banl, shall beobliged to take any action necessary to give effect tothe asset transfer orderY The liquidation of the 'rump'bank's estate, if this is governed by German corporateinsolvency law, will be covered by Art. 2, ninth indent,of the Directive whereby 'winding-up proceedings'

33 § 9 of the Act and Schelo, supra note 11. p. 188.34 13T-Dr17/3024,p.51.35 § II of the Act.36 The bridge bank may be Incorporated by the restruclurlng fund administered by the FMSA (see below 4.). see T. Hoche. 'Das Restrukturie­

rungsgesetz-Neue Wege In der 13ankenaufslcht' WM 2011. p. 46. 57.37 § 48g(7) of the German Banking Act. The U.K. Banking Act 2009 contains a similar prnvislon, see B. Hearnden and I. Whitfield. 'The Banking

Act 2009' Corporale Rescue and Insolvency (2009) 3 CRI 94. p. 99.38 Restrukturienl/lgsJondsgesetz - RStrtlktFG.39 ButlclrsanstaltJur Finam:marktslabUisierung.40 Schelo. supra note 11, p. 189.41 § 481(2) of the German Banking Act.

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Germany's Special Resolution Regime for Failing Banks

includes collective proceedings opened and monitoredby the administrative or judicial authorities of a Mem­ber State (as defined in the Directive) with the ainl ofrealising assets under the supervision of those authori­ties. including where the proceedings are terminatedby a composition or other, similar measure.

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