This post was also written by Artur Korn.

If you are a creditor of an insolvent German company, you may have come across the following difficult phenomenon: your contractual counterparty is unable to pay outstanding debts when they become due.

In order to maintain the business relationship you could agree to terms of payment entitling your contractual counterparty to pay its debts by instalments. However, after a period during which the debtor pays the instalments regularly, he suddenly files for insolvency.

Then comes the unpleasant surprise: after the insolvency administrator takes over business operations, he contests the payments made by your now insolvent contractual counterparty to you under the terms validly agreed– even though the agreed terms of payment served the purpose of maintaining the business relationship.

Such contestation (Pauliana action) may be based on several reasons, but in some cases the insolvency administrator contests on the assumption that the debtor paid the instalments with the intention of disadvantaging his other creditors. Moreover, the insolvency administrator asserts that you as the creditor should have known the debtor’s malicious intention because the terms of payment were made when the debtor was unable to pay the debts due (sec. 133 German Insolvency Code  (Insolvenzordnung – InsO)).

This argument meets the statutory requirements of sec. 133 InsO and hence, may lead to a repayment claim by the insolvency administrator. How can the creditor defend himself against the insolvency administrator’s allegations? How can the creditor keep the received payments, in particular when he was in good faith and did not know that the payments received were to the disadvantage of other creditors? As a general rule it is the insolvency administrator who has the burden of proving that the creditor had knowledge of such malicious intention and hence, the creditor could await the administrator’s arguments.

However, sec. 133 InsO provides that it shall be assumed that the creditor had such awareness if he knew of the debtor’s imminent insolvency.

Over the years the German Federal Supreme Court (Bundesgerichtshof – BGH) has  extended the application of sec. 133 InsO widely. Awareness shall be assumed when the debtor did not pay a significant amount of his outstanding debts over a certain time period and hence, the creditor has agreed to instalment payments to prevent the debtor from becoming illiquid, whilst still receiving the instalment payments. Moreover, it becomes even harder to disprove the assumption of being aware of the imminent insolvency if the creditor had reminded the debtor of the outstanding debts or threatened the debtor with enforcement measures or with the opening of insolvency proceedings.

Even though these guidelines from the BGH are not intended to be used generally but rather on a case by case basis, lower courts apply them without making any necessary distinctions. Liquidity problems of one contractual party should not necessarily lead to an automatic termination of a business relationship. But this is the result of the BGH’s approach since, if you don’t,  you risk being confronted with contestations and repayment claims by an insolvency administrator should your contractual counterparty file for insolvency at a later stage. This outcome is disastrous as it destroys the basis of each business relationship: trust.

And this basis is at risk, when parties take pre-emptive measures to reduce their own risk exposure. For example parties could ask for pre-payments before delivering/rendering services and/or will terminate the business relationship as soon as they receive an indication of liquidity problems with their business partner. The latter alternative in particular will lead to a macro-economic question of how to handle business relationships in global businesses where financial information does not always reflect the financial status correctly – considering also that for claw back claims the international jurisdiction of the courts of the member state in which insolvency proceedings were started has been extended by the latest decision of the ECJ (ECJ C-328/12 – Schmid).

There is an on-going discussion about amending sec. 133 InsO, which is about to be restarted since the new German Federal Government has put on its agenda an overall review of all insolvency regulations regarding Pauliana actions, including sec. 133 InsO.

On the other hand, the BGH and legal scholars are of the view that contestations under sec. 133 InsO can be reduced by merely applying the law correctly. In particular, they emphasize the need for a wide application of the contestation right in sec. 133 InsO to facilitate the administrator’s statutory obligation to claw back as many assets as possible in order to satisfy outstanding creditor claims. But it becomes clear that this can and shall not be borne by a business partner who was loyal to existing agreements and the businesses he had conducted with the now insolvent debtor.

The alternatives being discussed mainly consider reducing the contestation period from ten to four years or releasing the creditor from its (counter-)burden of proof. As both alternatives seem to be in line with the current rules, they do not prevent the insolvency administrator from contesting any payments on doubtful bases. Therefore, an amendment of sec. 133 InsO must reward and privilege the bona fide creditor. In general, the bona fide creditor should be able to raise the so-called objection of cash transaction (Einwand des Bargeschäftes) (sec. 142 InsO), meaning that the payment to the creditor is timely linked to his delivery/rendered services, against any contestation made by the insolvency administrator.   According to the existing rules the creditor is bared from raising this objection if the contestation is based on sec. 133 InsO. That exemption is obviously an incentive for the administrator to give his best shot and try to claw back anything even if the contestation time period is reduced and if he has the burden of proof.

In conclusion, an amendment of sec. 133 InsO should entitle a loyal and bone fide creditor, who trusted the debtor and maintained the business relationship, to object to a contestation based on the objection of cash transaction. This would ensure that the creditor’s trust in the legal and economic validity of the business relationship will not be negated when insolvency proceedings have been initiated upon his business partner.

It remains open whether the current Federal Government will amend sec. 133 InsO, but it is obvious that amendments are needed for the higher good of trustful business relations. Until then and in the light of the extended application of sec. 133 InsO, liquidity problems of business partners need to be handled with diligent care.