Vol 4 (2007) - Issue 6

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Taking down the Sword of Damocles: Definition of Illiquidity According to the German Federal Court of Justice

Introduction

‘Damocles was an excessively flattering courtier in the court of Dionysius II of Syracuse, a 4th Century BC tyrant of Syracuse, Italy. He exclaimed that, as a great man of power and authority, Dionysius was truly fortunate. Dionysius offered to switch places with him for a day, so he could taste first hand that fortune. In the evening a banquet was held, where Damocles very much enjoyed being waited upon like a king. Only at the end of the meal did he look up and notice a sharpened word hanging by a single piece of horsehair directly above his head. Immediately, he lost all taste for the fine foods and beautiful boys and asked leave of the tyrant, saying he no longer wanted to be so fortunate.’

Even if the German bankruptcy law nowadays does not represent imminent danger for the life and livelihood of managing directors and boards of directors, it does
contain peculiarities which both domestic companies as well as foreign companies with German holdings must take into consideration and the ignorance of which may result in unpleasant fines for the management.

One of the main issues is that the debtor’s management is often faced with Hobson’s choice when it comes to their duty to file for insolvency (i.e. in case of illiquidity or over-indebtedness): if they file too early, shareholders will sue them for ruining the company, and if they file too late, they will become liable to the creditors for the undue decrease of the insolvency assets. This dilemma was even amplified in the past due to the lack of a detailed legal definition of illiquidity, which is by far the most common reason for the opening of insolvency proceedings.

The following article intends to give a brief description of how to determine illiquidity according to German insolvency law, and what management needs to do in this event.

Definition of illiquidity according to German Federal Court of Justice

According to the law, a debtor is illiquid if he is unable to meet his due obligations (sec. 17 Insolvency Code, InsO). This definition sounds concise and easy, but due to a lack of high court precedents it was unclear for a long time under which conditions a debtor is regarded as being illiquid.

Discussion has frequently centered around whether even the smallest or shortest shortage was to be viewed as illiquidity or if small, temporary bottlenecks in payments should not be included. There were a number of opinions in this regard. In some cases – literal interpretations of the law – the opinion was that liquidity shortages, even if they only existed for one day, were sufficient for meeting the requirements of insolvency. According to this interpretation ‘very slight’ shortages – whereby ‘very slight’ shortages could be from 5%, to 20% or even up to 25% – were not hazardous.

The period of time granted to the debtor to overcome the illiquidity before he is obligated to file for bankruptcy was also disputed and ranged from one week
to 3 months.