Grounds for opening, the application and the course of German insolvency proceedings

An upholsterer runs her business as a sole trader. In October, invoices of €41,000 fall due, her account holds €6,500, and the bank has cancelled her overdraft. A supplier threatens to file for insolvency, and an acquaintance advises her to have over-indebtedness checked first. For her that advice is worthless: over-indebtedness is not a ground for opening proceedings against a natural person at all.

Illiquidity: the general ground for opening

Insolvency proceedings require a ground for opening, and the German Insolvency Code (InsO) knows exactly three. Which of them can apply depends less on the size of the debts than on the legal form: a sole trader faces different grounds from a GmbH or a UG.

Section 17(1) InsO calls illiquidity (Zahlungsunfähigkeit) the general ground for opening. General means that it applies to every debtor, whether a natural person, a partnership or a legal person, and that it supports the debtor's own application just as much as an application by a creditor.

The definition is in subsection 2. A debtor is illiquid if unable to meet the payment obligations that are due. The statute therefore looks at the present: it measures the liabilities that must be paid now against the means available now.

Two words carry the definition. "Due" excludes amounts payable only later, such as an instalment whose date has not yet arrived. "Unable" refers to actual capacity, not willingness: someone who could pay but will not is a defaulting debtor, not an illiquid one.

Sentence 2 contains a presumption that saves a great deal of work in practice. Illiquidity is as a rule to be assumed where the debtor has stopped making payments. A business that visibly no longer pays wages, rent and suppliers need not first produce a liquidity statement for the ground to be accepted.

Conversely, a single paid item proves nothing. Someone who pays the rent to keep the shop but leaves twenty other due invoices unpaid can still be illiquid. What counts is the overall picture of due obligations, not whether anybody at all still receives money.

The presumption has real consequences for those involved. A creditor who applies must, under s. 14(1), make the ground for opening credible. A visible cessation of payments is the easiest way to do so: returned direct debits, fruitless enforcement and other creditors' reminders already draw the picture.

Impending illiquidity: looking ahead 24 months

Section 18 InsO allows a step before illiquidity arrives. If the debtor applies for opening, impending illiquidity is also a ground under subsection 1. A creditor cannot rely on it: nobody may force another person into proceedings on the strength of a default that is merely threatened.

Subsection 2 moves the yardstick from due obligations to existing ones. A debtor faces impending illiquidity if he is likely to be unable to meet them when they fall due. Liabilities that already exist today but are payable only later are therefore counted too.

The statute sets a period for this forecast: as a rule, 24 months are to be used. Anyone considering the step therefore needs a two-year liquidity plan showing when the available means are likely to stop covering the amounts then falling due.

Why would anyone enter insolvency proceedings early of their own accord? Because an early application leaves more behind. Waiting until everything is due and nothing is left often means applying for proceedings whose costs the assets no longer cover. The court then rejects the application under s. 26 for lack of assets.

For companies, subsection 3 sets a limit. If not all members of the management body, all personally liable partners or all liquidators apply, impending illiquidity counts only if the applicants are authorised to represent the company. A co-managing director without power of representation cannot rely on it alone.

Over-indebtedness: only where nobody has unlimited liability

Section 19(1) InsO makes over-indebtedness (Überschuldung) an additional ground for legal persons. Under subsection 3 the same applies to a partnership where, at the end of the chain, no natural person has unlimited liability, such as the typical GmbH & Co. KG. It is no ground against a sole trader or a partnership with a human being fully liable.

The reason is simple. Where a person is liable with all of their assets, that liability protects the creditors for as long as they can pay. Where nobody stands behind the debts without limit, proceedings should be able to start once the assets no longer cover the debts, even if cash is still sufficient.

Subsection 2 sentence 1 defines it: over-indebtedness exists if the assets no longer cover existing liabilities, unless it is more likely than not in the circumstances that the business will continue over the next twelve months. The test thus has two stages, and the second can cancel the first.

A company with negative net assets is therefore not automatically over-indebted. If its management can show with a robust plan that the business will more likely than not survive the next twelve months, the ground falls away. Without such a forecast, the arithmetical shortfall is enough.

Sentence 2 removes certain items from the calculation: shareholder loans and economically equivalent claims for which subordination behind the other insolvency claims has been agreed. Such a subordination agreement can eliminate over-indebtedness without fresh money, because the liability drops out of the comparison.

The two forecast periods are easily confused because they answer different questions. The 24 months of s. 18 concern the ability to pay, the twelve months of s. 19 the survival of the business. Anyone testing both in one plan should show the periods separately rather than use a single figure for both.

Who may apply and what the application must contain

Under s. 13(1) InsO proceedings are opened only on a written application, never by the court of its own motion. Creditors and the debtor may apply. Under s. 2 the local court (Amtsgericht) at the seat of a regional court has exclusive jurisdiction, unless the federal states have designated other insolvency courts.

Local jurisdiction follows s. 3(1). The starting point is the debtor's general place of jurisdiction, for a sole trader usually the place of residence. If the centre of the self-employed activity is elsewhere, the court of that place has exclusive jurisdiction, for example where the workshop sits in the neighbouring town.

The debtor's application is more than one sentence. It must include a list of creditors and their claims. If the debtor runs a business that has not ceased, the list should highlight the largest claims, the largest secured claims, those of the tax authorities, those of the social insurance bodies and those arising from occupational pensions.

Figures on total assets, revenue and average number of employees in the previous financial year are added. They become mandatory, for example, where the debtor applies for self-administration. A declaration that the information is correct and complete must always be attached, and where an official form exists, subsection 4 makes it compulsory.

Under s. 13(2) the application may be withdrawn until the proceedings are opened or the application is finally rejected. If it is inadmissible, for example because information is missing, the court must under subsection 3 promptly ask for the defect to be remedied and allow a reasonable period for it.

Under s. 14(1) a creditor needs a legal interest in opening and must make both the claim and the ground for opening credible. If the debtor pays the claim afterwards, that alone does not make the application inadmissible. Once the application is admissible, the court hears the debtor.

Paying after the application also has a cost consequence. If the application is then rejected as unfounded, s. 14(3) places the costs of the proceedings on the debtor. Anyone who tries to settle a creditor's application by paying may therefore pay more than the claim alone.

For companies, s. 15(1) entitles each member of the management body to apply, for partnerships each personally liable partner, and also each liquidator. If a legal person has no managing director, each shareholder may apply too. If not all of them act together, subsection 2 requires the applicant to make the ground credible.

For a GmbH or UG, s. 15a InsO turns this right into a time-limited duty of the management, covered in the course on choosing between a GmbH and a UG. A sole trader has no such duty; he is liable with all his assets anyway.

From application to opening: interim measures

Weeks often pass between the application and the decision. Nothing that will later belong to the creditors should be lost in that time. Section 21(1) InsO therefore obliges the court to take every measure that appears necessary to prevent a change in the debtor's financial position that would harm the creditors.

• appoint a preliminary insolvency administrator
• set up a preliminary creditors' committee
• impose a general prohibition on disposals, or make the debtor's disposals subject to the consent of the preliminary administrator
• prohibit or suspend enforcement measures, except where immovable property is concerned
• order a preliminary redirection of mail

The preliminary administrator's position under s. 22 depends on the prohibition on disposals. If it is imposed at the same time, the power to manage and dispose of the debtor's assets passes to the administrator. The business owner can then no longer validly dispose of the bank account or the goods.

Under s. 22(1) sentence 2 this administrator must secure and preserve the assets and continue a running business until the decision, unless the court consents to a closure. He also examines whether the assets will cover the costs of the proceedings; the court may additionally instruct him as an expert on the ground for opening.

Without a prohibition on disposals, the court itself determines the preliminary administrator's duties under subsection 2; they may not go beyond those of subsection 1. In both cases subsection 3 lets him enter the business premises, inspect the books and demand information, and the debtor must support him.

If the assets are unlikely to cover the costs, the court rejects the application for lack of assets under s. 26(1). This does not happen if someone pays a sufficient advance or the costs are deferred under s. 4a. The rejection is published, and the debtor is entered in the register of debtors.

For a sole trader, rejection for lack of assets is the worst outcome. The debts remain in full, discharge of residual debt requires proceedings, and the register entry makes every new contract harder. A natural person therefore usually combines the application with a request for deferral of costs, explained in the second module.

If proceedings are opened, the court appoints an insolvency administrator under s. 27(1). The opening order names the administrator and the hour of opening; if the hour is missing, subsection 3 deems it noon on the day of the order. From then on, s. 80 transfers the power to manage and dispose of the estate to the administrator.

If the business has employees, the Federal Employment Agency secures their unpaid wages through insolvency pay; entitlement, amount and filing deadline are covered in the course on short-time work and insolvency pay.

The insolvency estate and the self-employed activity

Section 35(1) InsO sets the scope: the proceedings cover all assets the debtor owns at opening and acquires during the proceedings. A sole trader has no separation between business and private life. Workshop, customer receivables, savings account and car fall in principle into the same estate.

Under s. 36(1), whatever is not subject to enforcement is excluded. This includes the non-attachable part of income and the balance protected by a garnishment-protection account. Under subsection 3 ordinary household goods stay outside if selling them would yield a price grossly out of proportion to their value.

Section 36(2) has its own rules for the self-employed. The business books always belong to the estate. Certain work equipment that would be protected from attachment also falls into it, unless it is needed for an activity consisting of personal services. A one-person craftswoman is more likely to keep her hand tools than a machine hall.

The proceedings do not automatically end the activity. Under s. 35(2) the administrator must declare to a self-employed debtor whether assets from that activity belong to the estate and whether claims arising from it can be asserted in the proceedings. Subsection 3 calls this the release of the activity.

Once the activity is released, the debtor works on his own account. His new income no longer belongs to the estate; in return, s. 295a requires him to put the creditors in the position they would be in had he taken up appropriate employment. The second module shows what this means for his annual payments.

Under s. 35(3) the debtor must promptly inform the administrator when taking up or continuing a self-employed activity. If he asks for release, the administrator must respond promptly, at the latest after one month. The declaration is notified to the court, which publishes it.

Only now do the creditors come to the fore. Under s. 38, insolvency creditors are the personal creditors whose financial claim was founded at the time of opening. Under s. 174(1) they register their claims in writing with the administrator, attaching copies of the documents; subsection 4 also allows electronic filing.

One detail of registration is decisive for the debtor. If a creditor bases the claim on an intentional tort, an intentionally breached maintenance obligation or a tax offence, s. 174(2) requires the facts to be stated. Such claims later survive the discharge of residual debt.