Corporate crises: The seven deadly sins of management

The underestimated danger of personal liability

Just as "The Seven Deadly Sins" according to historian Sebastian Haffner (1964) led to the downfall of the German Empire in 1918, there are seven deadly sins for the management of a GmbH, GmbH & Co. KG or stock corporation in connection with crisis and insolvency. Although these do not result in the fall of an empire, they do result in the personal liability of the management. Moreover, that often leads to the destruction of the economic existence.

The management is the legal body of its company. It represents the company towards the shareholders and third parties. As such, it has a great responsibility towards the company, its business partners and the general public. It must therefore always base its actions on the so-called due care and diligence of a prudent and conscientious manager in accordance with sec. 15 b para. 1 sentence 2 of the German Insolvency Code (Insolvenzordnung - InsO). This responsibility becomes even more relevant when a corporate crisis occurs, because then the company and all those involved can suffer major damage for which they can seek compensation from the management. The seven deadly sins of a business manager are:

1. delaying insolvency,
2. making so-called prohibited payments,
3. payments to shareholders and related parties,
4. creation of new liabilities,
5. non-payment of social security contributions,
6. non-fulfilment of tax obligations, and
7. commission of insolvency crimes.

1. Mortal sin: Procrastination in insolvency

Hardly any company becomes insolvent overnight. Rather, an unexpected event often turns into a crisis by a concatenation of problems, which in the further course ends in insolvency. It is important for the business manager to recognize the signs of a company crisis at an early stage and to adjust his actions to the changed circumstances. The first signs of insolvency are:

• deteriorating liquidity,
• increased use of supplier credit,
• reminders,
• loss of receivables (e. g. due to customer insolvency),
• demand for repayment of shareholder loans or
• increased employee layoffs.

An insolvency check is essential in this context. If the company is threatened with insolvency or overindebtedness because of a crisis, the manager must file an application for the opening of insolvency proceedings without delay, but no later than three weeks after the insolvency or overindebtedness has occurred (sec 17, 19 InsO). If at least half of the share capital has been lost, the managing director must also convene a shareholders' meeting without delay. Above all, however, the managing director is obliged to avoid or eliminate over-indebtedness or insolvency. The following measures are suitable for this purpose:

• subordination,
• shareholder loan,
• debt waiver,
• ordinary capital increase,
• deferral agreements,
• assignments of claims,
• borrowing,
• so-called sale and lease back,
• bank moratoria, and
• salary waiver by the managing director.

In the final analysis, it is up to the manager to decide which measures are possible and sensible in each individual case. However, it makes sense to obtain help from external advisors at an early stage. It is of considerable importance for his liability whether he can later demonstrate credibly that he did everything possible to prevent insolvency and did so in consultation with qualified and experienced advisors.

If it subsequently transpires that the company was already insolvent or overindebted for some time before the insolvency application was filed, the manager will be personally liable. Old creditors, i. e. persons whose claims arose before the time of the insolvency application, are satisfied via the insolvency quota. On average, this rate for all corporate insolvencies is less than five percent, a rate that would regularly be higher if the application had been filed in good time. The manager is liable to the creditors for the difference between the actual and possible quota  which could have been achieved if the application was filed in good time.

2. Mortal sin: Prohibited payments

In a crisis, the manager must ensure that all company expenses are kept to a minimum. For this reason, every payment or other service that the manager executes or even allows entails the risk of his personal liability. This applies in the internal relationship vis-à-vis the company for payments that reduce mass or destroy the company's existence (which are asserted by the insolvency administrator after the opening of insolvency proceedings) and in the external relationship vis-à-vis new creditors (creditors whose claims arose after the time of the required filing of the insolvency petition), the social insurance carriers and the tax authorities (so-called "pass-through liability"). Pursuant to sec. 15 b InsO, he is liable from the time of the obligation to file for insolvency for all services or deliveries of the company for which no appropriate countervalue has flowed into the insolvency estate (so-called services without asset exchange). This also applies to the director of a limited company with its actual registered office in Germany. These so-called prohibited payments include in principle

• all payments on receivables older than 30 days, because then it is no longer a so-called cash transaction;
• payments on the employer's social security contribution, because this is not a wage component and no countervalue flows into the insolvency estate;
• debit mandates reducing the assets;
• other reductions in assets, such as deliveries of goods paid for in advance, unless this can give rise to a claim against a third party; and even
• incoming payments on an account with a debit balance (so-called “debit-side account”), as this results in a unilateral creditor preference in favour of the bank.

The manager may still pay

• the purchase price for required material within the cash business period (e. g. for the completion of a construction project);
• services necessary to maintain business operations, such as telephone, electricity, or liability insurance costs;
• the tax advisor for current accounting and consulting attorneys/auditors; or
• from a debit account as long as it is unsecured,

because these payments are generally consistent with the "due care of a prudent businessman".

3. Mortal sin: Payments to shareholders and related parties

In many cases, the manager is tempted to satisfy claims of shareholders, related parties (sec. 138 InsO) or certain business partners for personal reasons or with a view to his own future despite the crisis. However, such payments in the last three months before the insolvency application are typically reclaimed by the insolvency administrator by means of the insolvency avoidance. In the case of direct disadvantage, the insolvency administrator even demands back payments retroactively for up to two years. The same applies to all repayments on shareholder loans made in the twelve months prior to the insolvency application (sec. 129 et seq. InsO). This regularly not only causes annoyance among the recipients of payments, but can also lead to personal liability on the part of the manager pursuant to sec.  823 et seq. German Civil Code (Bügerliches Gesetzbuch – BGB).

4. Mortal sin: Creation of new liabilities

Towards creditors whose claims arose after the time of the required filing of the insolvency petition and have not been settled, or whose claims that have already been settled have been validly set off by the insolvency administrator pursuant to sec. 129 et seq. InsO were effectively contested by the insolvency administrator, the manager is liable personally in the event of insolvency delay in the amount of the defaulted claim pursuant to sec. 823 para. 2 BGB in conjunction with sec. 15 para. 1 InsO. It is precisely this liability that is often the cause of a private insolvency of the managing director.

5. Mortal sin: Failure to pay social security contributions

In principle, the manager is liable personally to the social security institutions for the non-payment of employee social security contributions. The failure to pay social security contributions is therefore a mortal sin, because there will be no discharge from residual debt granted in any subsequent private insolvency proceedings of the manager. In addition, failure to pay social security contributions is a criminal offense (embezzlement of wages) under sec. 266 a of the German Criminal Code (Strafgesetzbuch - StGB), which is punishable by a fine or imprisonment of up to five years.

6. Mortal sin: Failure to fulfil tax obligations

The sixth deadly sin of a business manager in a corporate crisis and insolvency is the violation of his tax obligations. Pursuant to sec. 69 of the German Fiscal Code (Abgabenordnung - AO), the manager is liable personally for taxes (in particular sales tax and payroll tax) that are not declared and/or paid on time. In this context, he is liable for the damage caused to the tax authorities if he does not submit the company's tax returns or does not do so on time and if he does not withhold the withholding taxes (in particular the wage tax) and pay them to the state. In the case of other taxes, the principle of equal treatment of creditors applies. If the available funds are not sufficient to pay off all tax debts, sales tax, trade tax or corporate income tax must be paid - to put it simply - according to the percentage share of the tax owed in the company's total liabilities. The non-fulfilment of tax obligations becomes a mortal sin above all because the business manager is not only threatened with criminal proceedings for tax evasion according to sec. 370 et seq. AO, which, like the withholding of contributions, can be punished with a fine or imprisonment of up to five years, but he will typically not be granted residual debt discharge in possible insolvency proceedings of his own.

7. Mortal sin: Committing insolvency crimes

The last potential mortal sin of a business manager is the commission of insolvency offenses. This is also because, in the event of a conviction for an insolvency offense to a fine of 90 daily rates or more or three months' imprisonment, the discharge of residual debt in private insolvency proceedings, which often follow from personal liability, is excluded (sec. 297 InsO). In addition, in the event of a conviction, the managing director may be unsuitable for a future position on the board of another company (cf. sec. 6 para. 2 German Act on Limited Liability Companies (Gesetz betreffend die GmbH - GmbHG). In these cases, the economic existence of the managing director is usually destroyed to the greatest possible extent.

These criminal offenses include, in addition to the aforementioned

• withholding and embezzlement of remuneration (sec. 266 a StGB) and
• tax evasion according to sec. 370 et seq. AO,
• the commission of the following offenses:
• bankruptcy offenses within the meaning of sec. 283 StGB,
• favouring creditors (sec. 283 c StGB),
• procrastination in insolvency (sec. 15 a para. 4 InsO),
• breach of trust (sec. 266 StGB), and
• fraud (sec. 263 StGB),

if they are committed by the manager in connection with an economic crisis of the company.

In order to counter the aforementioned dangers and risks even before a crisis, it is advisable for every business manager to seek external advice in order to protect himself personally. This is especially true when the first signs of a company crisis are already apparent. At this time advisors can be specialized lawyers and tax consultants.

Corporate crises can contain high personal liability risks for business managers. Seeking advice in good time can mitigate this.

Dr. Thomas Hausbeck and the insolvency law team at SKW Schwarz will be happy to assist you with any questions relating to liability risks for the managing director(s) in the corporate crisis.