Protective Shield Proceedings (Schutzschirmverfahren): a special kind of insolvency

(Last update: 9 April 2020)

Why have Esprit and Galeria Karstadt Kaufhof applied for the opening of so-called Protective Shield Proceedings (Schutzschirmverfahren)? After all, by initiating such proceedings, the two companies are foregoing both the recently adopted suspension of the obligation to file for insolvency and the extensive state "rescue packages" intended to mitigate the COVID 19 pandemic (short-time work compensation, KfW loans, etc.). So what are the advantages of Protective Shield Proceedings (Schutzschirmverfahren)?

What are Protective Shield Proceedings (Schutzschirmverfahren)?

Despite still occasionally being presented differently: Protective Shield Proceedings (Schutzschirmverfahren)are insolvency proceedings. They are a special variant of provisional self-administration and are intended to make it easier for companies to prepare for restructuring. To this end, the insolvency court orders a period of up to three months in which the company draws up an insolvency plan under the supervision of an insolvency monitor (Sachwalter) and the court. During this period, the company can continue to operate undisturbed, as it does not have to fear enforcement measures by creditors and can itself create debts incumbent on the estate ("Massenverbindlichkeiten").

How do you initiate Protective Shield Proceedings (Schutzschirmverfahren)?

Protective Shield Proceedings (Schutzschirmverfahren) are only initiated if the company is not yet illiquid at the time of application. However, illiquidity or over-indebtedness must at least be impending. Furthermore, a certificate of a third party experienced in insolvency matters must be submitted, stating the reasons and showing a situation of impending illiquidity or over-indebtedness, and not actual illiquidity. This third party may be, for example, a lawyer, tax consultant or auditor. In addition, the certificate must confirm that the intended restructuring is not manifestly without prospects of success.

What are the advantages of restructuring in insolvency proceedings and thus also in Protective Shield Proceedings (Schutzschirmverfahren)?

A major advantage of judicial restructuring as opposed to extra-judicial restructuring is the use of the money made available by the Federal Agency for Employment (Bundesagentur für Arbeit) for salaries owed by the insolvent company (so-called "Insolvenzgeld"). This enables the company to be continue operations for up to three months without personnel costs. Depending on the size of the workforce, this can have considerable restructuring effects. In addition, the non-deduction of taxes and social security contributions and the non-payment of interest and repayments also have a positive effect on liquidity.

In addition to the financial restructuring, the operational restructuring is also easier in insolvency proceedings. For example, continuing obligations (such as rental agreements) can be terminated with three months' notice, irrespective of the remaining term. The period of notice for dismissing employees is also limited to a maximum of three months, irrespective of the years of service. A maximum of two and a half months' salary has to be paid for social plan costs. In addition, the permanent exemption from unsecured old liabilities (e.g. pension provisions) through the insolvency proceedings also has a more than insignificant restructuring effect.

What additional advantages does self-administration offer in insolvency proceedings?

Insolvency proceedings can be opened either as regular insolvency proceedings or as self-administration proceedings. While in the former case the insolvency administrator "takes the helm", in the latter the company’s management remains "in the driver's seat". In self-administration, the management continues the company under its own direction. It is only assigned an insolvency monitor (Sachwalter) who monitors the implementation of the self-administration and regularly also provides advice. Another advantage, which should not be underestimated, is the term “self-administration”. Whilst insolvency in the classical sense is primarily associated with the entrepreneur’s failure and the break-up of his business, self-administration has now become established as a restructuring procedure and the term also no longer bares hardly any negative connotations in the public’s perception. Finally, the duration of self-administration is limited as a rule to six to eight months. This also has a positive effect on the company's business relations, as the business partners are more likely to remain with the company than in a regular insolvency lasting several years.

How high is the risk of customers/suppliers backing out during self-administration?

Companies often worry that suppliers and customers might back out during their self-administration, suppliers because they no longer receive full payment for goods already delivered during the self-administration and customers because they lose confidence in the company due to insolvency.

These concerns are rarely justified. In the vast majority of cases, suppliers have an interest in continuing to supply the company, as otherwise they would have to find new sales channels, entailing expenses and a loss of earnings. Customers do not usually react negatively to self-administration either, if clear and early communication is made about the planned restructuring measures. Especially in cases where the customer depends to a certain extent on the company threatened with insolvency (e.g. in the case of supply chains), the customer has a vested interest in the company concerned continuing to supply. In such cases, customers are often prepared to take measures to support its liquidity (e.g. buying up stocks). It is also possible that customers assume losses if it can be shown that the contribution margins achieved with the customer are not sufficient to cover the costs.

Does it always have to be Protective Shield Proceedings (Schutzschirmverfahren)?

Protective Shield Proceedings (Schutzschirmverfahren) are just one particular variant of provisional self-administration. Alternatively, provisional insolvency proceedings can also be conducted as (regular) provisional self-administration. The advantages of Protective Shield Proceedings (Schutzschirmverfahren) compared to provisional self-administration are limited. Often the company to be restructured has an interest in bringing along its "own" insolvency monitor (Sachwalter). This possibility is legally defined for Protective Shield Proceedings (Schutzschirmverfahren).

Although not expressly provided for, even in regular self-administration proceedings, through early consultation with the court the person whom the applicant company proposes to the court is usually appointed as the insolvency monitor (Sachwalter). If necessary, the insolvency monitor (Sachwalter) may be enforced by a unanimous decision of the provisional creditors' committee. A further advantage is the ability to create debts incumbent on the estate under simplified conditions in Protective Shield Proceedings (Schutzschirmverfahren). This requires special judicial authorization, which can be granted similarly in (regular) provisional self-administration if the court is consulted at an early stage.

A specific disadvantage of Protective Shield Proceedings (Schutzschirmverfahren) is the obligation to have a certificate issued before the initiation of such proceedings confirming that there is no illiquidity and that the restructuring is not manifestly without prospects of success. This leads to considerable additional costs; moreover, the initiation of proceedings is regularly delayed by two to four weeks.

Besides this, in Protective Shield Proceedings (Schutzschirmverfahren) there is considerable time pressure once the application has been filed, as an insolvency plan must be submitted within three months of the application. In contrast, no such time pressure exists in the case of (provisional) self-administration, even if the preparation of the insolvency plan is regularly also started at an early stage here.

Why do companies (nevertheless) resort to Protective Shield Proceedings (Schutzschirmverfahren)?

The reason why companies nevertheless resort to such proceedings is probably a psychological one in most cases. The term “Schutzschirm” [protective shield] suggests that the company in question only needs a short respite in order to continue operating after restructuring. Since Protective Shield Proceedings (Schutzschirmverfahren) – in contrast to (regular) provisional self-administration proceedings – are opened in the event of imminent illiquidity or over-indebtedness, but not in the event of illiquidity, it is often assumed that things are "perhaps not so bad after all".

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