C. Acquisition Financing from a German Perspective
As in other jurisdictions, an acquisition by institutional investors or strategic buyers is also regularly made through an acquisition vehicle. German acquisition vehicles usually have the legal form of a limited liability company (GmbH). Since the acquisition vehicle, which does not have any purpose other than acquiring the target, does not own any assets, it has to be funded by the shareholders with (quasi-) equity (i.e. stated share capital, equity in the form of capital reserves, shareholder loans) and with debt made available by banks or institutional investors (e.g. senior debt, second lien loans, mezzanine debt, high yield bonds) in order for the acquisition vehicle to be able to pay the purchase price to the seller. The ratio of debt to equity depends on the market situation, the volume of the transaction, the strategy and expected rate of return of the investor, the expected capability of the target (group) to service debt and interest from free cash flow, the envisaged rating of the target (group) after the acquisition, and the syndication environment.
II. Financing Process
The financing process for an acquisition financed in addition to the required portion of (quasi-) equity by senior bank debt can generally be divided into three phases: the process usually starts with a term sheet summarizing at least the basic economic terms of the proposed financing. On the basis of the term sheet the facility agreement is prepared, negotiated and signed. On the closing date, after the conditions precedent of the facility agreement have been delivered or waived, the bank (or the bank syndicate) makes the funds available for the payment of the purchase price.
1. Term Sheet
Term sheets can range from short forms of just a few pages summarizing the basic economic terms such as, for example, the types and amounts of the facilities, the interest rates and the maturity profiles to long forms of over 50 pages anticipating almost every detail of the facility agreement such as mandatory prepayments, market disruption, tax gross up, increased costs, representations and warranties, information undertakings, financial covenants, general undertakings, events of default, transfer conditions, conditions precedent and conditions subsequent, transaction security and administration and enforcement of the transaction security. The term sheet often, but not necessarily, forms part of a commitment letter with the arrangers of the facilities setting out the terms and conditions on which the arrangers either agree to arrange the syndication of the facilities on a best efforts basis or commit to an underwriting.
2. Facility Agreements
Facility agreements throughout Europe are generally based on the standard documentation of the Loan Market Association (LMA) in London which is governed by English law. Since 2007, the LMA has also been publishing a German law version which is specifically adapted to the requirements of German law and banking practice whilst otherwise retaining the form and substance of the English law LMA documents. The choice of English or German law as the governing law of the facility agreement as well as the choice of the English or German language ￼depends on the background of the parties involved, the syndication requirements and the jurisdiction of incorporation of the target (group).
At closing, the bank (or the bank syndicate) makes the funds for which a utilization request has been delivered available for the payment of the purchase price, provided that all conditions precedent of the facility agreement have been delivered or waived. One of the most important conditions precedent is the granting of comprehensive transaction security, such transaction security usually including security over the shares in the acquisition vehicle, in the target company and in (at least the most important) subsidiaries of the target company as well as over the assets of the target company and of (at least the most important) subsidiaries of the target company such as bank accounts, receivables, fixed assets and current assets. If the transaction security documents cannot be signed prior to the closing of the acquisition, the transaction security must be taken as a condition subsequent. As yet only in the context of strategic investors, but, as a consequence of the financial crisis, also in the context of a financial investor, lenders also frequently expect security in the form of payment guarantees from the respective investor itself.
III. Specific Issues under German Law
In the case of an investment in a target (group) incorporated in Germany or finance documents governed by German law, acquisition financing faces – in addition to tax implications, which are discussed in Part D. – specific issues under German law.
1. Maintenance of Stated Share Capital
According to the statutory capital maintenance rules of the Limited Liabilities Companies Act (GmbHG), a GmbH may not make payments to its shareholders if and to the extent such payments lead to the net assets of the GmbH falling short of its stated share capital or an existing shortfall being further increased. These rules also apply to up-stream guarantees and up-stream asset security given by a GmbH to secure financial indebtedness of its direct or indirect shareholders or the subsidiaries of such direct or indirect shareholders. A breach of the capital maintenance rules can result in personal civil and criminal liability of the management of the GmbH and of its shareholders to the extent the shareholders were involved in a shareholders resolution by which the GmbH was instructed to grant up-stream guarantees or up-stream asset security. Therefore, the managing directors of a GmbH which is asked to provide up-stream guarantees or up-stream asset security should request to add limitation language in order to limit the enforcement of up-stream guarantees and up-stream asset security or the amount of the enforcement proceeds which may be retained for distribution to the banks to that amount which is not required to cover its stated share capital, this amount, constituting the enforceable amount, being in principle equal to the distributable reserves of the GmbH.
b) Limitation Language
The typical limitation language which has evolved from the market does not just provide for the described limitation, but also for detailed rules that stipulate how the net assets and the ￼enforceable amount have to be calculated. For example, financial indebtedness incurred in breach of the finance documents and an increase in the stated share capital by conversion of funds of the GmbH are not usually taken into account for that purpose, even though such and other balance sheet adjustments which banks usually request lead to an artificial increase of the enforceable amount and might not be in compliance with the statutory rules for the calculation of the assets. Furthermore, limitation language also typically provides for rules for the formal process and the timeline for the calculation of the net assets and the enforceable amount after an enforcement notice has been served.
c) Other Legal Forms
The capital maintenance rules also apply in principle to a general partnership (OHG) and a limited partnership (KG) where the partners with unlimited liability are exclusively comprised of companies in the legal form of a GmbH. However, there are differences in the details. For example, if a GmbH & Co. KG, a limited partnership with the only general partner being a GmbH, gives an up-stream guarantee or up-stream asset security for the financial indebtedness of its general partner, limitation language should not be required. Even more far-reaching rules apply to the stock corporation (AG). An AG is prohibited from distributing any assets to its shareholders except for the distribution of its profits. This means that an AG, as a rule, cannot give up-stream guarantees and up-stream asset security at all.
d) Domination Agreements and Profit and Loss Transfer Agreements
The capital maintenance rules do not apply, and thus up-stream guarantees and up-stream asset security are in principle permitted if a domination agreement or a profit and loss transfer agreement is in place between the security grantor and the company for whose benefit the up- stream guarantee or up-stream asset security is given. The reason for this exception is that the security grantor as dominated company or profit transferring company receives by operation of statutory law a loss compensation claim against the other party of the domination agreement or the profit and loss transfer agreement. It is, however, unclear whether this exception also applies in a typical acquisition financing structure where the acquisition vehicle has no assets other than the shares in the target company and the loss compensation claim is not recoverable in the event that the transaction security is enforced.
e) Market Practice
Although third parties such as banks are not the addressees of the capital maintenance rules and the limitation language affects the value of up-stream guarantees and up-stream asset security considerably, most banks in Germany are familiar with the capital maintenance issue and are in principle prepared to accept limitation language. However, this is the market practice. No precedent is known where limitation language has already been tested in court. The area of up-stream guarantees and up-stream asset security is therefore still characterized by legal uncertainty, and the question to what extent up-stream guarantees and up-stream asset security may be given without incurring legal risks for the management must be carefully assessed on a case-by-case basis.
2. Maintenance of Liquidity
The managing director of a GmbH is personally liable for payments that the GmbH makes to its shareholders if and to the extent such payments resulted in the GmbH becoming illiquid, unless ￼the illiquidity was unforeseeable when using the diligence of a prudent business person. Generally, it is acknowledged that security given by a GmbH to secure financial indebtedness of its shareholders can qualify as a payment in that sense, but there are open questions as to the details. For example, there is no common view as to whether this rule applies to security over any asset or only to security over cash or assets which can be easily converted into cash. It is also unclear whether this rule only applies to the extent that the asset over which the security is given is no longer available for use to the business. To protect the managing directors of a GmbH from liability for causing the illiquidity of the GmbH when the creation of up-stream asset security is required, borrowers have started asking lenders to expand the scope of the limitation language, which was initially designed with a view to the capital maintenance rules, to the effect that the enforcement of up-stream asset security or the amount of the enforcement proceeds which may be retained for distribution to the banks is not only limited to the extent it is necessary to avoid a violation of the capital maintenance rules, but also to the extent it is necessary to avoid the illiquidity of the GmbH. Most banks in Germany are aware of this issue, but many of them are, at least at the moment, reluctant to accept this limitation as it further reduces the value of up-stream asset security.
3. Prohibition of Financial Assistance
An AG may not give any financial assistance to the buyer of its shares. This rule does not only apply to financial assistance with the acquisition itself, but also to any transaction following the acquisition that is closely connected with the acquisition such as the granting of up-stream asset security after the takeover of the AG has been completed and the buyer has taken control over the AG to secure the financing that was taken out for the acquisition. In principle, this does not apply if a domination agreement or a profit and loss transfer agreement is in place, but it is unclear whether this exception also applies in a typical acquisition financing structure (see 1.d) above). There are no financial assistance rules for the GmbH.
4. Prohibition of Compound Interest
Under German law, a lender and a borrower may not agree on compound interest in advance. Where delayed interest payments are concerned, instead of default interest on delayed interests, German law governed facility agreements therefore usually provide for lump sum damages to the amount of around 200 basis points above the then applicable interest rate to compensate for damages which the lender might incur due to the delayed interest payments, provided that the borrower still has the right to prove that no damages or lower damages have arisen. Although the prohibition of agreeing on compound interest in advance does not mean that the borrower could not be given the right to choose between payment of the interest in cash or accrual on the principal amount of the loan, after the claim for interest has fallen due, the prohibition of compound interest means that payments in kind (PIK) as they are typically used in English law mezzanine instruments are, under German law, not enforceable, and structures that aim to achieve the same result as a PIK structure have to be tested against the question of whether they constitute a circumvention of the prohibition of compound interest and are therefore not enforceable.
5. Voluntary Cancellations and Prepayments
Pursuant to mandatory rules of the German Civil Code (BGB), a borrower may voluntarily cancel a facility and make a prepayment with effect to the end of the applicable interest period without ￼the obligation to pay damages to the lender if the interest rate has not been fixed until the final maturity date. Any agreement that aims to exclude or impede this right is not enforceable. As acquisition finance facilities usually provide for roll over loans, this means that, for example, an obligation to pay a prepayment fee or a restriction of cancellations and prepayments to certain minimum amounts or multiples is not enforceable to the extent it shall apply to cancellations and prepayments which are made with effect to the end of an interest period.
6. Guarantee on First Demand
Facility agreements usually provide for payment guarantees “on first demand” under which the guarantor has to make payment merely upon a demand which meets the pre-agreed formalities, but under which the guarantor does in principle not have the right to prove that the guaranteed event has not occurred. According to German case law, which is still developing, only banks, credit institutions and international operating businesses may give a guarantee on first demand. A guarantee on first demand given by an entity that is not eligible to give a guarantee on first demand according to these rules may thus only constitute a simple payment guarantee.
In a judgment dating from 1992, the German Federal Supreme Court (BGH) treated a lender as a shareholder in a case where (i) the shares in the borrower were pledged in favor of the lender and the claims for dividends, for the compensation in case of an exit of a shareholder, for the liquidation proceeds in case of a liquidation and for the sale proceeds in case of a sale of shares were assigned or pledged to the lender, (ii) the shareholders of the borrower undertook to obtain the prior consent of the lender before exercising certain membership rights and (iii) the borrower agreed to the request of the lender that a consulting firm elected by the lender takes over the de facto management of the borrower. This decision has led to some uncertainty in the legal community whether, in the insolvency of the borrower, customary covenants in facility agreements in combination with share pledges can lead to the result that the lender is treated as a shareholder with the consequence that the loans of that lender are subordinated. This view, however, has become more and more unlikely as the BGH indicated in another judgment of 1998 that the power of a person to have influence on a company does not lead to being treated as a shareholder if that power is based merely on economic strength or contractual covenants.