Section 64 is the central provision for the liability of the managing director of a company in distress. If a managing director does not file for insolvency proceedings in time, although the GmbH being technically insolvent, he may be liable to a very considerable extent under this provision. Past precedent in this field has been described as "draconian", Schmidt/Uhlenbruck, Die GmbH in der Krise, Sanierung und Insolvenz, 5th ed. (2016), marginal number 11.38 with some even talking of the "modern torture" of the managing director.

If a GmbH becomes insolvent, it is part and parcel of the duties of the insolvency administrator to determine whether the petition for insolvency was filed in time and – if it was not – whether the managing director is personally liable on that account.

It is often apparent that the greatest concern of managing directors in the case of a delay in filing for insolvency is that they will render themselves liable to prosecution for the delay. Usually, however, the consequences of liability under section 64 have a much greater impact on them than any criminal liability.

1) Section 64 from the point of view of the managing director

a) Required action ahead of insolvency

The central act required of the managing director under section 64 is to verify at regular intervals whether there could be grounds for insolvency (illiquidity or overindebtedness) as soon as there is any indication that the company might be in crisis. If grounds for insolvency exist, section 15a (1) of the German Insolvency Code (InsO) requires the managing director to file a petition for insolvency without culpable delay, and within not more than three weeks. For as long as he delays in filing for insolvency, e.g. in order to explore restructuring options, he is not allowed – even in the three-week period – to make any payments or undertake any other asset-reducing measures if he wishes to avoid being held personally liable.

aa) Examination of grounds for insolvency

(1) Illiquidity

A solvent company must be in a position at all times, to meet its due obligations. Payment liabilities fall due at the time the agreed payment date or the payment date granted by the creditor expires. If the text on the invoice, for instance, says "payable solely net within 20 days", the invoice must be paid without deduction within 20 days. If an invoice contains no such text, it is due for payment immediately and not – as is often believed – only after 30 days or upon default in payment. The common practice of letting suppliers' invoices unpaid for a while and not paying them until after two or three months – something which suppliers often tolerate for the sake of maintaining the business relationship – is not permitted with a GmbH.

If a GmbH is unable to pay all its due obligations, it is illiquid.

(a) Tolerances

The Federal Court of Justice tolerates a temporary funding gap of 10%. Accordingly, a GmbH must be able to pay at least 90% of its due obligations if it is not to be considered illiquid. However, this only applies if it is not already evident that the funding gap will be greater than 10% in the near future. Moreover, a 10% funding gap is not tolerated in the long term.

The Federal Court of Justice also allows funding gaps of more than 10% if these can be closed or reduced to less than 10% again within three weeks. Even if a GmbH can only pay less than 90% of its due obligations, it is not illiquid if it can meet at least 90% of its due obligations at least within the next three weeks. Such a situation is known as a "temporary stagnations of payments".

In extreme exceptions the Federal Court of Justice tolerates an even longer existence of a liquidity shortfall of 10% if the liquidity gap can "with a likelihood approaching certainty" be closed or almost completely closed in the near future (three to six months). In principle, there should be no or virtually no liquidity gap, not even a gap of 10%, by the end of this time. Since this exception comes with considerable uncertainty, it can only be "risked" in close consultation with legal and business management experts. Generally no use is made of it.

(b) Avoiding illiquidity

If illiquidity is imminent, it can be avoided by an injection of funds. When planning the cash flow, therefore, the managing director must make sure that the necessary liquidity is provided in time, e.g. through an extension of the existing credit lines or by the shareholders contributing the necessary funds or providing a shareholder loan. It is also possible to sell goods and "make money" in this way. Common methods of acquiring liquidity include factoring or the sale-and-lease-back of fixed assets. Since the above three-week period is normally not sufficient for such measures, they need to planned and implemented in good time.

If the necessary funds cannot be obtained at short notice, deferral agreements may also be reached with creditors. However, these must be properly documented, normally in writing, so that they can be used as evidence later if necessary.

(2) Overindebtedness

(a) Mathematical overindebtedness

An enterprise is overindebted if its assets are no longer sufficient to cover its liabilities, or in other words liabilities exceed assets and the equity is therefore negative. In the case of a GmbH, overindebtedness alone establishes a duty to file for insolvency even if the GmbH is still solvent, i.e. can meet all its due obligations. Whereas illiquidity is felt "physically" (it is generally noticed when one can no longer pay one's bills), overindebtedness tends to "creep up". This is why it is so dangerous for managing directors: if a GmbH is overindebted, the managing directors are liable (or render themselves criminally liable) if they continue to manage the enterprise and do not file for insolvency. Overindebtedness is so difficult to spot because overindebtedness within the meaning of insolvency law is not necessarily the same as overindebtedness in the commercial or tax balance sheet.

If the commercial or tax balance sheet shows a shortfall not covered by equity, one can usually also assume overindebtedness as defined in insolvency law. If this is the case, immediate consideration must be given to whether, and if necessary how, the overindebtedness can be eliminated. Otherwise a request for insolvency must be filed.

Often, however, an enterprise is overindebted even though the commercial or tax balance sheet shows a positive equity. The commercial or tax balance sheet is produced on the assumption that the enterprise will be continued as a going concern (section 252 (1) no. 2 of the German Commercial Code (HGB)), whereas the overindebtedness balance sheet must be drawn up at liquidation values if the continuation of the enterprise is not overwhelmingly likely.

(b) Going-concern prognosis

The central issue for an assessment of overindebtedness is therefore whether the enterprise has a positive going-concern prognosis. This in turn demands a cash flow prognosis (and with it a detailed cash flow forecast) for the current and the subsequent financial year. Only if this cash flow prognosis indicates that the enterprise will in all expectation (with overwhelmingly likelihood) survive the next one to two years may the going-concern value from the commercial balance sheet be applied when assessing overindebtedness within the meaning of insolvency law.

If, on the other hand, the cash flow prognosis for the next one to two years indicates that the continued existence of the enterprise is not certain in terms of cash flow (at least not "overwhelmingly likely"), the assets on the assets side of the balance sheet may only be stated at their liquidation values (i.e. the probable proceeds from an individual auction). With respect to most enterprises this leads to their overindebtedness.

Only in rare cases does an enterprise have significant hidden reserves, e.g. if the assets of the company include a business property of high value that was acquired a long time ago and so is only shown on the assets side at a low book value. Hidden reserves may be revealed in the overindebtedness test and can, in individual cases, be sufficient to compensate for a shortfall not covered by equity or even the write-down of the other assets to their liquidation values in the event of a negative going-concern prognosis.

The overindebtedness test therefore hinges on the going-concern prognosis. The term overindebtedness can thus result in a misleading perspective. In reality, what usually matters in the case of overindebtedness is whether the enterprise has a prospect of continuing as a going concern or is about to become illiquid. Since the managing director must be able to demonstrate a positive going-concern prognosis if the situation is serious (and especially if everything did in fact go wrong and a positive prognosis subsequently proved to be incorrect), it is recommended that an external management consultant be commissioned to produce a going-concern prognosis if there are any signs of a crisis or the commercial or tax balance sheet shows a shortfall not covered by equity.

If the going-concern prognosis is positive, even mathematical overindebtedness is not harmful to going-concern values.

bb) Filing for insolvency

If a ground for insolvency exists (illiquidity or overindebtedness), the managing director must file for insolvency without undue delay. Section 64 indirectly formulates such a requirement to act by setting out the consequences of liability. Until 1 November 2008 the duty to file for insolvency was enshrined in section 61 (1) GmbHG. Since then the duty to file for insolvency has been contained in the German Insolvency Code (section 15a InsO). A failure to file for insolvency despite technical insolvency having occurred is a criminal offence (section 15 (4) InsO), even if the act was only negligent (section 15 (5) InsO).

Regardless of the requirement to act under criminal law, the managing director should file the necessary request for insolvency if he wishes to avoid liability pursuant to section 64.

cc) Withholding of payments

The managing director may also avoid any liability under section 64 by refraining from any measure that reduces the net worth of the company (or shrinks a subsequent insolvent estate). To a certain extent, therefore, he must "freeze" the company's activities, as it were. While business continues this is only possible for a limited and generally very short period of time, as otherwise the entire business activities will come to a stop. Since liability under section 64 begins from "second one" after technical insolvency has occurred (and not only after the three-week period allowed for filing the request has elapsed), the subsequent duties of conduct are particularly relevant for the managing director who wishes to act in accordance with his duties and make full use of the three-week period for filing.

(1) No payments

No more creditors may be paid once technical insolvency has occurred, in particular not from accounts in credit or current accounts in debit if the overdraft facility is secured against the assets of the company. Although payments may in theory still be made from an unsecured debit account, this might constitute a breach of duty towards the bank. It is not permitted, on the other hand, to receive payments on unsecured debit accounts. That is why the managing director is obliged to get in touch with the customers and persuade them to make their payments to a different account that is in credit rather than the account to which they might normally make them. If no such account exists, the managing director must open a credit account and persuade the customers to withhold their payments until then.

(2) No other reduction in net worth

The managing director may also not do anything that would result in a reduction in the net worth of the company when considered by itself. Nor may he deliver any goods if the customer has already paid for them in advance. Only if delivery of the goods generates a claim for the GmbH (as in the usual course of business) the goods may be delivered.

(3) "Permitted" payments

The managing director may only make payments if not doing so would threaten the collapse of the business. He may accordingly continue to pay electricity, water, gas and telephone bills. Generally he is allowed to pay suppliers on a cash-in-advance basis so that they supply the necessary raw materials. In addition, he may pay the employer's share of social insurance contributions as well as payroll taxes and VAT, because otherwise he could make himself personally liable towards the social security institutions or the tax authorities.

(4) Liability risks in the event that insolvency has occurred

The standard duties of the insolvency administrator in any insolvency proceedings include examining the possibility of liability claims against the managing director. The insolvency administrator will therefore always check when the insolvent GmbH was already technically insolvent, regardless of when the request for insolvency was actually filed. If it turns out that the GmbH was already illiquid or overindebted before the request for insolvency was filed, the managing director is liable for all payments and reductions in net worth occurring since that date. Even relatively short periods of time can lead to considerable liability amounts. Generally almost all expenditure of the enterprise constitutes prohibited payments within the meaning of section 64. Only a few payments are privileged (see a) cc) (3) above), and the privilege generally only applies for a short period of time. Since a technically insolvent enterprise rarely posts a profit, in the best case "breaking even", the expenditure is usually just as high as the sales (if not higher). The rule of thumb, therefore, is that the extent of the managing director's liability under section 64 corresponds in order of magnitude to the sales in the period of the delay in filing for insolvency. In the absence of any management liability insurance (D&O insurance), it is not uncommon for this liability to pose an existential threat for managing directors as well. Often the insolvency of a GmbH alone will perforce lead to the insolvency of the managing director also.

For this reason alone, it is vital to ensure that the request for insolvency is filed in time. For as long as the enterprise is "healthy", the conclusion of a D&O insurance policy is a matter of urgent consideration even for smaller GmbHs. Care must be taken to ensure that the policy terms include liability claims under section 64 and do not provide for any exclusion in the case of insolvency. The Higher Regional Court of Dusseldorf has recently decided OLG Dusseldorf, verdict of 20 July 2018 - 4 U 93/16  that a D&O-insurer is otherwise not obliged to cover liability claims under section 64.

2) From the point of view of the company

Section 64 has little relevance for the GmbH itself, at least for as long as it is "alive". The provision is ultimately only of relevance for the insolvency administrator. For the insolvency administrator, though, section 64 plays a major role in increasing the size of the insolvency estate, particularly as insolvencies in Germany are requested with an average delay of ten to twelve months. Nevertheless, in practice it is not easy for the insolvency administrator to demonstrate the claim.

a) Demonstration of illiquidity

If the illiquidity is to be determined precisely on the basis of a liquidity status, the liabilities due at every relevant point in time must be compared with the liquid assets available on those dates. Since the accounting departments of small GmbHs are often unable to analyse the due dates, frequently the accounting data will need to be processed all over again.

The burden of proof for the insolvency administrator can, however, be eased if a suspension of payments can be assumed on the basis of external indicators (section 17 (2) 2nd clause InsO). Such external indicators include enforcement measures of individual creditors, considerable levels of arrears with several or major creditors, in some circumstances also numerous reminders and enforcement notices for a long period of time and the fact that long overdue obligations had stopped being paid by the time insolvency proceedings were opened. If the insolvency administrator can demonstrate a suspension of payments on the basis of such external facts, the burden of proof is reversed. In that case the managing director he is taking legal action against would have to present a liquidity status and prove that the GmbH was still able to meet payments despite the external indicators.

b) Demonstration of overindebtedness

Given the considerable difficulties associated with valuation, it will likewise be far from simple for the insolvency administrator to prove overindebtedness if the commercial or tax balance sheet has not yet shown a negative equity. As soon, however, as the commercial or tax balance sheet shows a shortfall not covered by equity, the insolvency administrator can infer from this that the GmbH was also overindebted within the meaning of insolvency law. It is then up to the managing director at the centre of the legal action to prove that the GmbH was not actually overindebted (e.g. due to hidden reserves) or that it had a positive going-concern prognosis.

c) Demonstration of prohibited payments

Demonstration of the prohibited payments also requires a certain amount of effort, because the insolvency administrator must demonstrate all the payments in detail. This can be particularly complicated if the account balances varied sharply, e.g. an account being run temporarily in credit and temporarily in debit (known as an oscillating account). This is crucial for determining whether the outgoing or incoming payments are relevant for liability within the meaning of section 64.

d) Economic enforceability

Given the considerable liability amounts, a major role in the enforceability of the claim is played not least by the financial circumstances of the managing director. If no D&O insurance exists, it will therefore frequently be recommended that a financially oriented settlement with the managing director be sought instead of liability proceedings that can drag on for years.

3) From the point of view of the shareholders

Section 64 is of only secondary importance for the shareholders, because only in the rarest of cases can they be held liable under this provision. This would only happen if, through liability under section 64 – in the case of a very solvent managing director – the amount that can be realised for the insolvency estate is so high that, after all creditors of the estate (including the insolvency administrator) and all insolvency creditors (including those of lower rank) have been satisfied, there is an excess that can be distributed to the shareholders. While this set of circumstances is conceivable, since in terms of amount section 64 is not limited to the damage suffered by insolvency creditors, such a situation is really only possible in theory.

Section 64 sentence 3 establishes a right to refuse performance vis-à-vis shareholders Federal Court of Justice, verdict of 09.10.2012 – II ZR 298/11 = ZIP 2012, 2391, marginal number 18; very contentious - for an alternative view, Roth/Altmeppen, GmbHG, 8th ed. (2015), Section 64 marginal number 81; Baumbach/Hueck/Haas, GmbHG, 20th ed. (2013), Section 64 marginal number 107; HRG Munich, verdict of 06.05.2010 – 23 U 1564/10 = ZIP 2010, 1236, 1237 and HRG Munich, verdict of 22.12.2010 – 7 U 4960/07 = ZIP 2011, 225, marginal number 48 if the company is technically insolvent or if payment to the shareholder would exacerbate the technical insolvency or establish it in the first place.

4) Section 64 from the point of view of third parties

Section 64 establishes only an internal liability of the managing director towards the (insolvent) GmbH that is normally pursued by the insolvency administrator. Third parties can, however, come into the "enjoyment" of a managing director's liability under section 64 if the opening of insolvency proceedings is rejected for insufficiency of assets. In that eventuality third parties can attach the liability claim under section 64 against the managing director by way of individual enforcement Cf. Baumbach/Hueck/Haas, GmbHG, 20th ed. (2013), Section 64 marginal number 11 a; Roth/Altmeppen, GmbHG, 8th ed. (2015), Section 64 marginal number 9 if they have acquired an enforceable writ against the GmbH.