Newsletter Corporate - February 2017

Current issues concerning investments in Germany and German subsidiaries of US companies

The following provides a summary of issues that have attracted attention in the German M&A practice recently. For further information click the "Show More" link at the end.

  • M&A - Balance Sheet Guarantees: German case law has recently developed new requirements for drafting Balance Sheet Guarantees in Share Purchase Agreements. If not properly drafted, such Balance Sheet Guarantees may be regarded as so-called objective guarantees which are extensively interpreted and as a consequence may result in rather severe liabilities for a seller. Therefore, such Balance Sheet Guarantees have to be carefully drafted taking into account the latest developments and judgements in this regard.
  • M&A - Warranty and Indemnity Insurance: Warranty insurances have become more popular in Germany in recent years. However, the scope of their applicability and exclusions thereto, which are usually subject to the negotiations with the insurance providers, are now for the first time under review in a major litigation. As in Germany there is no established case law, precise drafting of the Representations & Warranties granted by a seller and mirroring this liability scheme in the Warranty and Indemnity Insurance is key.
  • M&A - Foreign Investment Control: German foreign investment control has recently become a new factor in planning investments in Germany, in particular because certain Chinese investments have been stopped by German authorities on this basis. There is a tendency by German authorities to construe the German foreign investment control more extensively then before with regard to certain important sectors. The relevant legal frame work is still under development, however, in the future it will often be required to liaise with German public authorities in advance and M&A transactions may also require to agree on public law agreements with German authorities on the use of sensitive business data in the future.
  • Data Privacy and Cybersecurity - New Legal Requirements: In about a year the new European Data Privacy Regulation will take effect, based on which companies in Germany and other European member states will have to boost their data privacy compliance programs and adjust their processing operations. Consequences for any non-compliance will be significant and will be based on a global turnover of the respective company. Companies which may be affected should take adequate actions for their German subsidiaries, such as getting an overview of the current status and starting to prepare for the following measures, purchasing data assets, reviewing data privacy compliance and overall taking a pro-active approach.
  • Employment Law – Pre- and Post-Transaction Considerations: German employment law, other than in some European jurisdiction, does not in any relevant way affect timing and deal certainly for investments in Germany. However, consideration will have to be made in advance to any post-M&A action plans relating to workforce restructuring. In particular any employee related due diligence should be conducted with a view on how to integrate the target’s business into the purchase’s own business in the post-closing phase.
  •  Tax Law – Deduction of Interest on Acquisition Financing and Repatriation of profits: Investments by U.S. investors in Germany should from a tax perspective be structured in a way that ensures interest deduction possibility on acquisition financing and efficient repatriation of profits.
  • Corporate Law

    M&A Related Aspects

    Recently, inter alia, the following issues have attracted attention in the German M&A practice.

    Balance Sheet Guarantee

    Customary Balance Sheet Guarantees in Share Purchase Agreements have recently been subject to a court ruling of the Higher Regional Court of Frankfurt whose consequences should be taken into account when negotiating such guarantees.

    The court had to decide on whether the disputed guarantee was drafted in an objective or subjective way and the consequences thereof for the determination of damages in case of a breach.

    The court decided that the relevant clause is an objective Balance Sheet Guarantee which has to be interpreted from the perspective of an objective observer and that the disputed with the effect that any related damages cannot be seen simply in the difference between the declared figure in the balance sheet and the actual figure. The damage rather has to be calculated taking into account the effect this breach would have had on the agreed purchase price.

    The foregoing court ruling demonstrates that Balance Sheet Guarantees, which in any event are among the key provisions in a Share Purchase Agreement, have to be drafted with utmost care to mitigate financial risks arising from unprecise wording and prevent situations where Balance Sheet Guarantees inadvertently qualify as objective guarantee with its severe consequences.

    Warranty and Indemnity Insurance

    Until a few years ago, certain deals could not be closed when Buyer and Seller were unable to agree on a usually acceptable guarantee system, such as the Balance Sheet Guarantee. Nowadays, using W&I Insurance has become a customary solution in German M&A practice.

    While in the United States it is quite common to close W&I Insurances, this concept is still new to the German M&A market, so that no case law has been established in this context.

    The acquisition of Grohe AG by the Lixil Group has led to the first major performance test of these W&I Insurances because the balance sheet with respect to JOYOU AG, a subsidiary of Grohe AG, was inaccurate. The legal dispute is focusing on the effects of contractual limitations and applicability of a W&I Insurance in case of wrongful acts and is the first major dispute that became public knowledge whose outcome remains still unclear.

    The initial principle of these W&I Insurances is to fully cover and mirror the warranties and indemnifications granted by the Seller under the Share Purchase Agreement. However, the W&I Insurances tend to exclude the liability for certain fields. These exclusions are the subject of negotiations between the parties. Our experience shows that  W&I Insurances tend to waive their exclusions against an increase of premium.

    To avoid facing claims under the W&I Insurance and as a consequence a loss of coverage, precise drafting and knowledge of the German practice in this regard is key, especially exclusions of the coverage of W&I Insurance and notification periods have to be analysed in detail.

    Foreign Investment Control – Global Protectionist Tendencies Give Rise to Think about Foreign Investment Control Restrictions

    Over the last years foreign investment control has been put on the agenda for investments in Germany and currently changes to the German foreign investment control rules are discussed.

    This is against the background that the German Federal Ministry of Economics and Technology has a general right to examine whether the public order or security of Germany is endangered by the direct or indirect acquisition of a German target through a non-European investor. In 2016, a discussion to intervene on the basis of such cross sectoral examination right by the German Federal Ministry of Economics and Technology has come up in connection with a number of transactions involving Chinese investors. The most prominent transactions affected by said examination right were the contemplated acquisition of Aixtron SE by Chinese investors (which eventually failed due to a veto by president Obama regarding the indirect acquisition of the US activities of Aixtron SE) and the contemplated acquisition of the majority of the shares in the German robot manufacturer KUKA AG by Chinese investors.

    There are little to no precedents in the German M&A market in which the general cross sectoral examination right under the German foreign investment control regime detrimentally impacted the acquisition of German targets. It remains to be seen, if the general foreign investment control rules in Germany will be used to politically influence the M&A market in general or if the discussion about a better protection of German companies against foreign investors has only come up in light of the upcoming elections in Germany in 2017. In any event, the potential impact of foreign investment control rules on transactions involving German companies needs to be assessed more thoroughly than in the past, irrespective of whether you want to invest or to divest in Germany. Subject to the specific circumstances of the transaction in question on will have to consider to approach the German authorities on foreign investment control aspects upfront to receive an indication on whether the specific transaction is regarded as sensitive from a foreign investment control perspective. We have also recently experienced that the German authorities may request the entering into public law agreements containing certain restrictions with respect to the transaction, if the target’s business is deemed as sensitive by the German authorities. There will be further development in the foreign investment control practice of the German authorities with respect to M&A transactions which will have to be taken into account when planning investments in Germany.

    Data Privacy and Cybersecurity

    Less than 18 months from now, the new European Data Privacy Regulation (“GDPR”) will take effect.  Germany and other European Union Member States will soon have new data privacy and cybersecurity laws that will require companies, including service providers outside the EU that either service customers or target European residents, to boost their data privacy compliance programs and adjust their processing operations.  The consequences for non-compliance will be significant.  GDPR authorizes fines of the greater of 4% of global turnover or € 20,000,000.  In addition, depending on the EU Member State, non-compliant companies face significant risk of class actions for injunctions and, damages that will likely lead to increased data privacy related litigation. Further, depending on the business sector and size of the business, companies may be subject to increased requirements on data IT security.

    Action Items for Corporates:

    • Get an Overview and Start to Prepare
      While May 2018 seems a long time to go, companies would be well-advised to immediately start preparing for GDPR compliance.  By the very nature of the technologies and systems affected it will likely require significant time to understand and then manage the data processing and transfer activities, whether within a group of companies or between a company and its outside vendors. For example, new applications that process personal data must be designed to incorporate the requirements of Privacy by Design and Privacy by Default which essentially require that applications be designed to not use more personal data than needed and/or have deactivated by default any features that go beyond what is required for a specific data processing purpose. In addition, applications must in general ensure that personal data will be physically deleted once the purpose for which such data was collected no longer exists.  While this may sound doable before May 2018, when GDPR goes into effect, the reality is that currently only a fraction of applications comply with these requirements. Non-compliance will, starting from May 2018 not only lead to the risk of significant fines but may actually be a show-stopper if a company wants to sell its applications or services to EU customers.
    • Purchase of Data Assets
      Where companies are considering the purchase of customer data from a company in the EU, they will need to carefully review and assess how such data can be transferred and used in compliance with data privacy laws. Supervisory authorities have become increasingly active in reviewing the sale of customer data and have issued significant fines in recent months where customer data was purchased without getting consent or at least notifying the concerned customers.  Non-compliance with data privacy laws could lead to both fines, but prohibition on use of the data entirely, thereby rendering the data asset worthless. 
    • Review Data Privacy Compliance of Data Sensitive Target Companies
      GDPR will also apply to non-EU companies that processes personal data received from EU customers or target EU residents with services or products (e.g., via online behavioral monitoring).  Investors are thus well-advised to carefully review whether the processing operations of a target are in compliance with EU data privacy law. The most innovative applications and/or services can be rendered worthless for the European market if they not comply, or cannot be made to comply, with the new GDPR requirements.
    • Take proactive approach
      Overall, companies should be proactive, and even communicate their efforts to customers to gain trust and a competitive advantage. Companies should adjust their strategy and turn the new laws into a key success factor.


    Employment Law

    German Employment Law provides for a rather high standard of employee protection and co-determination rights of employee representative bodies. This is especially true when it comes to M&A transactions and restructurings. However, these particularities can be dealt with:

    Pre-Transaction Considerations

    In M&A transactions, there are certain information rights vis-à-vis employee representative bodies of the target company that have to be taken into account.

    • Employee representative bodies at the target company have to be informed about the potential purchaser and his intentions with a view to the future business activity, particularly about the consequences for the employees.
    • However, employee representative bodies cannot stop or delay the transaction, even if they consider the information given is wrong, insufficient or no information has been provide at all.

    In case a change to the operation results from the transaction (e.g., a split of an operation in a carve-out scenario), co-determination rights are triggered which will require negotiations with the works council at the target company on a reconciliation of interests and a social compensation plan. However, dealing with these co-determination rights can only delay implementation of the change to the operation, but not completion of the transaction. Anyway, costs involved with and time necessary for these negotiations need to be considered beforehand.

    Post-Transaction Considerations

    Surprisingly, a lot of companies still underestimate the importance of integration of the acquired business. The main purpose of the employment due diligence should not only be to get a thorough understanding of the current employment terms and conditions of the target company, but also to to get a thorough understanding of how to integrate the business into the purchaser’s own business. Post-transaction aspects for example involve the merger of existing operations of the target company and the purchaser, merger with already existing entities of the purchaser in Germany, relocation of businesses and adjustments to headcounts.

    Post-closing restructuring (e.g., headcount reduction) will usually trigger co-determination rights of the works council since the restructuring will constitute a change to the operation. The target company will have to negotiate a reconciliation of interests and a social compensation plan with the works council in order to implement the restructuring. Restructuring may not be implemented without negotiations with the works council have been completed or finally failed.

    In companies employing more than ten employees in Germany, employees with continuous employment of more than six months enjoy termination protection which will usually lead to termination of employment by way of separation agreements and severance payments. By rule of thumb, employees receive severance of 0.5 up to 1.5 monthly gross salaries per year of service.

    Tax Law

    Inbound investments into German assets by US investors traditionally bring a variety of German tax issues to the fore. Two ever relevant topics are the deduction of interest on acquisition financing from the profit of the acquired company and the repatriation of profits from Germany to the US. Whereas the BEPS action plan of the OECD to fight “base erosion and profit shifting” has proposed changes for both topics, for now, the German rules will stay as they are.

    Deduction of Interest on Acquisition Financing

    Investors typically use both equity, shareholder loans and bank debt to finance the acquisition of German companies. As a matter of rule, interest on shareholder loans as well as bank debt are fully deductible from the profits of the target company under the following conditions:

    Repatriation of profits

    • Free cash can be paid (‘repatriated’) from the TargetCo to the non-German investor (its intermediate vehicles) as a repayment of shareholder loans or as a profit distribution.
    • Shareholder loans can be repaid abroad without any German tax consequence.
    • A profit distribution triggers German withholding tax (WHT) of 26.375%. The non-German investor (intermediate holding) can claim a WHT exemption or refund only if it is sitting in an EU jurisdiction or another jurisdiction with double tax treaty protection against German WHT on dividends. However, Germany will apply strict substance and activity tests to avoid refund of WHT in so called “treaty shopping” situations where the ultimate investor is not eligible for a WHT exemption or refund and the intermediate holdings sit in privileged jurisdictions, but lack substance or activity (merely passive holdings).
    • Certain common mitigation instruments are available to circumvent lack of substance or activity on the intermediate level. A cross-border merger of a German company with profit reserves onto an EU-company is a common instrument, as well as a so called cross-border conversion or a leveraged recapitalization which may also fit in a given scenario.
    • The BEPS action plan of the OECD foresees increased measures against so called treaty shopping (Action Point 7). The cross-border merger of a German company with profit reserves onto an EU company would become ineffective with regard to WHT mitigation under these rules (note that the tax authorities seemingly allege inefficiency under the current law in several individual proceedings). The legislator has not adopted these rules such that the law remains unchanged insofar.  With the caveat above, the abovementioned instruments - including the merger - remain still available for repatriation of profits.