German Corporate Law Update: Important Changes in Acquisitions and Investments

by Orrick, Herrington & Sutcliffe LLP
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Orrick, Herrington & Sutcliffe LLP

For companies interested in investing in, purchasing or selling German companies, here are several recent developments related to Data Privacy and Cybersecurity, M&A, Employment and Tax law that are helpful to keep in mind.

Data Privacy and Cybersecurity

Less than 18 months from now, the new European Data Privacy Regulation (“GDPR”) will take effect.  These new data privacy and cybersecurity laws will govern companies in Germany and other European Union member states, including service providers outside the EU that service customers or target European residents, to boost their data privacy compliance programs and adjust their processing operations.  The consequences for noncompliance 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, noncompliant 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 like a long way off, companies should immediately start preparing for GDPR compliance.  Because of the technologies and systems affected, it will likely require significant time to understand and 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 require that applications do not use more personal data than needed and deactivate by default any features that go beyond what is required for a specific data processing purpose. In addition, applications must ensure that personal data will be physically deleted once the purpose for which such data was collected no longer exists.  Today, only a fraction of applications comply with these requirements. Consequences of noncompliance will begin starting May 2018, and include significant fines and serious impediments 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 the 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 prior consent, or at least notifying the concerned customers in advance. In addition, noncompliance can lead to prohibition on the use of the data entirely, rendering the purchase of the data asset worthless. 
  • Review Data Privacy Compliance of Data Sensitive Target Companies
    GDPR will also apply to non-EU companies that process personal data received from EU customers or target EU residents with services or products (e.g., via online behavioral monitoring).  Investors should carefully review whether the processing operations of a target are in compliance with EU data privacy law. The most innovative applications and/or services will become incompatible with the European market if they do not comply, or cannot be made to comply, with the new GDPR requirements.
  • Take a Proactive Approach
    Overall, companies should be proactive and communicate their efforts to customers to gain trust and a competitive advantage.  

Corporate Law

For companies interested in investing in or purchasing German companies, here are several developments in the M&A arena to keep in mind.

Global Protectionist Tendencies Give Rise to Potentially Heightened Foreign Investment Control Restrictions

When investing in a German company through a non-EU entity, be aware that German authorities are exerting greater control than they used to when deciding whether to permit these transactions to go forward, and changes to the German foreign investment control rules are discussed.

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-EU investor. In 2016, a discussion to intervene on the basis of such right by the Ministry arose in connection with a number of transactions involving Chinese investors. The most prominent transactions were the contemplated acquisition of Aixtron SE by Chinese investors, which eventually failed due to a veto by President Obama, and the contemplated acquisition of a majority of shares in the German robot manufacturer KUKA AG by Chinese investors.

There are few precedents in the German M&A market in which the general cross‑sectoral examination right detrimentally impacted the acquisition of German targets. It remains to be seen, though, if the general foreign investment control rules in Germany will be used to politically influence the M&A market. In all cases, 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 divest in Germany. Anyone contemplating a transaction of this nature will have to consider whether to approach the German authorities in advance to receive an indication on whether the specific transaction is regarded as sensitive from a foreign investment control perspective. In some instances, we have seen that German authorities request a public law agreement containing certain restrictions with respect to the transaction, if the target’s business is deemed sensitive. We anticipate there will be further developments in this area.

Warranty and Indemnity Insurance Under Review in Major Litigation

Until a few years ago, certain deals stalled when Buyer and Seller were unable to agree on a mutually acceptable guarantee system, such as the Balance Sheet Guarantee. Now, using Warranty & Indemnity (W&I) Insurance has become commonplace in German M&A practice to avoid this stalemate.

While W&I Insurance is common in the United States, this concept is still new to the German M&A market. W&I Insurance usually fully covers and mirrors the warranties and indemnifications granted by the Seller under the Share Purchase Agreement, with certain exclusions of liability. These exclusions are the subject of heavy negotiations between the parties. Our experience shows that W&I Insurances tend to waive their exclusions against an increase of premium.

But now it looks as if the practice will be tested by the courts for the first time in major litigation. 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 focused on the effects of contractual limitations and applicability of W&I Insurance in case of an inaccurate balance sheet.

While we await the outcome, precise drafting and knowledge of the German practice in this regard is key to avoid similar lawsuits, especially an understanding of the exclusions of coverage of W&I Insurance and notification periods.

Court Interprets Balance Sheet Guarantee as Objective, With Consequences

Be careful when drafting Balance Sheet Guarantees in Share Purchase Agreements, as recent German case law imposes monetary consequences depending upon how the guarantee is categorized.

The question before the Higher Regional Court of Frankfurt (pronouncement of judgement: 07 May 2015) was whether the disputed guarantee was drafted in an objective or subjective way. Depending upon that finding, a different calculation will be used by the court when determining damages in the case of a breach.

In this instance, the court held that the relevant clause was an objective Balance Sheet Guarantee. Because of this, the court found that the figure must be analyzed from the perspective of an objective observer, and that damages could not be determined by looking at the difference between the declared figure in the balance sheet and the actual figure. Instead, damages were to be calculated by taking into account the effect this breach would have had on the agreed purchase price.

This ruling demonstrates that Balance Sheet Guarantees—one of the key provisions in a Share Purchase Agreement—must be drafted with utmost care to mitigate financial risks arising from imprecise wording that might render such guarantee as objective inadvertently.

Employment Law

German Employment Law protects employees and employee representative bodies. This is especially true when it comes to M&A transactions and restructurings. When entering into an M&A transaction, keep in mind these considerations with respect to workforce restructuring.

Pre-transaction Considerations

In M&A transactions, employee representative bodies of the target company have certain information rights.

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

In the event a change to the operation results from the transaction (e.g., a split of an operation in a carve-out scenario), codetermination rights are triggered. These rights will require negotiations with the works council at the target company on a reconciliation of interests and a social compensation plan. While they may delay implementation of the change to the operation, they cannot impede completion of the transaction, though costs and time necessary for these negotiations should be considered beforehand.

Post-transaction Considerations

A lot of companies still underestimate the importance of integration in the acquired business. The main purpose of the employment due diligence should not only be a thorough understanding of the current employment terms and conditions of the target company, but also an understanding of how to integrate the business into the purchaser’s own business. This understanding is necessary in the event of a merger of existing operations of the target company and the purchaser, a merger with already existing entities of the purchaser in Germany, or relocation of businesses and adjustments to head counts.

Postclosing restructuring (e.g., head count reduction) will usually trigger codetermination 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 unless negotiations with the works council have been completed or have finally failed.

For 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 at the company.

Tax Law

Inbound investments into German assets by U.S. investors traditionally bring two main German tax issues to the fore. The first is the deduction of interest on acquisition financing from the profit of the acquired company, and the second is the repatriation of profits from Germany to the U.S. Whereas the Organisation for Economic Co-operation and Development's (OECD) action plan to fight “base erosion and profit shifting” contains proposed changes for both topics, for now, the German rules will stay as they are.

Deduction of Interest on Acquisition Financing

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

  • The purchasing vehicle (AcquiCo) and the target company (TargetCo) are merged by way of corporate reorganization under the rules of the German Reorganization Act.
  • Alternatively, AcquiCo and TargetCo may be consolidated in a tax group by way of a profit and loss pooling agreement between the two.

In either scenario, interest on shareholder loans must meet the arm’s length test. The same may be relevant even for bank loans in certain situations (back-to-back financing, other).

The German “interest ceiling,” which stands at 30 % EBITDA, may not be exceeded. Exceeding net interest cannot be deducted from taxable income in any given year. Note, though, that the interest ceiling is not applied if the net debt per entity/tax group does not exceed a threshold of three million EUR, or if the investor can prove that the leverage of the German company is not relevantly higher than that of the entire group.

Repatriation of Profits

Free cash can be paid (“repatriated”) from the TargetCo to the non-German investor (its intermediate vehicle) as a repayment of shareholder loans or as a profit distribution. Likewise, 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 “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 cross-border conversion or a leveraged recapitalization.

The action plan of the OECD forecasts increased measures against “treaty shopping” (Action Point 7). The cross-border merger of a German company with profit reserves into 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 yet.  With the caveat above, the abovementioned instruments—including the merger—remain available for repatriation of profits.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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