The Legal Basis and Economic Rationale of Subordinating Shareholder Loans
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans The Legal Basis and Economic Rationale of Subordinating Shareholder Loans Xinyi Wang (11392410) Supervisor: Prof. RJ (Rolef) de Weijs Universiteit van Amsterdam July 2019 1 The Legal Basis and Economic Rationale of Subordinating Shareholder Loans Abstract The subordination of shareholder loans has been adopted broadly around the world. The U.S. and Germany are the two leading countries with the most sophisticated rules on the subordination of shareholder loans. However, the legal basis of the subordination in the two jurisdictions differs from one another. Despite the differences, the general principle of Corporate Law and Insolvency Law provides the legal basis for both of them. As an addition to the legal basis, economic rationale is of an equally great concern when examining whether the subordination would bring the desired outcome and efficiently modify the incentives of the shareholders who could otherwise make risky and inefficient investment decisions. From both a legal and economic perspective, this paper provides a justification to adopt subordination rules of shareholder loans. Firstly, this paper analyses whether the subordination is justified, based on the general principles of Corporate Law and Insolvency Law. Secondly, from the economic perspective, this paper studies whether subordination of shareholder loans could help to mitigate the conflicts of interest between shareholders and creditors, and prevent the shareholders from making poor investment decisions. As the first attempt in research, in this paper I have combed through the Prospect Theory and Shareholder loans. Keywords: Subordination, Shareholder Loans, Insolvency Law, Prospect Theory 2 The Legal Basis and Economic Rationale of Subordinating Shareholder Loans Table of Contents 1. Introduction ................................................................................................................ 4 2. Legal Practices and Rationale of Subordination. ....................................................... 8 2.1 Subordination of Shareholder Loans in the U.S. and Germany ........................... 9 2.2 Legal Basis: Corporate Law ............................................................................... 12 2.3 Legal Basis: Insolvency Law ............................................................................. 16 3. Economic Rationale of Subordinating Shareholder Loans ...................................... 20 3.1 Corporate Governance: Conflicts of Interest ..................................................... 20 3.2 Bright Side of Debt: Monitoring Power of Creditors ......................................... 22 3.3 Dark Side of Debt: Risk Shifting and Debt Overhang ....................................... 24 3.31 Risk Shifting ................................................................................................. 24 3.32 Debt Overhang .............................................................................................. 26 3.33 Dynamic Model of Risk Shifting and Debt Overhang ................................. 28 3.4 Prospect Theory: Why Would the Shareholders Like to Delay an Efficient Liquidation and Attempt an Unnecessary Rescue? .................................................. 34 3.41 Without Shareholder Loans .......................................................................... 38 3.42 With Shareholder Loans ............................................................................... 42 3.5 Cost of debt: Mismatch of the Risk and Cost..................................................... 45 4. Conclusion and Suggestion: ..................................................................................... 50 Bibliography ................................................................................................................ 53 3 The Legal Basis and Economic Rationale of Subordinating Shareholder Loans 1. Introduction Subordination of shareholder loans has been adopted in Germany, the U.S., Austria1, Spain2 and other jurisdictions, based on different legal principles with a different degree of restrictions. The debates on subordination rules vary based on different considerations, such as legal justification, political preference and also, very importantly, economic efficiency. In Germany - one of the first countries to bring about the case law 3 on subordination rule - the trend to tighten the restrictions on shareholders’ loan has been strong. It has brought them to the point where the subordination rule on shareholders’ loan is not only enforced solely under the condition that loans were granted at moment of crisis4, but the rule is being spread to all loans5. Does the trend suggest that, for the protection of the creditor’s claims, stricter rules on hybrid financing, especially shareholder loans are beneficial? A myriad of scholars in different countries such as Germany 6 , the U.S. 7 and the Netherlands 8 argue about the necessity to add the subordination rule to legislation. Even though the number of countries to include the subordination rule of shareholder loans in their corporate law code or insolvency law code is growing, the legal bases and economic rationale are still being disputed. In 1 Eigenkapitalersatz-Gesetz (EKEG – Austrian Act on Capital Replacing Financing) § 2. Here the legislation provides a rebuttable presumption of a crisis if the solvent ratio(equity/asset) is below 8%. 2 Ley Concursal (Spanish Insolvency Act) § 92. 3 BGH, 14.12.1959 – II ZR 187/57. 4 Gesetz betreffend die Gesellschaften mit beschränkter Haftung (GmbHG – Limited Liability Companies Act) § 32. The rule was modified in 2009. 5 See Insolvenzordnung (InsO – German Insolvency Code) § 39. 6 See e.g. Carsten P Claussen, 'Zeitwende im Kapitalersatzrecht' (1994) 85 GmbH-Rundschau 9.; Carsten P Claussen, 'Die GmbH braucht eine Deregulierung des Kapitalersatzrechts' (1996) 87 GmbH- Rundschau 316.; Dirk A Verse, 'Shareholder Loans in Corporate Insolvency–A New Approach to an Old Problem' (2008) 9 German Law Journal 1109. 7 See e.g. David Gray Carlson, 'The Logical Structure of Fraudulent Transfers and Equitable Subordination' (2003) 45 Wm & Mary L Rev 157.; Andreas Cahn, 'Equitable subordination of shareholder loans?' (2006) x17 European Business Organization Law Review (EBOR) 287. 8 See e.g. Roelf Jakob de Weijs, 'Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning against Creditors by Upholding the Debt–Equity Divide' (2018) 15 European Company and Financial Law Review 403.; RJ de Weijs, 'Vooruit met de achterstelling: over de positie van aandeelhoudersleningen in én voor faillissement' (2008) 139 Weekblad voor Privaatrecht, Notariaat en Registratie 313. 4 The Legal Basis and Economic Rationale of Subordinating Shareholder Loans general, there is a consensus that shareholders’ loans could be subordinated based on the objective of insolvency law, which is to protect the distributable value of bankruptcy assets and maximise the collective return to creditors9. But for many jurisdictions, the bankruptcy law is only procedural law, and the legal basis of subordination needs to be built upon substantive law, such as the example of corporate law10. Therefore, to justify the subordination of shareholder loans, it is also essential to root it in the principle of corporate law or other substantive law. Professor de Weijs summarised three groups of main arguments regarding subordination of shareholder loans11 including the arguments on the definitions of shareholder loans and types of capital the shareholders are required to provide, the influence of the shareholders loans on the incentives of shareholders, and the objectives of overall framework of insolvency law. The first and third group of arguments are targeting to the legal basis of subordinating shareholder loans. Different from the first group of arguments, the second group is raised from an economic perspective, addressing the effects of subordination on the incentives of shareholders to engage in an efficient or inefficient rescue. Until now, there has been no general consensus on the subordination of shareholder loans from the economic perspective. The efficiency of the subordination rules has not been proved by a credible method and most of the literature that discussed the economic efficiency of shareholder loans is based on numerical examples and biased to some extent12. Among the few economic analyses of subordination rules, one of the most outstanding and frequently discussed disagreements has been provided by Gelter. He stated that subordination of shareholder loans cannot prevent all the inefficient rescue, but it might even hinder the efficient 9 See Chapter 1 and 2, Vanessa Finch and David Milman, Corporate insolvency law: perspectives and principles (Cambridge University Press 2017). 10 For example, in China, the bankruptcy law is procedural law, the objective of which is to guarantee the fulfilment of obligations and rights conferred by the substantive law such as corporate law and contract law. Therefore, to include subordination rules inside Chinese legislation, we need to find the legal basis from the substantive law, such as corporate law and set the corresponding provisions in insolvency law (procedural law) to guarantee the enforcement of such rules. 11 See de Weijs, 'Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning against Creditors by Upholding the Debt–Equity Divide', 421-425. 12 See Martin Gelter, "The subordination