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
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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
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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
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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.
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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 of shareholder loans in bankruptcy," International Review of Law and Economics 26, no. 4 (2006).
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans rescue attempt13.
To decide whether it is beneficial or appropriate to subordinate shareholder loans, it is necessary to combine the analysis of legal and economic rationale. Is the shareholder at liberty to decide for himself upon the form and shape of his investment?14 Legal rationale provides the basic legislative logic and justification for subordination of shareholder loans. For instance, if a country has an insolvency law system without pari passu principle and lacks protection of a common pool distribution; or the corporate law does not provide a limited liability to shareholders and the shareholders are liable for all the debts in the firm, then in such jurisdiction it might be unjust to adopt the subordination of shareholder loans. Before we adopt a new rule, we need to ensure the aim and effect of such rule will match the principles and objectives of the existing law that governs related issues in the jurisdiction. Economics generally provides a behavioral theory for prediction of how people respond to laws15. The economic rationale, therefore, could help us to predict how the rules would influence the behavior of individuals subjected to them. Economic analysis could be used as an ex-ante instrument to predict the necessity and feasibility of the rules, or as an ex-post instrument to test the actual effect of the new rule and help to refine or amend the existing regulation in the future. Economic efficiency always interacts with the legal justification. As Philippon argued, inefficiencies create room for government intervention16 , thus, legislation is a tool to correct the inefficient distribution and behaviour.
A general analysis of both legal and economic rationale for subordinating shareholder loans is beneficial and necessary for the future study. Before a new rule is codified, it is recommended to find a legal rationale to support it and predict the economic influence in case such rule is adopted. Moreover, in the economic analysis, a
13 Martin Gelter, 'The subordination of shareholder loans in bankruptcy' (2006) 26 International Review of Law and Economics 478. 14 See de Weijs, 'Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning against Creditors by Upholding the Debt–Equity Divide', 418. 15 Robert Cooter and Thomas Ulen, Law and economics (Addison-Wesley 2016) 3. 16 Thomas Philippon, 'Debt overhang and recapitalization in closed and open economies' (2010) 58 IMF Economic Review 157: “Inefficiencies create room for government interventions.”
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans trade-off between the costs and benefits is one of the main concerns. All the rules might have their positive and negative influence, and it is necessary to balance it.
The research question here is as whether from the legal and economic perspective, subordinating shareholder loans is justified or efficient. This paper illustrates the research question by analysing the principles of the general legal framework and the economic influence on the behavior of shareholders.
The paper is divided into four sections. In the first section, I briefly introduce the concepts and legal practices of subordinating shareholder loans, and outline three groups of main arguments regarding the subordination-rules. In the second section, the legal basis for subordination of shareholders loans will be analysed based on the principles of corporate law and insolvency law. In the third section, the economic rationale will be shown from the perspective of corporate governance to explain that shareholder loans might give the shareholders more incentive to perform riskier behavior and aggravate the conflict of interest between shareholders and creditors. In the last section, a conclusion will be made, including my suggestion that subordination rules could be adopted if the legal principles discussed in section two are applicable in a given jurisdiction and that the conflict of interest between shareholder and creditors is of great severity.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans 2. Legal Practices and Rationale of Subordination.
As mentioned in the above section, there are main three groups of arguments regarding subordination rules. The first group of arguments consists of definitions of shareholder loans and types of capital the shareholders are required to provide, addressing mainly the legal basis of subordination. Shareholders are the “legal owners” of the firm from the legal perspective17, and as the owners of a firm, they should bear certain risks of daily operations, with the funds they injected inside the corporation18. However, since many jurisdictions have abandoned the minimum capital requirements in their corporate law19, it might be interpreted as shareholders are in no way obliged to bear risks anymore. This change might give shareholders a signal that the capital they have injected in the firm is not necessarily the risk-bearing capital with a non-fixed return20. On the basis of this argument, it might be wrongfully concluded that there is no legal basis to subordinate shareholder loans from corporate law perspective. The last group of arguments of subordination relates to the objective of overall framework of insolvency law. With the help of shareholder loans, the shareholders could capture the entire value of assets left in the firm by setting full security rights on their loans, which is inconsistent with the objective of bankruptcy frame to protect the creditor’s right and distribute the common pool under pari passu principle21.
Through elaborating the two groups of arguments mentioned above, I will analyse the legal rationale of subordinating shareholder loans in this section, based on
17 The issue of firm ownership is an ongoing debate, and scholars who support shareholders to be the legal owners justify their arguments as shareholders to be the holders of shares. But someone also believes that the ones with control right, govern the firm should be the legal owner. Based on the agency and principle theory, the separation of ownership and control right brings conflict of interest to the corporate governance, therefore in this paper shareholders are deemed to be the owners of the firm. 18 Equity is deemed to be a type of risk bearing capital without fixed return. 19 Reinier Kraakman, The anatomy of corporate law: A comparative and functional approach (Oxford University Press 2017) 124. 20 Jaap Barneveld, Financiering en vermogensonttrekking door aandeelhouders: een studie naar de grenzen aan de financieringsvrijheid van aandeelhouders in besloten verhoudingen naar Amerikaans, Duits en Nederlands recht (Kluwer 2014) 532. 21 See Philip R Wood, Principles of international insolvency, vol 1 (Sweet & Maxwell 2007) 874-890.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans the principles of two different legislations, which are corporate law and insolvency law.
2.1 Subordination of Shareholder Loans in the U.S. and Germany
The legal rationale regarding the rules addressing shareholders loans might be covered by various fields of legislation and many jurisdictions have adopted cross-effect22 on the subordination of shareholder loans. Andreas Cahn suggested that the shareholders loan could be subordinated based on the law of fraudulent conveyances and unlawful preferences, supplemented by a general prohibition of securing shareholder loans23.
For instance, in the U.S., the earlier case supporting subordination of shareholder loans was based on the misuse of corporate form resulted as an abuse of controlling power by the shareholders24, where subordination was a softer alternative of Veiling Piercing25. The shareholders will be liable for the adequacy capital resulted from such shareholder loans under bankruptcy procedure26. The notion of subordination as an equitable power of the bankruptcy courts comes from the Case Pepper v. Litton27. Jay L. Koh described the earlier objective of subordination as “aimed at piercing formal and legal subterfuges to ensure that bankruptcy estate was properly distributed among similarly situated creditors, preventing superficially legal behavior from creating unfair or inequitable advantages in priority28”. When exercising the equitable subordination, the court has its discretion to test the conduct of the shareholder “who provide shareholder loans, aiming to figure out whether there is an “inequitable conduct” hidden
22 Here the cross-effect refers to the subordination rules reflecting several principles across different fields of law. 23 See Cahn, 'Equitable subordination of shareholder loans?', 287. 24 William P Hackney and Tracey G Benson, 'Shareholder Liability for Inadequate Capital' (1981) 43 U Pitt L Rev 837, 863-878. 25 Ibid 863-888. 26 See Taylor v. Standard Gas and Electric Co., 306 U.S. 307, 59 S. Ct. 543 (1939). 27 Carlson, 'The Logical Structure of Fraudulent Transfers and Equitable Subordination', 198.; See Pepper v. Litton, 308 U.S. 295, 60 S. Ct. 238 (1939). In this case Litton’s claims was subordination because of the existence of fraudulent scheme, which impairs the rights of Pepper. 28 Jay L Koh, 'Equity unbound: A meaningful test for equitable subordination' (1997) 16 Yale L & Pol'y Rev 467: “Exercised by early courts as an application of their equity powers in bankruptcy, equitable subordination was aimed at piercing formal and legal subterfuges to ensure that a bankruptcy estate was properly distributed among similarly situated creditors. Courts flexibly examined the conduct of creditors, originally focusing on insiders, to prevent superficially legal behavior from creating unfair or inequitable advantages in priority.”
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans underneath such loans.
Even though the U.S. legislations made an effort to regulate the subordination rules based on a test of “inequitable conduct”, there is still no clear definition of “inequitable conduct”. The court has a certain extent of discretion to test the “inequitable conduct”. Based on article 510 of the US Bankruptcy Code 29 and following the landmark case In re Mobile Steele30, three conditions need to be met before subordination can be exercised: shareholder needs to behave in an inequitable manner, conduct must have resulted in injury creditors, and subordination must fit within the framework of the bankruptcy act31. The court has also articulated three general categories of inequitable conduct: 1) Fraud, illegality, or breach of fiduciary duties; 2) undercapitalisation; and 3) a claimant’s use of the debtor as a mere instrumentality or alter ego32. From the evolution of subordination rules on shareholder loans, we can determine that the initial rationale for such subordination has been covered by corporate law, which addressed the issue of abuse of controlling power and provision of inadequacy capital. Implementing the function of subordination in the US has relied on the insolvency law, during the distribution of bankruptcy assets33.
Similar with the U.S practice, the current German regulations on shareholders loans is also relying on the bankruptcy procedure34. However, the past legislation of
29 See United States Bankruptcy Code (Chapter XI of the Bankruptcy Act) § 510. Subordination (c): Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may— (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or (2) order that any lien securing such a subordinated claim be transferred to the estate. 30 In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977). 31 Richard Squire, Corporate Bankruptcy and Financial Reorganization (Wolters Kluwer Law & Business 2016). 32 Barry E Adler, Douglas G Baird and Thomas H Jackson, Bankruptcy, Cases, Problems, and Materials, vol 4 (Foundation Press 2016). 33 See note 29. 34 See Insolvenzordnung (InsO – German Insolvency Code) § 39: “The following creditors will rank after the insolvency creditors: v) claims for the repayment of shareholder loans. (1) Im Rang nach den übrigen Forderungen der Insolvenzgläubiger werden in folgender Rangfolge, bei gleichem Rang nach dem Verhältnis ihrer Beträge, berichtigt (..) nach Maßgabe der Absätze 4 und 5 Forderungen auf Rückgewähr eines Gesellschafterdarlehens oder Forderungen aus Rechtshandlungen, die einem solchen Darlehen wirtschaftlich entsprechen.”
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans subordination was covered in the corporate law35. Because the shareholder loans are automatic subordinated under current German law, a prerequisite of bankruptcy is not necessary even though the rule is coved in insolvency code36. One of the reasons that rules of subordination is moved from corporate law to insolvency law is to make sure a broad coverage of subordination rules that all kind of legal entities are subject to such rules. Subordination of shareholder loans was first brought to the case law in the 1950s. German codified the doctrine of subordination into article 32a GmbHG in 1980 as the complementary of case law. The loan provided by shareholders should be qualified as capital (equity) if such loan was granted at a moment of crisis 37 and otherwise the shareholders would have provided equity. Shareholders as the residual claimants would benefit the most if the firm could survive the crisis. Therefore, shareholders loans, representing a rescue attempt to save the value for shareholders, would not be justified to be repaid unless the other creditors have already been repaid in full. Currently, the rules of subordination on shareholder loans are applied to all the loans provided by a shareholder, merely with the exemption of the minority shareholder who is not involved in management and whose equity contribution is less than 10% of the total equity38. D.A. Verse provided the legal rationale of such strict rules on shareholder loans, as following: “The most plausible explanation is that subordination of all shareholder loans will simply ensure that the shareholders adequately participate in the entrepreneurial risk of the company.” 39 Given the history and background, rules regarding subordination could still be considered to be of corporate law nature. The bankruptcy code of Germany adopted the subordination rules within the insolvency proceedings to address the issues relate to transaction avoidance and ranking of distribution. Therefore, the main legal rationale of subordination of shareholder loans in Germany is also provided in the principle of solvency law, when the shareholder loans are standing on the balance sheet of an insolvent company, and a fair distribution
35 See Gesetz betreffend die Gesellschaften mit beschränkter Haftung (GmbHG – Limited Liability Companies Act) § 32. The provision now is repealed. 36 There might be no difference from the legal prospective, because the provisions are applicable when the firms go bankruptcy. If the business is running well, there would not be much difference whether the provision is provided only under bankruptcy-condition or not. But from the economic perspective, the influence will be different. This is going to be explained in Section 3.5. 37 See note 4. 38 See Insolvenzordnung (InsO – German Insolvency Code) § 39(4) & (5). 39 Verse, 'Shareholder Loans in Corporate Insolvency–A New Approach to an Old Problem', 1116.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans decision is hindered by such loans.
From the legal practice of the U.S. and Germany during the past fifty years, we can notice that principles of both corporate law and insolvency law jointly built up the legal bases of subordinating shareholder loans.
2.2 Legal Basis: Corporate Law
While establishing a firm, there are two types of financial instruments that investors in the company can use: equity and debt. The basic principles of corporate law provide two different types of protection for shareholders and creditors respectively, in order to guarantee the fairness of treatment and build a bridge between the shareholders and creditors with respect to their obligations and rights.
From the shareholder’s side, the corporate law principle provides protection through the principle of “owner shielding”, where the shareholders are liable only within the limitation of the capital they contributed40. The shareholders are encouraged to take a certain degree of risk without being liable to an unlimited amount of loss, since they need to fulfil the capital requirements in the first place 41. This brings more flexibility to the shareholders when making investment decisions. However, around the world in the last century, such flexibility needed to be guaranteed by a sufficient amount of initial capital base42. The minimum capital requirement has its roots in the 20th century continental Europe43.
40 See Henry Hansmann, Reinier Kraakman and Richard Squire, 'Law and the Rise of the Firm' (2005) 119 Harv L Rev 1335. 41 Some countries have already decreased the minimum capital requirements for privately held company to zero, where the shareholders would not liable for initial capital injection. To some extent, the “owner shielding” principle was weakened under the latest corporate law practice. 42 Currently, The Netherlands, Germany and other European countries have already abandoned the minimum capital requirement for privately held company (which is not listed in the public). Only public companies within the European Union are required to hold at least €25.000 in capital, although many countries go above this minimum requirement. Therefore, for those private companies (or we can call them close companies), the shareholders would not be liable for initial adequacy capital. 43 World Bank, 'Why are minimum capital requirements a concern for entrepreneurs?' (2013)
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans While from the creditor’s side, entity shielding functions as the opposite of the “owner shielding” to emphasize that it involves shielding of the assets of the entity — the corporation — from the creditors of the entity’s owners.44 Entity shielding consists of two components from the perspective of creditors to protect their rights and their investments. The first component is priority of distribution of the firm’s assets over the shareholders. Creditors, as fixed rate investors, will be guaranteed a fixed interest payment and repayment of principles as the root of the investment relationship. The second component of entity shielding is regarding to liquidation protection, where the shareholders of the firm are prohibited from withdrawing their shares of assets at will45.
Those two components jointly form the legal bases for the creditors protection and enable the creditors to claim for their portion of investments back when the owner the firms fails to manage the business and results in a default. Since the creditors have no direct control over the firms, nor do they have sufficient influence on the investment decisions46, their willingness to invest their money into the firms is largely based on trust towards the shareholders and managers, and the legal protection47. Therefore, those rights should be granted exclusively to the creditors, as they are not allowed to be involved in the daily business operations and lack a voting right on the important investment decisions. Without such bottom level protection, the shareholders would not be able to attract external funds from other creditors, and based on the historic experience, equity is not the best option to expand the balance sheet48.
If we allow the shareholders to act as creditors at the same time, they will be able to stay under the protection of the umbrella designed exclusively to protect the creditors49, and the umbrella is not big enough to protect everyone. As a result, the
44 Kraakman, The anatomy of corporate law: A comparative and functional approach 7-11. 45 Ibid. 46 See Michael C Jensen and William H Meckling, 'Theory of the firm: Managerial behavior, agency costs and ownership structure' (1976) 3 Journal of financial economics 305. 47 See Sattar A Mansi, William F Maxwell and John K Wald, 'Creditor protection laws and the cost of debt' (2009) 52 The Journal of Law and Economics 701, 721. 48 Stewart C Myers and Nicholas S Majluf, 'Corporate financing and investment decisions when firms have information that investors do not have' (1984) 13 Journal of financial economics 187. From the pecking order theory popularized by Myers and Majluf, issuing new equity to finance new investment is not attractive for firms and will send signals to outside investors that the price value of firm is overvalued. 49 Umbrella here refers to the distributable assets to creditors.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans creditors might be squeezed out from the umbrella and exposed to the ultraviolet rays of bankruptcy. The main concern here, regarding the shareholder loans, is the capital risk. The capital risk here means the risk of capital shortage to back up the daily running of the business, which potentially brings a threat to creditors. Moreover, under such condition, where shareholders are insufficiently exposed in the daily business, default risk might be also aggravated. Traditionally, there are three types of rules in corporate law addressing legal capital, to protect the rights of creditors: minimum capital prescription, restriction on distribution and specific actions under serious depletion of capital50.
The first type of traditional protection of the capital risk is the establishment of a minimum capital requirement when the corporation is initially established. The main aim of this principle is to guarantee the capital is not less than the paid in or subscription capital of the corporation, which might cause potential capital risk to the investors51. No external creditors would be willing to invest in a corporation if there is no sufficient equity remaining in it, where the shareholders will not take any risk of business failure. The creditors need to see the shareholder exposed in the game, by which the profits and losses of the shareholders and creditors are linked together. Therefore, adequacy capitalisation involves a basic commitment of shareholders, with a guaranteed buffer to suffering losses before the creditors’ money are exposed to a business failure. However, since the minimum capital requirement has been abandoned, the shareholders would not necessarily want to guarantee any initial capital. Based on the limited liability principle, shareholders are only liable for the capital they have provided for the company. Without the minimum capital requirements, it appears as if the shareholders are not obliged to bear risks anymore. From this perspective, the argument seems to be correct that the shareholders do not necessarily have to bear the risks of the firms52 and the creditors should learn to protect themselves.
50 Kraakman, The anatomy of corporate law: A comparative and functional approach 124. 51 Ibid. 52 Barneveld, Financiering en vermogensonttrekking door aandeelhouders: een studie naar de grenzen aan de financieringsvrijheid van aandeelhouders in besloten verhoudingen naar Amerikaans, Duits en Nederlands recht, 532.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans However, there are two other types of protection in corporate law. In most jurisdictions such as the U.S., Germany, and the UK, corporate law includes rules to restrict the dividend payments, share repurchases and other transactions, which might dilute the corporate assets53. The extent to which such restriction could protect the creditors largely depends on the scope of the restricted transactions. Allowing shareholders to provide with security rights on their loans is another method to dilute the assets. As illustrated in previous paragraphs, the capital injected by the shareholders into the firm shall not be withdrawn at will during a financial crisis or a bankruptcy based on the principle of “Entity Shielding”. At the same time, however, allowing secured shareholder loans is equivalent to allowing the shareholders to withdraw their investment during bankruptcy. From this perspective, J. Barneveld’s argument is not fully correct. The shareholders are not obliged to bear risks, but they need to bear the risk related to the capital they have already injected into the firm, and the capital should be interpreted broadly that, both equity and loans provided by shareholders should be regarded as risk-bearing capital and could not withdraw at will.
The last type of protection refers to the actions required to be taken under loss of capital. As the on-going business takes place, the balance sheet of a firm might be extended largely. The failure of business might cause a sudden capital shortage of a firm. The firm may result in a situation where the assets are less than the existing outstanding loans during a crisis. Therefore, the creditors will be facing a looming default risk when the residual capital is under water and the shareholders are not able to absorb the future loss by themselves, and as a result, the creditors’ investments are exposed. In Europe, there are rules following a big short fall of capital54. The risk distribution in such a situation might be twofold: It might be reasonable that creditors need to protect themselves from situations of a sudden capital shortfall. They need to be able to evaluate whether the interest payments on their loans are enough to compensate for the risks they might face initially, when they sign the lending contracts. The creditors receive payments (or coupon payments) periodically to compensate the default risk they might face. However, after the short fall happens, in most cases the
53 Kraakman, The anatomy of corporate law: A comparative and functional approach 125-126. 54 Ibid 126-127.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans firm would not have the adequacy capital to carry on daily business and some jurisdictions even require shareholders to inject new capital 55or file for bankruptcy56. If shareholders’ equity is underwater after a serious loss or the shareholders are not able to repay the debt in time, creditors could submit the bankruptcy application to the court to stop the future loss and claim for distribution of the available assets of the firm, preventing the shareholders from conducting any further activities which might magnify their loss. Under such circumstances, if the shareholders still want to save the business and continue the operations, they need to bear the risks of a future loss. Allowing (secured) shareholder loans would decrease the loss shareholders might suffer and give them incentives to continue the inviable business or make risky investment decisions. It is unjust to let the creditors bear these extra risks.
As a conclusion, the creditors need to protect themselves, but the shareholders should provide a sound and safe capital environment with good intentions and faith, before the creditors take any actions. Under the corporate law principle, if the shareholder loans give shareholders an incentive to dilute the corporate assets rather than to maintain a sound business, or induce any behavior to escape their limited liabilities, the shareholder loan could be subordinated.
2.3 Legal Basis: Insolvency Law
When facing insolvency, the management of a company, as well as the creditor are able to file for opening of the procedure of liquidation57. One of the most important functions of the insolvency law is to protect the fair distribution of bankruptcy assets of a firm, and to guarantee all the creditors would be treated fairly and equally58. Such equitable treatment happens within groups of creditors59. Shareholders, as holders of equity, are
55 See Code de commerce (French Commercial Code) § L. 224- 2. 56 See Insolvenzordnung (InsO – German Insolvency Code) § 5a and §19. 57 Here liquidation is the used as a “narrow term”, where assets of the liquidated company are sold out of insolvency and the company ceases to exist. Corporate debtor does not survive after the liquidation. 58 See the entire book of Royston Miles Goode, Principles of corporate insolvency law (Sweet & Maxwell, 2011). 59 See Finch and Milman, Corporate insolvency law: perspectives and principles: “creditors share rateably within the particular ranking that they are given on insolvency by the law – a system of ranking that draws distinctions between different classes of unsecured creditors.”
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans subject to residual distribution after all the creditors have been paid in full60. Therefore, equity class will stand in the last row during the bankruptcy assets’ distribution.
However, if the shareholder loans are not subordinated, the shareholders will jump into the class of creditors, even with the secured right attached in some cases61. Under such circumstances, some creditors might even rank lower than the shareholders, or at least as low as shareholders. From this point of view, the shareholders are not the claimants of the “residual” anymore. Since the controlling shareholders can easily get secured rights on their loans, they will choose to provide secured loans when the business is risky or its financial situation is unhealthy, and get a fixed return from the firms without bearing potential risks of losing any of their investments if the business fails, while still capturing all of the upside gain62. In the worst case, secured loans can give shareholders incentives to go bankrupt. After claiming the assets back based on the security rights, the shareholders could easily get a fresh start63. That is inconsistent with the principle of insolvency law, which aims to protect the creditors when business is not performing well, and to prevent the shareholders from expropriating the wealth of the creditors. In case of giving out shareholder loans, shareholders might cut the line during the bankruptcy distribution and be first to receive the payment, which weakens the shareholders’ incentives of risk management during daily operation. Such inequitable distribution will induce more frequent business failures64. Therefore, based on the objective to protect the creditors and the pari passu distribution principle65,
60 Based on the bankruptcy codes of different jurisdictions around the world, we can find that the shareholders rank at the bottom during bankruptcy distribution and are only subject to the residual assets, which is in line with the principle of corporate law that shareholders are the residual claimants. See Practical Law, 'Order of creditor and contributory ranking on a debtor's insolvency' 2014)
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans shareholder loans could be subordinated during the bankruptcy procedure.
Gelter argues that sometimes business might still be valuable and shareholder loans might be more beneficial to the firms66 than just liquidating the business and distributing the bankruptcy value. I want to emphasise that liquidation is the not the only result if the firm cannot survive the financial distress. Gelter designed his model by assuming that liquidation is the only alternative. However, in reality, the design of reorganization is to save the on-going business and change the structure of the right side of the balance sheet without altering the assets of the firm or leading the current business to failure. It happens when the business is still viable67, but there is a temporary solvency or liquidation problem and in most cases the solvency issues are caused by inefficient management and over leverage68. We can regard this as an alternative way to solve the debt overhang problem69. With reorganization, the equity will be rebuilt to an adequacy level through debt equity swap70. From the perspective of economic efficiency, one way to achieve the pareto efficient outcome is swapping debt for equity71. Also, the creditors could choose to cancel a part of the debt as a part of the reorganization plan72 and write off part of the debt to restructure the balance sheet. But the starting point of the reorganization plan is always a wipe-out of the equity holders, which is aligned with the principle of insolvency law. Therefore, if the shareholders are not willing to inject new equity into the corporation in order to engage in an efficient rescue, then the reorganization might take place and the creditors will eventually solve the problem by themselves. Allowing shareholders to provide loans to rescue the business is unnecessary if such attempt might cause unfair treatment and opposes the general principle of insolvency law. Therefore, subordination of shareholder loans is
66 See Gelter, 'The subordination of shareholder loans in bankruptcy'. Benefits here is to mitigate overhang problem, otherwise the shareholders will forgo an efficient rescue attempt without shareholder loans. 67 Mark J Roe, 'Bankruptcy and debt: A new model for corporate reorganization' (1983) 83 Colum L Rev 527. 68 Shareholder loans will induce overleverage problem because shareholders would prefer to invest in loans instead of equity during crisis. Even outside the crisis, shareholders still might provide (secured) loans if there are no subordination rules. This will be explained in details in section 3.1-3.5. 69 By reorganization, capital will be restored and unpaid debt will decrease, which mitigates the debt overhang problem. Debt overhang problem will be discussed in more details in section 3.32. 70 Reinhard Bork, Rescuing companies in England and Germany (OUP Oxford 2012). 71 See Philippon, "Debt overhang and recapitalization in closed and open economies.", 141-146. 72 Michelle J White, 'The corporate bankruptcy decision' (1989) 3 Journal of Economic Perspectives 129,
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans justified based on principle of the insolvency law, and the disadvantage of subordination could be compensated by the design of reorganization.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans 3. Economic Rationale of Subordinating Shareholder Loans
We have addressed the first and third groups of arguments regarding adopting of subordination-rules in the previous section. The legal bases from the perspective of general principles in corporate and insolvency law have been discussed. Now we are going to move to the second group of arguments summarized by Professor de Weijs73, which is one of the “strongest and most serious critiques” to against subordination rules. The main concern of this critique is the negative effects of subordination on the incentives of shareholders to engage an efficient rescue. Subordination might inefficiently increase the downside for shareholders if a rescue attempt fails. However, not many studies have examined the economic rationale behind the subordination of shareholder loans. Gelter said in his paper, “However, what is missing in the literature is a formal analysis of how, why and when subordination of shareholder loan creates the desirable incentive structure and when it fails to do so.74” He tried to solve this puzzle with an own designed theoretical model in his paper. He also introduced a discovery that subordination of shareholder loans can “prevent either socially undesirable or desirable rescue attempts.” 75 Gelter’s analysis targets the influence of subordination on risk shifting and debt overhang when the firm is highly leveraged.
In this section, I will re-address the same issue with the releasing of a few assumptions made by Gelter, including the risk preference of shareholders, ex-ante effect on the cost of debt and limitation of liquidation.
3.1 Corporate Governance: Conflicts of Interest76
Based on the pecking order theory, a debt is preferred to equity as long as the debt
73 de Weijs, 'Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning against Creditors by Upholding the Debt–Equity Divide', 423. 74 Gelter, 'The subordination of shareholder loans in bankruptcy', 9. 75 Ibid 23. Based on the model, he concluded that when the firm is overindebted, subordinating shareholder loans might prevent efficient rescue and not stop all the inefficient rescue. 76 There are three types of agency problems, The conflicts between shareholders and creditors; conflicts between shareholders and management; conflict between the controlling shareholders and minority
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans capacity has not reached its limit 77. There are different theories supporting the benefits of using debt as the main financing instrument78, one of which is the agency cost theory. Contrarily to the pecking order theory, the agency cost theory suggests that managers do not always run the firms with the objective of maximising the shareholder value; instead, they would rather engage in tunneling to transfer resources from the firm to their own benefit through self-dealing transactions at the expense of the shareholders79. This phenomenon represents one of the most common agency problems observed in companies, occurring between shareholders and directors. Separation of control rights and ownership brings efficiency to the corporations and improves the effectiveness of control rights. However, it also causes issues related to the agency problem, and the management to run excessive risks at the expense of shareholders. One of the main concerns in the field of corporate governance is conflicts of interest between different stakeholders80. Debt, as a tool to solve the agency problem between the shareholders and management, will help to increase the commitment level of the managers to the corporation. 81 However, besides the conflict of interest between management and shareholders, Jensen and Meckling identified another type of conflicts existing in the corporations between shareholders and creditors, where the shareholders engage in suboptimal investments82. Debt financing has its bright side - mitigating the conflict of interest between the shareholders and management; but it also has a dark side - inducing agency costs between the shareholders and the creditors, providing incentives for the shareholders to undertake riskier investment and forego the safe ones.
To determine whether the shareholder loans will inherit the bright side of debt and eliminate the dark side, it is essential to judge whether shareholder loans will increase the commitment of the management, as well as the shareholders, which could shareholders. The conflict between controlling shareholders and minority shareholders are not addressed in this section. 77 Financing comes from three sources: internal funds, debt and new equity. When the firm needs to finance an investment with external funds, debt is preferred to equity. 78 Such as Free cash flow theory of debt, Pecking order theory 79 Simon Johnson and others, 'Tunneling' (2000) 90 American economic review 22. 80 Rafael La Porta and others, 'Investor protection and corporate governance' (2000) 58 Journal of financial economics 3. 81 Michael C Jensen, 'Agency costs of free cash flow, corporate finance, and takeovers' (1986) 76 The American economic review 323. 82 Milton Harris and Artur Raviv, 'The theory of capital structure' (1991) 46 the Journal of Finance 297.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans be either a result of good incentives or just a mask to cover the real intentions of shareholders to expropriate the wealth of creditors. It is one of the main issues, to decide whether it is efficient to treat the shareholder loan as regular debt or it is more appropriate to subordinate it, or even re-classify it as equity. It needs to be stressed, however, that subordination in this case will merely work as a tool to discourage the shareholders from taking advantages through such hybrid financing instrument at the expense of other stakeholders, and the validity of such loans is still in place. This means that shareholders are still allowed to invest in firms in a form of loans; like Hoff 83argued, a shareholder is not obliged to solely finance the company through equity capital. But besides from Hoff’s opinion, shareholders still need to bear the risks when the firm is going bust regardless the form of investing.
3.2 Bright Side of Debt: Monitoring Power of Creditors
First of all, commitment of debt results from periodical interest payments in cash84 and a bankruptcy pressure85. This is the bright side of debt. Debt can be used to limit the availability of free cash flows to the managers (as well as shareholders) and commit them to a repayment schedule to avoid the cost of financial distress. At the same time, the creditors will act as supervisors of the business in the firm. When the firm makes investment decisions, it needs to consider their results, namely, whether they will increase the cost of financial distress or whether bad investment decisions will induce the bankruptcy claim of the creditors. Furthermore, such decision could increase the future cost of debt from the new external investors. If the significant creditors of a firm include institutional creditors such as banks, who have strong bargaining power, it might be able to increase the commitment level of its shareholders86. If the business is
83 See GTJ Hoff, 'De aandeelhouder als schuldeiser: een ongenode gast?' (2009) I Spinath, JE Stadig en M Windt (red), Curator en Crediteuren, Deventer: Kluwer 19. 84 See Jensen, 'Agency costs of free cash flow, corporate finance, and takeovers', 324-326. He suggested that debt contracts reduce the amount of "free" cash available to managers to engage in wasting investment. 85 See Sanford J Grossman and Oliver D Hart, 'Corporate financial structure and managerial incentives', The economics of information and uncertainty (University of Chicago Press 1982). Grossman and Hart pointed out another benefits of debt that bankruptcy is costly for managers and this will create an incentive for managers to work harder. 86 See Clifford W Smith Jr and Jerold B Warner, 'On financial contracting: An analysis of bond covenants' (1979) 7 Journal of financial economics 117. See also Andrei Shleifer and Robert W Vishny, 'A survey of corporate governance' (1997) 52 The journal of finance 737. Their monitoring power comes
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans not running well or too many risky investments are being made, the big creditors might put a financial pressure on the corporation and claim for insolvency issues. Additionally, some professional creditors might limit the financing or investment activities conducted by the debtors through Covenants87. Therefore, to avoid bankruptcy, the manager is going to run the business in a more prudential manner.
However, if the creditors are also shareholders, in most cases they will not be willing to claim for bankruptcy or impose any more financial pressure on the firm if the corporation is not running well. As a result, they will exercise their monitoring power insufficiently to contribute to the soundness of the investment decision and daily operations. Therefore, the monitoring function is weakened when the creditors are also shareholders. Moreover, enabling the shareholders to exercise the rights conferred exclusively to creditors will increase the monitoring costs of the firm even more if the shareholder loan is provided by the controlling shareholders. Given a parent company and its subsidiary, if the parent company is not only a shareholder but also a creditor of the subsidiary, the monitoring power from the outside creditors will be diluted by the parent company. That is because the parent company will always occupy a seat in the creditors’ meeting, which hinders the other creditors from exercising their rights when they need to take collective bargaining actions. Therefore, shareholder loans would not efficiently help to increase the commitment level of the management, and even might bring adverse impact.
Moreover, when the controlling shareholders88 provide shareholder loans, the conflicts of interest between shareholders and management is not the main concern any more. In this situation, the bright side of debt, which is to help solve the conflicts between shareholders and management, is neglectful. Thus, more attention needs to be payed to the dark side of debt, where shareholder loans might severe the conflicts
partly from the control rights they receive when firms default or violate debt covenants, and partly from the short maturity of debt, so borrowers need come back at regular, short intervals for more funds. 87 See Sudheer Chava and Michael R Roberts, 'How does financing impact investment? The role of debt covenants' (2008) 63 The journal of finance 2085. The creditors could use the threat of accelerating the loan to intervene in management. 88 Controlling shareholders are the ones who participate the daily operation for business and have significant influence on the decision making of the firm.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans between shareholders and creditors.
3.3 Dark Side of Debt: Risk Shifting and Debt Overhang
Here we take an assumption that the shareholder we are targeting is the controlling shareholder of the firm, owning 100 percent of the controlling rights. Under these circumstances, we can expect the management to run the firm for the benefit of the shareholder and the goal of this firm is to maximise the market value of capitalisation. Therefore, we can assume the conflict between the shareholders and management is at its minimum. The main conflict of interest here exists between the shareholder and the creditors. Whether the shareholder, at the same time, as a creditor, will increase his commitment level to the firm as a whole and mitigate the agency problem is the main concern here.
3.31 Risk Shifting
Risk shifting problem results from the conflict of interest between shareholders and creditors 89 . The incentives to make investment decisions are different for both shareholders and creditors. This is exactly what happened before the 2008 financial crisis in the banking sector. The banks’ debt capacity is growing when the economy is booming. As a consequence, banks are over leveraged and less prudential to their risk management during those periods90. By engaging in more risky investments, the equity holders of the banks will shift the risk of failed investment to the creditors, as well as depositors. Same as financial sectors, when the equity level is shrinking or in other words, the firm is highly leveraged, an increasing risk-shifting problem might take place in the firm regarding the investment choice, where the shareholders are prone to take excessive risk even though the project NPV91 is negative. This is one of the dark sides of a debt. The reason is that the loss will be borne mostly by the creditors while
89 Jensen and Meckling, 'Theory of the firm: Managerial behavior, agency costs and ownership structure'. 90 Anat R Admati and others, 'Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why bank equity is not socially expensive' (2013) 23 Max Planck Institute for Research on Collective Goods 91 NPV refers to the Net Present Value, which represents the difference between the present value of its benefits and the present value of a project or an investment. See Chapter 3 of Jonathan B Berk and Peter M DeMarzo, Corporate finance (Pearson Education 2007).
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans the upside gain will be earned by the shareholders92. The critical point needs to be aware of here is under what situation the risk-shifting problem might happen. Risk shifting mostly takes place when the company is not over indebted93, or in other words, there is still some equity left in the firm, but not sufficient to absorb the future loss from a volatile investment, where shareholders still will gain all the profits from upside94. In a private firm, wearing a double-hat as a creditor and shareholder at the same time, would it be profitable or reasonable for the shareholders to take less risky investments? Gelter95 has proven the incentive of risk-shifting by a theoretical model. Based on the analytical results provided by Gelter, subordinating loans under this scenario won’t bring any negative effect, but might not be sufficient to stop the excessive risk-taking of the shareholders96.
Considering there is an investment taken by a shareholder with negative NPV for the firm, where the project will destroy the value of the company as a whole. However, as a shareholder, he is not going to suffer a loss which is more than the capital contributed inside the firm in most of the cases97. Therefore, when there is barely any capital left in the balance sheet, the shareholder will not be afraid of losing the residual capital, and they will be more willing to take risky investment at the expense of the creditors. When the controlling shareholder provides a new investment in this firm, he is going to earn the upside of the gain based on its equity claim from the risky
92 Jensen, 'Agency costs of free cash flow, corporate finance, and takeovers'. 93 When the firm is overindebted, the risk shifting is still existing, but requires a higher-volatile return, for the reason that the upper side gain will first go to the creditors. Therefore, when the firm is overindebted, the firm will be pickier to risky investment, and more dangerous investment decision might be taken. This will be explained in the next part. 94 For example, there are 10 million assets in total available in the firm, with 1/10 equity. Now there are 2 million cash available in the firm to undertake an investment. There are two investment opportunities presenting here, one of which is a safe investment with 2 million initial investment and a return of 2.2 million for sure. Another one is a risky investment with 2 million initial investment but will have 70% chance to result at a failure and loss all the initial investment, and only 30% chance of success with a gain of 5 million. The NPV of this project is negative (0+30%*5-2= -0.5). But from the perspective of shareholder, this investment is profitable because the payoff for shareholder is positive (- 1*70%+3*30%= 0.2). The difference between the NPV of the project and the payoff the shareholders represents the loss of the creditors, where the creditors will suffer a loss of 0.7. The shareholders here will engage in the risky investment and shift the risk to the creditors’ side. 95 Gelter, 'The subordination of shareholder loans in bankruptcy'. 96 See ibid 13-16. Even though Gelter holds the opinion which goes against automatic subordination of shareholder loans, he does agree that subordination shows no negative consequences when the firm is not overindebted. Subordination of shareholder loans could partly internalize this risk, but not in full. 97 When there is no piercing the corporation’s veil taking place.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans investment, and merely lose limited capital as he provided. If we keep the total investment of this shareholder constant, allowing shareholder loans will not decrease the potential gain, but lower potential loss the shareholder is facing, which encourages the risk taking of this shareholder. Therefore, under this scenario, shareholder loans will aggravate the conflict of interest. When there is a new investment opportunity provided and the shareholder is not confident with the outcome of this investment, he might even invest in secured loan to take a try98. By doing this, the shareholders will always feel safe enough to engage in more risky investments. Therefore, the shareholder loans here will give the shareholder more incentive to take excess risk.
3.32 Debt Overhang
Besides risk-shifting, the debt overhang problem is also one of the dark sides of the debt99. If we go more extreme than the previous scenario, where the equity is even negative, there might be debt overhang issue triggered in the firm, where the shareholders will forgo the positive investment opportunities even though the new investment is a positive NPV project, for the reason that all the profits contributed by the new investment will first go to the pocket of the creditors instead of the shareholder. When the firm is facing financial difficulties and their market value of debt is lower than the face value, all the attempt of rescue will first go to make up the loss of the creditors and even might not contribute anything to the wealth of the shareholders. If the shareholders would like to provide more equity to compensate the creditors as much
98 For example, there are 10 million assets in total available in the firm, with 1/10 equity. Now there is only 2 million cash available in the firm to undertake an investment, and the external fund is not available. There are two investment opportunities presenting here, one of which is a safe investment with 3 million initial investment and a return of 3.1 million for sure. Another one is a risky investment with 3 million initial investment but will have 70% chance to result at a failure and loss all the initial investment, and only 30% chance of success with a gain of 6 million. To engage in any of the investment, the shareholder needs to provide another 1million investment. Without the shareholder loan the NPV of the risky project is negative (0+30%*6-3= -1.2) for the firm. Also, from the perspective of shareholder, this investment is not profitable because the payoff for shareholder is also negative (-2*70%+3*30%= - 0.5). The difference between the NPV of the project and the payoff the shareholders represent the loss of the creditors, where the creditors will suffer a loss of 0.7. The shareholders here will not engage in the risky investment, nor shift the risk to the creditors’ side. If we allow the shareholders to provide secured shareholder loans for the new investment, the payoff scenario for shareholders will change and shareholders will have a positive NPV (-1*70%+3*30%= 0.2). While the creditors will suffer more loss (-2*70%= -1.4). Therefore, allowing secured shareholder loans will encourage them to take more risky investment decisions. 99 See Owen Lamont, 'Corporate-debt overhang and macroeconomic expectations' (1995) The American Economic Review 1106.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans as possible, then it would be nice. But the shareholders are not charities, and they unlikely take such risk which transfers their wealth to the creditors. Therefore, under such scenarios the shareholders are not willing to put extra funds inside the corporation and they would like to claim for liquidation instead100.
Here we need to be aware that debt overhangs often happen when the equity has already been under the water and the current market value of debt has already been lower than the nominal value. Face value of the existing debt is bigger than the expected payoff of the new investment. Therefore, the shareholders here have incentive to forgo the good investment even though it is beneficial for the firm as a whole101. Some scholars, such as Gelter, argue that if we allow the shareholders loan as a whole, especially during a crisis, then it might help the shareholders to solve such debt overhang problem and engage in positive NPV investment. When the firm is facing the debt overhang problem, the firm is normally trapped in the negative equity, where the firm might wind up by the request of the creditors. Gelter argues that if the subordination of shareholders is provided, the shareholders are not encouraged to engage in the efficient rescue when there is a possibility that the rescue will help to restore the value of the creditors, and is beneficial for the firm as a whole102. However, by using theoretical model he did not give a clear conclusion in this scenario.103 He found out that when the firm is already over indebted, subordination will prevent some socially undesirable, but also some desirable rescue attempts104.
100 Filippo Occhino, 'Is debt overhang causing firms to underinvest?' (2010) Economic Commentary. 101 For example, there are 10 million assets in total available in the firm, with 15 million unpaid loans outstanding. Now there is only 2 million cash available in the firm to undertake an investment, and the external fund is not available. There is a safe investment opportunity presenting here. By investing 3 million in a new project, the firm can earn 4 million for sure. The NPV of this safe project is 4million- 3million=1million. However, the shareholders would not be willing to put another 1 million inside the firm to undertake the investment because all the initial investments and profits will contribute to repay the debt. 102 Gelter, 'The subordination of shareholder loans in bankruptcy', 17-24. 103 See ibid 20. Gelter finds out that overall, the effects of subordination are ambiguous when company is already overindebted. 104 See ibid 32. Gelter says “If an increase in the going concern value after the rescue was to be expected, the shareholder-creditor should be treated like a third-party creditor in bankruptcy. Otherwise, if the creditor is punished in bad states of the world, even where the rescue attempt was desirable, an inefficient disincentive is the result.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans 3.33 Dynamic Model of Risk Shifting and Debt Overhang
Debt overhang and risk-shifting are the two negative effects of over-leveraged financing, that cause two different types of wrongful investment decisions105. If we take a look at these two issues dynamically, we could uncover that debt overhang might occur together with risk-shifting, as long as there is enough of the upside income to compensate for the upside loss of the shareholders106. Therefore, as the iceberg of equity is melting, the risk-shifting breaks through the surface of water, and the debt overhang problem does not replace risk-shifting, but co-exists with it when the equity level keeps dropping down. In the debt overhang model, the flip side of an under-investment in a healthy and lucrative project is a potential over-investment in risky and harmful projects107. The graph below shows a dynamic movement of a solvency ratio108 and its relationship with risk shifting and debt overhang.
Graph 1: Green shadow represents the risk shifting problem and yellow shadow represents the debt overhang problem. As the solvency ratio dropping, the risk-shifting problems becomes more serious. At a certain point, the risky investment results as a failure and the equity is finally underwater, where a debt overhang situation will be triggered.
105 As described above, under risk-shifting scenario, the firm is going to take risky investment with negative NPV at the expense of creditors, while under debt overhang scenario, the firm is going to forgo a positive NPV project because of the shareholders might have possibility to transfer their wealth to creditors. 106 Jensen and Meckling, 'Theory of the firm: Managerial behavior, agency costs and ownership structure'. 107 Philippon, 'Debt overhang and recapitalization in closed and open economies'. 108 Here solvency ratio refers to equity ratio, which represents the ratio of equity and total assets, measuring the amount of assets that are financed by owners’ investments.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans We can observe a static outcome from the graph above, that when a firm is facing a crisis, a short fall of capital is being triggered. Risk-shifting is a first order problem, as it happens when the capital is still positive, but not sufficient to absorb the potential loss of a failed business. If the loss is big enough to devour all the equity, then the market value debt is going to decrease and the firm’s new income will be used first to compensate the creditor’s loss, and the debt overhang problem starts to influence the investment decisions of the firm. However, the risk-shifting problem does not disappear, instead, it evolves and becomes more volatile. Assuming the expected value of an investment is constant, the more volatile outcome is now required to fix the gap of the creditor’s loss before creating any profit109. Therefore, when a firm is in a situation of debt overhang, it does not only forgo the positive NPV project but will also undertake more risky ones (even with negative NPV).
Enabling shareholders to put extra debt on the balance sheet is not the tool to solve the debt overhang problem110. Debt overhang is caused by the imbalance of too much debt on the balance sheet, or in other words, too little equity on the balance sheet. If we consider shareholder loans as a regular type of debt, then increasing the shareholder loans means putting more debt on the balance sheet. As a result, a repeating loop might be triggered, which would only worsen the situation. Now we will change the static scenario illustrated above to a dynamic scenario, as below:
109 We assume there are two investment opportunities with a expect value of 10 (we ignore the initial investment here). The first investment is going to have an expected value of 10 with 100% probability and the second investment has a gain of 100 with 40% possibility and a loss of 50 with 60% possibility. If currently the firm has a total asset of 20 and debt of 30, shareholder would like to choose the second investment instead of first one, even though the second one is less risky and beneficial for the creditors. 110 Since the firm is already over indebted, shareholders might be very unwilling to put extra equity. Even though there are good investment opportunities, for the shareholders, they won’t really care about the creditors and be unwilling to contribute new equity to engage in the new investments. They only care about whether the firm will survive and whether their initial investment could be earned back. If there are even no external creditors would be willing to provide the loans, why the shareholders would like to? Because they want to extend the liquidation and to gamble for the future success. What is the next step if the rescue attempt results as a success? The debt overhang problem will probably shift to more serious risk-shifting problem. And risky investment will be taken again. The core solution for debt overhang is to build up enough capital but not to provide extra debt. Why not just reorganize the insolvent firm? Reorganization also can keep the going concern value of the firm, and at the same time it can solve the debt overhang problem, as well as risk-shifting. Therefore, using shareholder loan to solve the debt overhang problem is unnecessary and will cause new problem even it works out.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans
Graph 2: Green shadow represents the risk shifting problem and yellow shadow represents the debt overhang problem.
If the shareholders inject new capital in the form of loans, such rescue attempt results in a success, but the gain is not sufficient to bring the firm’s capital to an adequate solvency ratio in most cases. We can observe on the graph above that debt overhang problem is only being temporarily solved, but risk shifting is still outstanding, which will eventually bring the company back to the original debt overhang situation. Because the shareholders still would like to take risky behavior after the successful rescue attempt. Moreover, if the shareholder loans are secured, even much riskier investments might be undertaken, as explained above. As a result, the creditors might even suffer more loss at the end. The effect will be shown as below:
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans
Graph 3: Green shadow represents the risk shifting problem and yellow shadow represents the debt overhang problem. After the first successful attempt, the firm survived from liquidation. However, there is still not enough capital standing in the firm. Shareholders will take risky investments again and shift the risk to the creditors. As a result, the risky investments might result as a bigger failure than before, and swallow all the residual assets of the firm, which should be used to repay the loans to the creditors.
As a conclusion, the firms that expect to have valuable future growth opportunities should avoid having too much debt, rather than using shareholder loans as a last resort. As illustrated in Graph 4. below, unless the rescue attempt is significant enough to bring the capital of the firm to an adequate level, the debt overhang and the risk-shifting problem will not be completely solved. As suggested in the previous section, reorganization is a better alternative to solve the debt overhang problem than shareholder loans.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans
Graph 4: Green shadow represents the risk shifting problem and yellow shadow represents the debt overhang problem. The full line in red represents the scenario where the firm is running with sufficient capital, where the risk-shifting problem is mitigated.
To my opinion, the ex-ante preventive protection is even more important than ex-post rescue. Shareholder loans would not work as a preventive instrument for a crisis, but only as an ex-post rescue tool and could result in a risk shifting loop as explained above. The goal of insolvency regulation is not only to target ex-post measurement, but also to prevent 111 the shareholders from performing inappropriate behaviour beforehand 112 . Shareholders need to be aware of the unfavorable results of over leveraged financing and act in a prudential manner before engaging in risky behaviors. What is missing in Gelter’s model, is the ex-ante effect of such shareholder loans. By
111 With a clear distribution rules (preference law) stated in the bankruptcy code, the shareholders would know how bad the result could be if a business fails (in most of the cases, they will have nothing left). Therefore, they would be more prudent when making investment decisions to avoid ending up with a liquidation. From this perspective we can see the bankruptcy law functions not only acts as a resolution tool after the firm is insolvent, but also acts as a preventive tool to urge the shareholders and management to behave safely and properly. Moreover, as stated in DIRECTIVE (EU) 2019/1023 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on preventive restructuring framework “Preventive restructuring frameworks should, above all, enable debtors to restructure effectively at an early stage and to avoid insolvency, thus limiting the unnecessary liquidation of viable enterprises.”, we can see that liquidation and distribution of assets are not preferred by the EU legislators. Saving a viable business and keep a sound financial condition are more important. Therefore, we can indicate here that the objective general insolvency framework is also to encourage ex-ante preventive measures, rather than merely ex-post distributable and punitive measures. 112 He started with the assumption that the firm is facing a immediate liquidation in the near future. He did not consider what caused the firm to end up with such financial distress. The shareholder loans might give shareholder incentives to conduct risky investment before the firm is in trouble. Therefore, shareholder loans itself might be a cause of financial trouble of the firm. He neglected this in his paper.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans considering shareholder loans in the same way as the loans from external creditors, the risk-shifting will be amplified at the very beginning, when the business is still viable and the solvency ratio is still in a healthy range. Shareholders will always provide loans instead of equity if the investment might face any risk113. Furthermore, when the shareholders are facing debt overhang problem, they prefer to apply for liquidation directly and claim for the loans through bankruptcy distribution 114 . From this perspective, the shareholder loans provide an ex-ante incentive for shareholders to take extra risks and the overhang issue is a result of such incentives.
In general, a capital shortage is the cause of the agency problem between shareholders and creditors, which induces both debt overhang and risk shifting problems. This is one of the lessons we have learned from the 2008 financial crisis115. To keep the corporation running functionally and smoothly without financial difficulties, adequacy capital is the key. Any financing behavior which might increase the incentive of shareholders to provide less capital is not recommended.
Without adequacy capital, the shareholders will react similarly to a call option holder when facing investment decisions. We can regard shareholder loans as stock options (call option). With the stock option, only when the stock price is higher than the exercise price is it beneficial to exercise the option, otherwise the holder can always choose to not exercise the option and result with a zero pay off116. If the capital in the firm is not sufficient, and the shareholder loans will also not be subordinated (for an extreme scenario, the loan is even secured), then the position of the shareholders will be similar to holding a call option117. In the worst-case scenario, the shareholders will get a payoff similar to not exercising the option and end up with a zero payoff, while in
113 Here we focus more on the private companies, where the shareholders would not worry too much about the loss of controlling right by providing less equity. 114 In most cases, the shareholder loans will be provided in a mix form of secured debt and unsecured debt, where the shareholders could claim for the full value of secured together with part of unsecured loans by participating the distribution of common pool. 115 See Jihad Dagher, Benefits and costs of bank capital (International Monetary Fund 2016). 116 Since call option is a right but not an obligation, where the minimum payoff is zero if the holder of option dose not exercise the right of the option. The payoff function of a call option holder is MAX (stock price - strike price, 0). 117 If the equity of the firm is almost zero, the shareholders would almost loss nothing when the new investment fails and win all the upside if succeeds.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans the positive scenario shareholders could earn unlimited profits based on their equity rights. This phenomenon could be explained by the Black–Scholes option pricing model118, where higher volatility will bring extra value for the option holders119. As a result, the shareholders will choose the investment with higher volatility instead of a steady return, even though the total expected value might be the same120. Such a high volatility will bring the shareholders more opportunities to earn abnormal benefits while shifting the risk of loss to the other creditors. However, the more is being paid in capital standing in the firm, the more the shareholders will lose in the negative case scenario, where the highly volatile investment will not bring enough extra benefits to the shareholders to compensate for the downside loss of equity. Therefore, considering the behaviour of shareholders from the perspective of the call option holders, we can uncover that more risky investment decisions will be taken when the equity level is too low or in case shareholder loans are allowed. As opposed to the shareholders, the creditors are fixed rate return recipients. Highly volatile investment will not bring any extra value for them, but rather contrarily, it will lower the certainty of receiving the repayment of principles, destroying the market value of the debt. From the perspective of creditors, it is not beneficial or desirable to accept a highly volatile investment.
3.4 Prospect Theory: Why Would the Shareholders Like to Delay an Efficient Liquidation and Attempt an Unnecessary Rescue?
The scenarios discussed above are built on the situation where the shareholder is a risk neutral person, who values the loss and gain in the same way. Gelter also made such assumption in his paper and the risk preference was not addressed by him121. We ignored the risk preference of shareholders in the analysis of the previous section as well. However, according to the prospect theory, people’s risk appetite will shift when the wealth condition of such person is in a different position relative to the reference point122. In reality, the shareholders make their investment decisions based on many
118 See Chapter 21 Option Valuation, Berk and DeMarzo, Corporate finance. C=StN(d1) −Ke−rtN(d2). 119 See Karen Smith, 'Why does option value increase with volatility? – The “Balloon” Effect' 2012)
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans other factors besides the expected value of the project. Risk-loving and risk-averse investors will make different choices when facing the same opportunities.
Daniel Kahneman and Amos Tversky created and developed the prospect theory to describe the choice people make between probabilistic alternatives that involve risk and the probabilities of outcomes are uncertain123. There are four principles of the Prospect Theory. When there is a certainty of gain, most people would avoid performing risky behavior. But the utility function is reflected against the reference point. When the person is at a loss, they will shift to become a risk lover. Most commonly, when a person chooses between a certain gain and an uncertain gain with higher volatility and the same expected value, they would choose the certain gain option. However, when facing loss, they would prefer to take a risk to avoid such an outcome124.
We know shareholders are not rational agents, and their risk appetites are not constant. As I described above, the investment decision of the shareholders is not only determined by the NPV of the project, but also by their utility functions including the risk preference. Daniel Kahneman and Amos Tversky proved that under different wealth conditions, the shareholders view the probability with a different attitude. Therefore, when equity of the firm is already underwater, the shareholders would be standing below the reference point, where the utility function of the shareholders is in a convex shape. The graph below illustrates a simple example, which shows how a person makes decisions when facing risk and uncertainty.
uncertainty' (1992) 5 Journal of Risk and uncertainty 297. 123 Ibid. 124 Daniel Kahneman and Amos Tversky, 'Prospect theory: An analysis of decision under risk', Handbook of the fundamentals of financial decision making: Part I (World Scientific 2013).
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans
Graph 5: This is a modified graph of the basic model illustrating Prospect Theory125. And we assume the Y axis represents the utility of shareholders. When the shareholders are facing a gain above the reference point, they will have a decreasing marginal utility, namely, the more they gain, the less valuable it occurs to them126. However, if they are facing a loss below the reference point, they will shift their risk appetite to an increasing marginal utility curve. In this situation, they would like to gamble to mitigate the risk, and losing 50 for certain is worse than losing 100 or 0 with 50% probability each127.Therefore Point A is preferred to B, and Point D is preferred to Point C. Based on the Prospect Theory, a person will choose a certain gain of 50 instead of choosing a uncertain gain of 100 with probability of 50%, even though the expected value of those two choices are the same. However, the same person will not choose a certain loss of 50, instead, he will choose to gamble for either a loss of 0 or loss of 100 with same probability. This can be explained by the “Isolation Effect”128. And this risk- seeking behavior when someone is facing a loss, might explain why people always trap themselves in casino and result as a higher loss eventually (Considering a person just made a loss from the first round of casino game, if he quits the game immediately he will end up with a certain loss; however if he chooses to continue, he might result in a bigger loss with a high probability, or earning back the loss from last round with a low probability. Based on the prospect theory, the shift of risk appetite might push the person to start a new
125 The original graph is from Zvi Bodie, Alex Kane and Alan J Marcus, Investments and portfolio management (McGraw Hill Education (India) Private Limited 2013) 378. And this example is illustrated in details by Aurora Harley, 'Prospect Theory and Loss Aversion: How Users Make Decisions' 2016)
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans round of game and result in a bigger loss.
As illustrated by the graph above, when the firm is facing financial difficulties, the shareholders will act with a riskier attitude, which increases the volatility and uncertainty of the payoff. The reason for such excess risk taking is not only the agency problem mentioned above, but also the shifting of risk appetite. Enabling shareholder loans would encourage shareholders to take even more excess risk without extra cost, because the shareholders will feel less pain if they still have residues left in case the business results in failure. Therefore, to discourage risk-taking of the shareholders, subordination of shareholder loans is indispensable and would help to prevent the inefficient rescue attempts of the shareholders.
Prospect theory could be regarded as a complementary rationale to support the argument brought by Professor de Weijs129. He illustrates the excess risk-taking of shareholders at the expense of the creditors when shareholder loans are considered in the same way as other types of loans with a numerical example. In his example, he assumes the shareholders will make investment decisions based on the expected value of their equity, and shows that the upside potential will outweigh the downside loss of the possible failure of the rescue. If there were any non-subordination rules, the shareholders would rely their investment decisions more on the upside of the investment, while neglecting their loss to a certain extent when the rescue plan does not end in success. That is because they will join the creditors group if the liquidation takes place anyway, and receive a part of their initial investment back as a creditor. The prospect theory will bring this result even further, because when the shareholders are facing a loss, they will behave in a way riskier than before. This is caused by the shift of risk-preference.
I will illustrate the Prospect Theory here combined with a simple example to show that, the shareholder loans might delay an efficient liquidation. Through the example below we can see that even though immediate liquidation is the best option for
129 de Weijs, 'Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning against Creditors by Upholding the Debt–Equity Divide'.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans both the shareholders and the creditors, the shareholders still would engage in inefficient rescue with a negative pay off for all the stakeholders. And with the help of shareholders loans, the shareholders would even take risker investment decisions and cause more damages to the creditors. As one of the principles of corporate law is to encourage the shareholders to make wise investment decision130 , subordination of shareholder loans exactly reflects such general principle by preventing shareholders from undertaking unwise and dangerous investment decision.
3.41 Without Shareholder Loans
Let us assume that the shareholders initially invested 10 million of equity in the firm at T0. The firm also has an outstanding debt of 10 million, which needs to be repaid at T1. The total assets of the firm are 20 million at T0, including an office building of 5 million, some machines worth 2 million, inventory in storage worth 3 million and 10 million cash available for new investment. We will ignore the time value and discount factors here to simplify the example. In this case, the reference point will be the initial investment of the shareholders, namely, the equity value of 10 million.
Table 1: Initial balance sheet at T0131 Graph 6: Initial position of the shareholders at T0.
130 See Luis A. Aguilar, Commissioner, U.S. Securities and Exchange Commission, 'Looking at Corporate Governance from the Investor’s Perspective' (2014)
131 The method used here of balance sheets depicting the relative shares of finance by means of blocks
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans Shareholders are standing at a reference point when the equity is at its initial level. Any point below the reference point represents a loss.
Now at T1 the firm is facing a sudden loss because of failure of the investment at T0 and there is only 10 million of the assets left. All the cash has been invested in a failed project at T0 and zero profit is earned out of such project. The other assets are still at their original values. It is the exact point when the shareholders are still be able to pay back the debt but no equity is left in the firm anymore. If the liquidation took place at this moment, the shareholders would stand on the left-down corner of the reference point, where the shareholders lose their equity as a whole, suffering a certain loss of “10 million”. But at this moment, the creditors can still get paid in full if the instant liquidation takes place.
Table 2: Balance sheet at T1 after the firm is hit Graph 7: The position of shareholder at T1. The by a negative shock. shareholder is facing a loss of 10 compared with the reference point.
A guaranteed loss is painful for the shareholders; therefore, they will seek to extend the life of the business to earn their equity back. Now, let us assume there is a business that brings the shareholder a 40% chance of earning 10 million and 60% chance of 0 million at T2 with an initial investment of 5 million in cash at T1132. Due
has been developed by Joost de Vries, JBR Institute as part of the Financial Mind Map©. 132 To make the project even more risky, we could construct a higher volatile pay off case with the 20% chance of earning 11 million and 80% chance of losing everything with an initial investment of 5 million. Keep the other factors same as the previous example, under such scenario, the NPV of the project is
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans to depreciation, the machines will only worth 1 million at T2 instead of the original value of 2 million at T1, if the investment is being made. Without shareholder loans or external funds, the two possible outcomes at T2 are presented as below:
Table 3: Balance sheet at T2 if the investment results Table 4: Balance sheet at T2 if the investment as a success. results as a failure
We could calculate the NPV of this investment from three different perspectives:
1) Regardless of the capital structure of the firm, the stand-alone value of this project is 0.4 ∗ 10 푚푖푙푙푖표푛 + 0.6 ∗ 0 푚푖푙푙푖표푛 − 5푚푖푙푙푖표푛 − 1푚푖푙푙푖표푛 = −2푚푖푙푙푖표푛 2) From the perspective of the shareholders, they would get an NPV of -1.4:
0.4 ∗ 9 푚푖푙푙푖표푛 + 0.6 ∗ 0 푚푖푙푙푖표푛 − 5푚푖푙푙푖표푛133 = −1.4 푚푖푙푙푖표푛 3) From the perspective of the creditors, they would get an NPV of -0.6:
0.4 ∗ 10 푚푖푙푙푖표푛 + 0.6 ∗ 9푚푖푙푙푖표푛 − 10푚푖푙푙푖표푛134 = −0.6 푚푖푙푙푖표푛
From those results we can see that, both shareholders and creditors have negative pay off from this investment. The investment as a whole will bring a loss of 2 million distributed between the shareholders and creditors. Therefore, with an assumption of rationality and a risk neutral preference, neither a shareholder nor a creditor would make such an investment.
11*20%-5-1= -3.8 million( -1 represents the depreciation of the machines); the NPV for shareholder is 10*20%+0-5= -3 million; the NPV for creditors is 10*20%+9*80%-10= -0.8 million. It is a risky and non-profit project. But based on the prospect theory,20%*U (0) +80%*U (-15) might be higher than 100%* U (-10). Therefore, the shareholders still might undertake such risky project. 133 The shareholders need to invest in another 5 million new equity into the new project. Therefore, the cost of the project for shareholders is 5 million. 134 The creditors lent the firm initially 10 million and they would expect to receive the full amount if the firm chose to go liquidation immediately at T1. Therefore, cost of the creditors by taking this new project is the value they would have received if liquidation takes place at T1, which is 10 million.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans Based on the prospect theory, however, the shareholder perceives the effects of loss differently. If the shareholders fails the investment, he will end up with a loss of 15 million in total (10 million of an initial investment and 5 following investments), but if the investment does work out well, then the shareholder will mitigate his initial loss and arrive at a loss of 6 million (15 million equity contribution in total and 9 million equity at the end). Facing a certain loss of 10 million, the shareholders might gamble to mitigate the loss and take the risk of losing even more (15 million), ignoring the low probability of success. We can see this investment is a negative NPV project with only 40 percent of success; it would destroy the value for shareholders, creditors and the entire firm. But the shareholders will still choose that over an instant liquidation, which might be economically efficient to all the stakeholders including themselves. The graph below shows the risk preference and utility function of shareholders at T2.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans Graph 8: The position of shareholder at T2. By undertaking the investment, the expected utility of the shareholder will be at the value of point B, higher than the expected utility of immediate liquidation, which is at the value of point A135.
Therefore, the shareholders might take this bad investment at T1 instead of filing for the liquidation application. What is more, even at T2 the project results as a success, the equity of the firm is still lower than the initial value, which means the risk appetite of the shareholders are still risk seeking. This suggests that even the shareholder will keep taking risker investment decision after T2, even the new investment results as a success.
3.42 With Shareholder Loans
Now we are going to make the things even worse, where unsecured shareholders loans could be provided and not subjected to subordination rules. With the help of shareholder loans, a shareholder will take riskier investment decisions under the prospect theory, because they feel less pain when the bad scenario happens136. If the investment results in a success, the upside of the gain would stay the same as in the last scenario, while when the investment results in a failure, the downside loss will decrease for the shareholder. The new balance sheet at T2 is presented as below:
Table 5: Balance sheet at T2 if the investment results Table 6: Balance sheet at T2 if the investment as a success (with unsecured shareholder loans) results as a failure( with unsecured shareholder loans)
135 60%*U(-15)+40%*(-6)>100%*U(-10) 136 Here the shareholders would be able to join the distribution of 1 million assets.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans We can see from the tables that the shareholders would have 60% change to end up with a loss of 12 million in total (10 million of an initial investment and 2 million of shareholder loans), but if the investment does work out well, then the shareholder will mitigate his initial loss and arrive at a loss of 6 million. Compared with last scenario where there is no shareholder loan provided, the shareholders now improve their positions by mitigating the loss when the new investment results as a failure.
In the worst-case scenario137, the shareholders would provide the loans with full security rights pledged on the building, and they would not need to take the risks of any loss from the downside while keeping the gain from upside. The new balance sheet at T2 with secured shareholder loan is presented as below:
Table 7: Balance sheet at T2 if the investment results Table 8: Balance sheet at T2 if the investment as a success (with secured shareholder loans) results as a failure( with secured shareholder loans)
We can see from the tables that the shareholders would have 60% change to end up with a loss of 10 million in total (10 million of an initial investment), but if the investment does work out well, then the shareholder will mitigate his initial loss and arrive at a loss of 6 million. Compared with last two scenarios where there is no shareholder loan or only unsecured shareholder loans are provided, the shareholders now improve their positions by mitigating the loss if the new investment results as a
137 From the perspective of both non adjusting creditors as well as from the perspective of overall efficiency. We assume here the non-adjusting creditors would not be able to change the interest rate or restrict the behavior of shareholders by Covenant. Therefore, the externalities of shareholder loans could not be internalized here. This is going to be discussed again in the following section 4.5.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans failure; shareholders are not suffering any potential loss from the new investment. They will always have incentive to try an inefficient rescue without bearing any risks.
Considering shareholder loans equally with regular loans or allowing secured shareholder loans will decrease the downside loss of the shareholder without affecting the upper side gain, which aggravates the risky behavior of the shareholders. From Graph 9., we can see that shareholder loans improved the position of shareholders from B to C, and secured shareholder loans could even lift the utility of the shareholder to D. The higher the position resulting from the investment, the more likely are the shareholders to undertake risky investments. Therefore, shareholders are more willing to undertake a negative payout investment when shareholder loans are provided without subordination rules.
Graph 9: The position of shareholder at T2. By treating the shareholder loans equivalent as the external debt, the expected utility of the shareholder will be at the value of point C, higher than the expected utility
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans of immediate liquidation and providing a new investment with equity. By allowing secured shareholder loans, the shareholder will arrive at in the position of point D, with the highest expected utility compared with other scenarios
Subordination of shareholder loans, increasing the downside for shareholders in case a rescue attempt fails, will decrease the incentive of the shareholders to conduct such non-profit and risky investments. This risk-seeking behavior does not only pose a potential danger for the creditors, but it is also bad for the shareholders themselves. From the example provided above, the delay of liquidation will destroy the expected distributable value for all the creditors and the inefficient rescue wastes both time and money. Therefore, such inefficient rescue attempts need to be prevented, and subordination of shareholders loans will help the shareholders to take a more deliberate consideration on the risk they are taking.
3.5 Cost of debt: Mismatch of the Risk and Cost
Through a fair value of interest payment, the creditors will be compensated for bearing the risk of the loans they provided to the firm. To determine the value of corporate debt, three items are relevant: first, the rate of risk-free debt; second, the terms and restrictions in the indenture, such as maturity, coupon rate and seniority in the event of default; third, the probability of default 138 . The agency cost will influence the probability of default and the magnitude of loss during default. Shareholders bear the agency cost to debtholders, when the debt is issued if the debtholders correctly anticipate shareholders' future behavior139. When there is excess risk taken by the shareholders or when the financial distress is high, the creditors will react by raising the required rate of return on the debt, and eventually the shareholders have to pay the raised level of interest - bearing the costs of risky investment distortions by themselves.
Skeel and Krause-Vilmar argue140 that under financial distress, firms find it hard to raise capital; therefore, a shareholder loan would be a less costly option, as it saves
138 Robert C Merton, 'On the pricing of corporate debt: The risk structure of interest rates' (1974) 29 The Journal of finance 449. 139 Harris and Raviv, 'The theory of capital structure'. 140 David A Skeel and Georg Krause-Vilmar, 'Recharacterization and the Nonhindrance of Creditors' (2006) 7 European Business Organization Law Review (EBOR) 259.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans the firm from paying the costs associated with searching and negotiating with external creditors. It is perhaps true that the cost of debt may be lower with respect to the shareholder loans, but the lower cost of debt partners with implications which may increase the cost of other debt types.
Shareholders sometimes prefer to borrow the firm money with lower costs during financial distress because their only other options may include providing equity themselves or entering into a liquidation procedure, where they might stand to lose all of their equity and rights of control. Even though the shareholders only earn a lower amount of fixed interest through their loans, the intention for them to provide such loans is to ensure the continuity of the business and avoiding some potential uncertainty related to business risk, instead of the fixed return. Under financial distress the equity can have even negative returns; therefore, 0.00001% interest on the debt is better than nothing at all. On the contrary, the real gain comes from the unlimited upper side of the return on equity should the firm survive the distress eventually. Shareholder loans enable the shareholders to run the firm under distress without bearing extra risk on equity. At the same time, the shareholders will continue to be able to place claim on the bankruptcy assets should the business fail. Especially when there are no subordination requirements in bankruptcy procedures regarding the shareholder loans, the shareholder can get a secured position based on the secured shareholder loans. Therefore, they enjoy the upside of the business without suffering the downside of any losses. The low cost of shareholder loans represents a shift of risk from shareholders to creditors.
Banks, as a creditor with strong bargaining power, will adjust the interest rate if the shareholders loans exist in the corporation or subordinate the shareholder loans privately when they negotiate the lending contracts with the firm. Based on the research conducted in the U.S.141, the banks will ask for higher interest rates to compensate for the risk when the shareholders have strong controlling power on the firm. Shareholder loans, as a result of concentrated controlling power - normally negotiated between the parent company and subsidiaries - will increase the cost of debt of the subsidiaries.
141 Sudheer Chava, Dmitry Livdan and Amiyatosh Purnanandam, 'Do shareholder rights affect the cost of bank loans?' (2008) 22 The Review of Financial Studies 2973.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans However, there are also non-adjusting creditors142 who do not have a voice on the re- negation of the lending contract and non-interest-bearing creditors such as the suppliers, who receive no interest payments on the risk they bear. No matter how risk is distributed on the right side of the balance sheet among the investors, it must match with the risk on the left side of the balance sheet. Assuming all the other factors remain constant, switching shareholder loans and equity on the right side of the balance sheet will not decrease the risk level of the firm but redistribute it. The lower cost of shareholder loans doesn’t result in a lower risk for the total business, but instead it shifts the default risk to the other parties. As a result, a shareholder loan will increase the risk to the other creditors, and those creditors would not be able to increase their interest rate to compensate for such risk. This represents an unfair mismatch between the interest rate received by those creditors and the risks they need to bear. Therefore, the agency costs of shareholder loans are not internalized by increasing the cost of external debt. Such a mismatch brings extra benefits to shareholders and puts the loss on the shoulder of the other creditors.
Therefore, auto-subordination of shareholder loans might ensure that creditors are not exposed to the extra default loss from the beginning. Such ex-ante protection guarantees shareholder loans not to bring extra risk for the creditors - that they always rank in the bottom line if bankruptcy takes place. Here, I also wish to emphasize the difference of the ex-ante and ex-post rules of subordinating shareholder loans which, whilst having the same effect from the legal perspective, bring different economics values. The cost of debt must be adjusted to reflect the risk borne by the creditors. Automatic subordination as an ex-ante adjustment of shareholders’ liabilities will deliver certainty to the creditors that no ex-post shareholder loans shall affect the risk level of the firm. This simplifies the ex-ante estimation on risk borne by other creditors, making it easier to calculate the cost of debt143. Therefore, to achieve a more fair and
142 See Lucian Arye Bebchuk and Jesse M Fried, 'The uneasy case for the priority of secured claims in bankruptcy' (1995) 105 Yale LJ 857. Non-adjusting creditors are those that do not “adjust” the terms of their claims to anticipate or anyhow take into account the effects of new developments. 143 Because the automatic subordination brings a certainty for external creditors that shareholders would not be able to participate in the distribution of the assets in the common pool during bankruptcy procedure, the external creditors will not bear the risks that unanticipated shareholder loans might dilute the distributable value when the firm is insolvent.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans accurate value for the cost of debt, it might be more efficient to automatically subordinate shareholder loans unless there is sufficient evidence to prove that such loans are provided with good faith and are unlikely to cause extra damages to the creditors.
The signaling effect relating to asymmetric information is also relevant here. This might happen more often in publicly-traded companies. Shareholders would like to maintain the concentration of control; and when the company is running well, they would typically like to gain more profits from the equity and would hence be unwilling to provide a loan or let anyone dilute their controlling power. As a parent company, they would like to maintain control of the subsidiaries. If the parent companies choose to invest in their subsidiaries in debt instead of equity, this might be a sign that the expected return for shareholders, or the future expectation of return on equity, is not promising. It could also signal inadequate capital conditions 144 . This means that shareholder loans can be a negative sign of the financial health of a firm. In turn, this is likely to increase the cost of other types of debt because of adverse selection, despite the intention of such loans being not to expropriate the wealth of other creditors in some cases. Therefore, similar with the lemon problem in the second-hand car market145, firms will not use shareholder loans to finance unless the financial situation direly requires it; for instance, when the external markets are reluctant to provide funds and shareholders are not willing to inject extra capital. Without subordination, when the shareholders provide a loan instead of equity, the asymmetric information will give the public a signal that the firm is holding inadequate capital and is in danger of filing for bankruptcy. Resultantly, the firms with shareholder loans will find it is more difficult and expensive to obtain external loans. Subordination will make it less profitable for the shareholders if they want to expropriate the benefits of the creditors through such loans. Their loans will be paid at the most end anyway and they will not be able to escape the liability as an equity holder during bankruptcy procedure. Their loans, too, will be treated as equity within the bankruptcy distribution. If the shareholders still wish
144 This suggests that the conflict of interest between shareholders and creditors might be severe. 145 Srinivasan Balakrishnan and Mitchell P Koza, 'Information asymmetry, adverse selection and joint- ventures: Theory and evidence' (1993) 20 Journal of economic behavior & organization 99.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans to provide loans under such subordination conditions, it might be a signal that the business is viable and shareholders are in good faith. The subordination of shareholders, in such cases, will help reduce the vulnerability of the firm to the effects of adverse selection.
In general, the shareholder loans will bring externalized effect to other creditors, but such an effect could not be internalized in the cost of debt efficiently. Therefore, treating shareholder loans in the same manner as other loans will misprice the cost of capital in this firm. This will lead to external financial difficulties for the firm. We can conclude from the above analysis that shareholders loans would extend the life of businesses in danger, but also encourage the shareholders to take excessive risk as they engage in more volatile investments. Such excessive risk-taking will decrease the value of the creditors and hamper their claims on interest payments, as well as the principles. As such excessive risk will not be internalized by the cost of debt, the creditors will consequently be trapped in an unfair situation. Therefore, subordination of shareholder loans is beneficial.
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans 4. Conclusion and Suggestion:
Subordination of shareholder loans could easily find its roots from the perspective of legal justification and economic efficiency. From the perspective of corporate law and insolvency law we can see that subordination of shareholders loans could be justified based on the following reasons: firstly, it prevents shareholders from abusing their limited liabilities, especially when most EU countries have abandoned the rules of minimum capital requirements for private corporations. With the help of (secured) loans, the shareholders could avoid (any) risk exposed in the business. Secondly, based on the “Entity Shielding” principle, the shareholders of the firm are prohibited to withdraw their shares of assets at will, especially when the firm is in financial distress. The shareholders are only qualified to join the residual distribution after all the creditors have received payment in full. With the help of shareholder loans, the shareholders could get parts of their investment back during bankruptcy distribution and even jump to the front of the queue with secured loans. Subordination could prevent such an unfair situation and limit the imperfection of the common pool. Thirdly, the pari passu principle regarding bankruptcy distribution only takes place among the creditors who belong to the same class. Treating shareholder loans indifferently to other loans will break the boundary between the equity class and debt class, and equitable distribution across class is not justified based on the pari passu principle. For these reasons, subordination prevents such inequitable distribution from taking place.
Besides the legal basis, subordination of shareholder loans is also efficient under economics rationale. Shareholder loans, as a type of debt, carry both the dark and bright sides of debt, with the darker side outweighing compared to external debt. First of all, shareholders - who provide loans - do not behave as prudential as other external creditors to monitor the daily business of the firm and impose financial pressure when the firm is not running as efficiently as it should be. Second, when there is a capital shortage, or in other words, when the firm is over-leveraged, shareholder loans aggravate the risk-shifting problem. It would also not be sufficient in preventing a debt overhang situation. Using shareholder loans as a tool to solve the debt overhang problem might even cause a loop of risk-shifting and debt overhang. Reorganization, as an alternative of liquidation, could preserve the viable business and capture the going
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans concern value. By reconstructing the right side of the balance sheet, both risks shifting and debt overhang problem could be mitigated efficiently. Therefore, subordination could help to mitigate the risk-shifting problem, without hindering an efficient rescue. Thirdly, based on the Prospect Theory, shareholders might delay efficient liquidation and engage in an inefficient rescue attempt, even though the NPV can be negative for themselves and all other creditors. Shareholder loans might make it worse by letting shareholders feel less painful when the attempt fails. Consequently, subordination of shareholder loans is beneficial here. Lastly, the negative affect mentioned above could not be efficiently internalized through the fair price of debt. Creditors could not adjust the cost of debt based on the risk they bear and increase the interest rate when shareholders provide loans inside the firm. The externalities (agency cost) will be borne by the creditors and this brings economic inefficiency. Also, the shareholder loans will be regarded as a bad signal to the external investors. Automatic subordination of shareholder loans could provide ex-ante protection and decrease the externalities of shareholder loans.
In China, the suggestion of involving an equitable subordination rule inside corporate law (not bankruptcy law) was brought about in 2003, but there was no positive feedback from the legislation authorities until the case of Sha Gang Co., Ltd in 2015 146 . In this case, the Supreme People's Court mentioned that the equitable subordination rule of the US was instructive to this case147. During the past 10 years, there has been much discussion between scholars on adopting the subordination of shareholder loans inside the Chinese Legislation148. As I suggested in this paper, to figure out whether a new rule could be adopted in a certain jurisdiction, analysis of legal and economic rationale is essential. Therefore, to introduce the subordination rules into Chinese Legislation, we need to find the corresponding principles from Chinese corporate law and insolvency law and then test the economic efficiency of subordination and conclude on “ whether subordination of shareholder loans helps to
146 江平, '公司法与次级债权理论, 载赵旭东主编《 公司法评论》(第 1 辑)' . 147 符 望, '破产法面对关联公司债权的困境与深石原则的引入 ' (上海市第二中级人民法院,
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The Legal Basis and Economic Rationale of Subordinating Shareholder Loans mitigate the conflict of interest between the shareholders and creditors, and internalize the externalities of such loans”. This is going to be the topic for the future research.
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