Germany: New Rules For Shareholder Debt Financings : Reform Of The Law Governing The Equitable Subordination Of Shareholder Loans By The Limited Liability Company Modernization Act

A main focus of the anticipated reform of the law governing limited liability companies by the draft Act on the Modernization of the Law on Limited Liability Companies and the Prevention of Abuse (generally referred to as the "MoMiG" or "Modernization Act") is the new set of rules relating to shareholder debt financings. The reform of the rules regarding the equitable subordination of shareholder loans currently in place is desirable for two main reasons: on one hand, the current legal situation is unclear, due to the parallel applicability of statutory rules (Sections 32a and 32b of the German Limited Liability Company Act) and the additional rules imposed by German case law supplementing the statutory provisions. On the other hand, it is currently very difficult to ascertain at which point in time a loan must be recharacterized as equity capital.

Unclear Legal Situation

Pursuant to Sections 32a and 32b of the Limited Liability Company Act, during insolvency proceedings relating to the assets of a company, shareholders may claim repayment of loans advanced to the company when it was undercapitalized only as subordinated insolvency creditors. This rule also applies to other shareholder actions that, from an economic perspective, are equivalent to granting a loan to the company. Pursuant to the additional rules promulgated under case law, loans that are recharacterized as equity capital must not be repaid to the extent that the repayment amount is required to maintain the stated share capital of the company. These case-law rules therefore apply beyond the scope of application of the statutory rules since they prohibit repayment even prior to the initiation of insolvency proceedings to the extent the stated share capital of the company is affected.

Definition of "Equitably Subordinated Loans"

Prior to the legislative reform, it was unclear at which point in time a loan must be considered equitably subordinated. Pursuant to the statutory definition, this is the case if a shareholder loan is granted to the company in times of "crisis" or is not called for repayment during such times. According to the majority opinion in German jurisprudence, the main criterion for determining the existence of a crisis is the lack of creditworthiness of the company on the capital markets. If the company is not creditworthy, a shareholder acting "as an ordinary businessman" should provide the company with equity instead of debt. If such shareholder nevertheless provides debt to the company (or does not call existing debt), such debt will be recharacterized as equity.

Changes to Be Effected by the Modernization Act

The Modernization Act provides for the abolishment of the entire law governing equitable subordination of shareholder loans. The statutory provisions in Sections 32a and 32b of the Limited Liability Company Act will be deleted. In addition, the new Section 30, para. 1, sentence 3, of the Limited Liability Company Act clarifies that the repayment of shareholder loans does not fall under restrictions relating to the payment of funds required to maintain the stated share capital. This means that shareholder loans can no longer be recharacterized as equity and that the assessment of whether or not there is a crisis will become obsolete in the future.

Amending Section 39, para 1., no. 5, of the German Insolvency Code will shift the entire matter to the area of insolvency law. Currently, only loans that are recharacterized as equity are subordinated by statute in case of insolvency; such subordination will now be extended to all shareholder loans. Accordingly, when the Modernization Act enters into force, any repayment of shareholder loans will be subject to the—modified—rules of fraudulent conveyance under the German Insolvency Code (if such repayment was made within one year of the application for insolvency) and the German Fraudulent Conveyance Act (if the repayment was made within one year of obtaining an enforceable judgment).

As a quasi-compensational measure for the removal of the restriction relating to the payment of funds required to maintain the stated share capital, the new Section 64, sentence 3, of the Limited Liability Company Act tightens the liability of the managing directors: currently, the managing director is liable only for payments to the shareholders that are made after the company is unable to pay its due debts or has become overindebted. The reform provides that any payments that trigger the limited liability company's inability to pay its debts will lead to management liability, unless this was not foreseeable by a prudent businessman. This means that in the future, the managing director must, prior to any payment to the shareholders, assess whether such action "must lead" to the company's inability to pay (solvency test).

Currently, exemptions from the rules regarding equitable subordination of shareholder loans in case of restructurings and minor equity participations will be shifted in modified form to Section 39 of the Insolvency Code. Pursuant to the privilege regarding restructurings, in the future shareholders' loans will not be subordinated until the company is restructured in a sustainable manner, provided that the creditor acquires the shares in view of the restructuring. What is new is that the privilege regarding restructurings will in the future also apply to cases of imminent inability to pay debts as they become due, whereas current legislation provides that only the acquisition of shares during the actual inability to pay or overindebtedness is privileged. Pursuant to the privilege relating to minor equity participations, shareholders who are not managing directors and hold no more than 10 percent of the stated capital of the company are still exempt under the new rules.

A further novelty is the extended scope of application: whereas, for instance, in the case of stock corporations, the current rules in effect for equitable subordination generally apply only to loans of a shareholder holding more than 25 percent of the shares of the company, the new Section 39, para. 1, no. 5, of the Insolvency Code will apply to any German corporation or partnership that does not have a natural person as its general partner, as well as to foreign companies.

Conclusion

In general, the reform of the law governing shareholder debt financings is positive. The shift of this matter to the Insolvency Code is system-compatible and provides for a clear legal situation. However, the reform does not make shareholder debt financings easier. Shareholders still have to monitor the financial situation of the company due to the generally applicable subordination rules. In addition, the liability of the managing directors will be considerably tightened, which might lead to a "factual stoppage of payments" in doubtful cases.

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