Martin Gelter & Jürg Roth, Subordination of Shareholder Loans from a Legal and Economic Perspective, 2008; Also published in CESifo Dice Report - Journal for Institutional Comparisons, vol. 5, nr. 2, pp. 40-47, 2007.
Abstract: In closely-held corporations, the owners of a significant
amount of shares sometimes try to avert an impending bankruptcy by informally extending a loan, in the hope of financing a successful rescue attempt. For creditors, the continued operations of the company may result in a dissipation of even more liquidation value due to perpetuated and increased risk. For various reasons, courts and legislators are sometimes inclined to subordinate such
loans in bankruptcy, or to require their treatment as equity. While some legal systems, such as those of the UK, France or the Netherlands, provide for no specific rules and regulations on loans granted by shareholders to their companies in distress, the treatment of such loans varies significantly among countries using such a concept, which include Germany, Austria, Italy, Spain and the US. The basic idea can be outlined as follows: When the financial situation of a company deteriorates, third party loans may become unavailable at some point. If business operations cannot be continued without immediate cash supply, shareholders basically see themselves confronted with a double set of alternatives: First, they have to decide whether or not to liquidate their company. If they decide to continue their business, the second choice concerns the question whether to provide funds in form of equity or to grant loans. If they decide to grant loans and the company goes bankrupt nonetheless, statutory subordination excludes
them from equal participation in the proceeds of the estate. In practice, they normally suffer a total loss. In turn, third party creditors, whose interests were not taken into account in the decision to continue operations, but who very well bear its consequences, profit twofold: Ex post, their quota in the proceeds increases inasmuch as the shareholders’ claims are subordinated. Ex ante, they may benefit from the negative incentive deriving from imminent subordination to the extent it prevents shareholders from granting loans to companies that are potentially not capable of surviving. Under certain conditions, however, the incentive may be too weak or even counterproductive.
This paper proceeds as follows: The next section gives a comparative overview of how shareholder loans are treated by the law in a number of European jurisdictions and in the United States. Afterwards an economic perspective on subordination and its incentive effects on the basis of a model written by one of the authors is presented. It will be explained why the effects of subordination may sometimes be counterproductive. The last section offers some reflections on legal policy and possibilities of reform relating to the field.