Avoiding the requalification of loans under German and U.S. Law

Table of Contents

Bibliography

A. Introduction
I. Description of the Topic
II. Motives for Granting Shareholder Loans Instead of Contributing Equity

B. Rules Applicable to Loan Subordination
I. German Law
1. The Purpose of the Rules on Equity Substitution
a. Introduction
b. Speculation at the Costs of the Outside Creditors
c. Deception of Creditors
d. Insiders’ Finance Responsibility
e. Summary
2. Requirements of Loan Subordination
a. Shareholder Loan
aa. Substantive Point in Time
bb. Cases concerning the “Quasi-Shareholder”
b. Equity Function of the Loan
c. “Granting“ of a Loan
d. Exemptions
e. Differences between the Statute and the BGH Decisions
3. The Consequences of Equity Replacing Loans
4. Summary
II. US-Law
1. Recharacterization
2. The Doctrine of Equitable Subordination
a. Historical Development of the Doctrine of Equitable Subordination
aa. First Step: Doctrine of Piercing the Corporate Veil
bb. Second Step: The Doctrine of Equitable Subordination
cc. The Differences between Piercing the Corporate Veil and Equitable Subordination
b. Requirements for Applying Equitable Subordination
3. Application to Outside Lenders (Lender Liability)
4. Summary
III. Common Features and Differences of U.S. and German Law
1. Objectives
2. Different Historical Paths of Development
3. Rules Concerning Outside Lenders
4. Importance of Lenders’ Behaviour for Legal Classification
5. Results of the Comparison for Development of Measures to Avoid Subordination

C. Strategies for Avoiding Liability
I. German Law
1. Avoid Fulfilling the Requirements for Application
a. Qualification as Outside Lender
aa. Share of the Profits
bb. Power to Influence Fundamental Decisions
cc. Summary
b. Avoiding the Equity Function of the Loan
2. Fulfilling the Requirements of an Exemption
a. Minority Clause
b. Privilege for Rehabilitation
aa. Acquisition of Shares
bb. Intent to Rehabilitate
cc. Time of Rehabilitation
dd. Consistency of § 32 a (3) sentence 3 GmbHG
ee. Summary
II. US-Law
1. Avoiding Equitable Subordination
2. Avoiding Lender Liability
3. Avoiding Recharacterization
4. Summary
III. Strategies Applicable in both Legal Systems

D. Summary

Bibliography

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A. Introduction

I. Description of the Topic

The subordinating requalification of shareholder loans is currently one of the most discussed topics in international business law. A notable decision by Germany’s highest court of general jurisdiction, the Federal Court of Justice (“BGH”), has had a significant impact on banking practices in Germany and has also stimulated on the subordinating requalification of shareholder loan debate.^[1] This decision extended subordination beyond the common case of shareholder’s loans and applied the doctrine to a bank loan that was secured with a pledge of the company’s shares and with other substantial rights. Hence it has been becoming more and more complex for creditors to ensure that they will not come under such “equity substitution rules”. These rules have undesirable consequences, first among which is the subordination of loans. Subordinated claims are paid only after the other debts of the same debtor are paid in full.^[2] In the end, there are usually too few assets to satisfy the subordinated claims. Potential creditors thus have a serious interest in avoiding such subordinating requalification.

In the United States, the case law also contains additional rules about involuntary loan subordination. They are included in the doctrine of “equitable subordination” developed in the U.S. Supreme Court’s well known “Deep Rock”-decision^[3]. U.S. courts have developed their subordination doctrine together with the concepts of “recharacterization” and “lender liability”.^[4] The equitable subordination is frequently applied in the United States and strategies to avoid subordination are also needed in U.S. practice.

This paper will show how the subordination of shareholder claims can be avoided. As background, it will first describe briefly the requirements for the judicial subordination of a loan in Germany and the United States . It will then set out the differences and common features of the two systems. Finally it will present several strategies that may be used to avoid or at least reduce the risk of subordination.

II. Motives for Granting Shareholder Loans Instead of Contributing Equity

Before explaining why and how shareholder loans are subordinated, it is useful to examine the advantages a shareholder hopes to have by granting a loan instead of contributing equity to his company.

In insolvency proceedings creditors are satisfied first by payout of the remaining capital of the company. Hence, they bear a lower risk than the shareholders, and a shareholder can limit his risk by giving a loan instead of equity capital.^[5] Furthermore, it may be an advantage that the shareholder’s interest in the company remains equal in relation to the other shareholders despite his injection of funds.^[6] The company is able to save the costs of bargaining with and monitoring on outside lender by receiving a shareholder loan.^[7] The shareholders already monitor the management because of their investment in the company. For this reason an insider loan is generally cheaper.^[8] Moreover, increasing debt also increases leverage, and leads to a seemingly higher performance of the GmbH (Gesellschaft mit beschränkter Haftung)^[9] in terms of the earnings-to-equity-ratio. As a result, the GmbH’s credit rating could increase making the terms of financing on the capital markets more favourable. Another reason for giving a loan is flexibility. There are no corporate law formalities as in the case of a capital increase.^[10] Making loans is especially advantageous for shareholders who cannot control the management through their equity interests. Through the financial pressure they have a measure of influence over the GmbH’s management and can thereby mitigate the principal-agent-conflict^[11] by the threat of terminating the credit.^[12] Last goal in granting a shareholder loan is tax savings because payment of interest reduces the GmbH’s tax obligations in contrast to the distribution of dividends.^[13]

These advantages give shareholders concrete incentives to give money to their company in the form of a loan.

B. Rules Applicable to Loan Subordination

Before we can discuss the strategies for avoiding undesired subordination, we must explain in detail the rules applicable to loan subordination in both the German and the American systems.

I. German Law

The German equity substitution law was first developed by the predecessor of the BGH, the “Reichsgericht”,^[14] under § 826 of the German Civil Code (Bürgerliches Gesetzbuch – BGB). Because of the strict prerequisites of § 826 BGB,^[15] which requires an intentionally and immorally damaging action by the lending shareholder, later cases decided by the BGH leaned on an analogy to §§ 30, 31 of the Limited Liability Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung – GmbHG) in order to solve special cases of undercapitalization.^[16] First decisions on loan subordination were quite restrictive at first, but they gradually considered more and more loans as equal to equity.^[17] For instance, the rules concerning the subordination of claims were initially only applicable to limited liability companies. In a latter decision, the BGH also deemed loans granted to a stock corporation to replace equity.^[18] Further cases extended the scope of the equity substitution law. This extension was triggered by the attempt of the German legislator to enact the rules developed by the courts by adding the §§ 32 a, 32 b GmbHG, § 135 Insolvency Act (Insolvenzordnung – InsO) and § 6 Contestation Act (Anfechtungsgesetz – AnfG) in 1980.^[19] Section 32 a (3) sentence 1 GmbHG introduced an economic analysis as a guide for the courts.^[20] Under such view persons who hold a position equivalent to that of a shareholder vis-à-vis the GmbH also became subject to the rules on equity substitution. For instance, this has been applied to shareholder’s relatives^[21], subsidiary companies as defined in §§15-19 AktG^[22] as well as to trustees^[23]. As mentioned above, a decision has also applied the rules of subordination to pledgors^[24].

Doctrine developed in the courts will continue to apply despite the statutory rules – due to the gaps and inflexibility of the statutory law, ­­– thus fostering the development of a dual protection system in the rules on equity substitution.^[25]

Obviously, equity substitution rules can apply to a great number of cases. In order to understand how courts have interpreted the requirements for its application, the purpose of the rules on equity substitution needs to be explained.

1. The Purpose of the Rules on Equity Substitution

a. Introduction

Legal rules normally provide that all persons have to discharge their obligations.^[26] For these rules, the liability limiting function of a legal entity forms an exemption. A legal entity limits the liability of its shareholders, i.e. the shareholders are only liable for the debts of the entity up to the amount of their contributions. For this favour of limited liability given to the shareholders of a GmbH by § 13 (2) GmbHG, the shareholders have to comply with rules regarding the contribution and maintenance of the company’s funds.^[27] As long as they so comply, in principle, they are free to decide how to finance the company’s business.^[28] Generally, loans provided by a shareholder to a GmbH are treated like any other third party loans. This will change if the company comes into a financial crisis.^[29] In this event, granting of a shareholder loan has some adverse effects on outside creditors.

b. Speculation at the Costs of the Outside Creditors

It would seen at first glance that the granting of a shareholder loan would always have positive effects on the outside creditory^[30] because it improves the liquidity position of the company.^[31]

However, the shareholders’ ability to improve the economic outlook of the company by increasing debt even if there is very little equity capital, endangers the positions of the other creditors. It results in a higher leveraging of the company because the improved liquidity position is only achieved with an increase of debt. When additional creditors are added, the share of the existing creditors in the overall assets of the GmbH declines.^[32] Furthermore, when the company’s debts increase, the risk of insolvency also climbs. In the insolvency proceedings creditors receive a smaller return on their credits because of shareholder participates in the proceeding with his loan as pari-passu claimant. However, if the company recovers, the shareholder will not only earn his interest as every other lender but will also take part in the company’s earnings, which may be higher than the interest payments. In this way, the relation between risk bearing and participation in the profits no longer fulfils the balance provided by the rules of capital maintenance, and as the creditors have assumed it in their contracts with the GmbH. Moreover, the shareholder usually has superior knowledge about the prospects of the company because of his insider knowledge.^[33] As a result, the shareholder shifts a part of the risk he is supposed to bear to the outside claimants. The shareholder also circumvents the restrictions connected with the contribution of equity, beginning with formal requirements^[34] and ending with ranking in insolvency. In the end, the shareholder speculates at the costs of the outside creditors.^[35]

German law considers creditor protection to be very important,^[36] and thus does not accept the result described above. The possibility of transferring the costs and risks to third parties who are not compensated for it, would give an incentive to create unfair benefits at the disadvantages of others.^[37] Therefore avoid speculation by insiders at the risk of outside claimants may be what the rules pertaining equity substitution law attempt to achieve.^[38]

c. Deception of Creditors

By giving fresh capital to his company instead of liquidating it, a shareholder deceives new creditors concerning the company’s financial condition, especially its prospects for the future.^[39] Because of this deception, creditors may be more willing to grant loans. If the company enters bankruptcy, an increase in creditors means a decrease in quotas in insolvency proceedings and thus disadvantages for both old and new creditors. The deception is also known as a variation of “venire contra factum proprium”^[40] because a shareholder who gives money to his own company and will be the first to demand it back if the company does not recover, acts inconsistently.^[41]

One might assume that the goal of the rules on loan subordination was to prevent such deception. However, it is generally accepted that the rules of equity substitution will apply even if the creditors do not rely on a certain financial condition of the GmbH.^[42] Therefore, the purpose of the rules on equity replacing loans cannot be a mere avoidance of deception. Nevertheless, these considerations are implied in the doctrine of “Finanzierungsfolgenverantwortung” (insiders’ finance responsibility) found in German court decisions and scholarship.^[43]

d. Insiders’ Finance Responsibility

In order to avoid the described adverse effects on outside creditors, a shareholders’ freedom to finance his company has to be subject to limitations. Even if the company is in a poor financial condition, a shareholder may still either contribute more capital into the business or liquidate it.^[44] Since this freedom with regard to continuing the company’s business or to liquidating it corresponds to a shareholder’s responsibility to outside creditors, the described threats to such creditors arising from late capital injections may be prevented by restricting the shareholders’ freedom of financing the business.^[45] As a result, a shareholder is surely not obliged to contribute fresh capital to the GmbH in crisis, but if he continues the company’s business he will be liable for its viability, i.e. for the maintenance of the limitations of §§ 30, 31 GmbHG.

A shareholder with a substantial stake in a company may well be bound on giving the impression that the company is still prospering.^[46] The freedom to finance the company creates a responsibility towards others, and separation of the freedom from the responsibility would create an incentive for irresponsibility and a danger for creditors.^[47] The BGH and most scholars use the doctrine of in insiders’ finance responsibility to address this problem.^[48] This principle addresses all of the reasons for an equity substitution rule such as preventing the deception of creditors and mitigating the adverse effects of information asymmetries between insiders and outside creditors. The principle correlates power and liability. Thus not the “whether” but the “how” of financing is restricted by subordinating a loan to the rank of equity.^[49]

e. Summary

We have seen that the goal of the rules on the equity substitution is the enforcement of the insiders’ finance responsibility. In this way, the rule also extends the protection given by the rules of insolvency law designed to prevent preferential transfers.^[50] This related goal has to be born in mind because it is necessary to interpret the rules on equity restitution^[51] which are – all in all – fragmentary.

2. Requirements of Loan Subordination

Sections 32 a and 32 b GmbHG contain the requirements of loan subordination under German statutory law which is based on previous BGH decisions. Since the statutory rules were originally developed by the courts, their interpretation is strongly influenced by the pre-existing decisions and their equitable purposes.

a. Shareholder Loan

The first requirement of loan subordination pursuant to the rules of equity substitution is that a credit is given by a shareholder.

aa. Substantive Point in Time

A granted loan will only be subject to the substitution rules if the lender holds shares of the GmbH at the point in time when he gives the credit. It is irrelevant if the shareholder sells his shares after the subordination of the loan.^[52]

bb. Cases concerning the “Quasi-Shareholder”

Shareholders are not the only lenders who have to take the rules of equity substitution into consideration. Pursuant to courts which have developed rules in^[53] accordance with § 32 a (3) sentence 1 GmbHG, a creditor is also subject to the rules on equity-replacing shareholder loans if he has a position which is economically equivalent to that of a shareholder.^[54] These rules on loan subordination are very complex and therefore very hard to circumvent. The well known decision of the BGH in 1992, BGHZ 119, 191, has shown that it is very important for (bank) lenders to pay attention to the equity substitution rules when giving a loan. In the 1992 case, a shareholder of a GmbH had pledged its shares as security to a lending bank. The bank demanded additional securities because a pledge does not transfer shareholder rights to the pledgee.^[55] The shareholder then assigned his existing and future claims for distributions and payments out of liquidation and a potential sale price out of a share deal as security to the bank. Moreover, the pledgor’s exercise of shareholder rights was made subject to the bank’s consent,^[56] although these rights are the “unalienable core of shareholder rights”^[57]. Because of the transfer of these additional rights – especially the requirement of the bank’s consent to important resolutions ­­– to the pledgor, the BGH held that the bank held a shareholder-like position and thus the court applied the rules of equity substitution to the bank’s loan. The decision did not specifically state what kinds of special rights granted to a pledgee would trigger the application of the rules on equity-replacing shareholder loans. The court did, however, provide a safe harbour rule according to which the rules on equity-replacing shareholder loans would not be applicable to a pure share pledge that remains confined to its legal rules.^[58] Thus, in order for the substitution to apply it would seem that various elements must be taken together to conclude that, in a specific case, a pledgee has actually acquired a position equivalent to that of a shareholder. Moreover, since a typical pledge is not enough to trigger a creditor’s characterization as shareholder in terms of § 32 a (3) sentence 1 GmbHG, as the BGH has held, certain additional rights extended to the lender by some covenants of a loan agreement would then trigger the subordination of the claim.^[59]

Nevertheless, because there is only one significant decision in this field, it is very hard to assure the applicability or non-applicability of the rules of equity substitution in practice. I attempt to clarify the motives of the court in its application of the rules in part C.I. of this paper.

Generally it may be concluded that as long as a creditor has a similar finance responsibility as a shareholder, the rules referring to capital replacement will be applicable.^[60]

b. Equity Function of the Loan

Since the rules on the financing of a GmbH provide only that a minimum stated capital has to be paid in to the company, during the course of the company’s business, the shareholders will be completely free to decide about the GmbH’s financial composition. Thus shareholders may legally grant loans to the company just as any third party.^[61] As mentioned above,^[62] this changes if the company enters in a financial crisis. In such cases the shareholders have to behave in financial matters like prudent businessmen (§ 32 a (1) GmbHG). They are no longer free to decide whether to give a pari-passu ranking loan or a subordinated equity contribution to the company.^[63] As discussed above, courts assume that a loan granted in a time of a financial crisis has an equity function; as such, it will be subordinated.^[64]

A financial crisis is understood to be present, when the GmbH is either unable to obtain the credit from objective outside lenders at fair market rates that is necessary to continue its business,^[65] the company has a negative net worth (overindebted),^[66] or it is unable to pay its debts as they fall due (insolvent).^[67] A GmbH in a financial crisis will not be able to continue its business without fresh money and thus has to be liquidated.^[68] To trigger application of the subordination rules, the financial crisis must exist exactly in that point of time when the loan is granted. For evaluating the company’s condition when the credit is granted, all circumstances must be objectively evaluated.^[69] Circumstances such as insufficient stated capital evidence the existence.^[70]

c. “Granting“ of a Loan

Sections 32 a and 32 b GmbHG apply not only to the granting of fresh capital to the company in a time of a financial crisis. Loans granted at a time while the company was healthy may also be threatened with requalification as equity. If a financial crisis occurs, the lender will have either to apply for the GmbH’s liquidation or demand repayment of the loan, assuming that he has such right. A lender will normally have such right because whenever the borrower’s financial status adversely changes, the lender is, as a rule, entitled to call for full repayment of the loan pursuant to §490BGB.^[71] If the creditor neither liquidates the company nor accelerates the loan, his loan will be subordinated because the granted credit is considered to rolled over (“stehengelassen”) during the crisis and as such the rules of original equity replacing loans apply.^[72] This broad interpretation of the “granting” of a loan is necessary to prevent circumvention of the rules pertaining to equity substitution.

However, as shown above, loan subordination requires that the lender has some form of insiders’ finance responsibility. This responsibility does not exist without freedom of financing. This freedom consists of the lender’s ability to choose either to terminate the loan, liquidate the GmbH or accept the subordination. A creditor can only make a choice if he realizes that there are options. Therefore a subjective criterion, a knowledgeable decision of the lender, is needed.^[73]

A loan will only be subordinated if the lender recognized or had the possibility to recognize the crisis. If he had no such knowledge and he can prove it, his loan will not be subordinated.^[74]

d. Exemptions

Even if all of the requirements described above are fulfilled, a loan will not be subordinated if a legal exemption applies. These exemptions are contained in § 32 a (3) GmbHG. Pursuant to this provision, introduced 1998, shareholders that hold 10 % or less of the company’s shares and are not involved in its management are not subject to the rules of loan subordination. Moreover, if a creditor acquires the company’s shares during the crisis in order to rescue the company, the rules on substitution of equity capital will not apply to such creditor’s existing or newly extended loans.

e. Differences between the Statute and the BGH Decisions

Although the requirements of the equity substitution rules set forth in statutes and the decisions of the BGH are very similar, there are some substantial differences.^[75] While §§ 32 a and 32 b GmbHG are only applicable in the case of bankruptcy, judicial doctrine also prohibits repayment of subordinated loans outside of insolvency.^[76] In such cases, the GmbH’s manager is legally obliged by § 43 (3) GmbHG and an analogous application of §§ 30, 31 GmbHG to demand that any repayments the company has made on the loan be returned. Otherwise, the §§32 a and 32 bGmbHG do not only require that the actual deficiency in the amount of equity capital will be subtracted before the repayment of the subordinated shareholder loan, but also forbid repayment of any part of the loan whose repayment would reduce the assets required to cover the stated capital until the company has overcome its financial difficulties.^[77]

3. The Consequences of Equity Replacing Loans

If the requirements for re-qualifying a loan are met, the doctrine developed by the BGH will forbid any repayment of the loan as long as the GmbH is still unsound and its assets do not at least equal its stated capital before the commencement of insolvency proceedings.^[78] In the insolvency context, the law seeks to give outside claimants priority rights as is provided in §32a(1)sentence 1 GmbHG and § 39 (1) No. 5 InsO. This applies to the whole amount of the credit granted including any interest.^[79] As a consequence, the creditor usually fails in his demand for repayment.^[80] Pursuant to § 135 InsO, all payments on the loan made during one year before the initiation of insolvency proceedings are subject to a possible challenge by the insolvency administrator. The judicial decisions even allow a repayment to be challenged for up to five years before the insolvency proceedings. Furthermore, the shareholder lender may not set off debts to the company with the loan.^[81] The receiver may order that security furnished to the shareholder be returned to the company if it was transferred within ten years before the opening of insolvency proceedings. Lastly, under §32bGmbHG, if a third party loan has been extended because of a surety or guarantee from a shareholder, and it is repaid within one year before insolvency proceedings commence, the shareholder must either refund any payments made on the loan to the company, up to the value of the surety or guarantee at the time of repayment or hand the collateral over to the company for its own use.

4. Summary

As pointed out in the introduction, the rules pertaining to equity substitution may have very hard consequences for loans. There are, in particular, many pitfalls most would not expect in connection with covenants. Knowing the requirements of loan subordination is a first step towards avoiding its application. For loan subordination, the lender must be a shareholder or must have at least a shareholder-like position. Furthermore, he has to grant a loan to a GmbH in critical financial condition. In addition, the credit must have an equity function, i.e., prudent businessmen would have injected equity instead of borrowed capital. Finally, there are some important differences between the court developed rules and §§ 32 a and 32 b GmbHG, as well as §§ 129, 135 No.2, 143 InsO.

II. US-Law

Just as in Germany, shareholders in the United States are also allowed to make part of their investment in a corporation in the form of loans. Such loans are normally entitled to the same treatment in the event of corporate failure as loans from outsiders.^[82] However, shareholder credit to a company is also subject to certain limits in the United States. These limits are set by the principles of recharacterization and lender liability, and especially the doctrine of equitable subordination.

1. Recharacterization

Recharacterization does not subordinate a loan, but helps to determine whether a debt actually exists.^[83] “To be a creditor in bankruptcy the debtor must owe a debt to the claimant.”^[84] Whether there is a debt must be decided by the courts. If the transaction reflects the characteristics of an arm’s length negotiation, the loan will be characterized as debt. In the case of Roth Steel Tube co. v. Commissioner of Internal Revenue^[85] objective^[86] criteria have been developed to guide the application of recharacterization. These criteria include the name the parties have given to the grant of the money, whether a fixed maturity date and schedule of payments has been set, and whether the sum bears a fixed rate of interest to be paid in set payments. Other criteria which have to be taken into consideration are the source of repayment, the adequacy of capitalization, the identity of interests between the creditor and stockholders, the security given for the advances, the corporation’s ability to obtain financing from outside lending institutions, the extent to which the advances were subordinated to the claims of outside creditors, and the extent to which the advances were used to acquire capital assets, as well as the presence or absence of a sinking fund to provide repayment.^[87] An undercapitalization may be enough to trigger the recharacterization of an alleged loan into a capital contribution.^[88]

2. The Doctrine of Equitable Subordination

For a full understanding of the doctrine of equitable subordination, it may be useful to explain its historical development.

a. Historical Development of the Doctrine of Equitable Subordination

The doctrine of equitable subordination was developed to a certain extent in tandem with the principle of piercing the corporate veil.^[89] Therefore, the first step in my historical review will address this latter principle.

aa. First Step: Doctrine of Piercing the Corporate Veil

Because the concept of a substantial minimum stated capital to secure creditors’ interests was never present in the corporation law of most U.S. states, and in more recent time has been completely removed,^[90] and because of the common practice of issuing no par value shares to circumvent statutes in which stated capital equals par times shares issued,^[91] the courts were compelled to develop doctrines to deal with abuse of capital requirements, generally known as undercapitalization.^[92] One such doctrinal solution was the principle of piercing the corporate veil.^[93] This form of creditor protection required shareholders to finance the corporation adequately for the nature of its business. As the U.S. Supreme Court stated more than 50 years ago, “an obvious inadequacy of capital, measured by the nature and magnitude of the corporate undertaking, has frequently been an important factor in cases denying stockholders their defense of limited liability.”^[94] The contributed capital was deemed inadequate, if reasonably prudent men with general business background would have deemed the company undercapitalised.^[95] Undercapitalization was found, if “in the opinion of a skilled financial analyst, it would definitely be insufficient to support a business of the size and nature of the bankrupt in light of the circumstances existing at the time the bankrupt was capitalized” and “at the time when the advances were made, the bankrupt could not have borrowed a similar amount of money from an informed outside source.”^[96] Consequently, like under German law, the freedom to finance the corporation’s business must not result in shifting the risk of counter-party failure unfairly to the outside creditors. There must be a fair distribution of risks between equity-holders and creditors.^[97] An individual single shareholder should not be allowed to “risk[s] more than he invests”^[98]. If this is nevertheless done, the consequence is unlimited liability for the company’s shareholders.

bb. Second Step: The Doctrine of Equitable Subordination

The legislative purposes of bankruptcy law are not always well sewed by the consequences of piercing the corporate veil. U.S. courts have a general “power of equity” with which to achieve justice in individual cases. The courts have used this power to balance the treatment of the creditors, ensuring that they are treated in an equitable manner.^[99] To this end, U.S. courts gradually developed the doctrine of subordination because it achieved fair treatment of creditors without the sometimes harsh side effects of piercing the corporate veil.^[100]

The U.S. Supreme Court first developed the equitable subordination doctrine in 1939 in Taylor v. Standard Gas & Electric Co.^[101] In this case, Standard Gas filed a claim against its bankrupt subsidiary Deep Rock Oil Corporation based upon Standard’s loan to Deep Rock. The parent company was the only financier of Deep Rock and controlled it completely.^[102] The court held that Deep Rock was grossly undercapitalised and that there was mismanagement vis-à-vis the preferred stockholders. The Supreme Court did not treat the case as a candidate for piercing the corporate veil under the question of the instrumentality rule, which would have found Deep Rock to be just a department or agent of Standard Gas rather than an independent company.^[103] It chose the subordination route because of the purposes of the bankruptcy law and the ability of the court to craft a remedy in equity. With this power of equity, the Supreme Court counterbalanced the inequitable actions, i.e. undercapitalization of Deep Rock and mismanagement vis-à-vis preferred stockholders, by subordinating the parent company’s loan below the rank of the outside creditors’ claims.^[104] Later commentators have generally agreed that this was a more appropriate way to deal with the facts presented.^[105]

The decision had two important results: First, the power of equity was used to subordinate a claim in the insolvency context and this doctrine could then be used for all the cases connected to the financing of a corporation by insider loans. Second, the formal relationship between company and shareholder which was of great importance for the instrumentality rule was replaced by the fairness standard of equitable subordination. Hence inequitable conduct rather than a breach of legal formalities became the standard for subordinating a loan.^[106]

In Pepper v. Litton,^[107] which was decided in the same year, the Supreme Court confirmed its new doctrine of equitable subordination. Since then, this doctrine has been applied to cases in which a shareholder gives a loan to his company, thereby causing a deterioration of the outside creditors’ position because of the shifted risk.^[108] The courts seek to correct inequitable conduct of shareholder towards other creditors, deriving from either harmful behaviour of the shareholder or an insufficient capital contribution.^[109]

The application of the doctrine became more precise through the guidance offered in the decision of the Court of Appeals for the Fifth Circuit in In re Mobile Steel^[110]. The court developed a so-called 3-prong test.^[111] This test has been further developed by other courts. In 1978, the doctrine of equitable subordination was at last codified in § 510 (c) of the U.S. Bankruptcy Code.^[112]

The more practical and – first and foremost – more flexible fairness test of the doctrine of equitable subordination leads to its frequent application. Because business transactions were becoming more and more complex and complicated, the formal approach of the instrumentality rule was no longer practicable in many cases. The costs of examining evidence and computing damages in litigation was no longer necessary. Finally, the milder remedy of equitable subordination was an advantage. Therefore, this doctrine is commonly used.^[113]

cc. The Differences between Piercing the Corporate Veil and Equitable Subordination

Despite their common historical roots, there are differences between the doctrine of piercing the corporate veil and that of equitable subordination. The most obvious difference is the legal consequence of the two doctrines. While piercing the corporate veil leads to unlimited liability for shareholders, the only consequence of equitable subordination is the subordination of an insider loan in the context of insolvency “to the extent necessary to offset the harm that resulted”,^[114] without any further impact on the shareholder.^[115] Consequently, the doctrine of equitable subordination is more closely tailored to the remedy sought.^[116]

It is difficult to distinguish between the two doctrines on the basis of their requirements. The distinction is more clearly present in their consequences. Since the piercing of the corporate veil has broader consequences, the requirements for its application must be higher. Consequently, piercing of the corporate veil punishes the disregard of the corporation as a distinct entity while equitable subordination focuses on creditor’s unfair behaviour.^[117] The principle of piercing of the corporate veil also requires certain non-financing behaviour while equitable subordination requires an unfair financing behaviour of an insider e.g. a shareholder loan granted in order to compensate undercapitalization.^[118]

b. Requirements for Applying Equitable Subordination

The requirements for applying equitable subordination, which were somewhat vaguely explained in Deep Rock, are more clearly set forth in the 3-prong test laid down in In re Mobile Steele.

According to this 3-prong test, a shareholder loan is subordinated whenever the insider lender has engaged in some type of inequitable conduct.The concept of “inequitable conduct” is subject to many different interpretations by courts and is thus a “very slippery concept with little predictive value”.^[119] Not only outright fraud is “inequitable conduct”, but also “conduct which may be lawful, yet shocks one’s good conscience”^[120] falls in this category. Because equitable subordination was developed from the doctrine of piercing the corporate veil, inequitable conduct will in most cases be found if a loan is given to the debtor in lieu of an equity investment at a time when the debtor was undercapitalised.^[121] Such conduct may also result from a breach of faith by a fiduciary; an unjust enrichment is described as “unjust” or “unfair” even though it may be lawful.^[122] Hence the type of conduct found to be inequitable may vary significantly.^[123]

Since a court in its capacity as a court of equity seeks to undo a specific wrong rather than to punish generally,^[124] the second prong of the In re Mobile Steel test requires that the misconduct caused injury to the creditors of the bankrupt or conferred an unfair advantage on the lender of the challenged loan. Finally, the equitable subordination of a claim must not be inconsistent with the provisions of the Bankruptcy Act.^[125] This test is generally accepted by the courts as well as scholars.^[126] The reason behind this test is the need to uphold the equitable distribution of risk and opportunity of the various investors, i.e. shareholders and creditors: “Both the shareholders and the creditors in any enterprise assume some risk of its failure, but their risks are different. The shareholders stand to lose first, but in return they have all the winnings above the creditors’ interest if the Venture is successful; on the other hand the creditors have only their interest, but they come first in distribution of the assets.”^[127] A peculiar situation arises in the case that the same persons are shareholders and creditors, that “they are allowed to prove in insolvency on a parity with other creditors, yet they can use their control to take all the winnings which may be made on their advances while the company was successful, yet they will expose themselves only to creditor’s risks, if it fails.”^[128] This is unfair to other creditors and therefore the principle of equitable subordination is needed to avoid such unfair shifting of risk. Consequently, the most important part of the 3-prong-test is a finding of inequitable conduct.^[129]

3. Application to Outside Lenders (Lender Liability)

Because equitable subordination was developed from the principle of piercing the corporate veil, the addressees of equitable subordination are identical to those of the rules on veil piercing. Any person who is subject to a fiduciary duty and breaches this duty must bear the consequences of the piercing and subordination rules.^[130] Thus officers and directors of a company also have to take this danger into consideration when lending money to their company. The wording of § 510 (c) of the U.S. Bankruptcy Code, which is only applicable to insiders as defined in §101(31) U.S. Bankruptcy Code has the same result. The result of this definition is that non-inside lenders are not subject to equitable subordination.

[...]

---

^[1] BGHZ 119, 191.

^[2] Bank Security-Plehn, p. 447.

^[3] Taylor v. Standard Gas & Electric Co., 306 U.S. 307 (1939); In re Mobile Steele Co., 563 F.2d 692 (5th Cir. 1977).

^[4] See Gehde, p. 202 et seq..

^[5] Gehde, p. 72.

^[6] Vervessos, p. 34; Gehde, p. 71.

^[7] Vervessos, p. 33.

^[8] Gevurtz, p. 147.

^[9] Limited liability corporation.

^[10] Gehde, p. 70.

^[11] The principal-agent-conflict arises because of the asymmetric distribution of information between management and the shareholder.

^[12] Adams, p. 85 et seq.; Vervessos, p. 34 et seq.; Klaus, p. 288 et seq..

^[13] BFH, BStBl II 1992, 532; BMF-Schreiben vom 17.9.1992, BStBl I 1992, 653; Vervessos, p. 36; Gehde, p. 71 et seq..

^[14] RG JW 1938, 862, 864 et seq..

^[15] BGHZ 31, 258, 265; Kreis, p. 38.

^[16] BGHZ 31, 258, 271; BGHZ 67, 171, 174; 75, 334, 336; 76, 326, 328; 81, 252, 260 et seq.; 81, 311, 314.

^[17] BGHZ 67, 171; 69, 274; 75, 334; 76, 326; BGH WM 1972, 72.

^[18] BGHZ 90, 381.

^[19] Vervessos, p. 52.

^[20] Möller, p. 90 et seq..

^[21] BGH ZIP 1991, 366.

^[22] BGHZ 81, 311, 315 et seq.; BGH ZIP 1983, 1448, 1449; BGH NJW 1999, 2822; Schmidt, p. 1158 et seq..

^[23] BGHZ 31, 258, 267; 75, 334, 335 et seq.; 95, 188, 193.

^[24] BGHZ 119, 191.

^[25] st. Rspr, BGHZ 90, 370, 376; Sernetz, Rn. 712.

^[26] BGH NJW 1997, 1507 et seq.; generally about limited liability: Adams, p. 47 et seq..

^[27] Michalski-Heidinger, §§ 32a, 32b Rn. 7; Schmidt, ZHR 1983, p. 167; Wilhelmi, p. 82 et seq..

^[28] BGHZ 75, 334, 337; v.Gerkan/Hommelhoff-Hommelhoff, Rn. 2.8; Vervessos, p.124 et seq.; Hildebrand, p. 80 et seq.; Gehde, p. 53.

^[29] Goette, § 4 Rn. 2; Giesen/Brandi, Int’l Lawyer 1997, p. 1064.

^[30] as well as the shareholders, see above, A.II..

^[31] Matthes, p. 69.

^[32] v.Gerkan/Hommelhoff-Hommelhoff, Rn. 2.17; summary in Michalski-Heidinger, §§ 32a, 32b Rn. 8; Sernetz, Rn. 704.

^[33] Vervessos, p. 114 et seq..

^[34] E.g. concerning capital increases.

^[35] Sernetz, Rn. 703.

^[36] BGHZ 75, 334, 336; Haas, NZI 2001, p. 2.

^[37] Adams, p. 53.

^[38] Goette, ZHR 1998, p. 231.

^[39] Sernetz, Rn. 705; Haas, NZI 2001, p. 4.

^[40] Latin term for inconsistent behaviour; e.g. BGH NJW-RR 1998, 184.

^[41] BGHZ 31, 258, 272 et seq.; BGH WM 1972, 74, 75; BGHZ 67, 171, 175; BGHZ 75, 334, 336 et seq.; Goette, § 4 Rn. 6; Vervessos, p. 108 et seq.; Hildebrand, p. 82 et seq..

^[42] Haas, NZI 2001, p. 4.

^[43] BGHZ 90, 381, 389; Michalski-Heidinger, §§ 32a, 32b Rn. 11; v.Gerkan/Hommelhoff-Hommelhoff, Rn. 2.21; Hildebrand, p. 116.

^[44] Goette, § 4 Rn. 2; Michalski-Heidinger, §§ 32a, 32b Rn. 9; Castor, p. 29.

^[45] Goette, § 4 Rn. 4.

^[46] Lutter/Hommelhoff, ZGR 1979, S. 38; Raiser, § 19 Rn. 25; Schmidt, p. 885 et seq., 1153; Eichele, p. 30.

^[47] Adams, p. 53.

^[48] BGH DB 1995, 206, 207; BGH BB 1995, 377; Großkommentar-Henze, § 57 Rn. 106; v.Gerkan/Hommelhoff-Hommelhoff, Rn. 2.21 et seq.; Veil, ZGR 2000, p. 232; Rümker, ZGR 1988, p. 498; Reiner, FS für Boujong, p. 416; Schmidt, p. 532; Wilhelmi, p. 70 et seq..

^[49] v.Gerkan/Hommelhoff-Hommelhoff, Rn. 2.17; Castor, p. 32; Schouler, p. 27 et seq..

^[50] Haas takes this as (the only) purpose of equity substitution rules in Haas, NZI 2001, p. 9.

^[51] Schmidt, p. 1153.

^[52] MüHa-Mayer/Fronhöfer, § 52 Rn. 31 et seq..

^[53] Shareholder-like position.

^[54] BGH NJW 1982, 383; NJW 1988, 3143; NJW 1989, 982; BGHZ 106, 7, 10; 119, 191, 195/196; Claussen, GmbHR 1996, p. 318.

^[55] Giesen/Brandi, Int’l Lawyer 1997, p. 1051, which explains very extensively the German pledge pursuant to §§ 1205 et seq. BGB.

^[56] BGHZ 119, 191, 192.

^[57] Giesen/Brandi, Int’l Lawyer 1997, p. 1056.

^[58] See §§ 1205 et seq. BGB.

^[59] Fleischer, ZIP 1998, p. 316 et seq..

^[60] Schmidt, p.1159.

^[61] BGHZ 76, 330.

^[62] B.I.1..

^[63] Goette, § 4 Rn. 19.

^[64] MüHa-Mayer/Fronhöfer, § 52 Rn. 35.

^[65] BGHZ 76, 326, 330; Michalski-Heidinger, §§ 32a, 32b Rn. 41, 45; HeiKo-Bartl, § 32b Rn. 7a; Lutter/Hommelhoff §§ 32a/b Rn. 19; Blöse, ZIP 2003, p. 1691; Bieder, Rn. 11.

^[66] OLG Hamburg ZIP 1986, 228; Lutter/Hommelhoff, §§ 32a/b Rn. 33.

^[67] Michalski-Heidinger, §§ 32a, 32b Rn. 43 et seq.; Lutter/Hommelhoff, §§ 32a/b Rn. 18 et seq.; BGHZ 81, 262 et seq.; BGH ZIP 1990, 99 et seq.; very extensive: Böcker, p. 159 et seq..

^[68] BGHZ 76, 326, 329 f.; Schmidt, ZGR 1980, p. 571 f.; Götz, p. 41 et seq.; Castor, p. 79 et seq.; Kübler, p. 247; Goette, § 4 Rn. 18 et seq..

^[69] E.g. BGH NJW 1999, 3120; BGH NJW 1996, 720; Michalski-Heidinger, §§ 32a, 32b Rn. 45 et seq.; Lutter/Hommelhoff, §§ 32a/b Rn. 19.

^[70] Lutter/Hommelhoff, §§ 32a/b Rn. 20; see in Böcker, p. 163 et seq..

^[71] Michalski-Heidinger, §§ 32a, 32b Rn. 115.

^[72] BGH NJW 1995, 658; MüHa-Mayer/Fronhöfer, § 52 Rn. 18 et seq.; Michalski-Heidinger, §§ 32 a, 32b Rn. 21, 112 et seq.; Lutter/Hommelhoff, §§ 32a/b Rn. 45 et seq.; Raiser, § 38 Rn. 18; Schmidt, p. 1155 et seq.; Feddersen, FS Helmrich, p. 604; Westermann, ZIP 1982, p. 388.

^[73] Goette, § 4 Rn. 62 et seq.; Schmidt, p. 1155.

^[74] Lutter/Hommelhoff, §§ 32a/b Rn. 47 et seq.; Michalski-Heidinger, §§ 32a, 32b Rn. 108 et seq.; Goette, § 4 Rn. 65 et seq.; Hildebrand, p.118; v.Gerkan, ZGR 1997, p. 185.

^[75] Michalski-Heidinger, §§ 32a, b Rn. 22.

^[76] BGHZ 90, 370, 378 et seq.; Michalski-Heidinger, §§ 32a, b Rn. 24; Lutter/Hommelhoff, §§ 32a/b Rn. 102; Stadler, 17 J.L. & Com. 1997, p. 9.

^[77] Michalski-Heidinger, §§ 32a, b Rn. 25; The BGH limits the subordination up to the stated capital: BGHZ 76, 326, 332 et seq.; Rümker, ZIP 1982, p. 1386.

^[78] Goette, § 4 Rn. 126 et seq.; Lutter/Hommelhoff, §§ 32a/b Rn. 94.

^[79] Lutter/Hommelhoff, §§ 32a/b Rn. 94.

^[80] Goette, § 4 Rn. 148; Schmidt ZIP 1981, p. 695.

^[81] MüHa-Mayer/Fronhöfer, § 52 Rn. 55 et seq..

^[82] See, e.g. Obre v. Alban Tractor Co., 228 Md. 291, 179 A.2d 861 (1962).

^[83] In re AutoStyle Plastics, 269 F.3d 748 (6th Cir. 2001); Merkt, Rn. 341.

^[84] Diasonics, Inc. v. Ingalls, 121 Bankr. 626, 630 (Bankr. N.D. Fla. 1990).

^[85] 800 F.2d 625 (6th Cir. 1986).

^[86] Gehde, p. 243.

^[87] Roth Steel Tube Co. v. Commissioner of Internal Revenue, 800 F.2d 625 (6th Cir. 1986); In re AutoStyle Plastics Inc., 269 F.3d 726 (6th Cir. 2001); Diasonics, Inc. v. Ingalls, 121 B.R. 626 (Bankr.N.D.Fla. 1990); Brighton/Peabody, American Bankruptcy Institute Journal, p. 10; Gehde, p. 262 et seq..

^[88] Nozemack, Wash & Lee L.Rev. 1999, p. 711; In re Fabricators, Inc., 926 F.2d 1458, 1469 (5th Cir. 1991).

^[89] Scheel, p. 235.

^[90] E.g. Revised Model Business Corporation Act (RMBCA) §§ 6.01, 6.20, 6.21, 6.21 (b); Hay, Rn. 586 et seq..

^[91] E.g. California Corporation Code § 500; RMBCA §§ 1.40 (6), 6.40; Delaware General Corporation Law § 170.

^[92] Lutter, Festschrift Riesenfeld, p. 172.

^[93] 306 P 2d 1 (1957); United States v. Milwaukee Refrigerator Transit Co., 142 f.247, 255 (C.C.E.D. Wis. 1905); Bartle v. Home Owens Coop., Inc. 309 N.Y. 103, 127 N.E.2ed 832, 833 (1955); Lutter, Festschrift Riesenfeld, p. 172; Gehde, p. 206; Vervessos, p. 68 et seq.; Merkt, Rn. 313 et seq..

^[94] Anderson v. Abbott, 321 U.S. 349, 362 (1944).

^[95] Anderson v. Abbott, 321 U.S. 349, 362 (1944).

^[96] In re Mobile Steel Co. 563 F.2d 70; Matter of Multiponics, Inc. 622 F.2d 709 (5th Cir. 1980).

^[97] Gehde, p. 209; Lutter, Festschrift Riesenfeld, p. 173 et seq..

^[98] Easterbrook/Fischel, p. 40.

^[99] Local Loan Co. v. Hunt, 292 U.S. 234, 240 (1934); In re Mobile Steel, 563 F.2d; Scheel, p. 133.

^[100] Vervessos, p. 69; Nozemack, Wash & Lee L. Rev. 1999, p. 689.

^[101] 306 U.S. 307, 310 et seq. (1939).

^[102] Taylor v. Standard Gas & Electric Co., 306 U.S. 307, 310 et seq. (1939).

^[103] The Court of Appeals used this theory: Taylor v. Standard Gas & Electric Co., 96 F.2d 693.

^[104] Taylor v. Standard Gas & Electric Co 306 U.S. 307, 323; Gehde, p. 221 et seq..

^[105] In re Mobile Steel, 563 F.2d; Gehde, p. 221.

^[106] Merkt, Rn. 340; Gehde, p. 222 et seq..

^[107] 308 U.S. 295 (1938).

^[108] Pepper v. Litton, 308 U.S. 295, 305 et seq. (1938); for further explanation see above in B.I.1..

^[109] Pepper v. Litton, 308 U.S. 295, 309 et seq. (1938); Gehde, p. 225.

^[110] 563 F.2d 692, 696-697 (5th Cir. 1977).

^[111] Which is described in B.II.2..

^[112] The wording of § 510 (c) is as follows: “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.”.

^[113] Clark, p. 62 et seq..

^[114] In re 80 Nassau Assocs., 169 B.R. 832, 840 (S.D.N.Y. 1994).

^[115] Scheel, p. 236.

^[116] Wagner, p. 4.

^[117] Cox/Hazen, p. 115.

^[118] Matter of Clark Piep, 870 F.2d 1022, 1028 et seq. (5th Cir. 1989); Gehde, p. 213; Cox/Hazen, p. 115; Scheel, p. 238.

^[119] DeNatale/Abram, Bus. Law. 1985, p. 419.

^[120] DeNatale/Abram, Bus. Law. 1985, p. 419.

^[121] In re KDI Holdings, Inc., 277 B.R. 493, Bankr. LEXIS 1954, 50 (1999); Chaitman, Bus. Law. 1984, p. 1561.

^[122] DeNatale/Abram, Bus. Law., p. 419.

^[123] See e.g. In re Giorgio, 862, F.2d 933, 939 (1st Cir. 1988); In re Hyperion Enterprises, Inc., 155 B.R 555 (D.C.D. Rhode Island 1993).

^[124] Pepper v. Litton, 308 U.S. 295, 308 (1938); Chaitman, Bus. Law. 1984, p. 1561 et seq..

^[125] In re Mobile Steel, 563 F.2d 692, 700 (5th Cir. 1977).

^[126] E.g. see In re Georgio, 862 F.2d 933, 938 (1st Cir. 1988); In re ASI Reactivation , Inc. 934 F2d 1315 (4th Cir. 1991); French, Bankr. L. & Prac. 1995, p. 262; Clark, p. 53.

^[127] In re Loewer Gambrinus, 167 F.2d 318, 319 et seq. (2nd Cir. 1948).

^[128] In re Loewer Gambrinus, 167 F.2d 318, 319 et seq. (2nd Cir. 1948).

^[129] Gevurtz, p. 148.

^[130] Gehde, p. 321, 331.