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A recent decision by Germany's highest court of general jurisdiction, the Federal Court of Justice, has added to the long line of cases defining when loans made by shareholders in a limited liability company (GmbH) will be regarded as so-called "equity substitute loans" and what consequences this has. In the recent decision, the Court held that the failure of a shareholder to insist on prompt payment by his GmbH for goods sold by him to it could cause the unpaid amount to be treated as an equity substitute loan.
The decision is best understood after a brief review of the general rules. In a bankruptcy context, detailed statutory provisions exist. In addition, inside and outside of bankruptcy, a court-created doctrine applies.
1. Definition of equity substitute loans
Section 32a of the law on limited liability companies provides that a shareholder who makes a loan to his GmbH at a time when a reasonable businessman would have instead injected additional equity may not claim the amount of the loan in a bankruptcy or arrangement proceeding. The same applies to loans made by third parties to the extent secured or guaranteed by shareholders and to other actions by shareholders or third parties which are the economic equivalent of a loan. If the GmbH repays equity substitute loans within one year of commencement of a bankruptcy proceeding, the bankruptcy trustee can compel the shareholder to return the entire amount to the GmbH. Security granted by the GmbH with respect to equity substitute loans is also voidable in bankruptcy without temporal limit.
Inside and outside of insolvency proceedings, a shareholder who has received repayment of an equity substitute loan can be required to reimburse the GmbH, meaning its creditors, to the extent of the difference between the GmbH's net worth and the nominal amount of its stated capital. A shareholder receiving repayment of an equity substitute loan of DM 1 million can, for instance, be required to reimburse half of this amount if the GmbH had negative net worth of DM 400,000 and stated capital of DM 100,000 at the time of repayment. (If bankruptcy proceedings were commenced within one year of the repayment, the shareholder would have to reimburse the entire DM 1 million.)
Reasonable businessmen are expected to inject equity instead of making a loan when the GmbH is insolvent either in the sense of having negative net worth (using fair market values for company property) or in the sense of being unable to pay its debts as they fall due. Such a GmbH is said to be in a "crisis situation". Inability to obtain credit on the open market is another indication of a GmbH in crisis. While a shareholder may argue that he neither was nor should have been aware of the crisis, such pleas are seldom successful absent special circumstances and almost never for shareholders involved in managing the company.
Loans made before the inception of a crisis can later become equity substitute loans if not called for repayment at first opportunity after the crisis ensues. The terms on which the loan may be terminated are important in this connection, at least where these are at arm's length.
The doctrine of equity substitute loans has been held to apply to lease and rental relationships as well. Lease or rental of real or personal property by a shareholder to his GmbH at a time when the GmbH is insolvent or failure to terminate existing lease or rental relationships when a GmbH enters a financial crisis are in as much analogised to a loan. However, the consequence is not loss of ownership of the property involved by the shareholder, but rather an obligation to continue to make this property available to the GmbH or the bankruptcy estate free of rent. Much still remains to be clarified concerning such situations.
2. Equity substitute loans and stock corporations (AG)
The law of stock corporations (AG) does not contain statutory provisions analogous to those discussed above. However, the case law doctrine applicable in and out of bankruptcy to a GmbH and its shareholders is also valid in principle for stock corporations and certain of its stockholders. The doctrine does not apply to stockholders with tiny shares of stock, but probably applies to any shareholder holding a block of stock sufficient to prevent certain important shareholder decisions requiring a qualified majority under German law. Generally, such a blocking minority requires a 25 % share. In certain circumstances, the threshold might be even lower.
3. Consequences of equity substitute loans
The above doctrines do not by any means compel shareholders to inject new equity into a foundering GmbH. They are free to liquidate the company or place it in bankruptcy. (It will be recalled that German law requires the management of an insolvent company to file for bankruptcy.) Should, however, the decision be taken to provide the company with additional funds, the law seeks to give creditors priority rights thereto even if the funds are formally injected as debt.
It should also be stressed that "equity substitute loans", contrary to what the term implies, never become true equity. Firstly, such loans lose their equity substitute character if the GmbH weathers its crisis and again becomes solvent and creditworthy. While interest may not be paid on the loans until the GmbH's net worth again equals its stated capital, such interest (according to the prevailing view) continues to accrue on the books of the company and may also be paid out when the GmbH has returned to financial stability. Secondly, equity substitute loans are always shown as debt for accounting purposes, although certain authorities believe it should be identified as equity substitute debt either on the balance sheet or in a note. Thirdly, and perhaps most importantly, the Federal Tax Court has rejected the argument that equity substitute loans constitute equity for tax purposes and accepts the tax deductibility of interest accruing on such loans.
It should, however, be noted that the tax consequences of forgiveness (cancellation) of shareholder loans including equity substitute loans and their conversion into true equity is the subject of a case pending before the en banc panel of the Federal Tax Court. Among the questions to be decided is whether this procedure can cause the debtor company to realise income to the extent of the excess of the loan's face value over its fair market value.
4. Late collection of trade receivables as equity substitute loan
The case here reported upon involved a shareholder who sold goods to his GmbH but permitted the GmbH pay for these up to 8 1/2 months subsequent to delivery even after the GmbH had entered a crisis stage. Shortly before bankruptcy, payments were made which substantially reduced the level of overdue trade receivables. Since a reasonable businessman would probably have insisted on punctual payment or ceased deliveries, the Court held that such overdue receivables could constitute an equity substitute loan if the shareholder was aware of the GmbH's financial situation. An explicit contractual arrangement to defer payment was not required. However, the Court suggested that sound commercial reasons might exist for continuing to deliver goods since the GmbH apparently sold the purchased goods back to its shareholder after processing, which permitted netting of the resale price with the purchase price. Furthermore, the Court held that the amount of the equity substitute loan was to be determined with reference to the average amount of overdue receivables, not their total amount. The case was remanded for further findings on these issues.
The decision reported on shows that a shareholder should exercise caution when loaning money, renting property, or even selling goods or services to his GmbH. Existing loan, lease/rental, or trade relationships should be reviewed and possibly terminated if the economic fortunes of the company decline.
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