Germany: Debt-To-Equity Swaps To Be Codified In The ESUG

Last Updated: 16 April 2012
Article by Christoph Appel and Peter Etzbach

An Interesting Alternative For Creditors And Company In Crisis And Insolvency

Through the introduction of Sec. 225a of the German Insolvency Code [Insolvenzordnung, InsO] within the scope of the German Act to Further Facilitate the Restructuring of Enterprises [Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen, ESUG], attention has now been drawn to debt-to-equity swaps. The creditor of a company waives its claim (from the company's perspective: a debt) and acquires shares in such company (equity) in return. The ESUG has codified the share swap within the insolvency plan procedure; important questions, however, especially regarding the claim valuation, remain unanswered. The legislative reform will doubtlessly also boost swaps prior to insolvency.

Advantages for creditors and company

When a company is in crisis or insolvent, the creditor's claim generally no longer retains its value or full value. In this case, a debt-to-equity swap provides an effective method of improving the company's financial situation if the creditor still considers the company to have potential or is otherwise motivated to continue the company's existence – for example because it is an important customer or supplier. The debt-to-equity swap is generally accompanied by a reduction of the company's capital, where the previous registered or nominal capital of the company is reduced and then increased again by issuing new shares or stock. These new shares are then allocated to the "swapping" creditor. If the turnaround is successful, the value of the new shares in the company can be higher than the nominal amount of the previous claims.

Through a debt-to-equity swap it is possible for a company to substantially reduce its liabilities in one fail swoop if one or several creditors waive their claims. Interest and amortisation obligations lapse. At the same time the equity capital basis is strengthened. A further psychological component is that, through the swap, creditors express their expectation that the enterprise has a future on the market.

Swap outside of insolvency in two stages

Prior to insolvency, swaps are generally carried out in two stages: firstly, a simplified capital decrease is conducted in order to balance out value depreciations or cover other losses. For the required resolution of the shareholders' meeting of a German limited liability company (GmbH), a three-quarters majority is required; the general meeting of a German stock corporation (AG) requires both a simple majority of the votes cast as well as a three-quarters majority of the capital represented at the meeting. To be borne in mind in this connection is that the simplified capital decrease can only reduce the capital to at least the amount of the minimum nominal capital or minimum registered capital, respectively. A decrease below this amount (GmbH: 25,000 euro; AG: 50,000 euro) is only possible if no contribution in kind is determined. However, this is precisely the case with a debt-to-equity swap in the next stage.

The capital decrease is followed by a capital increase with contributions in kind. To this effect, the claim against the company is contributed by the creditor as a new shareholder or stockholder, excluding the subscription rights of the former shareholders. In case of a capital increase, however, the actual value of the claim is decisive for the amount of the contribution in kind, and when a company is in crisis this generally does not correspond to the claim's nominal value. To the extent the actual value of the claim is below that of the new share, the swapping creditor can be obliged to make further payments on grounds of its liability for the difference in amount. Evaluations of the claim to be contributed should therefore be obtained. However, such evaluations are not only indispensable for the correct claim value, they are also and specifically required for evidentiary purposes in case of later disputes over the correct valuation.

Besides the simple conversion of the company's liability into equity, a debt-to-equity swap is frequently accompanied by a cash capital contribution.

Interests of the former and new shareholders to be balanced out

Essential to the success of a debt-to-equity swap is the due consideration of the various motivations and goals of the former shareholders/stockholders and the former creditors now to be made shareholders. These need not necessarily be contrary, but are frequently difficult to reconcile. For the former shareholders, the continuity of the enterprise takes precedence, whereas the new shareholders do not necessarily view their participation in the company as a long-term investment, but wish to sell their new shares at a profit in the short to medium term. Far more likely to exacerbate a conflict, however, is the fact that the former shareholders lose their influence in the company due to the reduction of their interest resulting from the admission of new shareholders.

When using a debt-to-equity swap, further legal pitfalls needs to be watched out for: if the company is a listed AG or SE (European Company), the German Securities Takeover Act [Wertpapierübernahmegesetz, WpÜG] and the German Securities Trading Act [Wertpapierhandelsgesetz, WpHG] apply in particular. If certain share limits are exceeded this triggers specific obligations to notify or offer, with the corresponding possibilities of exemption. Notification and disclosure obligations as well as a possible execution prohibition pursuant to competition law must always be observed. The tax consequences of a debt-to-equity swap also need to be considered.

Swap in insolvency plan procedure now codified

According to the newly introduced Sec. 225a para. 2 sentence 1 InsO, the insolvency plan can stipulate that claims of creditors be converted into share or membership rights in the debtor, that is to say in the insolvent company. This therewith codifies debt-to-equity swaps within the framework of insolvency. A similar conversion was already possible prior to the introduction of the ESUG, albeit only with the consent of the shareholders affected, which regularly led to the swap's failure.

Now, however, the steps necessary for conducting a debt-to-equity swap, that is to say capital decrease, capital increase, subscription right exclusion and stipulation of contributions in kind, can be determined in the insolvency plan with a simple majority of the votes and the claim sum of the creditors. Moreover, the obstruction prohibition has been extended in the insolvency plan procedure, with the result that a consent can also be deemed given without a majority. It is no longer possible for a group to overthrow an insolvency plan if such plan would probably not put them into a worse position than they would have been in without such plan, if they are involved within a reasonable economic scope and if the majority of the voting groups consented to the insolvency plan.

The required measures for a swap in an insolvency plan procedure are identical to those for conducting a swap outside of insolvency. However, despite the introduction of the ESUG there is still the problem of valuing the claims to be converted. There are good arguments in favour of a nominal valuation. Here, however, it remains to be seen how the courts will answer this question.

Christoph Appel is a lawyer and junior partner, Dr. Peter Etzbach is a lawyer and partner of the law firm of Oppenhoff & Partner in Cologne.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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