1
The Legal Basis and Economic Rationale of
Subordinating Shareholder Loans
Xinyi Wang (11392410)
Supervisor: Prof. RJ (Rolef) de Weijs Universiteit van Amsterdam
2
Abstract
The subordination of shareholder loans has been adopted broadly around the world. The U.S. and Germany are the two leading countries with the most sophisticated rules on the subordination of shareholder loans. However, the legal basis of the subordination in the two jurisdictions differs from one another. Despite the differences, the general principle of Corporate Law and Insolvency Law provides the legal basis for both of them. As an addition to the legal basis, economic rationale is of an equally great concern when examining whether the subordination would bring the desired outcome and efficiently modify the incentives of the shareholders who could otherwise make risky and inefficient investment decisions. From both a legal and economic perspective, this paper provides a justification to adopt subordination rules of shareholder loans. Firstly, this paper analyses whether the subordination is justified, based on the general principles of Corporate Law and Insolvency Law. Secondly, from the economic perspective, this paper studies whether subordination of shareholder loans could help to mitigate the conflicts of interest between shareholders and creditors, and prevent the shareholders from making poor investment decisions. As the first attempt in research, in this paper I have combed through the Prospect Theory and Shareholder loans.
3
Table of Contents
1. Introduction ... 4
2. Legal Practices and Rationale of Subordination. ... 8
2.1 Subordination of Shareholder Loans in the U.S. and Germany ... 9
2.2 Legal Basis: Corporate Law ... 12
2.3 Legal Basis: Insolvency Law ... 16
3. Economic Rationale of Subordinating Shareholder Loans ... 20
3.1 Corporate Governance: Conflicts of Interest ... 20
3.2 Bright Side of Debt: Monitoring Power of Creditors ... 22
3.3 Dark Side of Debt: Risk Shifting and Debt Overhang ... 24
3.31 Risk Shifting ... 24
3.32 Debt Overhang ... 26
3.33 Dynamic Model of Risk Shifting and Debt Overhang ... 28
3.4 Prospect Theory: Why Would the Shareholders Like to Delay an Efficient Liquidation and Attempt an Unnecessary Rescue? ... 34
3.41 Without Shareholder Loans ... 38
3.42 With Shareholder Loans ... 42
3.5 Cost of debt: Mismatch of the Risk and Cost... 45
4. Conclusion and Suggestion: ... 50
4
1. Introduction
Subordination of shareholder loans has been adopted in Germany, the U.S., Austria1, Spain2 and other jurisdictions, based on different legal principles with a different degree of restrictions. The debates on subordination rules vary based on different considerations, such as legal justification, political preference and also, very importantly, economic efficiency.
In Germany - one of the first countries to bring about the case law3 on subordination rule - the trend to tighten the restrictions on shareholders’ loan has been strong. It has brought them to the point where the subordination rule on shareholders’ loan is not only enforced solely under the condition that loans were granted at moment of crisis4, but the rule is being spread to all loans5. Does the trend suggest that, for the protection of the creditor’s claims, stricter rules on hybrid financing, especially shareholder loans are beneficial? A myriad of scholars in different countries such as Germany6, the U.S.7 and the Netherlands8 argue about the necessity to add the subordination rule to legislation. Even though the number of countries to include the subordination rule of shareholder loans in their corporate law code or insolvency law code is growing, the legal bases and economic rationale are still being disputed. In
1 Eigenkapitalersatz-Gesetz (EKEG – Austrian Act on Capital Replacing Financing) § 2. Here the
legislation provides a rebuttable presumption of a crisis if the solvent ratio(equity/asset) is below 8%.
2 Ley Concursal (Spanish Insolvency Act) § 92. 3 BGH, 14.12.1959 – II ZR 187/57.
4 Gesetz betreffend die Gesellschaften mit beschränkter Haftung (GmbHG – Limited Liability
Companies Act) § 32. The rule was modified in 2009.
5 See Insolvenzordnung (InsO – German Insolvency Code) § 39.
6 See e.g. Carsten P Claussen, 'Zeitwende im Kapitalersatzrecht' (1994) 85 GmbH-Rundschau 9.;
Carsten P Claussen, 'Die GmbH braucht eine Deregulierung des Kapitalersatzrechts' (1996) 87 GmbH-Rundschau 316.; Dirk A Verse, 'Shareholder Loans in Corporate Insolvency–A New Approach to an Old Problem' (2008) 9 German Law Journal 1109.
7 See e.g. David Gray Carlson, 'The Logical Structure of Fraudulent Transfers and Equitable
Subordination' (2003) 45 Wm & Mary L Rev 157.; Andreas Cahn, 'Equitable subordination of shareholder loans?' (2006) x17 European Business Organization Law Review (EBOR) 287.
8 See e.g. Roelf Jakob de Weijs, 'Harmonization of European Insolvency Law: Preventing Insolvency
Law from Turning against Creditors by Upholding the Debt–Equity Divide' (2018) 15 European Company and Financial Law Review 403.; RJ de Weijs, 'Vooruit met de achterstelling: over de positie van aandeelhoudersleningen in én voor faillissement' (2008) 139 Weekblad voor Privaatrecht, Notariaat en Registratie 313.
5 general, there is a consensus that shareholders’ loans could be subordinated based on the objective of insolvency law, which is to protect the distributable value of bankruptcy assets and maximise the collective return to creditors9. But for many jurisdictions, the bankruptcy law is only procedural law, and the legal basis of subordination needs to be built upon substantive law, such as the example of corporate law10. Therefore, to justify the subordination of shareholder loans, it is also essential to root it in the principle of corporate law or other substantive law.
Professor de Weijs summarised three groups of main arguments regarding subordination of shareholder loans11 including the arguments on the definitions of shareholder loans and types of capital the shareholders are required to provide, the influence of the shareholders loans on the incentives of shareholders, and the objectives of overall framework of insolvency law. The first and third group of arguments are targeting to the legal basis of subordinating shareholder loans. Different from the first group of arguments, the second group is raised from an economic perspective, addressing the effects of subordination on the incentives of shareholders to engage in an efficient or inefficient rescue. Until now, there has been no general consensus on the subordination of shareholder loans from the economic perspective. The efficiency of the subordination rules has not been proved by a credible method and most of the literature that discussed the economic efficiency of shareholder loans is based on numerical examples and biased to some extent12. Among the few economic analyses of subordination rules, one of the most outstanding and frequently discussed disagreements has been provided by Gelter. He stated that subordination of shareholder loans cannot prevent all the inefficient rescue, but it might even hinder the efficient
9 See Chapter 1 and 2, Vanessa Finch and David Milman, Corporate insolvency law: perspectives and
principles (Cambridge University Press 2017).
10 For example, in China, the bankruptcy law is procedural law, the objective of which is to guarantee
the fulfilment of obligations and rights conferred by the substantive law such as corporate law and contract law. Therefore, to include subordination rules inside Chinese legislation, we need to find the legal basis from the substantive law, such as corporate law and set the corresponding provisions in insolvency law (procedural law) to guarantee the enforcement of such rules.
11 See de Weijs, 'Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning
against Creditors by Upholding the Debt–Equity Divide', 421-425.
12 See Martin Gelter, "The subordination of shareholder loans in bankruptcy," International Review of
6 rescue attempt13.
To decide whether it is beneficial or appropriate to subordinate shareholder loans, it is necessary to combine the analysis of legal and economic rationale. Is the shareholder at liberty to decide for himself upon the form and shape of his investment?14 Legal rationale provides the basic legislative logic and justification for subordination of shareholder loans. For instance, if a country has an insolvency law system without pari passu principle and lacks protection of a common pool distribution; or the corporate law does not provide a limited liability to shareholders and the shareholders are liable for all the debts in the firm, then in such jurisdiction it might be unjust to adopt the subordination of shareholder loans. Before we adopt a new rule, we need to ensure the aim and effect of such rule will match the principles and objectives of the existing law that governs related issues in the jurisdiction. Economics generally provides a behavioral theory for prediction of how people respond to laws15. The economic rationale, therefore, could help us to predict how the rules would influence the behavior of individuals subjected to them. Economic analysis could be used as an ex-ante instrument to predict the necessity and feasibility of the rules, or as an ex-post instrument to test the actual effect of the new rule and help to refine or amend the existing regulation in the future. Economic efficiency always interacts with the legal justification. As Philippon argued, inefficiencies create room for government intervention16, thus, legislation is a tool to correct the inefficient distribution and behaviour.
A general analysis of both legal and economic rationale for subordinating shareholder loans is beneficial and necessary for the future study. Before a new rule is codified, it is recommended to find a legal rationale to support it and predict the economic influence in case such rule is adopted. Moreover, in the economic analysis, a
13 Martin Gelter, 'The subordination of shareholder loans in bankruptcy' (2006) 26 International Review
of Law and Economics 478.
14 See de Weijs, 'Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning
against Creditors by Upholding the Debt–Equity Divide', 418.
15 Robert Cooter and Thomas Ulen, Law and economics (Addison-Wesley 2016) 3.
16 Thomas Philippon, 'Debt overhang and recapitalization in closed and open economies' (2010) 58 IMF
7 trade-off between the costs and benefits is one of the main concerns. All the rules might have their positive and negative influence, and it is necessary to balance it.
The research question here is as whether from the legal and economic perspective, subordinating shareholder loans is justified or efficient. This paper illustrates the research question by analysing the principles of the general legal framework and the economic influence on the behavior of shareholders.
The paper is divided into four sections. In the first section, I briefly introduce the concepts and legal practices of subordinating shareholder loans, and outline three groups of main arguments regarding the subordination-rules. In the second section, the legal basis for subordination of shareholders loans will be analysed based on the principles of corporate law and insolvency law. In the third section, the economic rationale will be shown from the perspective of corporate governance to explain that shareholder loans might give the shareholders more incentive to perform riskier behavior and aggravate the conflict of interest between shareholders and creditors. In the last section, a conclusion will be made, including my suggestion that subordination rules could be adopted if the legal principles discussed in section two are applicable in a given jurisdiction and that the conflict of interest between shareholder and creditors is of great severity.
8
2. Legal Practices and Rationale of Subordination.
As mentioned in the above section, there are main three groups of arguments regarding subordination rules. The first group of arguments consists of definitions of shareholder loans and types of capital the shareholders are required to provide, addressing mainly the legal basis of subordination. Shareholders are the “legal owners” of the firm from the legal perspective17, and as the owners of a firm, they should bear certain risks of daily operations, with the funds they injected inside the corporation18. However, since many jurisdictions have abandoned the minimum capital requirements in their corporate law19, it might be interpreted as shareholders are in no way obliged to bear risks anymore. This change might give shareholders a signal that the capital they have injected in the firm is not necessarily the risk-bearing capital with a non-fixed return20. On the basis of this argument, it might be wrongfully concluded that there is no legal basis to subordinate shareholder loans from corporate law perspective. The last group of arguments of subordination relates to the objective of overall framework of insolvency law. With the help of shareholder loans, the shareholders could capture the entire value of assets left in the firm by setting full security rights on their loans, which is inconsistent with the objective of bankruptcy frame to protect the creditor’s right and distribute the common pool under pari passu principle21.
Through elaborating the two groups of arguments mentioned above, I will analyse the legal rationale of subordinating shareholder loans in this section, based on
17 The issue of firm ownership is an ongoing debate, and scholars who support shareholders to be the
legal owners justify their arguments as shareholders to be the holders of shares. But someone also believes that the ones with control right, govern the firm should be the legal owner. Based on the agency and principle theory, the separation of ownership and control right brings conflict of interest to the corporate governance, therefore in this paper shareholders are deemed to be the owners of the firm.
18 Equity is deemed to be a type of risk bearing capital without fixed return.
19 Reinier Kraakman, The anatomy of corporate law: A comparative and functional approach (Oxford
University Press 2017) 124.
20 Jaap Barneveld, Financiering en vermogensonttrekking door aandeelhouders: een studie naar de
grenzen aan de financieringsvrijheid van aandeelhouders in besloten verhoudingen naar Amerikaans, Duits en Nederlands recht (Kluwer 2014) 532.
9 the principles of two different legislations, which are corporate law and insolvency law.
2.1 Subordination of Shareholder Loans in the U.S. and Germany
The legal rationale regarding the rules addressing shareholders loans might be covered by various fields of legislation and many jurisdictions have adopted cross-effect22 on the subordination of shareholder loans. Andreas Cahn suggested that the shareholders loan could be subordinated based on the law of fraudulent conveyances and unlawful preferences, supplemented by a general prohibition of securing shareholder loans23.
For instance, in the U.S., the earlier case supporting subordination of shareholder loans was based on the misuse of corporate form resulted as an abuse of controlling power by the shareholders24, where subordination was a softer alternative of Veiling Piercing25. The shareholders will be liable for the adequacy capital resulted from such shareholder loans under bankruptcy procedure26. The notion of subordination as an equitable power of the bankruptcy courts comes from the Case Pepper v. Litton27. Jay L. Koh described the earlier objective of subordination as “aimed at piercing formal and legal subterfuges to ensure that bankruptcy estate was properly distributed among similarly situated creditors, preventing superficially legal behavior from creating unfair or inequitable advantages in priority28”. When exercising the equitable subordination, the court has its discretion to test the conduct of the shareholder “who provide shareholder loans, aiming to figure out whether there is an “inequitable conduct” hidden
22 Here the cross-effect refers to the subordination rules reflecting several principles across different
fields of law.
23 See Cahn, 'Equitable subordination of shareholder loans?', 287.
24 William P Hackney and Tracey G Benson, 'Shareholder Liability for Inadequate Capital' (1981) 43 U
Pitt L Rev 837, 863-878.
25 Ibid 863-888.
26 See Taylor v. Standard Gas and Electric Co., 306 U.S. 307, 59 S. Ct. 543 (1939).
27 Carlson, 'The Logical Structure of Fraudulent Transfers and Equitable Subordination', 198.; See
Pepper v. Litton, 308 U.S. 295, 60 S. Ct. 238 (1939). In this case Litton’s claims was subordination because of the existence of fraudulent scheme, which impairs the rights of Pepper.
28 Jay L Koh, 'Equity unbound: A meaningful test for equitable subordination' (1997) 16 Yale L & Pol'y
Rev 467: “Exercised by early courts as an application of their equity powers in bankruptcy, equitable subordination was aimed at piercing formal and legal subterfuges to ensure that a bankruptcy estate was properly distributed among similarly situated creditors. Courts flexibly examined the conduct of creditors, originally focusing on insiders, to prevent superficially legal behavior from creating unfair or inequitable advantages in priority.”
10 underneath such loans.
Even though the U.S. legislations made an effort to regulate the subordination rules based on a test of “inequitable conduct”, there is still no clear definition of “inequitable conduct”. The court has a certain extent of discretion to test the “inequitable conduct”. Based on article 510 of the US Bankruptcy Code29 and following the landmark case In re Mobile Steele30, three conditions need to be met before subordination can be exercised: shareholder needs to behave in an inequitable manner, conduct must have resulted in injury creditors, and subordination must fit within the framework of the bankruptcy act31. The court has also articulated three general categories of inequitable conduct: 1) Fraud, illegality, or breach of fiduciary duties; 2) undercapitalisation; and 3) a claimant’s use of the debtor as a mere instrumentality or alter ego32. From the evolution of subordination rules on shareholder loans, we can determine that the initial rationale for such subordination has been covered by corporate law, which addressed the issue of abuse of controlling power and provision of inadequacy capital. Implementing the function of subordination in the US has relied on the insolvency law, during the distribution of bankruptcy assets33.
Similar with the U.S practice, the current German regulations on shareholders loans is also relying on the bankruptcy procedure34. However, the past legislation of
29 See United States Bankruptcy Code (Chapter XI of the Bankruptcy Act) § 510. Subordination (c):
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.
30 In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977).
31 Richard Squire, Corporate Bankruptcy and Financial Reorganization (Wolters Kluwer Law &
Business 2016).
32 Barry E Adler, Douglas G Baird and Thomas H Jackson, Bankruptcy, Cases, Problems, and Materials,
vol 4 (Foundation Press 2016).
33 See note 29.
34 See Insolvenzordnung (InsO – German Insolvency Code) § 39: “The following creditors will rank after
the insolvency creditors:
v) claims for the repayment of shareholder loans.
(1) Im Rang nach den übrigen Forderungen der Insolvenzgläubiger werden in folgender Rangfolge, bei gleichem Rang nach dem Verhältnis ihrer Beträge, berichtigt (..) nach Maßgabe der Absätze 4 und 5 Forderungen auf Rückgewähr eines Gesellschafterdarlehens oder Forderungen aus Rechtshandlungen, die einem solchen Darlehen wirtschaftlich entsprechen.”
11 subordination was covered in the corporate law35. Because the shareholder loans are automatic subordinated under current German law, a prerequisite of bankruptcy is not necessary even though the rule is coved in insolvency code36. One of the reasons that rules of subordination is moved from corporate law to insolvency law is to make sure a broad coverage of subordination rules that all kind of legal entities are subject to such rules. Subordination of shareholder loans was first brought to the case law in the 1950s. German codified the doctrine of subordination into article 32a GmbHG in 1980 as the complementary of case law. The loan provided by shareholders should be qualified as capital (equity) if such loan was granted at a moment of crisis 37 and otherwise the shareholders would have provided equity. Shareholders as the residual claimants would benefit the most if the firm could survive the crisis. Therefore, shareholders loans, representing a rescue attempt to save the value for shareholders, would not be justified to be repaid unless the other creditors have already been repaid in full. Currently, the rules of subordination on shareholder loans are applied to all the loans provided by a shareholder, merely with the exemption of the minority shareholder who is not involved in management and whose equity contribution is less than 10% of the total equity38. D.A. Verse provided the legal rationale of such strict rules on shareholder loans, as following: “The most plausible explanation is that subordination of all shareholder loans will simply ensure that the shareholders adequately participate in the entrepreneurial risk of the company.”39 Given the history and background, rules regarding subordination could still be considered to be of corporate law nature. The bankruptcy code of Germany adopted the subordination rules within the insolvency proceedings to address the issues relate to transaction avoidance and ranking of distribution. Therefore, the main legal rationale of subordination of shareholder loans in Germany is also provided in the principle of solvency law, when the shareholder loans are standing on the balance sheet of an insolvent company, and a fair distribution
35 See Gesetz betreffend die Gesellschaften mit beschränkter Haftung (GmbHG – Limited Liability
Companies Act) § 32. The provision now is repealed.
36 There might be no difference from the legal prospective, because the provisions are applicable when
the firms go bankruptcy. If the business is running well, there would not be much difference whether the provision is provided only under bankruptcy-condition or not. But from the economic perspective, the influence will be different. This is going to be explained in Section 3.5.
37 See note 4.
38 See Insolvenzordnung (InsO – German Insolvency Code) § 39(4) & (5).
12 decision is hindered by such loans.
From the legal practice of the U.S. and Germany during the past fifty years, we can notice that principles of both corporate law and insolvency law jointly built up the legal bases of subordinating shareholder loans.
2.2 Legal Basis: Corporate Law
While establishing a firm, there are two types of financial instruments that investors in the company can use: equity and debt. The basic principles of corporate law provide two different types of protection for shareholders and creditors respectively, in order to guarantee the fairness of treatment and build a bridge between the shareholders and creditors with respect to their obligations and rights.
From the shareholder’s side, the corporate law principle provides protection through the principle of “owner shielding”, where the shareholders are liable only within the limitation of the capital they contributed40. The shareholders are encouraged to take a certain degree of risk without being liable to an unlimited amount of loss, since they need to fulfil the capital requirements in the first place 41. This brings more flexibility to the shareholders when making investment decisions. However, around the world in the last century, such flexibility needed to be guaranteed by a sufficient amount of initial capital base42. The minimum capital requirement has its roots in the 20th century continental Europe43.
40 See Henry Hansmann, Reinier Kraakman and Richard Squire, 'Law and the Rise of the Firm' (2005)
119 Harv L Rev 1335.
41 Some countries have already decreased the minimum capital requirements for privately held company
to zero, where the shareholders would not liable for initial capital injection. To some extent, the “owner shielding” principle was weakened under the latest corporate law practice.
42 Currently, The Netherlands, Germany and other European countries have already abandoned the
minimum capital requirement for privately held company (which is not listed in the public). Only public companies within the European Union are required to hold at least €25.000 in capital, although many countries go above this minimum requirement. Therefore, for those private companies (or we can call them close companies), the shareholders would not be liable for initial adequacy capital.
43 World Bank, 'Why are minimum capital requirements a concern for entrepreneurs?' (2013)
<https://www.doingbusiness.org/content/dam/doingBusiness/media/Annual-Reports/English/DB14-Chapters/DB14-Why-are-minimum-capital-requirements.pdf> accessed 01 July,2019.
13 While from the creditor’s side, entity shielding functions as the opposite of the “owner shielding” to emphasize that it involves shielding of the assets of the entity — the corporation — from the creditors of the entity’s owners.44 Entity shielding consists of two components from the perspective of creditors to protect their rights and their investments. The first component is priority of distribution of the firm’s assets over the shareholders. Creditors, as fixed rate investors, will be guaranteed a fixed interest payment and repayment of principles as the root of the investment relationship. The second component of entity shielding is regarding to liquidation protection, where the shareholders of the firm are prohibited from withdrawing their shares of assets at will45. Those two components jointly form the legal bases for the creditors protection and enable the creditors to claim for their portion of investments back when the owner the firms fails to manage the business and results in a default. Since the creditors have no direct control over the firms, nor do they have sufficient influence on the investment decisions46, their willingness to invest their money into the firms is largely based on trust towards the shareholders and managers, and the legal protection47. Therefore, those rights should be granted exclusively to the creditors, as they are not allowed to be involved in the daily business operations and lack a voting right on the important investment decisions. Without such bottom level protection, the shareholders would not be able to attract external funds from other creditors, and based on the historic experience, equity is not the best option to expand the balance sheet48.
If we allow the shareholders to act as creditors at the same time, they will be able to stay under the protection of the umbrella designed exclusively to protect the creditors49, and the umbrella is not big enough to protect everyone. As a result, the
44 Kraakman, The anatomy of corporate law: A comparative and functional approach 7-11. 45 Ibid.
46 See Michael C Jensen and William H Meckling, 'Theory of the firm: Managerial behavior, agency
costs and ownership structure' (1976) 3 Journal of financial economics 305.
47 See Sattar A Mansi, William F Maxwell and John K Wald, 'Creditor protection laws and the cost of
debt' (2009) 52 The Journal of Law and Economics 701, 721.
48 Stewart C Myers and Nicholas S Majluf, 'Corporate financing and investment decisions when firms
have information that investors do not have' (1984) 13 Journal of financial economics 187. From the pecking order theory popularized by Myers and Majluf, issuing new equity to finance new investment is not attractive for firms and will send signals to outside investors that the price value of firm is overvalued.
14 creditors might be squeezed out from the umbrella and exposed to the ultraviolet rays of bankruptcy. The main concern here, regarding the shareholder loans, is the capital risk. The capital risk here means the risk of capital shortage to back up the daily running of the business, which potentially brings a threat to creditors. Moreover, under such condition, where shareholders are insufficiently exposed in the daily business, default risk might be also aggravated. Traditionally, there are three types of rules in corporate law addressing legal capital, to protect the rights of creditors: minimum capital prescription, restriction on distribution and specific actions under serious depletion of capital50.
The first type of traditional protection of the capital risk is the establishment of a minimum capital requirement when the corporation is initially established. The main aim of this principle is to guarantee the capital is not less than the paid in or subscription capital of the corporation, which might cause potential capital risk to the investors51. No external creditors would be willing to invest in a corporation if there is no sufficient equity remaining in it, where the shareholders will not take any risk of business failure. The creditors need to see the shareholder exposed in the game, by which the profits and losses of the shareholders and creditors are linked together. Therefore, adequacy capitalisation involves a basic commitment of shareholders, with a guaranteed buffer to suffering losses before the creditors’ money are exposed to a business failure. However, since the minimum capital requirement has been abandoned, the shareholders would not necessarily want to guarantee any initial capital. Based on the limited liability principle, shareholders are only liable for the capital they have provided for the company. Without the minimum capital requirements, it appears as if the shareholders are not obliged to bear risks anymore. From this perspective, the argument seems to be correct that the shareholders do not necessarily have to bear the risks of the firms52 and the creditors should learn to protect themselves.
50 Kraakman, The anatomy of corporate law: A comparative and functional approach 124. 51 Ibid.
52 Barneveld, Financiering en vermogensonttrekking door aandeelhouders: een studie naar de grenzen
aan de financieringsvrijheid van aandeelhouders in besloten verhoudingen naar Amerikaans, Duits en Nederlands recht, 532.
15 However, there are two other types of protection in corporate law. In most jurisdictions such as the U.S., Germany, and the UK, corporate law includes rules to restrict the dividend payments, share repurchases and other transactions, which might dilute the corporate assets53. The extent to which such restriction could protect the creditors largely depends on the scope of the restricted transactions. Allowing shareholders to provide with security rights on their loans is another method to dilute the assets. As illustrated in previous paragraphs, the capital injected by the shareholders into the firm shall not be withdrawn at will during a financial crisis or a bankruptcy based on the principle of “Entity Shielding”. At the same time, however, allowing secured shareholder loans is equivalent to allowing the shareholders to withdraw their investment during bankruptcy. From this perspective, J. Barneveld’s argument is not fully correct. The shareholders are not obliged to bear risks, but they need to bear the risk related to the capital they have already injected into the firm, and the capital should be interpreted broadly that, both equity and loans provided by shareholders should be regarded as risk-bearing capital and could not withdraw at will.
The last type of protection refers to the actions required to be taken under loss of capital. As the on-going business takes place, the balance sheet of a firm might be extended largely. The failure of business might cause a sudden capital shortage of a firm. The firm may result in a situation where the assets are less than the existing outstanding loans during a crisis. Therefore, the creditors will be facing a looming default risk when the residual capital is under water and the shareholders are not able to absorb the future loss by themselves, and as a result, the creditors’ investments are exposed. In Europe, there are rules following a big short fall of capital54. The risk distribution in such a situation might be twofold: It might be reasonable that creditors need to protect themselves from situations of a sudden capital shortfall. They need to be able to evaluate whether the interest payments on their loans are enough to compensate for the risks they might face initially, when they sign the lending contracts. The creditors receive payments (or coupon payments) periodically to compensate the default risk they might face. However, after the short fall happens, in most cases the
53 Kraakman, The anatomy of corporate law: A comparative and functional approach 125-126. 54 Ibid 126-127.
16 firm would not have the adequacy capital to carry on daily business and some jurisdictions even require shareholders to inject new capital 55or file for bankruptcy56. If shareholders’ equity is underwater after a serious loss or the shareholders are not able to repay the debt in time, creditors could submit the bankruptcy application to the court to stop the future loss and claim for distribution of the available assets of the firm, preventing the shareholders from conducting any further activities which might magnify their loss. Under such circumstances, if the shareholders still want to save the business and continue the operations, they need to bear the risks of a future loss. Allowing (secured) shareholder loans would decrease the loss shareholders might suffer and give them incentives to continue the inviable business or make risky investment decisions. It is unjust to let the creditors bear these extra risks.
As a conclusion, the creditors need to protect themselves, but the shareholders should provide a sound and safe capital environment with good intentions and faith, before the creditors take any actions. Under the corporate law principle, if the shareholder loans give shareholders an incentive to dilute the corporate assets rather than to maintain a sound business, or induce any behavior to escape their limited liabilities, the shareholder loan could be subordinated.
2.3 Legal Basis: Insolvency Law
When facing insolvency, the management of a company, as well as the creditor are able to file for opening of the procedure of liquidation57. One of the most important functions of the insolvency law is to protect the fair distribution of bankruptcy assets of a firm, and to guarantee all the creditors would be treated fairly and equally58. Such equitable treatment happens within groups of creditors59. Shareholders, as holders of equity, are
55 See Code de commerce (French Commercial Code) § L. 224- 2. 56 See Insolvenzordnung (InsO – German Insolvency Code) § 5a and §19.
57 Here liquidation is the used as a “narrow term”, where assets of the liquidated company are sold out
of insolvency and the company ceases to exist. Corporate debtor does not survive after the liquidation.
58 See the entire book of Royston Miles Goode, Principles of corporate insolvency law (Sweet &
Maxwell, 2011).
59 See Finch and Milman, Corporate insolvency law: perspectives and principles: “creditors share
rateably within the particular ranking that they are given on insolvency by the law – a system of ranking that draws distinctions between different classes of unsecured creditors.”
17 subject to residual distribution after all the creditors have been paid in full60. Therefore, equity class will stand in the last row during the bankruptcy assets’ distribution.
However, if the shareholder loans are not subordinated, the shareholders will jump into the class of creditors, even with the secured right attached in some cases61. Under such circumstances, some creditors might even rank lower than the shareholders, or at least as low as shareholders. From this point of view, the shareholders are not the claimants of the “residual” anymore. Since the controlling shareholders can easily get secured rights on their loans, they will choose to provide secured loans when the business is risky or its financial situation is unhealthy, and get a fixed return from the firms without bearing potential risks of losing any of their investments if the business fails, while still capturing all of the upside gain62. In the worst case, secured loans can give shareholders incentives to go bankrupt. After claiming the assets back based on the security rights, the shareholders could easily get a fresh start63. That is inconsistent with the principle of insolvency law, which aims to protect the creditors when business is not performing well, and to prevent the shareholders from expropriating the wealth of the creditors. In case of giving out shareholder loans, shareholders might cut the line during the bankruptcy distribution and be first to receive the payment, which weakens the shareholders’ incentives of risk management during daily operation. Such inequitable distribution will induce more frequent business failures64. Therefore, based on the objective to protect the creditors and the pari passu distribution principle65,
60 Based on the bankruptcy codes of different jurisdictions around the world, we can find that the
shareholders rank at the bottom during bankruptcy distribution and are only subject to the residual assets, which is in line with the principle of corporate law that shareholders are the residual claimants. See Practical Law, 'Order of creditor and contributory ranking on a debtor's insolvency' 2014)
<https://uk.practicallaw.thomsonreuters.com/9-518-5211?transitionType=Default&contextData=%28sc.Default%29> accessed 26 June, 2019.
61 There is even online service to assist shareholders to register for the security rights and the shareholder
loans are even regarded as one of the “most common methods” of funding new businesses. See more details on <https://www.jewellmoore.com.au/2015/11/20/securing-shareholder-loans/> accessed 27 June, 2019.
62 See the examples in Section 3.1-3.4.
63 E.g. Mcgregor Holding Netherlands B.V. in Amsterdam (Noord-Holland) was declared bankrupt by
the court in Amsterdam in 2016 and the business restarted with new owners who were the same shareholders. The shareholders provided secured shareholder loans to the firm and claimed for the loans based on security right when the firm went bankrupt. In 2007 company was declared a second bankruptcy.
64 Ibid.
18 shareholder loans could be subordinated during the bankruptcy procedure.
Gelter argues that sometimes business might still be valuable and shareholder loans might be more beneficial to the firms66 than just liquidating the business and distributing the bankruptcy value. I want to emphasise that liquidation is the not the only result if the firm cannot survive the financial distress. Gelter designed his model by assuming that liquidation is the only alternative. However, in reality, the design of reorganization is to save the on-going business and change the structure of the right side of the balance sheet without altering the assets of the firm or leading the current business to failure. It happens when the business is still viable67, but there is a temporary solvency or liquidation problem and in most cases the solvency issues are caused by inefficient management and over leverage68. We can regard this as an alternative way to solve the debt overhang problem69. With reorganization, the equity will be rebuilt to an adequacy level through debt equity swap70. From the perspective of economic efficiency, one way to achieve the pareto efficient outcome is swapping debt for equity71. Also, the creditors could choose to cancel a part of the debt as a part of the reorganization plan72 and write off part of the debt to restructure the balance sheet. But the starting point of the reorganization plan is always a wipe-out of the equity holders, which is aligned with the principle of insolvency law. Therefore, if the shareholders are not willing to inject new equity into the corporation in order to engage in an efficient rescue, then the reorganization might take place and the creditors will eventually solve the problem by themselves. Allowing shareholders to provide loans to rescue the business is unnecessary if such attempt might cause unfair treatment and opposes the general principle of insolvency law. Therefore, subordination of shareholder loans is
66 See Gelter, 'The subordination of shareholder loans in bankruptcy'. Benefits here is to mitigate
overhang problem, otherwise the shareholders will forgo an efficient rescue attempt without shareholder loans.
67 Mark J Roe, 'Bankruptcy and debt: A new model for corporate reorganization' (1983) 83 Colum L Rev
527.
68 Shareholder loans will induce overleverage problem because shareholders would prefer to invest in
loans instead of equity during crisis. Even outside the crisis, shareholders still might provide (secured) loans if there are no subordination rules. This will be explained in details in section 3.1-3.5.
69 By reorganization, capital will be restored and unpaid debt will decrease, which mitigates the debt
overhang problem. Debt overhang problem will be discussed in more details in section 3.32.
70 Reinhard Bork, Rescuing companies in England and Germany (OUP Oxford 2012).
71 See Philippon, "Debt overhang and recapitalization in closed and open economies.", 141-146.
19 justified based on principle of the insolvency law, and the disadvantage of subordination could be compensated by the design of reorganization.
20
3. Economic Rationale of Subordinating Shareholder Loans
We have addressed the first and third groups of arguments regarding adopting of subordination-rules in the previous section. The legal bases from the perspective of general principles in corporate and insolvency law have been discussed. Now we are going to move to the second group of arguments summarized by Professor de Weijs73, which is one of the “strongest and most serious critiques” to against subordination rules. The main concern of this critique is the negative effects of subordination on the incentives of shareholders to engage an efficient rescue. Subordination might inefficiently increase the downside for shareholders if a rescue attempt fails. However, not many studies have examined the economic rationale behind the subordination of shareholder loans. Gelter said in his paper, “However, what is missing in the literature is a formal analysis of how, why and when subordination of shareholder loan creates the desirable incentive structure and when it fails to do so.74” He tried to solve this puzzle with an own designed theoretical model in his paper. He also introduced a discovery that subordination of shareholder loans can “prevent either socially undesirable or desirable rescue attempts.” 75 Gelter’s analysis targets the influence of subordination on risk shifting and debt overhang when the firm is highly leveraged.
In this section, I will re-address the same issue with the releasing of a few assumptions made by Gelter, including the risk preference of shareholders, ex-ante effect on the cost of debt and limitation of liquidation.
3.1 Corporate Governance: Conflicts of Interest
76Based on the pecking order theory, a debt is preferred to equity as long as the debt
73 de Weijs, 'Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning
against Creditors by Upholding the Debt–Equity Divide', 423.
74 Gelter, 'The subordination of shareholder loans in bankruptcy', 9.
75 Ibid 23. Based on the model, he concluded that when the firm is overindebted, subordinating
shareholder loans might prevent efficient rescue and not stop all the inefficient rescue.
76 There are three types of agency problems, The conflicts between shareholders and creditors; conflicts
21 capacity has not reached its limit 77. There are different theories supporting the benefits of using debt as the main financing instrument78, one of which is the agency cost theory. Contrarily to the pecking order theory, the agency cost theory suggests that managers do not always run the firms with the objective of maximising the shareholder value; instead, they would rather engage in tunneling to transfer resources from the firm to their own benefit through self-dealing transactions at the expense of the shareholders79. This phenomenon represents one of the most common agency problems observed in companies, occurring between shareholders and directors. Separation of control rights and ownership brings efficiency to the corporations and improves the effectiveness of control rights. However, it also causes issues related to the agency problem, and the management to run excessive risks at the expense of shareholders. One of the main concerns in the field of corporate governance is conflicts of interest between different stakeholders80. Debt, as a tool to solve the agency problem between the shareholders and management, will help to increase the commitment level of the managers to the corporation.81 However, besides the conflict of interest between management and shareholders, Jensen and Meckling identified another type of conflicts existing in the corporations between shareholders and creditors, where the shareholders engage in suboptimal investments82. Debt financing has its bright side - mitigating the conflict of interest between the shareholders and management; but it also has a dark side - inducing agency costs between the shareholders and the creditors, providing incentives for the shareholders to undertake riskier investment and forego the safe ones.
To determine whether the shareholder loans will inherit the bright side of debt and eliminate the dark side, it is essential to judge whether shareholder loans will increase the commitment of the management, as well as the shareholders, which could
shareholders. The conflict between controlling shareholders and minority shareholders are not addressed in this section.
77 Financing comes from three sources: internal funds, debt and new equity. When the firm needs to
finance an investment with external funds, debt is preferred to equity.
78 Such as Free cash flow theory of debt, Pecking order theory
79 Simon Johnson and others, 'Tunneling' (2000) 90 American economic review 22.
80 Rafael La Porta and others, 'Investor protection and corporate governance' (2000) 58 Journal of
financial economics 3.
81 Michael C Jensen, 'Agency costs of free cash flow, corporate finance, and takeovers' (1986) 76 The
American economic review 323.
22 be either a result of good incentives or just a mask to cover the real intentions of shareholders to expropriate the wealth of creditors. It is one of the main issues, to decide whether it is efficient to treat the shareholder loan as regular debt or it is more appropriate to subordinate it, or even re-classify it as equity. It needs to be stressed, however, that subordination in this case will merely work as a tool to discourage the shareholders from taking advantages through such hybrid financing instrument at the expense of other stakeholders, and the validity of such loans is still in place. This means that shareholders are still allowed to invest in firms in a form of loans; like Hoff 83argued, a shareholder is not obliged to solely finance the company through equity capital. But besides from Hoff’s opinion, shareholders still need to bear the risks when the firm is going bust regardless the form of investing.
3.2 Bright Side of Debt: Monitoring Power of Creditors
First of all, commitment of debt results from periodical interest payments in cash84 and a bankruptcy pressure85. This is the bright side of debt. Debt can be used to limit the availability of free cash flows to the managers (as well as shareholders) and commit them to a repayment schedule to avoid the cost of financial distress. At the same time, the creditors will act as supervisors of the business in the firm. When the firm makes investment decisions, it needs to consider their results, namely, whether they will increase the cost of financial distress or whether bad investment decisions will induce the bankruptcy claim of the creditors. Furthermore, such decision could increase the future cost of debt from the new external investors. If the significant creditors of a firm include institutional creditors such as banks, who have strong bargaining power, it might be able to increase the commitment level of its shareholders86. If the business is
83 See GTJ Hoff, 'De aandeelhouder als schuldeiser: een ongenode gast?' (2009) I Spinath, JE Stadig en
M Windt (red), Curator en Crediteuren, Deventer: Kluwer 19.
84 See Jensen, 'Agency costs of free cash flow, corporate finance, and takeovers', 324-326. He suggested
that debt contracts reduce the amount of "free" cash available to managers to engage in wasting investment.
85 See Sanford J Grossman and Oliver D Hart, 'Corporate financial structure and managerial incentives',
The economics of information and uncertainty (University of Chicago Press 1982). Grossman and Hart pointed out another benefits of debt that bankruptcy is costly for managers and this will create an incentive for managers to work harder.
86 See Clifford W Smith Jr and Jerold B Warner, 'On financial contracting: An analysis of bond
covenants' (1979) 7 Journal of financial economics 117. See also Andrei Shleifer and Robert W Vishny, 'A survey of corporate governance' (1997) 52 The journal of finance 737. Their monitoring power comes
23 not running well or too many risky investments are being made, the big creditors might put a financial pressure on the corporation and claim for insolvency issues. Additionally, some professional creditors might limit the financing or investment activities conducted by the debtors through Covenants87. Therefore, to avoid bankruptcy, the manager is going to run the business in a more prudential manner.
However, if the creditors are also shareholders, in most cases they will not be willing to claim for bankruptcy or impose any more financial pressure on the firm if the corporation is not running well. As a result, they will exercise their monitoring power insufficiently to contribute to the soundness of the investment decision and daily operations. Therefore, the monitoring function is weakened when the creditors are also shareholders. Moreover, enabling the shareholders to exercise the rights conferred exclusively to creditors will increase the monitoring costs of the firm even more if the shareholder loan is provided by the controlling shareholders. Given a parent company and its subsidiary, if the parent company is not only a shareholder but also a creditor of the subsidiary, the monitoring power from the outside creditors will be diluted by the parent company. That is because the parent company will always occupy a seat in the creditors’ meeting, which hinders the other creditors from exercising their rights when they need to take collective bargaining actions. Therefore, shareholder loans would not efficiently help to increase the commitment level of the management, and even might bring adverse impact.
Moreover, when the controlling shareholders88 provide shareholder loans, the conflicts of interest between shareholders and management is not the main concern any more. In this situation, the bright side of debt, which is to help solve the conflicts between shareholders and management, is neglectful. Thus, more attention needs to be payed to the dark side of debt, where shareholder loans might severe the conflicts
partly from the control rights they receive when firms default or violate debt covenants, and partly from the short maturity of debt, so borrowers need come back at regular, short intervals for more funds.
87 See Sudheer Chava and Michael R Roberts, 'How does financing impact investment? The role of debt
covenants' (2008) 63 The journal of finance 2085. The creditors could use the threat of accelerating the loan to intervene in management.
88 Controlling shareholders are the ones who participate the daily operation for business and have
24 between shareholders and creditors.
3.3 Dark Side of Debt: Risk Shifting and Debt Overhang
Here we take an assumption that the shareholder we are targeting is the controlling shareholder of the firm, owning 100 percent of the controlling rights. Under these circumstances, we can expect the management to run the firm for the benefit of the shareholder and the goal of this firm is to maximise the market value of capitalisation. Therefore, we can assume the conflict between the shareholders and management is at its minimum. The main conflict of interest here exists between the shareholder and the creditors. Whether the shareholder, at the same time, as a creditor, will increase his commitment level to the firm as a whole and mitigate the agency problem is the main concern here.
3.31 Risk Shifting
Risk shifting problem results from the conflict of interest between shareholders and creditors89. The incentives to make investment decisions are different for both shareholders and creditors. This is exactly what happened before the 2008 financial crisis in the banking sector. The banks’ debt capacity is growing when the economy is booming. As a consequence, banks are over leveraged and less prudential to their risk management during those periods90. By engaging in more risky investments, the equity holders of the banks will shift the risk of failed investment to the creditors, as well as depositors. Same as financial sectors, when the equity level is shrinking or in other words, the firm is highly leveraged, an increasing risk-shifting problem might take place in the firm regarding the investment choice, where the shareholders are prone to take excessive risk even though the project NPV91 is negative. This is one of the dark sides of a debt. The reason is that the loss will be borne mostly by the creditors while
89 Jensen and Meckling, 'Theory of the firm: Managerial behavior, agency costs and ownership structure'. 90 Anat R Admati and others, 'Fallacies, irrelevant facts, and myths in the discussion of capital regulation:
Why bank equity is not socially expensive' (2013) 23 Max Planck Institute for Research on Collective Goods
91 NPV refers to the Net Present Value, which represents the difference between the present value of its
benefits and the present value of a project or an investment. See Chapter 3 of Jonathan B Berk and Peter M DeMarzo, Corporate finance (Pearson Education 2007).
25 the upside gain will be earned by the shareholders92. The critical point needs to be aware of here is under what situation the risk-shifting problem might happen. Risk shifting mostly takes place when the company is not over indebted93, or in other words, there is still some equity left in the firm, but not sufficient to absorb the future loss from a volatile investment, where shareholders still will gain all the profits from upside94. In a private firm, wearing a double-hat as a creditor and shareholder at the same time, would it be profitable or reasonable for the shareholders to take less risky investments? Gelter95 has proven the incentive of risk-shifting by a theoretical model. Based on the analytical results provided by Gelter, subordinating loans under this scenario won’t bring any negative effect, but might not be sufficient to stop the excessive risk-taking of the shareholders96.
Considering there is an investment taken by a shareholder with negative NPV for the firm, where the project will destroy the value of the company as a whole. However, as a shareholder, he is not going to suffer a loss which is more than the capital contributed inside the firm in most of the cases97. Therefore, when there is barely any capital left in the balance sheet, the shareholder will not be afraid of losing the residual capital, and they will be more willing to take risky investment at the expense of the creditors. When the controlling shareholder provides a new investment in this firm, he is going to earn the upside of the gain based on its equity claim from the risky
92 Jensen, 'Agency costs of free cash flow, corporate finance, and takeovers'.
93 When the firm is overindebted, the risk shifting is still existing, but requires a higher-volatile return,
for the reason that the upper side gain will first go to the creditors. Therefore, when the firm is overindebted, the firm will be pickier to risky investment, and more dangerous investment decision might be taken. This will be explained in the next part.
94 For example, there are 10 million assets in total available in the firm, with 1/10 equity. Now there are
2 million cash available in the firm to undertake an investment. There are two investment opportunities presenting here, one of which is a safe investment with 2 million initial investment and a return of 2.2 million for sure. Another one is a risky investment with 2 million initial investment but will have 70% chance to result at a failure and loss all the initial investment, and only 30% chance of success with a gain of 5 million. The NPV of this project is negative (0+30%*5-2= -0.5). But from the perspective of shareholder, this investment is profitable because the payoff for shareholder is positive (-1*70%+3*30%= 0.2). The difference between the NPV of the project and the payoff the shareholders represents the loss of the creditors, where the creditors will suffer a loss of 0.7. The shareholders here will engage in the risky investment and shift the risk to the creditors’ side.
95 Gelter, 'The subordination of shareholder loans in bankruptcy'.
96 See ibid 13-16. Even though Gelter holds the opinion which goes against automatic subordination of
shareholder loans, he does agree that subordination shows no negative consequences when the firm is not overindebted. Subordination of shareholder loans could partly internalize this risk, but not in full.
26 investment, and merely lose limited capital as he provided. If we keep the total investment of this shareholder constant, allowing shareholder loans will not decrease the potential gain, but lower potential loss the shareholder is facing, which encourages the risk taking of this shareholder. Therefore, under this scenario, shareholder loans will aggravate the conflict of interest. When there is a new investment opportunity provided and the shareholder is not confident with the outcome of this investment, he might even invest in secured loan to take a try98. By doing this, the shareholders will always feel safe enough to engage in more risky investments. Therefore, the shareholder loans here will give the shareholder more incentive to take excess risk.
3.32 Debt Overhang
Besides risk-shifting, the debt overhang problem is also one of the dark sides of the debt99. If we go more extreme than the previous scenario, where the equity is even negative, there might be debt overhang issue triggered in the firm, where the shareholders will forgo the positive investment opportunities even though the new investment is a positive NPV project, for the reason that all the profits contributed by the new investment will first go to the pocket of the creditors instead of the shareholder. When the firm is facing financial difficulties and their market value of debt is lower than the face value, all the attempt of rescue will first go to make up the loss of the creditors and even might not contribute anything to the wealth of the shareholders. If the shareholders would like to provide more equity to compensate the creditors as much
98 For example, there are 10 million assets in total available in the firm, with 1/10 equity. Now there is
only 2 million cash available in the firm to undertake an investment, and the external fund is not available. There are two investment opportunities presenting here, one of which is a safe investment with 3 million initial investment and a return of 3.1 million for sure. Another one is a risky investment with 3 million initial investment but will have 70% chance to result at a failure and loss all the initial investment, and only 30% chance of success with a gain of 6 million. To engage in any of the investment, the shareholder needs to provide another 1million investment. Without the shareholder loan the NPV of the risky project is negative (0+30%*6-3= -1.2) for the firm. Also, from the perspective of shareholder, this investment is not profitable because the payoff for shareholder is also negative (-2*70%+3*30%= - 0.5). The difference between the NPV of the project and the payoff the shareholders represent the loss of the creditors, where the creditors will suffer a loss of 0.7. The shareholders here will not engage in the risky investment, nor shift the risk to the creditors’ side. If we allow the shareholders to provide secured shareholder loans for the new investment, the payoff scenario for shareholders will change and shareholders will have a positive NPV (-1*70%+3*30%= 0.2). While the creditors will suffer more loss (-2*70%= -1.4). Therefore, allowing secured shareholder loans will encourage them to take more risky investment decisions.
99 See Owen Lamont, 'Corporate-debt overhang and macroeconomic expectations' (1995) The American
27 as possible, then it would be nice. But the shareholders are not charities, and they unlikely take such risk which transfers their wealth to the creditors. Therefore, under such scenarios the shareholders are not willing to put extra funds inside the corporation and they would like to claim for liquidation instead100.
Here we need to be aware that debt overhangs often happen when the equity has already been under the water and the current market value of debt has already been lower than the nominal value. Face value of the existing debt is bigger than the expected payoff of the new investment. Therefore, the shareholders here have incentive to forgo the good investment even though it is beneficial for the firm as a whole101. Some scholars, such as Gelter, argue that if we allow the shareholders loan as a whole, especially during a crisis, then it might help the shareholders to solve such debt overhang problem and engage in positive NPV investment. When the firm is facing the debt overhang problem, the firm is normally trapped in the negative equity, where the firm might wind up by the request of the creditors. Gelter argues that if the subordination of shareholders is provided, the shareholders are not encouraged to engage in the efficient rescue when there is a possibility that the rescue will help to restore the value of the creditors, and is beneficial for the firm as a whole102. However, by using theoretical model he did not give a clear conclusion in this scenario.103 He found out that when the firm is already over indebted, subordination will prevent some socially undesirable, but also some desirable rescue attempts104.
100 Filippo Occhino, 'Is debt overhang causing firms to underinvest?' (2010) Economic Commentary. 101 For example, there are 10 million assets in total available in the firm, with 15 million unpaid loans
outstanding. Now there is only 2 million cash available in the firm to undertake an investment, and the external fund is not available. There is a safe investment opportunity presenting here. By investing 3 million in a new project, the firm can earn 4 million for sure. The NPV of this safe project is 4million-3million=1million. However, the shareholders would not be willing to put another 1 million inside the firm to undertake the investment because all the initial investments and profits will contribute to repay the debt.
102 Gelter, 'The subordination of shareholder loans in bankruptcy', 17-24.
103 See ibid 20. Gelter finds out that overall, the effects of subordination are ambiguous when company
is already overindebted.
104 See ibid 32. Gelter says “If an increase in the going concern value after the rescue was to be expected,
the shareholder-creditor should be treated like a third-party creditor in bankruptcy. Otherwise, if the creditor is punished in bad states of the world, even where the rescue attempt was desirable, an inefficient disincentive is the result.
28 3.33 Dynamic Model of Risk Shifting and Debt Overhang
Debt overhang and risk-shifting are the two negative effects of over-leveraged financing, that cause two different types of wrongful investment decisions105. If we take a look at these two issues dynamically, we could uncover that debt overhang might occur together with risk-shifting, as long as there is enough of the upside income to compensate for the upside loss of the shareholders106. Therefore, as the iceberg of equity is melting, the risk-shifting breaks through the surface of water, and the debt overhang problem does not replace risk-shifting, but co-exists with it when the equity level keeps dropping down. In the debt overhang model, the flip side of an under-investment in a healthy and lucrative project is a potential over-investment in risky and harmful projects107. The graph below shows a dynamic movement of a solvency ratio108 and its relationship with risk shifting and debt overhang.
Graph 1: Green shadow represents the risk shifting problem and yellow shadow represents the debt overhang problem.As the solvency ratio dropping, the risk-shifting problems becomes more serious. At a certain point, the risky investment results as a failure and the equity is finally underwater, where a debt overhang situation will be triggered.
105 As described above, under risk-shifting scenario, the firm is going to take risky investment with
negative NPV at the expense of creditors, while under debt overhang scenario, the firm is going to forgo a positive NPV project because of the shareholders might have possibility to transfer their wealth to creditors.
106 Jensen and Meckling, 'Theory of the firm: Managerial behavior, agency costs and ownership
structure'.
107 Philippon, 'Debt overhang and recapitalization in closed and open economies'.
108 Here solvency ratio refers to equity ratio, which represents the ratio of equity and total assets,
