University of Amsterdam Master’s Thesis Law and Finance LLM
The Subordination of Shareholder Loans: Does Turkish Law Require A Reform to Introduce the Subordination of Shareholder Loans?
Author: Esra Dündar
Student number: 12847046
E-mail: esradundar0000@gmail.com
Supervisor: dhr. prof. dr. R.J. (Rolef) de Weijs Date of Submission: 24 July 2020
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ABSTRACT
This research studies the subordination of shareholder loans through legal and economic analysis with an aim to provide a proposal for a potential reform to introduce the compulsory subordination to Turkish law. In order to provide legal basis, it analyzes the legal rationale of subordination of shareholder loans from corporate and insolvency law perspectives. Then, it provides the examples of different implementations of shareholder loan subordination in the United States, Germany and Austria. For economic analysis, the impact of shareholder loans on opportunism by shareholders and therefore the expropriation of outsiders, especially creditors, through shareholder loans are studied. In order to fully understand the advantages and disadvantages of subordination, the effect of subordination on investment incentives of shareholders is reviewed. The effect on investment incentives is studied by discussing the incentive distortions for rescue finance based on prior research in the literature. These analyses, together with legal rationale, suggest in favor of the subordination of shareholder loans. Therefore, it provides an analysis to understand whether the doctrine of subordination of shareholder loans comply with the Turkish law principles and its recent reforms. The research concludes that subordination of shareholder loans should be introduced to Turkish law not only due to legal justification and the efficiency of subordination rules regarding shareholder opportunism but also to support the development, and rapidly fulfil the needs of recent Turkish legal reforms.
Keywords: shareholder loan, subordination, corporate law, insolvency law, shareholder
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TABLE OF CONTENTS
1. Introduction ... 4
2. The Overview of Legal Rationale and Different Implementations of Compulsory Subordination ... 6
2.1. Shareholder Loans and Compulsory Subordination ... 6
2.2. The Overview of the Legal Arguments for Compulsory Subordination ... 7
2.2.1. The Corporate Law Perspective ... 7
2.2.2. The Insolvency Law Perspective ... 9
2.3. The Comparison of Different Jurisdictions and Their Rationale ... 12
2.3.1. The United States ... 13
2.3.2. Germany ... 14
2.3.3. Austria ... 16
3. The Impact of Compulsory Subordination on Shareholder Opportunism and Investment Incentives of Shareholders ... 16
3.1. Shareholder Opportunism ... 18
3.2. Investment Incentives and Rescue Finance ... 23
3.2.1. Investment Incentives When Company is Not Overindebted ... 25
3.2.2. Investment Incentives When the Company is Overindebted ... 29
3.2.3. The Overall Analysis on Investment Incentives ... 34
4. The Current Structure under Turkish Law and The Proposal to Introduce Compulsory Subordination ... 36
4.1. Overview of The Current Legislation and Reforms of Turkish Law ... 36
4.2. Turkish Corporate Law ... 37
4.3. Turkish Insolvency Law ... 43
4.4. The Proposed Structure for Compulsory Subordination Reform and Required Further Research ... 46
5. Conclusion ... 49
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1. Introduction
The various financing choices enable companies to build a healthy and efficient capital structure that will serve them the best. Even though companies are thought to freely choose from different financing options, the capital structure of a company is of utmost importance not only for the company itself but also for other corporate constituencies and even for real economy (Berk & DeMarzo, 2017). Therefore, financing tools and capital structure has been studied widely and become subject to a variety of rules and restrictions. Compulsory subordination of shareholder loans is one of the interesting yet controversial issues that reflects the concerns regarding the capital structure from legal and corporate finance perspectives. It has been discussed by both legal and economic analysis by its proponents and opponents. However, the doctrine of compulsory subordination of shareholder loans is studied mostly from a theoretical perspective. The strongest arguments in favor of compulsory subordination come from corporate law, insolvency law, and economic perspectives. The main arguments under corporate law support subordination of shareholder loans to claims of other creditors based on the characteristics of shareholders, limited liability and risk-bearing nature of their investment while insolvency law argument is based on protection of corporate asset pool to prevent acts detrimental to creditors (de Weijs, 2018). From an economic perspective, it is argued that shareholder loans exacerbate the risk of moral hazard and provides a backdoor to conduct self-serving behaviors at the expense of outsiders (Landuyt, 2018). As opposed to arguments for subordination, the strongest main argument against subordination focuses on economic efficiency. It argues that the subordination of shareholder loans prevents efficient rescue attempts that could otherwise be initiated without subordination (Gelter, 2006).
There is not any widely accepted conclusion on the debate on compulsory subordination both from legal and economic perspectives. The debate failed to draw enough attention in some countries, whereas in some other countries, subordination gained more support and ended with the codification of compulsory subordination such as Germany and the US. The implementation of compulsory subordination under those jurisdictions differs in terms of the treatments and restrictions as to apply subordination. However, some countries have discussed subordination and drafted legal rules however those amendments failed to become a law. Besides Switzerland and the UK, Turkey is also one of the countries (Türk, 2016).
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The unspotted and very short story of compulsory subordination of shareholder loans is highly intriguing. The compulsory subordination was enacted by the new Turkish Corporate Law no 6102. However, the same rule was annulled just before the new Turkish Corporate Law entered into force. The Turkish legal and economic literature is very limited on the subordination of shareholder loans with not even a handful of scholars to the best of my knowledge. Unfortunately, neither the new rule provided nor the annulment thereof could spark curiosity except for few scholars that argued in favor of compulsory subordination and criticized the annulment (Çeker, 2012). On the other hand, unlawful implementations of shareholder loans such as a tool to handle unregistered revenues or to stripping corporate assets in the vicinity of insolvency are not rare practices in Turkey (Türk, 2016). The above-mentioned arguments in favor of subordination and the unlawful practices in Turkey may suggest that compulsory subordination could be a great reform for Turkey. However, this conclusion requires more attention and research on the doctrine in order to understand whether compulsory subordination is beneficial both from legal and corporate finance perspectives and whether it complies with Turkish corporate law and insolvency law.
The primary concern and the aim of my research is to provide an overview of the subordination of shareholder loans and to understand whether it can be argued and is legitimate both from legal and economic perspectives. Both the main arguments under corporate and insolvency law. Under economic analysis, the risk associated with increased opportunism by shareholders and therefore externalities imposed on creditors and the prevention of value-increasing rescue attempts will be reviewed. Since the aim of this study is to provide a reform suggestion to Turkish law in case subordination will be justified, I will review the compliance of subordination with primary principles and recent reforms of Turkish corporate and insolvency law. Therefore, the comparative law analysis will be accompanied by normative methodology to compare different jurisdictions, outline similarities and differences with those legal systems, and finally to provide a reform suggestion to Turkish law.
Section 2 will provide the legal arguments and review of different jurisdictions after a brief introduction to the compulsory subordination of shareholder loans. Under Section 3, the effect of subordination on shareholder opportunism and investment incentives will be provided. Section 4 will provide a review of Turkish law in relation to subordination doctrine and will provide a
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proposal to introduce the subordination of shareholder loans. Section 5 will provide for the conclusion.
This research is limited to closed joint-stock companies and limited liability companies and concerns the private law claims excluding public law claims.
2. The Overview of Legal Rationale and Different Implementations of Compulsory Subordination
2.1. Shareholder Loans and Compulsory Subordination
Shareholder loan is a financing tool provided to the company by its shareholders as a debt and not as an equity. There are various reasons why a shareholder chooses to finance the company through shareholder loans instead of committing equity. These reasons, amongst others, could be to have lower risk than equity investment, obtain higher returns through interest payments or enabling the company to obtain tax benefits. Since shareholder loans, due to its debt character, ideally provides for a fixed return and interests payments and such interests payments can be deducted from the taxable income of the company as a tax shield.
The treatment of shareholder loans differs in every jurisdiction. Some jurisdictions provide for the compulsory subordination of shareholder loans and restrictions on its repayment and security interests whereas some jurisdictions have no rules to subordinate such loans and permit secured shareholder loans.1 In between these two opposite positions, we also see some jurisdictions where compulsory subordination doctrine is applied by the courts in certain circumstances and supported by legal doctrine even though the legislation does not provide an explicit rule such as Switzerland and the Netherlands (Orval, 2011; Rohde & Spillmann, 2016).
The effect of the compulsory subordination doctrine differs based on the rules adopted in the relevant jurisdiction. However, the basic idea of the compulsory subordination is to lower the ranking of shareholder loans below the claims of the outside creditors of the company or to treat it as an equity contribution in insolvency. Therefore, compulsory subordination excludes shareholders from equal participation with outside creditors of the company. It may take place as an insolvency law concept or a corporate law concept. In addition to subordination to outside
1 Subordination can take place through a contractual, structural or equitable subordination. The doctrine reviewed here is equitable subordination.
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creditors’ claims or being treated as equity, compulsory subordination as applied in some jurisdictions provides for restrictions on repayment of the loans such as a ban on withdrawals of the loans or repayments especially when the firm is in financial distress and restrictions on security rights such as banning to provide security for the loans (Verse, 2008).
2.2.The Overview of the Legal Arguments for Compulsory Subordination
The doctrine of compulsory subordination of shareholder loans has not been an easy topic and there are different legal and economic arguments whether such loans shall be treated any different than outside debt by its proponents and opponents. The legal justification in favor of compulsory subordination derives from the aspects of both corporate law and insolvency law. Corporate law arguments are mainly associated with the principles related to capital requirements, limited liability, and the nature of shareholders as residual claimants. On the other hand, insolvency law arguments are mainly based on the principles for the preservation of going-concern value and fair distribution within creditors. I will briefly review the main legal arguments below under corporate and insolvency law.
2.2.1. The Corporate Law Perspective
Corporate law aims to set forth a legal form for enterprises and control the conflicts among the corporate constituencies to pursue the end-goal of increasing aggregate social welfare (Armour, Hansmann, Kraakman, & Pargendler, 2017). To understand the rationale of the subordination doctrine under corporate law, the distinctions between shareholders and creditors, and also debt and equity should be made. While debt is a fixed claim, equity is a residual claim, derived from the risk-bearing capital, that increases in the upside scenario but wipes out first when the company is in financial distress. This explains the control power and ownership rights granted to shareholders (de Weijs, 2018). Providing risk-bearing investment by shareholders is balanced with limited liability principle. Limited liability shields shareholders’ personal wealth from creditors’ claims and enables them to limit the downside risk for shareholders (Armour, Hansmann, Kraakman, & Pargendler, 2017). Without prejudice to exceptions, limited liability principle restrains creditors to recourse to shareholders when the company cannot pay its debts and therefore company assets become the only source to back their claims. Therefore, providing priority to creditors over shareholders on the company assets and shielding company assets from
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shareholders and their creditors are the other side of the coin to protect creditors through entity shielding. Creditors2, that are not the owners of the company and lack control over the company, require such protection to have their claims backed by company assets and to prevent shareholders and shareholders’ personal creditors to withdraw or destruct company assets securing their claims (Armour, Hansmann, Kraakman, & Pargendler, 2017). To that end, shareholders should bear the responsibility for the consequences of their financing decisions (Gelter, 2006). Otherwise, it would conflict with the risk-bearing investment and provides a way to abuse the limited liability principle. It is the point where the main corporate law argument in favor of the subordination of shareholder loans appears. Shareholders, through providing loans that are not subordinated, become creditors of the company with a fixed claim. It enables them to avoid providing risk-bearing capital and to back their fixed claims by company assets while still maintaining control over the company and minimizing shareholders’ downside risk. Shareholder loans without subordination, especially when the loans are secured, shift the entrepreneurial risk to other creditors, and provide a guaranteed return to shareholders to facilitate a win-win situation (Skeel & Krause-Vilmar, 2006). This structure destroys the protection of creditors and paves the way for increased shareholder opportunism. Since avoiding the consequences of their decisions and minimizing their risk, expropriation of creditors and any other acts of moral hazard become inevitable both when the company is solvent and insolvent. Subordination of shareholder loans prevents speculations at the expense of outside creditors (Türk, 2016). Therefore, shareholder loans should be subordinated to the claims of outside creditors in line with principles of the established legal form and the function of corporate law.
The reasoning becomes even more clear when an illiquid company that cannot borrow money from outside creditors, is taken as an example. If shareholders decide to continue business and fund the company through loans instead of equity, it will worsen the situation of other creditors and make other creditors share the entrepreneurial risk of the decision to maintain the company as opposed to increased incentives of shareholder for risk-shifting (gambling for resurrection). However, shareholders should be the ones who should bear the entrepreneurial risk due to their
2 Even though professional/strong creditors such as banks or other financial institutions may have a great deal of control over the debtor company, ordinary creditors such as trade creditors or small suppliers cannot obtain such a control and adjust their claims. With that said, efficient contractual protection by either professional creditors or individual creditors with small claims, requires creditors to monitor the company efficiently which may pose higher monitoring costs than expected losses. The observations show that debt covenants are underenforced (Squire, 2010).
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decision-making power. This is also argued to be conflicting with the principle of legal appearance due to leading a misleading picture where the company is actually financially distressed where it would not obtain any loans otherwise (Türk, 2016). More importantly, shareholders, as insiders and owners of the company, may withdraw their loans in the vicinity of insolvency as to rescue their investments as opposed to creditors who lack the inside information on the company’s financial situation. This example shows the importance of restrictions on repayments and security interests along with mere subordination since lack of such restrictions still leads the same result with shareholder loans without subordination. Therefore, equal treatment should not be expected and cannot be fair when shareholder creditors and outside creditors are not equal in terms of control and information over the company. This requires a different treatment to shareholder loans as opposed to the argument that shareholders should rank as any other creditor since the money provided by them is as green as other people’s money (de Weijs, 2018).
As explained, sound capitalization and maintenance of equity capital are essential for creditors however it should be made clear that the objective of compulsory subordination is not to force or held shareholders liable for providing additional equity in crisis since shareholders are not under such an obligation. The purpose and the basis of the main argument here are to make shareholders bear the financial consequences of their decisions and prevent them transfer entrepreneurial risk to creditors (Verse, 2008). Otherwise, it would be against the limited liability principle and create additional liability for shareholders whereas the only capital commitment liability of shareholders is to pay their capital subscription or to provide additional capital to continue business when the company is in financial distress. In line with capital maintenance rules, compulsory subordination does not force shareholders to commit extra capital or take more risks de facto, rather it makes sure that they bear the entrepreneurial risk deriving from their own decisions in a crisis and reduce the scope of value-decreasing opportunism.
2.2.2. The Insolvency Law Perspective
Insolvency law aims for the protection of creditors’ claims and fair distribution within creditors with the highest payout possible. Insolvency law should not favor the debtor in a way that may provide incentives not to comply with its obligations (Tolmie, 2003). It is important to preserve the assets available to back creditors’ claims and to prevent acts that may lower the
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concern and liquidation value or the acts that are detrimental to creditors. Therefore, insolvency law provides rules and safeguards aiming to protect creditors, prevent wealth extraction, and transfer value from creditors to shareholders. Some examples of those rules are restrictions on dividend payments in the vicinity of insolvency, preferences, or rules on avoidance for certain transactions.
In many jurisdictions, if not in all jurisdictions, shareholders, as residual claimants, can only receive payments after all other creditors are paid since they rank at the bottom for equity claims in liquidation. However, shareholder loans without subordination enable shareholder-creditors to rank the same with outside creditors in insolvency and their participation dilutes the assets available for creditors. The scope of transfer of wealth and debt dilution increases in case the face value of debt and the premium is not adjusted well and therefore cannot offset the dilutive effect on creditors’ recoveries.3 A more serious threat emerges for claims of non-adjusting creditors including non-voluntary creditors. Since they generally do not have security interests and lack the power to protect themselves such as receiving information on the company’s financial situation or putting pressure on the management to make payments even if they are aware of the crisis. Last but not least, secured shareholder loans create one of the biggest concerns for outside creditors (Skeel & Krause-Vilmar, 2006). Outside creditors with fully secured claims may not be affected by shareholder loans. However, the shareholder with secured shareholder loans would have priority over unsecured creditors and the remaining claims of secured creditors. In such a case, the rules provided by insolvency law such as avoidance or restriction on dividend payments, become inoperative (de Weijs, 2018). de Weijs also points to the risk of claiming repayments from creditors through transaction avoidance to make payments to shareholders. The benefits that can be created by shareholder loans and securities provided to shareholders, conflict with the insolvency law principles and becomes a tool to circumvent the law and to unfairly favor shareholders.
Shareholder loans alter the bargaining power of shareholders before and during bankruptcy and reorganization procedures if they are allowed to participate as a creditor for the claims under shareholder loans. When the firm defaults or goes into bankruptcy, the conflict of interest
3 If the shareholder loan is provided with unfair terms, it provides new assets that is lower than the face value of the debt. Therefore, the new assets (being the cash received) cannot neutralize the dilutive effect of the debt on especially for the unsecured creditors (Squire, 2010).
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between creditors gain more importance since one group may act at the expense of others and cause a lower liquidation value. When shareholder-creditors are involved in decision-making procedures in bankruptcy or reorganization, they have a say and power to impact the outcome. It may have an adverse ex-ante and ex-post effect on the firm and other creditors. As an ex-ante effect, it may lead to overleverage since it will subsidy shareholder-creditors and shareholders will be able to divert value from creditors thanks to their creditor position. As an ex-post effect, it may lead to unfair distribution depending on the bargaining and voting power of shareholder-creditors. In case the shareholder loan is secured, it may lead to collusion between senior creditors and shareholders at the expense of junior creditors. Therefore, subordination rules prevent such ex-ante and ex-post effects of shareholder loans.
Despite the arguments in favor of subordination rules under insolvency law, the tradeoff between creditor protection and the desirability of potentially successful rescue attempts should also be reviewed (Armour, Hertig, & Kanda, 2017). Preventing viable business from liquidation through facilitating improved reorganization and rescue opportunities is also an important aspect of insolvency law. The risk to prevent voluntary financing and especially rescue attempts by shareholders was the prevailing argument leading the Swiss discussion on subordination rules when the subordination provision was removed from the draft corporate law (The Grand National Assembly of Turkey, 2008). Gelter finds out that subordination rules may prevent efficient rescue attempts when the liquidation value does not cover the value of debt while it may prevent some inefficient rescue attempts when the liquidation value is higher than the value of debt (Gelter, 2006).4 However, it is debatable whether such a rescue attempt is actually socially desirable or instead just an example of re-distribution of risk, as risk-shifting. Providing shareholder loans for socially desirable rescue attempts may be the case when a firm is illiquid but it should be carefully analyzed for insolvent companies. In case the firm is insolvent, such a rescue attempt would most probably be re-distributing the risk between creditors and therefore questionable in terms of its efficiency and maximization of social welfare when compared to a scenario where it preserves the business value through different means. In practice, instead of preserving the existing company and its shareholders and managers, different business
4 Gelter’s conclusion is analyzed below under investment incentives. It shows us that his conclusions is limited to only certain cases where a definite conclusion on the effect on rescue attempt is not feasible due to numerous variables.
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acquisition tools and voluntary or court-run procedures where creditors have a say may provide for the protection of value (that would still be efficient and socially desirable) while not imposing externalities. For example, a rescue attempt when the firm is insolvent or illiquid could be desirable in case it is conducted through reorganization and providing upside potential to creditors to make it a fair solution instead of diverting value from creditors and favoring shareholders at the expense of creditors.5 Therefore, socially desirable rescue attempts can be facilitated through other means. It should also be considered that it requires a great deal of financial analysis to determine whether a rescue attempt was a socially desirable one for a now-bankrupt company together with hindsight bias (Landuyt, 2018).
Moreover, the subordination rule should not be restricted with its impact on incentives of shareholders for rescue attempts without considering the legal theory, its mechanisms, and other impacts on corporate governance especially on shareholder opportunism. As explained under both corporate law and insolvency law perspectives, it is relevant to corporate structure, limited liability, entrepreneurial risk and internalization of costs, creditor protection, liquidation quotes, and fair distribution within insolvency creditors. Whereas, enabling efficient rescue attempts can be reached through various means of insolvency law instead of focusing on subordination rules which cannot provide a general conclusion for its impact on efficient rescue attempts.
2.3.The Comparison of Different Jurisdictions and Their Rationale
While some jurisdictions such as the United Kingdom and France do not provide specific regulations for shareholder loans, some jurisdictions provide for explicit regulation on shareholder loans such as the United States, Germany, Australia, Italy, and Spain. Also, courts in some other jurisdictions rule for subordination absent of explicit rules such as the Netherlands and Switzerland (Türk, 2016; Verse, 2008). There are different treatments of shareholder loans in jurisdictions where various forms of compulsory subordination are enforced. It ranges from automatic subordination to much more limited subordination of only some shareholder loans under certain circumstances. In order to present different examples of the treatment of shareholder loans, I will review the rules of the United States, Germany and Austria. Amongst those jurisdictions, Germany is the most comprehensive one subordinating all shareholder loans
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whereas the United States and Austria do not provide for such an automatic subordination of all shareholder loans.
2.3.1. The United States
Compulsory subordination doctrine takes two forms under US law which are equitable subordination and recharacterization(Wheaton, 2015). These two doctrines differ in terms of its historical developments, their functions, and the requirements to apply subordination to shareholder loans. Recharacterization aims to identify the funds provided by the insiders including shareholders to the company as equity or debt questioning whether a debt exists or not. It requires to apply multiple factors test developed by the case law (Skeel & Krause-Vilmar, 2006). Even though the doctrine is argued to focus on whether the status of funds is ambiguous and it is not well-documented (which is defined as Truth based on the Robert Clark’s typology; Clark, 1977) rather analyzing the likelihood of destroying value for creditors as to constitute inequitable conduct which should be the concern of the codified doctrine of equitable subordination, the test’s factors are criticized to focus on nonhinderance analysis again based on Clark’s typology, by authors (Skeel & Krause-Vilmar, 2006). As to the function of recharacterization, the shareholder loans are not subordinated to claims of outside creditors but treated as equity.
Equitable subordination, on the other hand, does not deal with the question of whether a legitimate and valid debt exists, or the funds were provided as a capital contribution. Rather, it deals with whether a legitimate creditor including shareholder-creditors acted inequitably or not (Skeel & Krause-Vilmar, 2006). A claim of a creditor or a shareholder can be subordinated by the court if the creditor acted inequitably. It requires i) inequitable conduct; ii) injury to creditors or an unfair benefit to the challenged claimant; and iii) that subordination does not conflict with other provisions of the bankruptcy code. It is also possible to see both recharacterization and equitable subordination doctrines to be accompanied to each other (Scheler et al., 2006).
As mentioned above compulsory subordination may also deal with repayment and security interests related to shareholder loans apart from merely subordinating those claims. The secured shareholder loans bear especially huge importance since how the security interests are treated may enable shareholders to circumvent the subordination rules and provide shareholders a safe harbor guaranteeing them to win in the upside and not to lose in the downside scenario.
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However, US law does not provide for specific rules on repayment of shareholder loans or its security interests. Both the repayment and security interests are dealt with general provisions of preferences and fraudulent transfers (Verse, 2008). With that said, secured shareholder loans may constitute a factor to conclude that the shareholder acted inequitably (de Weijs & Good, 2015).
2.3.2. Germany
German law on shareholder loans did not start with the legislation of such rules but the courts’ ruling in favor of subordination in specific cases by analogy with existing rules on capital maintenance and distribution. Those judge-made rules paved the way for the codification of rules on subordination of shareholder loans that substitute for equity under the Limited Liability Companies Act (GmbHG - Gesetz betreffend die Gesellschaften mit beschränkter Haftung) (Verse, 2008). Later, the equity substitution was transformed to automatic subordination of all shareholder loans by the reform in 2008 while also abolishing the corporate law provisions and providing the relevant provision under the Insolvency Act (InsO – Insolvenzordnung) making it clear that it applies to all companies with limited liability.6 Under Section 39 of Insolvency Code, automatic equitable subordination of all shareholder loans and preserves the same exemptions under previous law.
Before the 2008 reform, equity substitution provided for the subordination of shareholder loans granted or not withdrawn when the company is in crisis.7 A shareholder loan would be accepted as equity substituting if a reasonable shareholder would rather make an equity contribution which is defined as the crisis of the company under the annulled provision of German law (Verse, 2008). Based on the court precedents, a company that is insolvent or unworthy of credit was deemed to be in crisis. As opposed to the previous rules, the current provisions under German insolvency law provides for the subordination of all shareholder loans regardless of whether it is provided or not withdrawn in the crisis. The reform was an attempt to make the
6 The current law resembles the Spanish law on shareholder loans where subordination does not require the crisis or under capitalization of a company. Under Spanish law, loans granted by parties that are specially related to the debtor are subordinated to other claims by the Spanish Insolvency Code in bankruptcy of the debtor. These parties are insiders such as managers, shareholders with a capital share above certain thresholds and group companies. Withdrawal of such loans and security interests are subject to avoidance within certain time periods (Lutter, 2006). 7 This criterion resembles some factors under the eleven-factor test developed by the US jurisprudence such as questioning the adequate capitalization or ability to obtain outside finance.
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rules on the corporate legal form more attractive to investors (de Weijs & Good, 2015). Automatic subordination of all shareholder loans provides simplicity and certainty removing discussions on the crisis of the company which was seen as a positive consequence of the current law (Verse, 2008). Subordination rule does not apply for the loans that fall under the exceptions under the current law which were existed under the previous provisions. The exemptions are provided for the loans extended by the shareholders who doesn’t have control in the company (the non- executive shareholder of the company who holds capital share below certain ratio) and the outside investor who obtained shares in the company as a rescue attempt (Verse, 2008). Without prejudice to the exemptions provided for non-managing shareholders and outside investors, two other aspects of compulsory subordination are applied in Germany. These are restrictions on the repayment of shareholder loans and the security interests thereof, that is not the case in the US. The repayment of shareholder loans in the year prior to the filing for the opening of an insolvency procedure was made subject to transaction avoidance and shareholders cannot invoke security rights. The repayments of all shareholder loans made within a one-year period before or after the filing of insolvency proceedings are subject to transaction avoidance.8 The security interests, granted prior to a ten-year period, of all shareholder loans are also subject to avoidance.
Subordination rules, once again, become subject to an amendment however this time it was due to the concerns related to the risk of and to mitigate the unforeseeable financial consequences of the COVID-19 pandemic. Under the Act to Temporarily Suspend the Obligation to File for Insolvency and to Limit Directors’ Liability in the Case of Insolvency Caused by the COVID-19 Pandemic, the obligation to file a request for insolvency under certain cases is suspended until September 30, 2020 (Federal Law Gazette, 2020, March 27). As one of the consequences of the suspension, the new shareholder loans (fresh money) granted during the period of the suspension is deemed not to constitute prejudice to creditors and subordination and repayment restrictions will not apply to those loans up until 30 September 2023. Therefore, the claims regarding such loans will not be subordinated and repayments may not be challenged by an insolvency
8 Verse (2008) explains the current law and he states that the new rules differ from the previous practice applied by that reaches up to 10 years for the avoidance of the shareholder loans’ repayments. He argues that new rules provide a safe harbor for the repayments made prior to the period of one year however increase the risks for the cases where the company becomes unexpectedly insolvent.
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administrator in subsequent insolvency proceedings by 30 September 2023. However, the security interests granted for shareholder loans remains subject to avoidance transaction.
2.3.3. Austria
Austrian law on the subordination of shareholder loans is similar to pre-2019 German rules. It was also codified after the court rulings similar to the development of German rules. Shareholder loans provided when the company is in crisis or in other words is balance sheet insolvent or overindebted, are subordinated (de Weijs, 2018). Austrian rules, however, provides an additional precise and rebuttable presumption that prevents the discussion regarding crisis and creditworthiness as opposed to pre-2019 German law. Accordingly, if the solvency ratio of a company is below 8% and the hypothetical debt redemption period is more than fifteen years, it shall be presumed to be in crisis, unless the company does not need to be reorganized (Gelter & Roth, 2007). Therefore, it provides a basis to prevent ambiguous discussions on crisis and creditworthiness.
Austrian rules apply both as a corporate law and also insolvency law concept (Gelter & Roth, 2007). Similar to other legislations, specific exemptions are provided. Similarly, subordination also applies to funds provided by outside creditors under certain circumstances. Repayment of loans and security interests are subject to transaction avoidance without prejudice to time limits.
3. The Impact of Compulsory Subordination on Shareholder Opportunism and Investment Incentives of Shareholders
From shareholders perspective, shareholder loans provide several benefits such as reduced risk than equity investment or higher rate of return on their investment plus the fixed interest payments even when the company does not distribute dividends. Therefore, in case shareholder are allowed to fund their company with either capital contribution or providing loans as debt without any restriction on the latter, they may choose to finance the company through shareholder loans due to several benefits such as lower risk or higher return on their investment. From the company’s perspective, shareholder loans, similar to any other loans extended to the company, can be utilized to provide funds either to finance new investments or continued operations of the company or even a rescue attempt that may save a viable business. In fact,
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shareholder loans are seen as an important tool to facilitate desirable rescue attempts and it constitutes the main argument against compulsory subordination (Gelter, 2006). Loans extended by shareholders may also provide for the cheapest financing available due to lower transaction costs (Landuyt, 2018). This aspect may suggest that shareholder loans are not only benefits the shareholders but also beneficial for the company and serve for the benefit of all corporate constituencies such as minority shareholder, outside creditors or even employees. Therefore, one may argue against the compulsory subordination doctrine in order not to disincentivize shareholders to provide funds to their own company together with the argument that shareholder should not be treated differently for the money as green as other people’s money (de Weijs, 2018). However, these arguments may not be necessarily true all the time and lack the overall evaluation of the impact of shareholder loan and its compulsory subordination on shareholder opportunism.9 Therefore, it is essential to question, before arguing against or in favor of compulsory subordination, whether shareholder loans increase the scope for shareholder opportunism as to enable them to conduct self-serving behavior at the expense of others, without internalization of costs. It should be noted that non-adjusting creditors are more prone to be affected by shareholder opportunism since they lack the opportunity to adjust their risk towards shareholders’ opportunistic behaviors. Whereas, strong creditors can adjust their claims either ex ante or ex post based on the volatility of the company’s business or expected opportunistic behaviors of shareholder.
Furthermore, shareholder loans distort shareholders’ decisions also when rescue finance is in question that can lead to various agency conflicts and lead to an increased vulnerability of other parties involved in business. Even though compulsory subordination may deter socially desirable rescue attempts under limited circumstances, shareholder loans may also pave the way for shareholders to expropriate outside creditors under different circumstances. Therefore, a comprehensive analysis of various situations is required to understand the impact on investment incentives of shareholders especially when the company is insolvent or financially distressed. I will review the investment incentives of shareholders for conducting rescue attempts when shareholder loans are in place separately with a special focus after reviewing the potential impacts of shareholder loans on different aspects of shareholder opportunism.
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3.1.Shareholder Opportunism
Shareholder loans may contribute to the escalation of the conflicts between shareholders and outside creditors.10 Shareholder loans without any restriction facilitates an additional tool for shareholders to obtain unfair advantages and conduct opportunistic behaviors. The opportunism of shareholders at the expense of outside creditors may take variety of forms either through stealing, conducting transactions which are not at arm's length or any other means to transfer wealth to themselves. Similarly, the misconduct facilitated and incentivized by shareholder loans may take different forms however the most crucial ones are asset dilution, asset substitution and debt dilution, when shareholder loans are in place without compulsory subordination.
Firstly, shareholder loans can be used for asset dilution, to conduct excess benefit transactions with favorable terms without adequate compensation to shareholders at the expense of creditors (Skeel & Krause-Vilmar, 2006). Asset dilution describes the situation where corporate assets are prone to be milked out of corporate pool in favor of shareholders at the expense of creditors whose claims are backed by those assets (Landuyt, 2018). As explained by Landuyt, conduct of asset dilution examples led to famous and founding equitable subordination case, Deep Rock, ruled by the American Supreme Court (Landuyt, 2018). This issue is more crucial in countries with weak financial reporting measures due to the risk for immoral acts in practice by registering shareholder loans on paper without providing any loan (Çeker, 2012). Subordination of shareholder loans together with restrictions on repayment rules and security interests may eliminate such behaviors and creditors become immune from its effects on corporate assets due to subordinated claims of shareholders and repayment and security restrictions.
Both Clark and other authors discussed the argument that such misconducts can be also dealt with fraudulent conveyance law and veil-piercing (Clark, 1977). Both concepts require lengthy judicial process, financial review and various requirements to provide remedy to creditors (Gelter & Roth, 2007). Therefore, it may not be possible to pass these requirements while the transaction still constitutes an asset dilution in practice, or it
10 I use the term shareholders to refer insider shareholders that are either controlling shareholders and/or shareholder-managers excluding minority shareholders that are considered to be outsiders (La Porta et al., 2000).
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becomes too late when the court finally renders its decision to receive the claim back from shareholder due to its decreased wealth. Therefore, compulsory subordination provides for an ex-ante prevention by restrictions on payments and security interests with a certain time limit. It also provides for a precise rule eliminating the difficulties of financial and judicial review and the risk of hindsight bias.
Secondly, shareholders, as residual claimants, are inclined to take excessive risk and invest in projects with negative net present value when discounted at the relevant cost of capital, in case the relevant loss will be borne by outside creditors. It may be conducted through asset substitution, shifting the risk of loss to creditors by changing the risk profile of existing assets (Armour, Hertig, & Kanda, 2017).11 Shareholders’ incentive for asset substitution is expected to be higher when shareholders could lend through shareholder loan instead of equity. It is because that investing through shareholder loans instead of equity, increases shareholder’s expected share when shareholder loans are not subordinated to claims of other creditors (de Weijs, 2018). Even worse, security interests granted for shareholder loans provide a guarantee for recovery of existing investment and lowers the downside risk or shift it fully to creditors. In case shareholders benefit from this structure, their incentives to increase volatility of existing assets will be higher to capture higher returns since creditors will bear the externalities of the alteration of risk. Even though, it is also argued that subordination may lead to increased risk-shifting incentives, it is not seen possible due to risk preferences of shareholders (Landuyt, 2018).
Last but not least, shareholder loans may also cause and used for debt dilution, which is another form of risk alteration through obtaining new debt. Shareholder loans increase the total borrowing of the firm just like other borrowings. However, shareholder loans possess a bigger threat on existing creditors due to two main reasons. First, shareholders would choose to provide loans instead of equity when they cannot attract outside debt because the
11 The problem of risk shifting increases when the firm value is close to the face value of firm’s borrowings. Therefore, this problem is discussed in relation to the incentives of shareholder for rescue finance by various scholars. I will separately review the investment incentives of shareholders either to conduct a rescue attempt below. However, the analysis of risk-shifting behavior should not be limited to incentives for rescue attempts. Shareholders’ risk-shifting behaviors should also be analyzed for the companies that are not yet insolvent. Since increased incentives for asset substitution due to shareholder loans will exacerbate such value-reducing behavior that increases the volatility of the firm (therefore lowers the probability of repayment) and may eventually harm creditors if it ends up reducing the firm value to place the company in financial distress.
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investment is risky or value-decreasing for outside investors (Landuyt, 2018). Therefore, shareholder loans would facilitate new investments to fund risky projects. Secondly, if shareholder loan is extended on more favorable terms for shareholders, the loan proceeds are probably lower than the face value of debt which cannot mitigate the impact of debt dilution as it would in case of outside debt taken with arm’s length principle (Squire, 2010). Also, such loans may be withdrawn early enough when the company is in financial distress by shareholders who benefit from information advantage. In case the company goes into bankruptcy, shareholder loans enable shareholders to participate in bankruptcy procedures as a creditor to divert value from outside creditors. Financing through secured shareholder loan creates even a better scenario for shareholders that at the end either she obtains the upside gain of her investment, or only the outside creditors lose with no additional risk to shareholder in downside of risk.
Even though the main group of corporate constituencies affected the most by shareholder loans is outside creditors that are more prone to wealth transfer through shareholder loans, it may also lead to shareholder opportunism at the expense of minority shareholders. In principle, shareholders as equity investors (residual claimants) have homogeneous incentives which could be to maximize shareholder value (Armour, Hansmann, Kraakman, & Pargendler, 2017). However, there are various conflicts of interests between controlling shareholders and minority shareholders (Jenson & Meckling, 1976). Controlling shareholders enjoy private benefits of control and may exploit minority shareholders through diverting disproportionate benefits at the expense of other shareholders (Enriques et al., 2017). Some examples for such behaviors are related party transactions, transfer pricing and intercorporate loans (Jiang et al., 2010). A simple model provided by La Porta, provides that the expropriation of minority shareholders is less when controlling shareholder has higher cash-low rights (Porta et al., 2002). It is because the controlling shareholder will optimize the costs inquired by expropriation which rise proportionately to the cash-flow rights in the company. Therefore, the controlling shareholder will not be able to extract wealth when its equity stake reaches at a certain rate based on the maximization of its cash flows and benefits of expropriation minus the costs of expropriation proportionate to its cash-flow ownership. Shareholder loans provide an opportunity for controlling shareholders to circumvent this barrier. Providing shareholder loans instead of equity makes it possible for the majority shareholder to maintain its equity at a certain level while
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continuing to maintain its control rights and provide required funds to maintain the business. This structure distorts the relation between control rights and cash-flow rights at the expense of minority shareholders.12 Therefore, shareholder loans will increase the risk of shareholder opportunism vis-à-vis minority shareholder due to increased range of expropriation.
Shareholder loans also creates a threat for minority shareholders when the company is in financial distressed. Shareholders through providing loans to the company gain creditor status which may cause additional conflicts of interests between controlling and minority shareholders during insolvency. Moreover, if the shareholder loan is secured, the controlling shareholder’s interests, considering its secured claim, may differ substantially from other shareholders with only residual claims.13 Such distortion may lead a higher risk of opportunistic behaviors since the risk of exploitation is higher when the interest of shareholders is not aligned well or conflict with others (Xu, 2009). Through shareholder loans, controlling shareholders may shift the risk of its investment decisions to minority shareholders together with outside unsecured creditors and avoid internalizing the costs of its decisions as much as required by its controlling power. This situation also applies for the insolvency procedures since controlling shareholders may choose reorganization plans which are detrimental to minority shareholder as a result of collusion with senior creditors.
In addition to opportunistic behaviors of shareholders facilitated by shareholder loans at the expense of creditors and minority shareholders, the behaviors and incentives of managers may also be affected by the existence of shareholder loans. It may cause value-decreasing opportunism by managers (either shareholder managers or outside managers) when they pursue their own interest rather than acting in shareholders’ interest (Armour, Enriques, et al., 2017). In such cases, debt can act as a substitute for shareholder monitoring (Jensen, 1986). Debt mitigates agency costs through mandatory interest payments (and therefore bankruptcy pressure) and enabling monitoring by creditors especially when there is free cash flow that the company has
12 Separating control rights from cash-flow rights led to critics and some restriction on several ownership structures under various jurisdictions such as dual class ownership or empty voting (Enriques et al., 2017). Shareholder loans resembles some similarities with these structures and the same concerns may arise. Since, in case of shareholder loans, shareholders are also creditors of the company and may act in a way to undermine other shareholders’ welfare in case their claims deriving from shareholder loans requires to do so.
13 The controlling shareholder may also choose to provide loans in order to receive higher returns than equity would provide or receive payments substituting dividends when the company is not distributing dividends. It would create an inequal return on the investments of controlling shareholders and minority shareholders.
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enough cash flows to undertake all investment opportunities with positive net present value. Such favorable effect of debt is higher with increased monitoring by professional creditors such as banks that have branches specialized in assessing risk and monitoring debtor behavior (Armour, Hertig, & Kanda, 2017). Nevertheless, it applies for all creditors as long as it creates payment and bankruptcy pressure whether the firm is solvent or not (Nini et al., 2012). In contrast, shareholder-creditor may not be able to monitor the firm as good as an outsider creditor that generally has specialized assessment practice and experience. Shareholder creditors may also not constitute enough bankruptcy pressure on the management since bankruptcy may be detrimental to shareholders too. To illustrate, where the shareholder loans are secured and equity value is already wiped out, shareholders do not share the same concern as other creditors especially with non-adjusting creditors regarding preserving the liquidation value. Shareholders may be inclined to postpone bankruptcy to maximize the value of their option to stay and hope to receive value in upside potential. If shareholders have secured shareholder loans which will prevent shareholders to lose value in liquidation (due to lower liquidation value as long as the security interest covers the loan), shareholders will not be inclined to register loss and file for bankruptcy and may even support to continue business and commit inefficient rescue attempts based in its option value on equity. Therefore, substituting outside debt with shareholder loans may decrease or eliminate the pressure on the management to take an action for timely liquidation instead of pursuing their own interests. Gelter’s conclusion that subordination of shareholder loans prevents some inefficient rescue attempts may support this conclusion (Gelter, 2006). The flip side of the coin is that the subordination of shareholder loans and especially restrictions on repayments and security interests may increase incentives of shareholders to monitor better and commit timely liquidation due to the raised stake (Landuyt, 2018).
As seen above, shareholder loans without any restriction of compulsory subordination creates an opportunity to conduct self-serving behaviors and increases the risk of shareholder opportunism both at the expense of creditors and minority shareholders. It also takes away constructive features of debt when outside debt is subsidized by shareholder loans. Secured shareholder loans create the worst scenario for creditors and minority shareholders. Therefore, compulsory subordination together with restrictions on repayment and security interests is helpful to reduce the scope of opportunistic behaviors of
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shareholder and reduce the risk of wealth transfers away from outsider creditors, especially for non-adjusting creditors.
3.2.Investment Incentives and Rescue Finance
Gelter created a model to explain the impact of shareholder loans in rescue attempts (Gelter, 2006). He qualifies a rescue attempt as socially desirable and efficient if the total expected value (E(A)) minus the required investment (D) exceeds the liquidation value (L). He then analyzes when a shareholder would initiate a rescue attempt under two scenarios where the liquidation value (L) covers the debt (P) (not yet overindebted) and where it does not (overindebted).
Under Gelter’s model, in case of liquidation, the shareholder will receive the residue of the liquidation value L, after the debt (P) is paid with a minimum outcome of zero. In case of a successful rescue attempt she will receive the realized value of (A), minus debt (P), based as her residual claim. If the rescue attempt is not successful, her recovery will depend on whether the shareholder loan is subordinated. The payoff for the shareholder, when she only has equity stake without an existing shareholder loan, is shown under Table 1.
Table 1 Shareholder’s Payoff
Liquidation14 (L-P) (L-P)
Rescue Attempt With Subordination Without Subordination
Max (A-P, 0) Max (A-P, !.($)
!&')
The shareholder will initiate a rescue attempt if the rescue attempt maximizes her stake. As applied to the model, the shareholder would provide the loan (D) if the maximum expected payoff for shareholder is higher than the value she would receive in case of liquidation, that is Max (L-P,0) both with subordination and without subordination. Therefore, Gelter
14 The liquidation payoff is Max(L-P,0) however it will always be equal to (L-P) since the company is not overindebted and the debtors will recover their claims fully (L>P+SP).
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(2006) creates two incentive equations with subordination and without subordination to show when the shareholder will provide funds to the company to initiate a rescue attempt. It is shown under Table 2. He, then separates his analysis, one being when the company is not overindebted (L>P) and the second one being when the company is overindebted (L<P), since the relation between (L) and (P) creates a difference on the results. He concludes that the subordination of shareholder loans may deter some inefficient rescue attempts while some inefficient rescue attempts will still take place. He also finds out that subordination may also deter some efficient rescue attempts.
Table 2
Incentive Equations of the Shareholder
With Subordination Without Subordination Rescue attempt
initiated if:
E[Max(A-P, 0)]-D> Max(L-P, 0) E[Max(A-P, !.($)
!&')]-D> Max(L-P, 0);
Without prejudice to the accuracy of Gelter’s model, his model is restricted to a certain case where the shareholder has only equity interest in the company and the debt (P) is not secured. However, the payoff structure and consequently the incentive equation will differ under different scenarios. For example, if the shareholder has an existing shareholder loan previously lend to the company, the outcome will differ due to her claim as a creditor leading to a potential increase in her expected payoff. Similarly, if the already existing shareholder loan or alternatively debt (P) is secured, the payoff for the shareholder will also change. In case the debt (P) includes both secured and unsecured claims, it also alters the situation. These cases where the payoff and therefore incentive of the shareholder alter are numerous. In fact, any variable affecting shareholders’ stake will alter her investment incentive for a rescue attempt. Those variables are without limitation are solvency/insolvency of the company, the relation between liquidation value, expected value of the rescue attempt, shareholders’ expected value from the rescue attempt, the portion of
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outside debt and the required new investment for the rescue attempt and also the nature of the outside debt the shareholder loan (security interests) and the existence of any non-residual claims of shareholders as existing shareholder loans.15 Those variables change the efficiency and incentive cutoffs and their relative position and thus the effect of subordination on rescue attempts.
In order to provide a wider perspective on the effects of subordination and to show that Gelter’s model is actually applies only under specific circumstances, I will include the existing shareholder loans and different nature of outside debt (whether secured or not) into consideration. In reality, the company would have both secured and unsecured debt and provides for more complicated capital structure. However, even when existing shareholder loans and secured outside debt is included, it will provide us with different payoffs and incentive equations than Gelter’s model provided that would suffice to show that a definite conclusion on the effect of subordination is not possible and this conclusion of Gelter for solvent companies does not hold true.
I will separate my analysis into two parts, one when the company is not overindebted and the one when the company is not overindebted, following Gelter’s structure. For the simplicity, I will provide for either unsecured outside debt or secured outside debt without including both secured and unsecured debt at the same time.16
3.2.1. Investment Incentives When Company is Not Overindebted
Since there is now an existing shareholder loan, the company is not overindebted when liquidation value exceeds the total of outside debt and shareholder loan (L>P+SP). In case of the outside debt is secured or shareholder loans are subordinated, the shareholder will rank below the outside creditor for her claims on existing shareholder loan and equity. Thus, the existing shareholder loan does not affect her payoff. On the contrary, in case the outside debt is unsecured and shareholder loans are not subordinated, it will provide additional payoff to the shareholder pro rata to her existing claim under shareholder loan. Including an existing shareholder loan (SP) with unsecured or secured outside debt, the
15 Plus, there are also other variables that may alter the effect of subordination such as the risk appetite of shareholders, efficiency of financial reporting or other legal protections provided for creditors.
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payoff to the shareholder is shown below under Table 3. As seen from the Table 3, secured debt and existing shareholder loan alter the payoff to shareholder provided under Gelter’s model.
Firstly, if the outside debt is secured, the payoff is the same whether the shareholder loan is subordinated. Secured debt cancels out the payoff from D when subordination is not applied. Therefore, as long as the outside debt is secured, the subordination does not affect the investment incentives.17 Secondly, if outside debt is not secured, subordination of shareholder loan gives the same payoff as if the outside debt is secured. However, if outside debt is unsecured and the existing shareholder loan is not subordinated, the payoff changes to Max(A-P, ($%&%&')!.($%&')), in comparison to Max (A-P, '.(!)'&%) provided under Table 1 because the new payoff includes the payoff from the existing shareholder loan. When subordination applies, the payoff becomes Max (A-P, 0).
We need to analyze the expected value for the shareholder to understand whether a rescue attempt will be initiated. The shareholder will initiate a rescue attempt when the expected value from the rescue attempt minus the new investment exceed her expected value from liquidation. For example, the shareholder will initiate a rescue attempt when her expected payoff from the rescue E[Max((A-P), ($%&%&')!.($%&'))], minus investment amount D, exceeds her
expected payoff from liquidation (L-P) when subordination does not apply. Following
Gelter’s terminology of cutoff, these incentive cutoffs are shown under Table 4. Similar to the change in the payoff, expected value and incentive equation changes due to the impact of existing shareholder loan when there is an existing shareholder loan and outside debt is unsecured as shown under Table 4.
17 It should be noted that, if the company had both secured and unsecured debt at the same time, subordination would lead to different payoff. However, I do not include both type of debts at the same time for the simplicity.
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Table 3 - Shareholder’s Payoff When Company is not Overindebted ( L>P+SP)
P is secured P is not secured
With Subordination Without Subordination With Subordination Without Subordination
Liquidation (L-P) (L-P) (L-P) (L-P)
Rescue Attempt Max(A-P, 0) Max(A-P, 0) Max(A-P, 0) Max(A-P, !.($%&')
($%&%&'))
Table 4 - Incentive Equations of the Shareholder When Company is not Overindebted ( L>P+SP)
P is Secured P is not secured
With Subordination Without Subordination With Subordination Without Subordination Rescue attempt initiated if: E[Max(A-P), 0)]-D> (L-P) ; E[Max(A,P])>L+D E[Max(A-P), 0)]-D> (L-P) ; E[Max(A,P])>L+D E[Max(A-P), 0)]-D> (L-P) ; E[Max(A,P])>L+D
E[Max((A-P), (*+&+&,)).(*+&,))]-D> (L-P);
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In order to understand the effect of subordination on the prevention of efficient or inefficient rescue attempts, we need to compare the incentive equation with the efficient rescue equation.18 It will show us the range of investment incentive compared to the efficient range. If the incentive equation with subordination provides a range that is within the range of efficiency equation, while the incentive equation without subordination provides a wider range, it suggests that the subordination prevents inefficient rescue attempts. If the range of incentive equation is not withing the efficiency range, it suggests that subordination may promote inefficient rescue attempts to be taken or at least does not prevent them based on the range of the incentive equation without subordination. Since subordination does not alter the incentive incentives when outside debt is secured, I will only provide the spectrum of rescue attempts when the debt is unsecured. Figure 1 shows relation between the incentive cutoffs with subordination and without subordination and the efficiency cutoff.19
Figure 1 - Incentive and Efficiency Spectrum when P is unsecured
0 E(A) E[Max(A,P)]
(With subordination)
E[Max(A, P+($%&%&')!.($%&'))] (Without subordination)
L+D
Efficient and not prevented
Inefficient and not prevented by subordination
Inefficient and prevented by subordination
Inefficient however no incentive both under subordination and without subordination
(1) (2) (3) (4)
18 The efficiency cutoff is when the expected value of the investment E(A) minus the new investment (D) exceed the liquidation value (L), E(A)>D+L.
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As shown under Figure 1, when outside debt is not secured, subordination does not prevent efficient rescue attempts since the shareholder conduct a rescue attempt only when
Max(A,P)>L+D, that always lead to rescue attempts within the range of E(A)-D>L (including the range 1 and 2). However, we need to compare it with the range of the investment incentive without subordination that is Max(A, P+($%&%&')!.($%&'))>L+D including the ranges 1, 2 and 3. The comparison shows us that subordination will prevent inefficient rescue attempts where Max(A, P+($%&%&')!.($%&'))>L+D>Max(A,P) which is the range 3. Some inefficient rescue attempts where E(A)<L+D< Max(A,P) will still occur since it is within the scope of the range of incentives with and without subordination.
In contrast to Gelter’s scenario, we observe a difference when if (P) is not secured and shareholder loan is not subordinated. The expected payoff under Table 1 is E[Max (A-P,
'.(!)
'&%)], whereas the expected payoff with existing shareholder loans without subordination
is E[Max(A, P+($%&%&')!.($%&'))]. Therefore, existing shareholder loan creates a wider range of 3 and this incentive cutoff moves to the right since it includes the expected value from the existing shareholder loans in comparison to the payoff under Table 1. Meaning that existing shareholder loans will increase the incentive range of shareholders as long as they have expected payoff from such loans at the expense of the outside debt. However, when the shareholder loans are subordinated it prevents the incentive cutoff to move to a wider range of 3. Since ($%&%&')($%&') > (%&')(') held true, we can conclude that compulsory subordination prevents a larger spectrum of inefficient rescue attempts under range 3 when there is existing shareholder loans. In other words, the subordination disincentivizes shareholders against even more inefficient rescue attempts (under rage 3 that is L+D<E[Max(A,P)]< E[Max(A, P+($%&%&')!.($%&'))]) when there is an existing shareholder loan.
3.2.2. Investment Incentives When the Company is Overindebted
The company is already overindebted if the liquidation value is lower than the total of outside debt and shareholder loan (L>P+SP) since the total debt includes outside debt and
