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The Subordination of Shareholder Loans in Bankruptcy

Martin Gelter

Fordham University School of Law; European Corporate Governance Institute (ECGI)

January 17, 2005

Harvard Olin Fellows' Discussion Paper Series No. 4, 1/2005
International Review of Law and Economics, Vol. 26, No. 4, 2006

In several European countries and in the US, doctrines of corporate or insolvency law allow courts to subordinate loans given by shareholders to companies under certain circumstances. An important example is the German equity substitution doctrine (Eigenkapitalersatzrecht), which covers shareholder loans given in times of crisis. Similarly, but under a somewhat different set of circumstances, the equitable subordination doctrine in the US allows courts to subordinate corporate debt to shareholders. This paper, which is motivated by the German and Austrian discussion, uses an economic model to analyze incentive effects in a typical situation, where, in a closely-held corporation, a shareholder attempts to save the company from almost certain liquidation by informally extending a personal loan. It is shown that, even though subordination deters some inefficient rescue attempts, it will also destroy the incentives for some efficient ones, which suggests that its scope of application should be understood narrowly. Furthermore, it will not deter all inefficient rescue attempts, which may mean that in such cases, more severe penalties should be imposed.

Number of Pages in PDF File: 38

Keywords: Close corporations, bankruptcy, subordination, equity substitution, capital structure

JEL Classification: G32, G33, K22

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Date posted: January 26, 2005 ; Last revised: December 14, 2007

Suggested Citation

Gelter, Martin, The Subordination of Shareholder Loans in Bankruptcy (January 17, 2005). Harvard Olin Fellows' Discussion Paper Series No. 4, 1/2005; International Review of Law and Economics, Vol. 26, No. 4, 2006. Available at SSRN: http://ssrn.com/abstract=654222 or http://dx.doi.org/10.2139/ssrn.654222

Contact Information

Martin Gelter (Contact Author)
Fordham University School of Law ( email )
140 West 62nd Street
New York, NY 10023
United States
646-312-8752 (Phone)
HOME PAGE: http://law.fordham.edu/faculty/10929.htm
European Corporate Governance Institute (ECGI)
Brussels, B-1050
HOME PAGE: http://www.ecgi.org/members_directory/member.php?member_id=621
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