The Subordination of Shareholder Loans in Bankruptcy

Abstract:     
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.

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

JEL Classifications: G32, G33, K22

Working Paper Series