Subordination of Shareholder Loans from a Legal and Economic Perspective

Abstract:     
In closely-held corporations, the owners of a significant amount of shares sometimes try to avert an impending bankruptcy by informally extending a loan, in the hope of financing a successful rescue attempt. For creditors, the continued operations of the company may result in a dissipation of even more liquidation value due to perpetuated and increased risk. For various reasons, courts and legislators are sometimes inclined to subordinate such loans in bankruptcy, or to require their treatment as equity. This article gives a brief overview of the legal basis of subordination in Germany, Austria, Italy, Spain, and the United States, and provides references to the laws of a number of other countries. It also explores the incentive effects of subordination, which are partly beneficial and partly detrimental, and discusses possible implications for legal reform, including the recent German legislative proposal.

Keywords: Close corporations, bankruptcy, insolvency, equitable subordination, recharacterization, equity substitution, capital structure, MoMiG, Eigenkapitalersatz

JEL Classifications: G32, G33, K22

Accepted Paper Series