The Federal Court of Justice (Bundesgerichtshof – BGH) on 5 March 2015 issued a decision (case no. IX ZR 133/14, available here) that is of immense relevance for all creditors and debtors that face the need of a subordination agreement (Rangrücktrittvereinbarung) under German law. Basically, the court hammered out in clear terms the legal scope and nature of a subordination agreement and its position at the intersection of insolvency law, contract law and the law of unjust enrichment. The BGH had to deal with two questions concerning clawback rights of an insolvency administrator, this being unjustified enrichment and gratuitous benefit. More importantly for the daily business of restructuring the BGH discussed and decided on necessary conditions that need to be fulfilled in order for the management of a company to not include a liability in the special balance sheet for the overindebtedness test.

Underlying facts

In the case at hand the management of a German limited liability company (GmbH) applied for insolvency proceedings on 26 June 2008. The insolvency proceeding was opened on 14 October 2008. The company received two loans in a nominal amount of €8 million. Both agreements were subject to a subordination agreement that the parties entered into prior to filing for insolvency. After the subordination agreement had been signed the company paid to the creditor and amount of €341,180.49 in interest during the first quarter of 2008. The insolvency administrator of the company sued the creditor for repayment of this amount.

Questions raised

The major questions that the BGH had to deal with were (i) what the conditions and minimum requirements of a subordination agreement are, (ii) if the mentioned payment is subject to a claim for unjustified enrichment and (iii) if the mentioned payment is subject to a clawback due to gratuitous benefit.

Answers by the BGH in summary

The BGH ruled that the key conditions and minimum requirements for a subordination agreement that is signed in order to avoid overindebtedness are as follows: A subordination agreement has to be a contract between the debtor and the creditor. The parties are generally free to define the scope and content of such an agreement. If the contract has the purpose to avoid the obligation to file for insolvency the contract has to cover that the liability does not need to be included in the balance sheet prior and after the opening of an insolvency proceeding over the assets of the debtor. A subordination agreement is a contractual prohibition of payment which only allows payments from free assets outside of the insolvency proceeding and in insolvency proceeding junior to all claims from insolvency creditors in the meaning of §InsO, that said it is not necessary to agree that the satisfaction of subordinated claims is pari passu with the shareholders claims. The BGH confirmed by this that it is sufficient to agree that a repayment can be made from any free assets (freies Vermögen). There is no necessity to agree that the claim is only allowed to be repaid partly or in full from a future profit in the balance sheet or a profit in case of liquidation. Further a creditor must be permanently hindered by such an agreement to assert his claim, a subordination that is limited in time is not sufficient. In addition it was made clear, that any interest or ancillary costs would also be subordinated in case the principle that is part of a subordination agreement.

The BGH also made clear that the subordination agreement is an agreement in favour of third parties (Vertrag zugunsten Dritter) and is, in this case, an amendment agreement to the existing facility agreement. Since the parties, this being all other creditors, indirectly benefit from such an agreement it can only be terminated between the original parties in case the debtor is not in financial distress any more. Any change or lifting of contract that would lead to an obligation to file for insolvency would be invalid.

Based on this the BGH ruled out that there is a claim for unjust enrichment since the debtor is paid to the creditor money that was subordinated and thus not due. That said there was no legal basis for the payment. The BGH also confirmed a clawback claim based on gratuitous benefit. In the legal environment of insolvency law a gratuitous benefit is normally already given, in case of the debtor gives assets away to a third-party without getting a comparable economical benefit. This is the case if the debtor pays the debt of the claim that is not due.

Conclusion

This is a major insolvency law court decision because it clarifies the scope and limits of a subordination agreement, both as to the legal nature and parties of such a contract and also as to its meaning within German insolvency law. What was left out is the tax law side of this issue, something the court could not rule on as it is not empowered to make decisions in the area of tax law. This is rather left to the Federal Fiscal Court (Bundesfinanzhof – BFH). The BFH, in recent case law, has held that a subordination agreement, if done right, will not cause the creation of taxable profits. However, thorny questions if the interrelation of the insolvency law, contract law and tax law facets of subordination remain. Therefore, debtors and creditors who are about to engage in a subordination agreement need to carefully consider the legal implications thereof.