On 27 October 2011, the German parliament adopted the Law for Further Facilitation of the Restructuring of Businesses (Gesetz zur Erleichterung der Sanierung von Unternehmen, ESUG), which entered into force on 1 March 2012. In particular, legislators have increased the importance of debtequity swaps as part of this reform. Significant practical obstacles that previously often caused debt-equity transactions to fail have now been removed.
Previous legal framework
A “debt-equity swap” involves conversion of existing debt capital into equity. The focus is thus not on introducing fresh capital, but on converting capital into financial and legal equity. The introduction of this debt takes place via a capital increase comprising noncash contributions. The debt typically then expires as a result of confusion or due to conclusion of a separate release agreement.
Even this rough outline of a debt-equity transaction is sufficient to provide an indication of the practical obstacles involved. The potential obstruction created by existing shareholders is one significant factor. An effective capital increase requires a resolution to increase the share capital. This in turn necessitates a resolution by a majority sufficient to amend the articles of association in the annual general meeting or shareholders’ meeting. Furthermore, a debt-equity swap is frequently preceded by a reduction or decrease in capital. This likewise requires a resolution by a majority sufficient to amend the articles of association in the annual general meeting or shareholders’ meeting in accordance with sections 229 et seq of the Stock Corporation Act (Aktiengesetz, AktG) and sections 58a et seq of the Limited Liability Companies Act (GmbH-Gesetz, GmbHG).
A further practical problem lies in valuing the debts to be converted. Since these transactions typically take place at times of financial crisis, liability risks are increased. Overvaluation of debts at the time of contribution is subject to restrictive regulations regarding capital raising and the risk of being held liable for the difference between the value of the contribution in kind and the initial contribution (Differenzhaftung).
Changes resulting from the ESUG
Having identified potential obstruction by existing shareholders and the risk of Differenzhaftung as significant barriers to transactions, a new situation has now arisen when an insolvency plan procedure is used. Surprisingly, debt-equity swaps have now been officially recognised in the context of this seldom-used option. The objective behind this move was to boost the attractiveness of insolvency plan procedures.
The new section 217(2) of the Insolvency Act (Insolvenzordnung, InsO) makes it possible to resolve the issue of consent. It explicitly provides that participation or membership rights of existing shareholders can be included in the plan. Section 225a(2) InsO explicitly highlights the possibility of a debt-equity swap in the constructive part of the insolvency plan.
Existing shareholders merely vote on acceptance of the insolvency plan as one of a number of groups. Additional resolutions under company law – e.g. on capital decreases or increases – are not required. Under section 254a(2) InsO, these are deemed to have been agreed to through acceptance of the insolvency plan. Existing shareholders are prohibited from obstructing the plan under section 245(1) (3) InsO, i.e. they are not permitted to withhold their consent if they are unlikely to be worse off due to the plan than they would be without the plan. In practice, it will be difficult for shareholders to prove they would be worse off. If no plan procedure takes place, normal insolvency proceedings follow. The shareholders’ stake in the company would then typically be worthless because creditors only receive partial satisfaction.
Section 254(4) of the InsO, which is of huge practical significance, then comes into play following approval of the insolvency plan. In accordance with this provision, the company cannot make any claims arising from overvaluation of debts in the insolvency plan after creditor claims have been converted into equity. Consequently, participants in a debt-equity swap are protected from Differenzhaftung risks in the insolvency process, in contrast to the position under general company law.
Impact of the amendments on banking law
The amendments have made it possible for lenders to acquire a majority shareholding in company via an insolvency plan procedure. At the latest, the ownership structure changes as a result of the dilutive effect of capital increases. The extent of this effect depends on the company’s indebtedness and the valuation of the debts to be converted.
It should be noted, however, that a lender will only carry out a debt-equity swap to the extent of his unsecured debts. If a lender has sufficient security for his debts, there is no incentive to become a provider of unsecured capital instead. This view is borne out by existing transaction practice. Typical investors in the context of a debt-equity swap are hedge funds and investment banks which purchase subordinate debt of companies whose going concern value is higher than their liquidation value.
The decision to carry out a debt-equity swap is also significantly influenced by the applicability of “restructuring privilege” as defined in section 39(4)(2) of the Insolvency Act. As a general rule, all shareholder loans must be satisfied subordinately in the event of insolvency, as per section 39(1)(5) InsO. However, an exception – the restructuring privilege – applies where a creditor acquires shares for the purpose of restructuring at a time of threatened or actual insolvency or over-indebtedness. The subordination principle is suspended until effective reorganisation has taken place. The critical significance of the restructuring privilege for the lender arises from the right to contest provided for by section 135(1)(2) InsO. Under this provision, it is possible to challenge a legal transaction which grants satisfaction of a shareholder’s demand for repayment of a loan under section 39(1)(5) InsO if the transaction took place within one year of applying for the opening of insolvency proceedings or subsequent to them. The law assume that the entire debt-equity swap is covered by the restructuring privilege – and that this is therefore not a claim within the meaning of section 39(10(5) InsO. However, due to its narrow wording, this is only clear with regard to the creditor’s existing debts, and not for debts that have been converted into shares. There is thus the risk of a later challenge to contributions in kind made by a new shareholder under section 135(1)(2) InsO if a company becomes insolvent within one year after implementation of a debtequity swap. This uncertainty also makes a debt-equity swap look less attractive.
Unlike English and American law, the amendments do not allow conversion of borrowed capital into equity capital unless the individual creditors consent. Even though the compulsory inclusion of individual creditors and lenders may be economically advantageous for the avoidance of potential “free rider situations” in individual cases, section 225a(2) InsO expressly provides that a transformation of creditor claims into participant or shareholder rights is not permissible if the creditor in question does not consent.
The ESUG significantly facilitates future implementation of debt-equity swaps. Important practical obstacles, such as the potential for obstruction by existing shareholders and the drastic consequences of Differenzhaftung, have been defused. However, the reforms still fail to provide for compulsory conversion of debt into equity capital. The extent to which the reforms lead to increased use of insolvency plan procedures and boost the debt-equity transactions market remains to be seen.