Shareholders' responsibility to finance a company
Binding versus non-binding letters of comfort
Binding letter of comfort versus profit and loss transfer agreement
Termination of binding letter of comfort
Comment
Shareholders' responsibility to finance a company
Under German company law, shareholders of a company are not obliged to contribute more funds to their company than the share capital specified in the articles of association. It is completely legal to establish a German limited company with a minimum share capital of €25,000 to carry out a high-risk business where losses of several million euro could easily be generated. However, if major losses occur and the company becomes over-indebted, insolvent or both, the directors of such company must inform the shareholders. The directors must, in fact, convene an extraordinary shareholders' meeting as soon as the company's net capital has been reduced to only half the amount of the share capital. If insolvency looms, the shareholders must decide whether they want the company to continue trading; if that is the case, they must then also decide on measures to support the company and avoid possible insolvency proceedings.
A common measure to redress the liquidity of a company is through shareholder loans. The legal regime governing such loans was reshaped under the 2008 company law reform. Further, in order to avoid over-indebtedness (balance-sheet insolvency), shareholders may additionally declare a subordination of their loans to the company. However, such subordination must be worded carefully in order to avoid undesired fiscal effects, as it may otherwise cause extraordinary profits and thereby trigger taxes. As an alternative to loans, shareholders may provide a letter of comfort.
Binding versus non-binding letters of comfort
A parent company may address a letter of comfort to its subsidiary or to creditors of such subsidiary. Depending on the wording, it may:
- produce a legal obligation against its issuer (ie, a binding letter of comfort); or
- contain only a non-binding and therefore unenforceable statement of some moral value – if any (ie, a non-binding letter of comfort).
In order to prevent over-indebtedness and insolvency of the beneficiary, the letter of comfort must be binding. In a binding letter of comfort, a shareholder typically declares to its subsidiary that it will provide – at any time – the necessary financial means required by the subsidiary to fulfil its financial obligations and cover any adverse balance. Such a letter of comfort is traditionally seen as suitable to relieve the subsidiary's directors from the duty to file for insolvency proceedings – provided that the parent company is in sufficient financial standing to fulfil its financing obligation.(1)
Binding letter of comfort versus profit and loss transfer agreement
A similar effect with respect to possible losses has a domination, and profit and loss transfer agreement under Sections 291 and following of the Public Company Act. Such an inter-company agreement provides that all losses – but also all profits – be transferred from the subsidiary to its parent company. As to the losses, it means that the parent company will be obliged towards its subsidiary to pay an amount equal to such losses at the end of the financial year.
It is often used to create tax unity between a subsidiary and a parent company, whereby the losses of one company diminish any taxable profits of the other. In order to create the desired fiscal effect, such agreement must be entered into for at least five years. Further differences with respect to a binding letter of comfort are that the shareholders must decide on such agreement and the agreement must be registered and made public.
Termination of binding letter of comfort
While the scope and terms of a letter of comfort depend on its exact wording, there has been a debate for some years about whether the parent company could terminate a letter of comfort if the financial situation of the subsidiary deteriorated.
The debate began with the Celle Higher Regional Court's(2) rather astonishing judgment in 2000. The court ruled that the insolvency receiver of an insolvent company had no claim against the parent company on the basis of a binding letter of comfort, which the parent company had issued some months before the insolvency proceedings started explicitly in order to avoid insolvency. The court argued that the letter of comfort had not been used by the subsidiary with respect to third parties, and that the subsidiary itself – although insolvent – had suffered no damage due to the missing financial aid. In particular, the court found that the parent company had to be protected as it clearly intended only to keep its subsidiary afloat during a financial crisis. This primarily objective could no longer be achieved as insolvency had in fact occurred, and therefore the letter of comfort had become irrelevant.
The Munich Higher Regional Court took a different view in 2004(3) – a case in which a binding letter of comfort was granted to a struggling subsidiary with the aim of avoiding insolvency proceedings via sufficient funding. The court held that if a parent company does not fulfil its financing obligation and thus does not prevent the insolvency, then it has caused damage to the subsidiary and must therefore cover any adverse balance.
Eventually, in 2010 the Federal Court of Justice(4) had the opportunity to cast decisive vote in the debate and found a compromise. The court held in this case that the parent company was possibly entitled to terminate the binding letter of comfort which it had granted to its subsidiary, even if such termination right had not been explicitly agreed. The court held that it had to be ascertained whether such a termination right had been tacitly agreed. It was the court's view that an implicit termination right would have been agreed if there were a common understanding between the parent company and its subsidiary that the letter of comfort was issued only in order to gain time, so that the parent company could evaluate whether it was worthwhile to take financial measures to save the subsidiary from insolvency. If there was such a common understanding, then the parent company could terminate the obligations deriving from the letter of comfort after the evaluation had been completed (with a negative result). The case was therefore remitted to the Frankfurt/Main Higher Regional Court. However, the Federal Court of Justice clarified that the termination was effective only for the future (ie, it did not prevent claims by the subsidiary's insolvency receiver to cover debts fallen due by the time the termination had been declared).
When preparing a letter of comfort, the parent company will have to take care to limit its liability as far as possible. For example, it may state a maximum sum to be paid under the letter of comfort and/or explicitly provide for a termination right. However, the more that the parent company reduces its liability, the less that the letter of comfort is suitable to provide comfort and, in particular, prevent insolvency. In addition, the parent company will have to waive any repayment claim against the subsidiary in general,(5) or at least in case of insolvency.(6) As the parent company will be responsible to pay all uncovered debts until termination, it will have to check thoroughly the financial position of its subsidiary when issuing the letter of comfort.(7)
For further information on this topic please contact Karl von Hase at GSK Stockmann & Kollegen by telephone (+49 211 86 28 37 31), fax (+49 211 86 28 37 44) or email ([email protected]gsk.de).
Endnotes
(1) Loitz/Schulze, Jahresabschlussprüfung bei Vorliegen von Patronats-/Rangrücktrittserklärungen, DB 2004, 769 ss; von Rosenberg/Kruse, Patronatserklärungen in der M&A-Praxis und in der Unternehmenskrise, BB 2003, 641 ss.
(2) June 28 2000, 9 U 54/00, BeckRS 2000 30119818.
(3) July 22 2004, 19 U 1867/04, BeckRS 2004 30471040.
(4) September 20 2010, II ZR 296/09, NJW 2010, 3442 (STAR 21 case).
(5) Raeschke-Kessler/Christopeit, Die harte Patronatserklärung als befristetes Sanierungsmittel, NZG 2010, 1361, 1366.
(7) Heeg, Die Kündigung von Patronatserklärungen in der Krise der Gesellschaft, BB 2011, S 1160, 1164.