In a recent case before the Federal Supreme Court, the majority shareholder of a company, who also acted as the chairman of its board of directors, had rented several commercial premises to the company. In 2000 and 2001 the company carried out substantial maintenance and reconstruction work on these premises on the understanding that the work would be reimbursed by the shareholder. Also in 2000 and 2001, the majority shareholder granted several loans to the company. The loans had fixed terms, but the shareholder never demanded repayment of any of them on maturity. The company was in financial difficulty in 2000 and continued to suffer substantial losses in 2001 and the first half of 2002. The shareholder was aware of the distressed financial condition of the company. At the end of July 2002, the company was declared bankrupt.
The case focused on two actions that both occurred less than 30 days before the declaration of bankruptcy (ie, at a time when the financial difficulties of the company were evident). First, the company and the shareholder entered into new lease agreements for the same premises, which significantly increased the rent for the leased premises, although the fixed term of the existing lease agreements had not yet expired. Second, the company issued to the shareholder an invoice for the work it had performed in 2000 and 2001. The payment terms of the invoice issued by the company stated that the amount payable would be offset against and deducted from the shareholder loan granted to the company.
Both actions were the subject of a challenge by the bankruptcy administration, which was sustained by the competent cantonal court and then appealed to the Federal Supreme Court by the shareholder. In particular, the court had to decide whether the set-off declared by the company was valid.
In its reasoning, the court examined whether the shareholder could rightfully offset his claim against the company's claim under the rules of the Debt Enforcement and Bankruptcy Act. As a general rule, a set-off of claims is permitted in the event of bankruptcy, provided that certain requirements are met. However, giving particular consideration to the fact that the shareholder's claim arose from a loan to the company, the court analysed whether this loan should be considered as debt or as equity.
The court held that in consideration of the principle of the legal duality between the company and its shareholders, shareholder loans in general are to be qualified as debt. However, the principle of legal duality is not absolute. The court maintained that the applicability of this principle is no longer justified if all or the substantial majority of the funds of the company (directly or indirectly) belong to one and the same person (ie, the company is merely an instrument of this person who is economically identical to the company), and the duality between the company and its shareholders is abused. In such cases, the Federal Supreme Court has previously pierced the corporate veil and treated the controlling (sole or majority) shareholder and the company as one subject.
Based on this reasoning, the court advanced the view that in the case at hand – despite formally being two separate legal persons – the shareholder and the company were economically identical. Unfortunately, the court did not elucidate in detail the facts that had led to the conclusion that the legal duality between the shareholder and the company had been abused. However, two factors have apparently influenced the court's decision.
First, the company, when issuing the invoice, declared that the invoiced amount would be offset with the shareholder loan; this, however, was not in the interests of the company and harmed the other creditors. Furthermore, the invoice was issued less than one month before the declaration of bankruptcy at the end of July 2002, while the work had been performed in 2000-2001.
Second, the new lease agreements, which contained significantly worse terms for the company, were concluded at a time when the company's bankruptcy was imminent and the existing agreements had not yet expired. As a result of considering the company and the shareholder as one subject, the court concluded that the shareholder loan was to be considered equity of the company, and that, therefore, the shareholder had no counterclaim which could be offset against his liability in relation to the work performed by the company.
Consequently, the shareholder was held to pay to the bankruptcy administration the entire amount owed to the company for the maintenance and repair work.
The Federal Supreme Court decision lacked detailed reasoning and remains rather nebulous as to which conditions will lead to a piercing of the corporate veil and the requalification of a shareholder loan as equity of the company. Despite the court's rather unclear reasoning and possible further factual elements that might have influenced the court's decision, this case shows that the actions taken by a controlling shareholder shortly before the declaration of bankruptcy will be scrutinised closely by the bankruptcy administration and the competent courts. Also, it seems likely that this decision will strengthen the tendency of bankruptcy administrations to requalify shareholder loans given to financially distressed companies as equity, especially in cases where certain facts indicate that the legal duality between the shareholder and the company has been abused and the interests of the company and the shareholder have been mixed.
As a result, a controlling shareholder should ensure that the shareholder's and the company's decision making is clearly separated, and that all actions taken by the financially distressed company are in the best interests of this company (and not of the shareholder or the group). Furthermore, before providing additional funds to a distressed company in the form of a shareholder loan, all the relevant circumstances – in particular all relationships between the distressed company and its controlling shareholder, and the likelihood of a bankruptcy in the near future – should be carefully assessed.
For more information please contact Maja Baumann or Dominik Kaczmarczyk at Lenz & Staehelin by telephone (+41 44 204 1212), fax (+41 44 204 1200) or email ([email protected] or [email protected]).