A recent decision by the lower regional court of Düsseldorf (LG Düsseldorf) in the context of the investigation into the criminal insolvency of Dresden-based ponzi-scheme Future Business (Infinus) provides an opportunity to shed some light on the continuous evolving legal situation regarding contractual debt-subordination.
Practical relevance of the topic
First of all, the question to which extent it is legally permitted to contractually subordinate a claim by means of general terms and conditions is not only of an academic nature. Modern financial instruments, like corporate bonds, bonded loans and also profit-sharing rights, are in practice often subject to contractual subordination in order to categorize the respective “liabilities” as “equity-equivalent position”. Particularly in the case of growth-oriented companies which have high capital and liquidity requirements, the subordination enables the company to, on the one hand, obtain a (further) bank financing and, on the other hand, prevent a possible duty to file for insolvency after the investor funds have been used-up.
Even after the re-introduction of the so-called “two-tier test of over-indebtedness” (“zweistufiger Überschuldungsbegriff”) to establish an over-indebtedness within the meaning of § 19 (2) of the German Insolvency Act (“Insolvenzordnung”, “InsO”), subordination-agreements continue to play an important role. In addition to the balance-sheet effects associated with an (effective) subordination, they can also prevent a company’s (impending) inability to pay its debt, if containing a so-called “pre-insolvency enforcement barrier” (“vorinsolvenzliche Durchsetzungssperre”; discussed below). Finally, an (effective) subordination agreement will also affect the business continuation forecast to be establised in the context of the overindebtedness-test.
The hereinafter discussed decisions of the LG Düsseldorf and the German Supreme Court (in civil proceedings, “Bundesgerichtshof”, “BGH”) are also interesting because they are based on avoidance actions in insolvency proceedings. The different outcome of the respective procedures clarifies the potential consequences of (faulty) debt-subordination agreements.
Contractual Subordination through general terms and conditions?
Although the BGH in a judgment issued in 2014 confirmed the validity of a debt-subordination contained in the general terms and conditions, the decisive reasons for its decision are probably not to be generalized. In the leading judgement of 2015 discussed here, the BGH has left this question open.
Prior to that decision, the lower regional court of Hamburg (LG Hamburg) rejected the inclusion of a subordination-agreement via general terms and conditions in 2013, at least in the case of insurance contracts, as a breach of good faith. Pursuant to Section 307 (1) Sentence 1 BGB, general terms and conditions which unduly disadvantage the user contrary to bona fide obligations are invalid. In the case of the LG Hamburg, the debt-subordination contained in the general terms and conditions was intended to unduly disadvantage the policyholder, according to the court, since it allowed the insurer to offer bank-like services which would normally be subject to public authorization. Additionally, the debt-subordination was seen as easing the pressure on the insurer during a crisis and possibly preventing the occurrence of over-indebtedness. On the other hand, the LG Hamburg considered the policyholders’ risk of a loss as being considerably higher than that of normal creditors, because they would have to step behind other creditors even before the event of the crisis. As a result, they would thereby be equated with shareholders for which the institute of contractual subordination was originally intended. However, the policyholders’ rights differ quite considerably from those of shareholders, especially regarding opportunities for information. Shareholder are regularly aware of the fact that their participation is a genuine entrepreneurial commitment with a corresponding entrepreneurial risk, which is why in such cases a contractual debt-subordination is deemed to be admissible. On the conclusion of an insurance, however, the situation is different and these considerations are not transferable according to the LG Hamburg. Hence, the court dismissed the respective terms and conditions containing a debt-subordination.
In its ruling as of March of this year, the LG Düsseldorf has ruled that the inclusion of a subordination-agreement via general terms and conditions, which contains contradictory regulations regarding the rank-depth, runs contrary to the transparency requirement of § 307 (1) sentence 2 BGB and is thus invalid. In the case, the interpretation of two clauses relating to the level of subordination led to different results. Therefore, the court considered that the contracting party could not easily recognize the rights conferred on it against other creditors. However, the court did not rule out an inclusion of a subordination-agreement via general terms and conditions principally.
All in all, the question whether and under which circumstances a subordination-agreement can be implemented via general terms and conditions has not yet been finally determined by the courts. Accordingly, companies which issue “alternative” financial instruments should only cautiously introduce debt-subordination clauses in their terms and conditions.
General remarks on the formulation of a debt-subordination agreement
Regardless of the question of the (general) admissibility of subordinate agreements in general terms and conditions, the question is, how to formulate an individually agreed subordination in manner compliant with the law. Here, a decison of the BGH in 2015 contains useful advice for the practice. In particular, the BGH clarified the required depth, or “ranking”, of a (then “qualified”) subordination in order to avoid over-indebtedness. Accordingly, the agreement of a subordination only for the period following the commencement of insolvency proceedings (although suggested by the wording of § 19 para. 2 sentence 2 InsO (“insolvency proceedings”)) is insufficient in order to avoid the obligation being treated as a deferred item in the status of over-indebtedness. Rather, a wording is required which also provides for a subordination prior to insolvency. Accordingly, the contractual subordination should also contain a pre-insolvency enforcement barrier ((“vorinsolvenzliche Durchsetzungssperre”). Furthermore, the BGH clarified that neither a subordination to the rank of § 199 InsO nor a complete waiver of the claim are necessary. Sufficient, but also necessary, is a subordination of the claim behind those mentioned in § 39 (1) No. 5 InsO. On the other hand, a subordination behind single creditors is as insufficient as a time-limited subordination.
Finally, the BGH has decided the question about the dogmatic nature of the debt-subordination agreement in a way to be manageable in practice by declaring that a contractual subordination is an act of debt-alteration in favor of third parties. This decision is practically relevant because, on the one hand, this does alter the claim with regard to its rank, but not with regard to its content (which becomes important for tax purposes, see below). On the other hand, because of the third-party effect, the ranking can only be changed with the consent of the other creditors. This means that an amicable suspension of the debt-subordination between the debtor and the creditor concerned is possible without the cooperation of the other creditors only if the debtor is not / no longer materially insolvent.
The BGH, though, has not discussed the tax consequences of contractual subordination. In this respect, according to a relatively up-to-date judgment of the German Federal Tax Court (“Bundesfinanzhof” (BFH)) from 2015 a formulation of the debt-subordination agreement according to which the subordinated claim is ultimately to be paid “only from future annual surpluses as long as they exceed existing losses or from a possible liquidation surplus” is not sufficient, since the so-called “current economic burden” of the debtor is missing. In such a case, the tax prohibition on the passivation of assets leads to a taxable book profit. On the other hand, the required “current economic burden” according to § 5 para. 2a EStG shall, according to BFH (and also the Federal Ministry of Finance, BMF), be present if the liabilities are to be discharged also from “any other free assets” of the debtor. Then a taxable passivation of the liability does not need to be carried out.
On the merits of the case, the BGH ruled that, given the qualification of a qualified contractual subordination, a repayment made to the respective creditor could be claimed as a payment without a legal basis in accordance with general civil law regulations as well as avoided as a gratuitous benefit according to § 134 InsO. In accordance with this approach, the LG Düsseldorf decided that the repayment in the case underlying its decision could not be requested due to a lack of a qualified contractual subordination.
Finally, in particular, the BGH’s leading decision is positive, since it gives the long-awaited practical guidelines for the formulation and application of at least invididually negotiated debt-subordination agreements – which are the usual recoures in business-turnarounds. On the other hand, the question of the implementation of contractual subordination through general terms and conditions still remains unanswered and should be treated with great care.