Corporate finance: promissory note loans

In my loose sequence on possibilities of corporate financing, after Sale and Lease Back (here), this time I will turn to the so-called Schuldscheindarlehen (promissory note loan), which has resurfaced from oblivion again since the last financial crisis. Particularly in the current corona crisis, some companies are apparently “sucking up” liquidity with the help of this instrument: Bosch, for example, took out loans with a volume of 2 billion euros by June 2020 by placing a promissory note loan (here), and as recently as April 2020, automotive supplier Schaeffler issued promissory notes with a volume of 350 million euros (here).

1. Basics

From a legal point of view, the “Schuldschein” mentioned in § 344 (2) of the German Commercial Code (“Handelsgesetzbuch“, “HGB“), but not further explained, represents the loan agreement (§ 488 German Civil Code (“Bürgerliches Gesetzbuch“, “BGB“) of the merchant. The borrower’s note is not a debenture (bond) within the meaning of §§ 793 et seq. BGB, nor is it any other (fungible) security, but merely constitutes a document of evidence pursuant to § 371 BGB. In contrast to the syndicated loan agreement, in which several financial institutions conclude a loan agreement with the borrower, a series of identical individual loan agreements are issued to the lenders when promissory notes are issued. The standardization of the loan agreements, the fact that no rating is required and the low costs compared to other types of financing make the borrower’s note loan interesting for companies. The possibility of issuing promissory notes to non-banks, i.e. institutional investors such as pension funds and insurance companies, also broadens the circle of potential lenders.

With the onset of the last financial crisis, the promissory note loan, which until then had tended to be a Sleeping Beauty, has suddenly become more attractive, simply because “normal” financing channels, such as bond issues, were closed during the crisis. Since the financial crisis, the issue volume has been growing steadily and at the end of 2019 was around EUR 27bn (here).

2. Promissory note loans in the corporate crisis

The advantage of the relatively simple issuance of promissory notes is countered by a variety of problems in the crisis of the issuer, which are often not considered when issuing them: For example, in a crisis the issuer faces a large number of creditors who, in contrast to a syndicated loan, for example, have no legal relationship with one another. Thus, contract adjustments for the sake of the restructuring of the company (such as deferrals or interest rate reductions) are only possible with the consent of each individual borrower’s note creditor.

As a rule, borrower’s note loans are not backed by collateral, so that on the other hand, in case of doubt, all that remains for the respective creditor vis-à-vis the crisis company is the threat of extraordinary termination in order to force the borrower to take targeted restructuring steps.

In addition to the legal reasons for extraordinary termination to which every lender is entitled under §§ 490, 314 BGB, the specific terms of the borrower’s note often provide for other reasons for termination, such as non-compliance with the agreed financial covenants, breach of contractual obligations (e.g. the non-compliance with a negative pledge agreement) or a cross-default.

In contrast to syndicated loan agreements, each borrower’s note creditor alone decides on the exercise of its right of termination. As a result, individual investors may threaten to exercise their right of termination and claim the nominal amount due to them immediately and in full plus interest and any incidental claims. This is particularly risky if the occurrence of such a right of termination or the pronouncement of termination results in termination rights with respect to other financing instruments of the debtor due to the effects of the above-mentioned cross default clauses or third maturity clauses (so-called cross-acceleration).

Termination for good cause is always only permissible within a reasonable period of time after the reason for termination becomes known. Late termination may violate § 242 BGB. An (extraordinary) termination may also constitute an abusive exercise of rights, in particular a termination at an inappropriate time. This restriction of the right of termination is stipulated as a contractual accessory obligation or as a fiduciary duty for all types of contracts in §§ 627 para. 2, 671 para. 2, 675 para. 1 and 723 para. 2 BGB. A termination an inopportune time is deemed to have occurred if it occurs “out of the blue”, i.e. without warning and without giving the borrower the opportunity to refinance, if necessary, or if a restructuring concept is jeopardized by termination, although the restructuring does seem to have merits.

3. Conclusion – think from the end

In view of the problems described here for both sides – i.e. both the issuer and the lenders in the context of a promissory note loan – the crisis situation should be anticipated as early as at the issuance of the promissory note and an attempt should be made to incorporate certain mechanisms into the contract that preserve the ability to act in the crisis. For example, one could consider – following the provisions of the SchVerschrG (the German Bond Act) – already providing for the possibility of a “joint representative” of the promissory note holders in order to facilitate coordination during restructuring.

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