Subordinated Liabilities

What are subordinated liabilities?

Subordinated liabilities (subordinated debt) are debts of a company that are paid in insolvency proceedings only once the claims of all senior creditors have been satisfied in full. Insolvency proceedings are the court procedure in which the remaining assets of a company that is unable to pay its debts or is over-indebted are distributed to its creditors. Subordinated creditors receive only what is left after all others, often little or nothing.

Subordination arises in two ways. It follows from the law, above all for loans from shareholders (Section 39 (1) no. 5 of the German Insolvency Code, Insolvenzordnung, InsO). Or creditor and debtor agree on it in the loan agreement or in a separate agreement, which is then called a subordination agreement (Rangrücktritt; Section 39 (2) InsO). Typical examples are shareholder loans, convertible loans with a subordination agreement and subordinated loans from promotional institutions or funds. Economically, subordinated and convertible loans belong to mezzanine capital, the hybrid forms between equity and debt capital. A particularly far-reaching subordination agreement, the qualified subordination agreement (qualifizierter Rangrücktritt), additionally determines whether a claim counts in the test for over-indebtedness.

Statutory subordination of shareholder loans

Since the GmbH reform of 2008 (MoMiG), claims for repayment of a shareholder loan are subordinated in insolvency. The same applies to claims from transactions that economically correspond to such a loan. Unlike under the earlier law, it does not matter whether the loan was granted or left in place during a crisis. Treated in the same way are, for example, claims that a shareholder defers for longer than is customary and, under certain conditions, loans from affiliated companies.

Two groups are exempt. The small shareholder privilege (Kleinbeteiligtenprivileg, Section 39 (5) InsO) applies to shareholders who are not managing directors and hold at most 10% of the share capital. The restructuring privilege (Sanierungsprivileg, Section 39 (4) sentence 2 InsO) protects, until sustainable restructuring, creditors who acquire shares in the event of impending or actual illiquidity or over-indebtedness in order to restructure the company.

Contractual and qualified subordination agreements

A subordination agreement is an agreement by which a creditor ranks its claim behind the claims of other creditors. It is possible for any claim, including loans from outside lenders. Practice distinguishes two levels:

• Simple subordination agreement: The creditor ranks behind the other creditors or some of them. This governs the distribution in insolvency proceedings but is not sufficient to remove the claim from the over-indebtedness test.
• Qualified subordination agreement: The creditor ranks behind all claims that are subordinated by law, down to and including shareholder loans (Section 39 (1) nos. 1 to 5 InsO). In addition, the creditor undertakes not to enforce the claim even before insolvency proceedings, for as long and to the extent that its satisfaction would lead to illiquidity or over-indebtedness.

Case law sees in the qualified subordination agreement a contract for the benefit of the company's creditors. Once the company is insolvent, the parties can no longer simply cancel it. Payments made despite the block can be reclaimed by the insolvency administrator.

For tax purposes, what matters is the source from which the claim may be repaid. If repayment is permitted only from future profits or from a surplus on liquidation of the company, the liability falls away in the tax balance sheet (Section 5 (2a) of the German Income Tax Act, Einkommensteuergesetz, EStG). Derecognising it can then trigger a taxable gain without any cash flowing. The wording that repayment is also permissible from other free assets is therefore widespread.

In German funding rounds, convertible loans and subordinated loans from investors often contain a qualified subordination agreement so that they do not weigh on the company's over-indebtedness test. If a company accepts loans from many private lenders, for example through a crowdfunding platform, the block serves a further purpose. According to the practice of the financial supervisory authority, it prevents the acceptance of the funds from being treated as deposit-taking business requiring a licence.

Subordinated liabilities in the over-indebtedness test

Under Section 19 (2) InsO, a company is over-indebted if its assets no longer cover its existing liabilities. This does not apply where the continuation of the business over the next twelve months is more likely than not (going-concern forecast). If this forecast is negative, an over-indebtedness statement follows. This special balance sheet values the assets at liquidation values, that is, at the prices that could be obtained on winding up and individual sale.

In this statement, shareholder loans must in principle be recognised as liabilities. They are disregarded only if subordination behind all claims under Section 39 (1) nos. 1 to 5 InsO has been agreed (Section 19 (2) sentence 2 InsO). Statutory subordination alone is not sufficient. Practice treats loans from outside lenders with an equivalent subordination agreement in the same way. If over-indebtedness exists, the managing directors must file for insolvency without culpable delay, at the latest six weeks after it occurs (Section 15a InsO).

For illiquidity (Section 17 InsO), the subordination agreement has only a limited effect. A debtor is illiquid if it cannot meet its due payment obligations. A blocked claim does not count among these; a liquidity gap towards suppliers, employees and banks, however, is not closed by the subordination agreement.

Avoidance of repayments on shareholder loans

Repayments on shareholder loans in the last year before the insolvency filing or after it can be challenged by the insolvency administrator (Section 135 (1) no. 2 InsO). For security provided by the company for such a loan, a period of ten years applies. It is irrelevant whether the company was in crisis at the time of payment or whether there was an intention to disadvantage creditors. The shareholder must repay what was received; the loan claim then revives, albeit subordinated.

In addition, Section 135 (2) InsO covers the repayment of a bank loan for which a shareholder has provided security or given a guarantee; the shareholder must then make reimbursement. If a shareholder loan is repaid from the company's funds on completion of a company sale, the payment remains open to challenge for one year. This is one reason why such loans are often sold and assigned to the buyer together with the shares.

Subordinated liabilities from the banks' perspective

Banks do not assess a borrower's capitalisation by balance sheet equity alone. They often count subordinated shareholder loans as economic equity. The prerequisite is usually a subordination agreement in favour of the bank and a declaration to leave the loan in place (Belassungserklärung), by which the shareholder undertakes not to withdraw the loan during the term of the credit. External subordinated funds, for example from promotional institutions or specialised funds, cost more interest than a secured bank loan because their provider is paid last in the worst case.

In the commercial balance sheet, a loan with a subordination agreement remains a liability because it has to be repaid. Balance sheet equity arises only when the shareholder waives the claim and the amount is placed in the capital reserve. For tax purposes, such a waiver counts as a contribution only to the extent of the recoverable portion; the non-recoverable portion in principle leads to taxable income at the company.

At credit institutions themselves, subordinated liabilities are a separate balance sheet item. With an original term of at least five years and further features under the European capital requirements rules (CRR), they count as supplementary capital (Tier 2) within own funds.

Worked example: subordinated liabilities in the over-indebtedness statement

A software GmbH reports total assets of EUR 4.0 million. On the liabilities side are EUR 0.6 million of equity, EUR 0.8 million of founder loans with a qualified subordination agreement and a declaration to leave the loan in place in favour of the house bank, and EUR 2.6 million of other liabilities.

• Balance sheet equity ratio: EUR 0.6 million divided by EUR 4.0 million = 15%
• Economic equity from the bank's perspective: EUR 0.6 million plus EUR 0.8 million = EUR 1.4 million
• Economic equity ratio: EUR 1.4 million divided by EUR 4.0 million = 35%

After the loss of a major customer, the going-concern forecast turns negative. In the over-indebtedness statement, the assets at liquidation values are still worth EUR 3.1 million.

• Without a qualified subordination agreement: liabilities EUR 2.6 million plus EUR 0.8 million = EUR 3.4 million; assets EUR 3.1 million; shortfall EUR 0.3 million, the company is over-indebted
• With a qualified subordination agreement: liabilities EUR 2.6 million; assets EUR 3.1 million; surplus EUR 0.5 million, no over-indebtedness

The subordination agreement decides here on the duty to file for insolvency and buys time to reorganise the financing. It does not prevent illiquidity.

Distinction: subordination, mezzanine capital and senior debt capital

• Mezzanine capital: an economic umbrella term that includes, besides subordinated loans, silent partnerships and profit participation rights. The typical legal feature is subordination.
• Senior debt capital: bank loans and trade payables are served in insolvency before the subordinated claims. Secured creditors are in addition paid in advance from their collateral.
• Vendor loan: In a company purchase, the seller often ranks its loan behind the banks' acquisition financing. The subordination is then part of a creditor agreement (intercreditor agreement).

Common mistakes

• Subordination agreement without a pre-insolvency block. If the subordination applies only to the insolvency proceedings, the loan remains in the over-indebtedness statement as a liability.
• Interest not covered. If the subordination agreement extends only to the loan amount, accrued interest must still be recognised as a liability.
• Repayment only from future profits. Such an arrangement triggers income for tax purposes without liquidity flowing in.
• Repayment before the crisis. Repayments in the last year before the insolvency filing can be challenged, even if the company appeared healthy at the time.
• Subordination confused with equity. Interest and maturity remain. A subordinated loan that falls due shortly after a funding round shortens the reach of the new funds.

Frequently asked questions

Is a loan with a subordination agreement equity?

No. In the commercial balance sheet it remains a liability that bears interest and is repaid. Banks may count it as economic equity, and in the over-indebtedness statement it is disregarded where there is a qualified subordination agreement.

Does statutory subordination also apply to loans from investors?

Only if the investor is a shareholder or is treated like one and does not fall under the small shareholder privilege. Holders of a convertible loan who are not yet shareholders are in principle subject only to the contractually agreed subordination.

Does a subordination agreement have to be notarised?

No. The subordination agreement is a contract between creditor and company that is not subject to any form requirement. Written form is customary so that auditors and, where applicable, an insolvency administrator can follow the content.

May a shareholder loan be repaid before insolvency?

In principle yes, provided no qualified subordination agreement blocks payment. The prohibition on payments to protect the share capital (Section 30 (1) of the German Limited Liability Companies Act, GmbHG) expressly does not apply to shareholder loans. The repayment remains open to challenge for one year, however, and the managing directors are liable if the payment was bound to render the company unable to pay its debts (Section 15b (5) InsO).

How do buyers treat shareholder loans in a company purchase?

As financial liabilities, that is, as part of net debt. In the bridge from enterprise value to equity value, the value of the shares, they are deducted unless they are assigned to the buyer on completion. In the second case, the buyer pays part of the total price for the loan claim and the rest for the shares.

The Roemer Capital view

Before a funding round, Roemer Capital records shareholder loans and subordinated funds by amount, interest, maturity and subordination agreement. New investors do not want their capital to flow into repaying old loans. Whether loans are extended, contributed to the capital reserve or converted is therefore clarified with the shareholders before the term sheet is negotiated. The wording of the subordination agreement is a matter for the company's law firm.

In a company sale, Roemer Capital classifies shareholder loans in the purchase price bridge and clarifies with the sellers' advisers whether they are repaid or sold along with the company on completion. The two routes differ in avoidance risk and tax treatment; the decision belongs before the first draft of the purchase agreement.