The bank as a third party with equal status to shareholders in the case of insolvency contestation.

Herbert Wiehe

CMS, Cologne

herbert.wiehe@CMS-HS.com

The German Federal Court of Justice has ruled that three criteria must be met for equal status: (1) profit participation of the lender; (2) influence of the lender on the management; and (3) rights of the lender equivalent to those of a shareholder.

Pursuant to Section 135 (1) no 2, 39 (1) no 5 German Insolvency Statute ('InsO'), repayments of shareholder loans may be contested in the event of the company's insolvency. The legal consequence is that the opponent of the contestation, ie, the lender, must reimburse the shareholder loan to the insolvency estate. Lenders of the insolvency debtor who are not formally shareholders may, under certain circumstances, be treated in the same way as shareholders. A new decision of the German Federal Court of Justice ('BGH') now provides more legal certainty on the criteria for such equation.

Decision of the German Federal Court of Justice of 13 July 1992 (reference number II ZR 251/91) under the law of equity substitution

The BGH affirmed that a lender has equal status to a shareholder only if the bank receives a pledge on the borrower's shares and, by means of further ancillary agreements, is granted a position which, according to its specific form, is equal or at least close to the position of a shareholder in economic terms (atypical pledgee). The decisive factor is that the pledgee has far-reaching powers to influence the management and organisation of the company.

Following that decision, and in view of the German Act to Modernise the Law governing Private Limited Companies and to Combat Abuses of 23 October 2008 ('MoMiG'), there was extensive discussion on alternative criteria in the legal literature.

From a financial perspective, the key terms were shareholder-equivalent participation in the company's assets, own interest in the financing of the company,[1] variable revenue participation[2] and participation in entrepreneurial opportunities and risks.[3]

Other authors favoured an administrative point of view, looking at information and inspection rights,[4] assumption or influence of administrative rights,[5] participation or co-determination rights,[6] entrepreneurial influence[7], the possibility of influencing risk-increasing entrepreneurial strategies[8] and the possibility of influencing the management of the company,[9] as well as the de facto takeover of the management[10].

Membership aspects included a shareholder-like interest in the fate of the company,[11] an entrepreneurial activity[12] and a membership character of the influence on the management and the interest pursued in the exertion of influence,[13]

Decision of the German Federal Court of Justice of 25 June 2020 (reference number IX ZR 243/18) under MoMiG (double-sided fiduciary relationship)

The specific facts on which the decision of 25 June 2020 was based now gave the BGH the opportunity to develop the three criteria under which a bank will be treated in the same way as a shareholder. The granting of security for a loan does not in itself constitute a sufficient basis for equal status. Rather, it is necessary for the third party to go beyond its role as a lender based on profit participation, influence on management and holding rights of a shareholder.

For the criterion of profit participation to be met, it is not sufficient that the bank is entitled to the loan repayment and the interest claim. Also insufficient are a borrower's retention obligation imposed by the bank, the determination of a participation of the bank in realisation proceeds and other payments in a trust agreement if these are limited in volume to the bank's claims including ancillary claims such as interest and costs. Furthermore, a reservation of consent by the trustee to distributions and withdrawals contained in a trust agreement is also not sufficient. Even if the profits were to accrue primarily to the bank, this was based on the bank's claims under the loan agreement and thus primarily constituted ‘only’ security.

It is not sufficient for the influence on the management that a person selected by the bank is appointed as the borrower's managing director if the bank has no further possibilities of exerting influence on the managing director (for example, through an authority to issue instructions on the part of the bank or an obligation of the managing director to coordinate their actions as managing director with the bank). Furthermore, it is not enough to select the trustee's managing director, who is authorised to appoint and dismiss the borrower's executive bodies, if the bank has no legal power to influence the managing director's decisions.

The Court left open whether the criterion of holding rights similar to those of a shareholder is fulfilled if the bank can exercise all shareholder rights on its own. In any case, neither a formal participation in the liable capital is required, nor does the amount of the loan have to be comparable to the minimum quota of Section 135 (1) no 2, 39 (1) no 5 of InsO. On the other hand, it is not enough for the bank to make a specific reorganisation concept a condition for granting the loan, and for the borrower to undertake to commission a specific company to implement the concept and to comply with the specifications of the reorganisation report. The same applies to the trustee's obligation to align its activities with the requirements of the restructuring plan. An obligation on the part of the borrower to retain accruing profits, the agreement of a reservation of consent by the banks for a distribution of profits or withdrawal in favour of the limited shareholder are not sufficient either.

In contrast to the decision of the BGH of 13 July 1992, the Court held that, even if the shareholders can no longer decide on fundamental issues on their own responsibility, this would not give the lender equal status to a shareholder. The decisive factor is who has the decision-making authority – even if only in the form of reservations of consent.

Finally, an overall consideration of the circumstances of the individual case is required: the three criteria must be comparable in their entirety to the legal position of a shareholder.

Significance of the decision in terms of practical applications

The decision allows its central considerations to be applied to typical practical situations. Since all agreements serving the lender's pure security interest are harmless, pledges and assignments of profit claims by way of security are just as harmless as obligations to make mandatory prepayments. In such cases, the lender's security mass is normally reduced, either because there is special collateralisation on the assets concerned or because the borrower's equity structure changes. One might hesitate in the case of unscheduled repayment obligations due to excess cash. However, even in this case, the lender does not receive a share in the profits like a shareholder. The unscheduled repayment reduces their counterparty risk. As a lender, they are rewarded for having taken a high risk in the first place.

Caution is advised, however, in the case of partial loans, such as those found in mezzanine financing. Other forms of hybrid financing which are not typical bank loans will also remain relevant in this context. Variable revenue shares remain particularly dangerous if they grant payment claims over and above contractual interest and redemption claims.

Financial covenants in the form of financial ratios such as an equity ratio, a gearing ratio, a debt service coverage ratio, a leasing ratio (in the case of real estate financing), a default ratio (in the case of loan refinancing) or collateral coverage (in the case of asset-based financing), which the borrower must comply with over the term of the loan, do not play a role as the bank must be in a position to check these in the event of a deterioration in assets or a change in risk.

Other covenants, such as information obligations, do not lead to equality either, since the lender must demand information under credit law. Environmental and social standards are not enforced because the lender wants to appear as a shareholder, but for social, ecological or investment policy reasons. Obligations to comply with money laundering regulations or sanction rules are based on regulatory policy. When weighed against a large number of other obligations, the bank's legitimate interest in being declared harmless by the BGH should prevail.

Voting rights and other participation rights to which shareholders are entitled should not be granted to the lender.

In summary, the banks' role as pure lenders without equal status to shareholders is strengthened by this new case. The GBH has dispelled the uncertainty that has influenced German legal opinions on this topic for decades.