Subordination of Shareholder Loans in Estonian Law

Author:Andres Vutt
Position:Magister iuris, Lecturer of Civil Law, University of Tartu

1. Introduction - 2. The nature of a subordinated loan - 3. The legal approach to shareholder loans in EU and other countries - 3.1. The European Union - 3.2. Germany - 3.3. The United States of America - 4. The legal approach to shareholder loans in Estonia - 4.1. Subordination of loans by legislation - 4.2. Loan subordination agreements - 5. Conclusions


Andres Vutt

Magister iuris, Lecturer of Civil Law, University of Tartu

Subordination of Shareholder Loans in Estonian Law

1. Introduction

One basis of a Continental European company are the capital rules whose purpose is the protection of creditors of companies and which prohibit the repayment of contributions to shareholders during the lifetime of a company. The concept of capital rests on the assumption that a company's assets are constituted by means of share capital, on account of which the creditors can satisfy claims submitted by them against the company2. Whether this objective can be achieved by means of capital rules is a different matter. It is clear that all business activities require a certain amount of capital. At the same time, the corresponding limits have not been established in Continental European law; the amount of obligatory investment has instead been determined by minimum capital requirements. In legislation, these requirements are established as universal for all companies and the company's actual capital needs are not taken into account3. If shareholders invest in a company in such a way that the share capital is constituted in a minimum amount prescribed by legislation and the rest of the capital needed for the company's activity is lent to the company, they have fulfilled their obligation to form share capital of a certain amount, but it is clear that the equity capital investment they made is not sufficient. In this way they do, however, create the possibility to take the investment from the company without having to undergo complicated procedures. It must also be taken into account that several Continental European countries either have already removed the minimum capital requirement from their legislation or plan to do this in the near future, which means that any formal equity capital investment requirement will cease to exist in these companies. In these conditions, the likelihood will further increase that all capital necessary will be given to the company as a loan.

It may also be inevitable that shareholders give loans to companies, because if a company is facing financial problems and needs additional capital to continue its activity, it is often in a situation in which acquiring additional capital from third parties (including banks) is impossible as all securable assets are already encumbered or third parties do not want to take excessive risks. In addition, capital from shareholders may be less expensive. In this case, there are also two possibilities: to make an equity capital investment (particularly by means of increasing share capital) and to give the company a loan.

The main difference between the forms of financing derives from bankruptcy rules. Although in both cases the investment is made by the same persons, their legal status is diametrically different - in order for a loan to be repaid, an ordinary claim can be submitted in bankruptcy proceedings, while returning equity capital can only be considered after the satisfaction of all claims submitted by creditors.

A question arises as to whether such discretion can be complete. As giving a loan and making equity capital investment are financially equal investments from the point of view of the company and its creditors, merely providing this with a certain legal form should not be of determinative importance. While a shareholder is subject to the limited liability principle, the legal practice of each country also knows exemptions from this principle. Thus, there is no doubt that a claim for compensation of damages can be submitted against a shareholder who has been dishonest in his activities.

The issue regarding the legal status of loans given to a company by a shareholder primarily concerns whether such loans can be treated as regular loans or not. Here, problems may stem from different circumstances. At the same time, situations may arise wherein there are no negative objectives in giving a loan to the company in the form of an investment and the shareholders themselves agree that their claims are to be satisfied after the claims of all other creditors are satisfied. This choice, for instance, is justified in a situation in which a company needs a large investment for starting its activities, one that will no longer be needed after this. If the entire investment is made in equity capital in such a situation, it can only be returned by means of decreasing share capital, but this is an extremely long-term procedure accompanied by expenses. Considering that the duration of the procedure for decreasing capital exceeds six months according to the law, if the respective decision is made on the date of possibility of payment, the shareholders have to wait a very long time for their money, which is clearly economically ineffective because during this time the capital remains in the hands of the company, which no longer needs it.

The other problem regarding loans from shareholders is this: if we acknowledge the special status of shareholder loans, how is it possible to inform third parties thereof? As the corresponding publication is effected by means of the annual report, the central issue here is how these loans could and should be recorded in the balance sheet. It must be taken into account that false preparation of an annual report can be regarded as submission of incorrect information concerning the company's financial situation4 under the Penal Code5.

2. The nature of a subordinated loan

A subordinated loan is usually defined as a loan that is subject to repayment upon termination of the debtor after the claims of all other creditors6. A subordinated loan is therefore a conditional claim of the lender against a company and the condition of repayment of debt is the prior satisfaction of claims of all other creditors of the company. On a regulatory basis, a loan can be subordinated by the law but in this case the legislation must include standards that prescribe the qualification of certain loans as subordinated loan. A loan may also be rendered subordinated by agreement, in which case one of the parties must be the provider of the loan. The other party to such an agreement is generally the recipient of the loan (the company), but it cannot be ruled out that a subordination agreement is concluded between the creditors and the company as a recipient of the loan does not enter this agreement7.

In the Continental European judicial area, the issue of subordinated loans is primarily treated under capital rules, which are based on two primary postulates: capital must be paid in and capital cannot be repaid8.

3. The legal approach to shareholder loans in EU and other countries
3.1. The European Union

The Second Company Law Directive9 , which regulates capital, includes provisions concerning distributions made to shareholders (in Article 15), but these rules concern only payment of interest to shareholders related to dividends and shares; they do not address other payments. In addition, the directive is only applicable to public limited liability companies and, although many Member States have also established similar requirements for private limited liability companies, it is not obligatory for these10. In view of the extreme strictness of the directive in protecting capital, such an unfinished solution is further confirmation of the claim that, despite its strict requirements, the directive is in fact ineffective and does not regulate certain economically relevant issues that have repeatedly been pointed out by several authors11.

The rules of European law regarding subordinated loans are included in banking directives, where they are handled in connection with prudential norms12. However, as the emphasis of these rules is different, there are also no rules regarding the possibility of subordinating loans. In addition, most companies fall outside the scope of application of these directives13.

3.2. Germany

In Germany, matters related to shareholder loans have been resolved differently at different times. First, the issue was dealt with in case law concerning limited liability companies. In these cases, by applying sections 30 and 31 of the Gesetz betreffend die Gesellschaften mit Beschränkter Haftung (GmbHG)14 , the courts have considered loans to be subordinated loans when the loan was given to a company already experiencing solvency problems15. The GmbHG in its § 30 lays down the prohibition of making payments to shareholders from assets that are necessary for preserving share capital, and § 31 sets forth the repayment obligation for payments made in violation of this prohibition. In 1984, the German Federal Supreme Court (BGH) extended these principles to public limited companies, though as a limitation stating that the shares of the shareholder providing the loan must account for more than 25% of the share capital16. The courts relied on § 57 (on the contribution payment obligation of shareholders) and § 62 (on liability of shareholders in the case of illegitimate payments) of the Aktiengesetz17 (AktG).

In 1990, the matter of subordinated loans was regulated in Germany by means of legislation: § 32a and § 32b of the GmbHG, with the corresponding amendments made in 1994 to sections 39 and 135 of the Insolvenzordnung18 (InsO) and § 6 of the Anfechtungsgesetz19 (AnfG).

In § 32a of the GmbHG, it is specified that if a shareholder has provided a company with a loan in a situation in which he could have increased the share capital as a diligent entrepreneur, he may claim the repayment of this loan in...

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