Vol 2 (2005) - Issue 2

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Debt-for-Equity Swap as a Restructuring Tool under German Law

I. Concept and importance of the debt-for-equity swap as a restructuring tool

A debt-for-equity swap is a restructuring component in which a lender acquires equity of the debtor company in exchange for the contribution of debt which is owed by the company to the lender. The creditor uses the respective claim for repayment of loans to ‘pay’ for his interest in the company. As part of a capital increase, he contributes all or part of his claims to the equity of the company undergoing restructuring and by this means can reduce or eliminate existing or imminent overindebtedness.

The accompanying reduction in financing costs strengthens the company’s profitability. This has a positive effect on other creditors - one that in psychological terms is not to be underestimated - in that they assume the company has a greater capacity to restructure itself with respect to the operational business and in turn are more willing to make investments themselves in order to stabilize the situation and avert the crisis. This same effect is seen among suppliers and customers, who regain trust in the company’s ability to survive as a result of the creditor’s new interest.

In addition to these indirect effects, the new shareholder gains the opportunity to have a direct influence on the success of the restructuring. His interest in the company entitles him to be consulted in entrepreneurial decision-making, and this permits him to take an active part in the formulation of objectives within the company. At the same time, the entrepreneurial influence of the existing shareholders is limited. In the event that the restructuring is successful, he has the opportunity to share in the increase in the company’s value (which may exceed the value of the original debt), known as ‘upside potential.’

Nevertheless, the debt-for-equity swap as a restructuring measure tends to be viewed with suspicion among the relevant groups in Germany. The primary reason for this is the rigid system of liability in corporate law; with its far-reaching consequences irrespective of fault, it makes potential lenders shy away from using debt conversion to provide equity to companies that require restructuring. With the new provisions on the minority shareholding privilege and the restructuring privilege, lawmakers have to a certain extent ameliorated the counterproductive effect of this liability. This gives rise to positive effects on the institution of the debt-for-equity swap as well.

II. Commercial and legal framework

When a company enters a state of crisis, both its shareholders and its creditors (banks, in particular) are faced with the fundamental question of whether the company should be liquidated or whether an attempt should be made to restructure it. For the creditors, this decision is dependent on numerous factors, particularly the expected default risk in the event of liquidation, the expected future performance of the business, and in some cases pressure from the public and the media.

If a decision is made to attempt a restructuring, the question that then arises is whether to implement it outside or as part of a formal insolvency proceeding. If the restructuring is to take place outside an insolvency proceeding, any existing grounds for insolvency must immediately be eliminated because the managing directors of a Gesellschaft mit beschränkter Haftung (GmbH) and the managing board of an Aktiengesellschaft (AG) must file a motion to open an insolvency proceeding with respect to the company’s assets immediately - no later than three weeks after the company first becomes overindebted or insolvent. Restructuring within an insolvency proceeding has the advantage that there is no compulsion to completely eliminate the insolvency or over indebtedness immediately.