Vol 6 (2009) - Issue 5

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Debt/Equity Swaps in Germany

1. Introduction

The current financial crisis has led to a significant increase in the number of companies which are having to go through a financial restructuring. Borrowers are facing both cashflow issues as they struggle to service the large levels of debt taken on during the liquidity bubble and balance sheet issues as the value of the assets on their balance sheets drop.

Against this backdrop, lenders are looking for ways in which to effect successful financial restructuring. An increasingly popular solution is the debt/equity swap under which part of the outstanding debt is converted into shares of the borrower. A debt/equity swap deleverages the balance sheet of the troubled company (thereby making the company appear stronger financially to prospective customers/suppliers and investors) and at the same time improves the cashflow by reducing the debt service requirements.

This dual effect on both the balance sheet and the cashflow can help to avoid over-indebtedness and illiquidity and can therefore avoid the need for the directors of the troubled company to file for insolvency. For the lender, such a swap can help to ensure the success of the restructuring, and can be particularly helpful if there are concerns about other restructuring routes. The lender will also gain additional rights through its equity stake (such as investor veto rights), and may be able to negotiate a return to it which more than compensates it if the company is subsequently sold – in other words, the lenders will share in any future success of the company.

Though there are many positive effects which can make a debt/equity swap an attractive restructuring option, the legal framework and potential pitfalls differ quite substantially across different jurisdictions. This article looks at the position in Germany, and in particular the key issues which commonly arise when looking at a debt/equity swap involving the two major German corporate forms, the stock cooperation (Aktiengesellschaft, AG) and the limited liability company (Gesellschaft mit beschränkter Haftung, GmbH).

This article does not cover the tax consequences of a debt/equity swap, but advance tax planning for both the troubled company and its lenders is essential. In particular, the company may lose the benefit for tax purposes of carrying forward its losses as a consequence of a debt to equity swap, and the conversion of a loan which is not fully recoverable may create a taxable profit.

2. Legal qualification
2.1. Capital increase

Under German law, debt/equity swaps are treated as capital increases of the company against consideration in kind. The usual process for a debt/equity swap is that the company increases its share capital. The lenders then subscribe for the new shares. As consideration for the allotment of the new shares, the lenders transfer to the company the relevant amount of debt. After the transfer, the debt is automatically extinguished by operation of law as the borrower and lender of the transferred debt are the same legal entity.

It should be noted that in the case of both the AG and the GmbH an increase in share capital requires the approval of 75% of the shareholders who are present and voting at a meeting called to approve such increase. In practice, the lender and the company will need to ensure before such meeting that sufficient shareholder support for the debt/equity swap is obtained. In this context, it is helpful that German courts have ruled that for an AG, the shareholders are obliged to support a restructuring (in particular a capital increase) if this is the only way that the company wll be able to continue to trade as a going concern. This ruling is generally expected to be applicable for GmbHs as well.

However, even with this ruling, in practice it may be difficult to hold a shareholders’ meeting for timing reasons. First, the statutory notice periods of at least one month for the AG and usually no less than two weeks for the GmbH need to be observed. Secondly, ‘professional plaintiffs’ (who buy small stakes in companies which are getting into financial difficulties) may try to delay key decisions with a view to seeking payment from the company in return for their cooperation.