A Capital Question, Should Shareholder Loans be Automatically Subordinated?

Summary

SUMMARY

Whether or not shareholder loans should be automatically subordinated in bankruptcy is a much discussed topic in corporate and insolvency law. In this article I show that, because of the existence of non-adjusting creditors, shareholder-managers will sometimes have the incentive to take excessive risk. The subordination of shareholder loans forces the shareholder to internalize these costs. On the other hand, subordination of shareholder loans might also deter the undertaking of desirable projects. On balance, it is likely that subordination is efficient and reduces the agency cost of debt. Furthermore, I will show that shareholders should bear more risk because they are better monitors, do not suffer from information asymmetries and have higher expectations of default. Therefore, if shareholders and outside creditors could hypothetically bargain ex ante in a world without transaction costs on the rank of their debt claim, there is not much doubt that they would agree on subordination. Proving that subordination of shareholder loans is inefficient would imply that the subordinated position of equity is inefficient – and further shake the concept of legal capital on its foundations.

KEYWORDS

Agency Cost of Debt; Subordination; Shareholder Loans; Capital Structure; Limited Liability; Non-Adjusting Creditors

INTRODUCTION

The existence of a rationale for the by law automatic subordination of loans provided by a shareholder (’inside debt’) on insolvency (or liquidation) of a limited liability company has caused much ink to flow from the pens of academics and other company and insolvency law experts without reaching consensus. For example, about half of the respondents to the consultation of the High Level Group of Company Law Experts instituted by the European Commission deemed that subordination (of inside debt) was undesirable, while another 41% believed subordination is a valuable feature of corporate and insolvency law. This debate is also reflected in the prevailing law, some jurisdictions have rules automatically subordinating shareholder loans, others not. Although the liquidation dividend flowing to unsecured creditors is known to be low to non-existing on average, case law in many jurisdictions shows that oft en the (automatic) subordination of shareholder loans does matter to the outside creditors.