A pay-out of dividends to shareholders after the profit was carried forward can be contested in insolvency proceedings

Contesting a debtor’s transactions in insolvency proceedings is the key tool for the insolvency administrator to increase the debtor’s estate for the benefit of its creditors. The interpretation of the rules of insolvency claw back in the German Insolvency Code (Insolvenzordnung) is therefore of great practical importance especially, but not only, for shareholders, as shown by the ruling of Germany’s Federal Court of Justice on 22 July 2021 (IX ZR 195/20) discussed here.

Interpretation of “Legal acts economically corresponding to a shareholder loan”

Payments made to shareholders to redeem shareholder loans or restitution claims resulting from legal acts corresponding economically to a loan have a high risk of being contested by the insolvency administrator. Payments the debtor made in the year before filing for commencement of insolvency proceedings to satisfy such claims can be contested in any event (section 135(1) no. 2 German Insolvency Code). The same applies to collateral security provided to secure such claims in the last ten years before filing for insolvency (section 135(1) no. 1 German Insolvency Code).

It is often unclear what legal acts “correspond economically” to such a loan. Especially if profits are paid out to shareholders which were not generated in the immediately preceding financial year, it remained unclear for some time whether those provisionally retained profits were the equivalent of a shareholder loan. Schleswig Higher Regional Court (ruling of 8 February 2017 – 9 U 84/16) found that the rules protecting a company’s share capital under sections 30 and 31 German Limited Companies Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung) prevented the corresponding application of the insolvency claw back rules regarding shareholder loans in the case of equity dividends. In 2013, Koblenz Higher Regional Court argued in favour of a classification as a claim equivalent to a loan (ruling of 15 October 2013 – 3 U 635/13) and thus argued that repayments could be subject to insolvency claw back based on section 135 German Insolvency Code.

Federal Court of Justice creates legal clarity on distribution of retained profits

In the ruling discussed here, the Federal Court of Justice sided with Koblenz Higher Regional Court.

In the case at hand, the sole shareholder of the debtor company decided in 2009 to carry forward the profit made in the financial year 2008 to new account. A few months later, the shareholder made the amending shareholder resolution to distribute part of that profit and had the amount paid out to him. When insolvency proceedings were initiated shortly afterwards, the company’s insolvency administrator requested the shareholder to repay the distributed profits. The insolvency administrator now prevailed before the Federal Court of Justice, as in the lower court instances.

Profit carried forward is a “funding decision for the benefit of the company”

In the opinion of the Ninth Division of the Federal Court of Justice, a shareholder makes a funding decision for the benefit of the company when adopting a resolution not to distribute profits but to carry it forward to new account. As in case of a loan, the company is given a capital value for temporary use, which the sole shareholder can have distributed anytime via an amending resolution, the Court said. If this pay out scenario were not subject to claw back, the Court said, section 39(1) sentence 1 no. 5 and section 135(1) no. 2 German Insolvency Code could be circumvented by choosing a legal structure.

In accounting terms carrying forward profits is company equity, whereas a shareholder loan is debt capital. However, section 39(1) sentence 1 no. 5 and section 135(1) no. 2 German Insolvency Code are not limited to debt capital. Rather, what is decisive is that the shareholders procure or leave their company a sum of money which, without their actions, would not otherwise be available as part of the company’s assets and so the company obtains additional funds. The Court noted that this was also the case for a legal or de facto deferral of the shareholder’s claim against the company.

No claw back in the case of “forced deferral”

However, the retention of dividends is not comparable to a shareholder loan if that retention is based on forced deferral. Although not relevant to the case at hand, the Federal Court of Justice gives the example of major losses occurring after the balance sheet date, but before a resolution is passed on how to treat the company’s profits. The shareholder is prevented by the capital retention rules from distributing the profits if the necessary assets to retain the ordinary share capital would otherwise be exhausted (section 30(1) sentence 1 German Limited Liability Companies Act). In such a case, the shareholder does not voluntarily decide to retain the profit.

Classification and assessment of the ruling

Consistent continuation of previous Federal Court of Justice case law

The ruling is no surprise. It continues the consistently creditor-friendly interpretation of claw back criteria in the case law of the highest German civil court. The Court’s comments on capital retention make it clear that carrying forward profits is only equivalent to a shareholder loan if, at the time of the resolution, there was not yet any capital impairment, in other words, if the shareholders are free to distribute or retain profit. The ruling appears to be transferrable to releasing and distributing voluntarily created profit reserves as well. The Federal Court of Justice does not go into detail on the situation in which a shareholder cannot control the appropriation of profits alone. If minority shareholders have voted against the retention, there are good arguments to suggest that they have not made a funding decision for the benefit of the company and that a subsequent distribution to them cannot be clawed back under section 135(1) no. 2 German Insolvency Code.

Consequences for the funding practice

In light of this ruling, from an insolvency law perspective the retention of profits has no clear advantage compared to distribution and subsequent issuing of a shareholder loan. That is at least true for shareholders who control the decision on retention and thus make a funding decision. However, subject to tax considerations, distribution and a subsequent loan to the company as needed will be preferable as this offers more flexibility. One advantage of the loan in terms of insolvency claw back law could arise in certain cases where the loan agreement is subject to a law other than German law, i.e. a law which is less claw back-friendly. Thus, in certain circumstances, and provided that the choice-of-law clause in the loan agreement does not constitute a circumvention, Article 16 European Insolvency Regulation and section 339 German Insolvency Code open up the defence for shareholders against a claw back claim that the repayment would not be subject to claw back or otherwise challengeable under the applicable foreign law, unlike under German insolvency law.

Impact on M&A transactions

The decision of the Federal Court of Justice also affects shareholder loans in connection with M&A transactions. If the seller has granted a shareholder loan to the subsidiary to be sold in the past, the seller will be keen to minimise his claw back risk concerning the shareholder loan and any repayment made to the buyer after closing. This risk has existed in principle since the decision of the Federal Court of Justice of 21 February 2013 (IX ZR 32/12). In the past, one of the options discussed to minimise the seller’s risk was for the selling shareholder to contribute the loan repayment claim to the company’s free capital reserve. However, it must now be assumed that under the conditions set out by the Federal Court of Justice this also constitutes a financing decision for the benefit of the company and that the contribution to the free capital reserve corresponds economically to the shareholder loan granted by the seller. Accordingly, releasing and distributing the reserve later might be subject to claw back not only against the receiving buyer but also against the seller. In order to avoid the risk from the seller’s point of view, other recognised options regarding recommendable transaction structures would need to be considered. Depending on the circumstances at hand, one solution might be to dissolve and distribute the contribution immediately after it has been made, so that there is no financing on the part of the shareholder. However, this must be examined in each individual case. In doing so, it must also be taken into account that distributions made during the ongoing financial year may have certain tax drawbacks.

Read our other article on further landmark decisions by the Federal Court of Justice in company law from 2021.