Not only for reorganisation: Dept to Equity Swap

A company is in crisis. The financing servicing is at risk, and refinancing through banks is difficult due to the existing financing structure. In simple terms, the idea of swaps is to exchange debt for equity without raising additional funds: the creditor deposits his claim against the company in the company and receives shares in this company in return.

The debt-to-equity swap is a long-established and proven option for corporate reorganization in the USA and England, which has also been gaining importance in Germany for 15 years.

What are the applications?

1. Company reorganisation

Companies that have built up debt at the expense of equity despite good business models in uncertain times can reduce their debt ratio and increase their equity by converting debt to equity. This measure lowers financing costs and increases the company’s general creditworthiness in times of increasingly strict bank lending risk criteria.

This measure can be applied both outside and within the insolvency reorganization. Outside of restructuring under insolvency law, it is part of the management’s duties (Section 43 (1) GmbHG – German Limited Liability Companies Act- , Section 93 (1) AktG -German Stock Corportion Act-) to consider these options. However, they can only implement a restructuring with the consent of the existing shareholders. These requirements change in insolvency proceedings. In such proceedings, management can implement a swap against the will of the existing shareholders (§ 225a InsO -German Insolvency Code-). This possibility even applies to the protective shield proceedings that precede the insolvency proceedings as a voluntary option (Section 270d InsO). It, therefore, offers restructuring prospects that go beyond the individual case and open up new financing prospects in cooperation with institutionalized lenders.

Even more it is also essential for corporate bonds. According to the German Bond Act (Schuldverschreibungsgesetz – SchVG), bondholders can achieve the conversion of corporate bonds into company shares by majority resolution under Section 5 (3) No. 5 SchVG if the bond conditions provide for this possibility and the conditions of the SchVG are otherwise complied with. As soon as the expected return on the bond falls below the expected return on equity and there is a legitimate opportunity to participate in the company, specialized bond investors, in particular, will resort to these funds if management could restructure the operational business. In the regulated market, the responsible persons must observe the obligation to publish a prospectus (Section 3 (1) WpPG -German Securites Prospectus Act-) when issuing new company shares.

2. Strengthening the equity base

The simple conversion of debt positions into equity is a popular balance sheet and banking policy method. Without injecting liquidity, it strengthens a company’s equity base and, thus, its rating with the respective banks. The equity ratio is one of the banks’ most essential rating parameters and, therefore, a fundamental prerequisite for borrowing.
In addition to raising funds from banks, this also improves the conditions for raising venture capital or private equity to take strategic partners on board. Often, such investors demand a swap unless they hold liquidation preferences harmless.

3. Streamlining the shareholder structure

Strategic equity measures may also be appropriate if it is necessary to transform the economic influence of lenders into shareholder rights under company law. The motives for this are manifold. At the very least, this ensures that lenders are more closely associated with the opportunities and risks of the company and cannot unilaterally withdraw capital in times of crisis. Although the parties could ensure a similar result through debt law provisions in the loan agreement, in this case, the lender lacks the shareholder’s participation rights (decision-making power, entitlement to profits, and company value).

4. Tax optimization/loss allocations

By converting loans into mezzanine capital (debt to mezzanine), e.g., profit participation rights, silent partnerships, or profit-participating loans, management could combine effects in the commercial balance sheet with special tax effects. Depending on the terms of the mezzanine capital, it can be recognized in the balance sheet under equity to avoid over-indebtedness. Depending on the structure, losses incurred by the company could also be transferred to the investors. However, this would require an explicit agreement on loss sharing and may also have tax implications depending on how the program is structured.

What are the challenges under company law?

You can implement a debt-to-equity swap regularly in the form of a combined capital reduction with a subsequent capital increase. With the simplified capital reduction (Section 58a GmbHG; Sections 229ff AktG), existing impairments in the existing shares and other losses will be covered as far as possible. The subsequent capital increase is the legal cause for the formation of new company shares. The parties transferred their capital claim into the corporation to cover the capital claim respective to the new shares. The existing shareholders shall be excluded from their subscription rights to the newly created shares for legal purposes.

The valuation of the company is of particular importance. As a rule, creditors and existing shareholders will only agree if they have an answer to the question of the value of the amount of contribution. This complex issue is not trivial and requires the involvement of valuation experts in case of doubt, as the valuation scenarios between insolvency/liquidation and successful reorganization of the business plan, including financing success, open up a considerable valuation range.

However, the valuation discounts of the receivable due to any crisis scenarios of the company are, at best, plausibly derived and documented to avoid a subsequent claim for the excess valuation by an insolvency administrator. In the event of insolvency, the administrator could believe in claiming the difference from the original creditor if he thinks the parties have overvalued their receivables at the time of the share swap (differential liability risk).

In the case of a debt-to-mezzanine swap, the terms of the swap must be worked out in great detail in the terms and conditions of the mezzanine, taking into account similar valuation challenges.

What do you have to consider from a tax law perspective?

You carry out a debt-to-equity swap by contributing a capital claim to the company’s assets in return for an equity position (company shares). In cases of reorganization, the amount of the non-recoverable portion of the receivable is generally taxable for the company. The tax liability applies to both corporation tax and trade tax. Therefore, the comprehensible, plausible derivation of the receivable and company value is necessary for minimizing this unpopular restructuring profit as far as possible.

The reorganization profit is tax-free, subject to the other requirements of Section 8 (1) KStG -German Corporation Tax Law- in conjunction with Section 3a EStG -German Income Tax Act-. However, the pitfalls of these conditions lie in the details. In particular, you must take special care when explaining the need for reorganization and the company’s ability to do the reorganization. The restructuring decree (Federal Ministry of Finance BMF of 27 March 2003 IV A 6-S 2140-8/03) has become irrelevant with the decision of the Federal Tax Court – BFH of 23 August 2017 I R 52/14).

Outside of reorganization cases or in all cases, you can prove the receivable’s unimpaired recoverability; the reorganization gains issue is irrelevant. Nevertheless, existing income tax loss carryforwards may be lost under Sections 8c and 8d KStG, as the issue of new shares also results in a changed shareholder structure.