The German Federal Supreme Court has submitted questions to the European Court of Justice (the “ECJ”) which will determine whether non-German law governed shareholder loans to German borrowers are subject to the German insolvency law principle of equitable subordination.

If the ECJ finds that the governing law of the contract determines the issue, this may provide a route to avoiding equitable subordination. This would be a major and important development for financing of German companies.

Background

The case in question (file no.: IX ZR 229/23) concerned an Austrian company’s Austrian law loan to its German subsidiary.  The German insolvency administrator subsequently appointed over the subsidiary demanded claw back of loan repayments made in the run up to insolvency, which was challenged by the parent on the grounds that Austrian law applied to the loan, and the loan was not challengeable under Austrian law.

Equitable Subordination in Germany

In a German insolvency, shareholder loans are equitably subordinated, a key factor in many investment structures and new money financings. This means any shareholder funding to a German subsidiary is commercially treated as equity with the additional consequences that: 

• German insolvency officeholders can claw back shareholder loan repayments made within the twelve months prior to insolvency, and security granted within the previous ten years; and

• lenders holding share pledges must strictly limit their influence over the pledged company’s daily management to avoid risk of recharacterisation of the debt to equity.

The effectiveness of attempts to circumvent the equitable subordination rules by using a non-German governing law for a shareholder loan agreement has been subject to significant debate. The key issue is whether the governing law of the contract (lex causae) or the law of the insolvency (lex fori concursus) applies to the shareholder loan in the event of the subsidiary’s insolvency. Even if shareholders successfully argue that the law of the contract applies:

• the shareholder needs to show that such foreign law “does not allow any means of challenging” the loan – a high hurdle to surmount; and

• depending on the details of the case, insolvency officeholders may still challenge the choice of law provision as an abusive means of circumventing German insolvency law.

Referral by the German Federal Supreme Court to the ECJ

• Under the EU-Insolvency Regulation, the law of the insolvency determines “…the ranking of claims …” (Art. 7(2)(i)) and “the rules relating to the voidness, voidability or unenforceability of legal acts detrimental to the general body of creditors” (Art. 7(2)(m)). However, an exemption applies to limb (m) if the loan is governed by the law of another EU member state which “does not allow any means of challenging that act” (see Art.16).

• In its judgment of 16 January 2025, the German Federal Supreme Court found that the German equitable subordination rules relate to the ranking of claims within the meaning of limb (i) and that the ability for officeholders to claw back payments made in breach thereof also relate to ranking (i.e. not limb (m)) and so the exemption under Art. 16 does not apply.

Potential impact on the structuring of sponsor financings and new money provision in German restructuring situations

• If the ECJ disagrees with the German Federal Supreme Court and does not qualify the claw back of subordinated loans effectively as a waterfall provision, this would mean that companies could likely avoid the risk of equitable subordination by submitting their loans to the law of another EU member state that does not allow any means of challenging payments in respect of the loan on the basis of equitable subordination. This could make new investments from within EU member states more attractive and even allow for an acquisition of the distressed company without the need for an S6 Restructuring Opinion beforehand.

• The ECJ’s decision may also impact German law’s approach to financings granted by entities outside the scope of the EU-Insolvency Regulation, e.g. England or the U.S., as German domestic international private law (as applicable to non-EU situations) is similar to EU law on this issue.

• Going further, if the ECJ finds that equitable subordination does not apply for cross-border shareholder loans, it is quite possible that Germany may eventually abolish equitable subordination entirely, ensuring equal treatment for German parents and allowing unprecedented flexibility in shareholder financing.

• Finally, whilst the German Court’s ruling focused on governing law only, it would seem prudent for lenders to consider also using a non-German SPV from the relevant jurisdiction (e.g. Luxembourg or Netherlands), to avoid the potential risk that the choice of law is argued to be an abuse of law.