Article Law360

A New Distressed Claims Trading Landscape In Germany

In a familiar scene for claims traders in U.S. Chapter 11s, the German Supreme Court (Bundesgerichtshof, hereinafter, “BGH”),[1] in a string of recent decisions, has held that disabilities and defenses to a claim generally “travel with it” when it is transferred to a third-party purchaser. In doing so, the court has begun to align itself with prevailing practice in the U.S. in the wake of the Third Circuit’s recent decision in KB Toys. In future, funds active in the German distressed debt market will need to tread carefully to ensure the validity of their claims, especially in light of the German bankruptcy regime’s harsh treatment of shareholder loans and related transactions.

The BGH Decisions

In 2011, in a much anticipated decision, the BGH held that proofs of claim filed by a former 10 percent shareholder of the debtor could be subordinated if the former shareholder sold its shares during the year prior to the petition date.[2] Section 39 of the German Bankruptcy Code automatically subordinates loans granted by shareholders holding 10 percent or more of a company’s shares. The court’s decision was widely viewed to stand for the converse proposition, as well: claims purchased from a shareholder remain “tainted” for a period of at least one year, even if the purchaser is a nonshareholder.[3]

In 2013, the court issued its second opinion on the issue, holding that payments made during the year prior to the petition date to a transferee of a shareholder loan who acquired the loan during that same one-year period could be recovered either from the shareholder-transferor or the nonshareholder-transferee (i.e., both transferee and transferor bear joint and several liability for the recovery).[4]

Section 135 of the German Bankruptcy Code, the counterparty to Section 39, enables the bankruptcy trustee to recover any payments made on a shareholder loan during the year prior to the petition date. Thus, the 2013 opinion served as the counterpoint to the 2011 opinion, confirming that subordinated claims remain “tainted” — both with respect to priority as well as for avoidance action purposes — for an entire year subsequent to transfer of the subordinated claim.

The Third Circuit’s KB Toys Opinion

The BGH’s recent jurisprudence mirror recent developments under U.S. Chapter 11. In November 2013, the Third Circuit issued its opinion in KB Toys, disallowing claims filed by a claims trader because the claims would have been subject to avoidance in the hands of the seller and the claims trader, as a sophisticated market participant, was not a “good-faith purchaser.”[5]

Section 502(d) of the U.S. Bankruptcy Code disallows any claim where the entity holding that claim has received avoidable transfers but not returned them to the estate. In KB Toys, the seller received preferential transfers during the 90 days prior to the petition date and subsequently sold its claims. The amounts were not returned to the estate.

In a previous case interpreting Section 502(d) in the claims-trading context, the District Court for the Southern District of New York had refused to disallow or equitably subordinate claims held by purchasers based on the inequitable conduct of the sellers, ruling that “equitable subordination and disallowance [were] personal disabilities of the claimant” tainting the sold claim only when it is “assigned, not when it is sold.”[6] The Third Circuit explicitly rejected this approach, enacting a broad rule that a purchaser cannot “cleans” claims otherwise subject to subordination or disallowance.

Claims Remain Tainted — Even Loans with Burdensome Covenants and Options to Acquire Shares in the Borrower May be at Risk in a German Process

The BGH’s decisions, in some respects, go beyond the Third Circuit’s holdings. The German Bankruptcy Code’s equitable subordination of shareholder loans is consistently stringent.

First, a German bankruptcy court will not perform a balancing test, as in a U.S. Chapter 11 recharacterization analysis, to determine whether a shareholder loan should be subordinated.[7] If the shareholder holds more than 10 percent of the debtor’s capital, its loan claims will be subordinated to all other general unsecured claims.[8]

Second, the statutory definition of “shareholder loans” includes transactions that are “economically similar” to shareholder loans. This potentially encompasses debt claims held by nonshareholders arising under financing arrangements containing overly burdensome covenants that allow the lender to control the debtor’s affairs[9] as well as claims held by holders of mere stock options (as opposed to actual shares).[10]

Third, by relying explicitly on § 404 of the German Civil Code, which allows a debtor to assert all defenses to a claim that it could have asserted against the claim’s original holder,[11] the BGH appears to have expressed an intention to extend its 2013 decision beyond the shareholder context. In other words, the KB Toys set of facts, while not specifically before the BGH, likely would have been decided the same way.


In other respects, the German court tailored its rulings more narrowly — and, for claims traders, more favorably — than did the Third Circuit in KB Toys. Specifically, the BGH expressly left the door open for cleansing of “tainted” shareholder claims by basing its holdings on the one-year look-back period in Section 135 of the German Bankruptcy Code.[12]

Pursuant to the 2011 and 2013 opinions, the “taint” of equitable subordination applies only for one year, thus, if the debtor does not file for bankruptcy within that period, the claims purchaser should be in the clear. As noted, however, the one-year rule applies only for claims that would be subordinated because of the seller’s status as 10 percent shareholder. Claims subordinated or subject to avoidance for any other reason potentially will remain so (though the BGH has yet to opine specifically on this issue, even though its reliance on § 404 BGB indicates that this would be the case).

[1] The BGH is Germany’s court of last resort in civil matters to the extent a dispute presents no constitutional issue.
[2] BGH Judgment, Nov. 15, 2011 — II ZR 6/11 (hereinafter, the “2011 opinion”).
[3] Carli/Laier, GWR 2012 at 36; Ruhle, BB 2012 at 283.
[4] BGH Judgment, Feb. 21, 2013 — IX ZR 32/12 (hereinafter, the “2013 opinion”).
[5] In re KB Toys Inc., --- F.3d ---, 2013 WL 6038248 (3d Cir. Nov. 15, 2013).
[6] Enron Corp. v. Springfield Associates (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007).
[7] Compare In re Autostyle Plastics Inc., 269 F.3d 726, 749-750 (6th Cir. 2001) (setting forth the generally accepted factors for determining whether debt should be recharacterized as equity: (a) names given to the instruments; (b) whether fixed maturity, interest rate and payment schedule were agreed; (c) source of repayments; (d) adequacy of debtor’s capitalization; (e) identity of interests between creditor and shareholder; (f) security provided; (g) debtor’s ability to obtain third-party financing; (h) whether contractually subordinated; (i) whether financing used to obtain capital assets; (j) whether sinking fund exists for repayments).
Notably, pre-2008 German law provided for subordination of shareholder loans
[8] The German Code provides shareholders a statutory safe harbor from subordination if its shareholdings were acquired in the context of a restructuring. The safe harbor ceases to apply once the debtor has been “sustainably restructured,” generally meaning that once the debtor has continuously been able to obtain financing in the capital markets for a period of at least one year, the safe harbor will no longer apply. See Wittig FS K. Schmidt 2009 at 1743, 1758; Gehrlein, WM 2011 at 577, 584 et seq.; see also Hirte/Knof, WM 2009 at 1961, 1969-70 (arguing that safe harbor should continue to apply until the end of the year following the year in which the debtor is no longer threatened by insolvency).
[9] In a 1992 opinion, the court ruled that financing provisions that essentially enabled a lender to control the debtor’s governance and operations subjected the lender to capital maintenance rules otherwise applicable only to shareholders. See BGH Judgment, July 13, 1992 — II ZR 251/91. The opinion triggered speculation over whether the court would extend its rationale to subordinate debt claims under financing arrangements containing overly burdensome covenants.
[10] Neuhof, WM 2005 at 405, 409 (arguing nonexercised options can cause shareholder to be deemed to be in a position “economically similar” to a shareholder if the shareholder is irrevocably entitled to the shares); Freitag/Mülbert, in: Staudinger, BGB, Bearb. 2011, § 488 ¶ 89 & 224 (arguing options can cause same if holder also effectively dominates the borrower in combination with strict financial and business covenants); but see Obermuller, Insolvenzrecht in der Bankpraxis ¶ 5,580 (options only relevant if actually exercised). See also Uhlenbruck/Hirte InsO 13. Ed. 2010 § 39 ¶ 74 (arguing “acting in concert” provisions governing disclosure requirements under German securities law should determine whether options should cause a shareholder holding less than 10 percent to be deemed “economically similar” to a 10 percent shareholder).
[11] See id. 2013 Opinion ¶ 29.
[12] See, e.g., 2013 Opinion ¶ 30; 2011 Opinion ¶ 16.