Debt-to-Equity Swaps in German Restructurings

What debt to equity swaps achieve

Debt to equity swaps convert creditors' claims into shares in the debtor company. For an over-leveraged company, the swap reduces debt and interest, improves the balance sheet and can remove over-indebtedness; for creditors, it replaces a claim with limited recovery prospects by an equity stake with upside if the restructuring succeeds.

In German restructurings, debt to equity swaps are used by lenders, bondholders and distressed investors to take control of companies, sometimes against the will of existing shareholders. They can be implemented consensually under company law, through a restructuring plan under the StaRUG or through an insolvency plan, and each route has different requirements for valuation, shareholder involvement and protection against later claims.

Three legal questions dominate every swap: how the contribution of a claim is valued for capital purposes, how existing shareholders are dealt with, and how the waiver of debt is treated for tax purposes. The answers determine whether a swap is legally robust and economically sensible, and they should be analysed together rather than one after the other, because a structure that works under company law may fail for tax reasons or vice versa.

Contribution in kind and valuation of claims

In a debt to equity swap outside a plan, the creditor subscribes for new shares in a capital increase and contributes its claim against the company as a contribution in kind; the claim is extinguished by confusion. For a GmbH, the resolution on the capital increase must specify the object of the contribution in kind and the nominal amount of the shares concerned (§ 56(1) GmbHG).

The decisive issue is value: a claim against a company in crisis is not worth its nominal amount, but only what it is economically worth given the company's ability to pay. If the value of the contribution falls short of the nominal amount of the shares, the subscriber must pay the shortfall in cash (§§ 56(2), 9(1) GmbHG). This differential liability is a serious risk for creditors who swap at nominal value.

Creditors therefore usually subscribe for new shares at a nominal amount that reflects the fair value of their claims, with the remaining amount of the claim allocated to the capital reserve or waived. A valuation report supports the determination. For a stock corporation, the contribution in kind is also subject to an audit by an independent auditor and review by the court in the registration process. Alternatively, a creditor can waive part of the claim and subscribe for new shares in cash, which is then used to repay the remaining claim, although such structures must be examined carefully under the rules on hidden contributions in kind.

Debt to equity swaps in insolvency plans and StaRUG plans

Insolvency plans and StaRUG plans make debt to equity swaps considerably easier. An insolvency plan can provide that creditors' claims are converted into shares, although not against the will of the creditors concerned, and can include a capital reduction or increase, contributions in kind, the exclusion of subscription rights and compensation for departing shareholders (§ 225a(2) InsO). The StaRUG contains a corresponding rule for restructuring claims (§ 7(4) StaRUG). Shareholders form a separate group in the plan and can be crammed down if the statutory conditions are met.

A crucial advantage of the plan route is protection against valuation claims. Where claims are converted into shares under an insolvency plan, the debtor cannot assert claims against the former creditors for overvaluation of the claims after the plan has been confirmed (§ 254(4) InsO); the StaRUG contains an equivalent rule for confirmed restructuring plans (§ 67(5) StaRUG).

This removes the differential liability risk that makes consensual swaps difficult. In addition, resolutions and declarations included in a confirmed plan are deemed to have been made in the required form, which avoids separate notarial deeds and shareholder meetings. Our insights on insolvency plan proceedings and cross-class cram-down under the StaRUG explain how plans are adopted.

Tax on restructuring gains under § 3a EStG

When creditors waive part of their claims or contribute claims at less than nominal value, the company records income from the release of debt.

Without special rules, this restructuring gain would be taxable, possibly creating a tax burden that undermines the restructuring. German tax law therefore exempts increases in business assets or business income from a debt waiver for the purpose of a company-related restructuring (§ 3a(1) EStG), and the exemption also applies for trade tax purposes. A company-related restructuring requires that, at the time of the waiver, the company is in need of and capable of restructuring, the waiver is suitable for restructuring and the creditors act with the intention to restructure (§ 3a(2) EStG).

The exemption comes at a price: in the year of the restructuring and the following year, tax options must be exercised so as to reduce profits, and existing loss carryforwards and other tax attributes are used up against the restructuring gain before it is exempt. Where the swap is implemented by contributing claims, the portion of the claim that exceeds the fair value is usually treated as a waiver. Taxpayers often seek a binding ruling from the tax authorities in larger cases.

Loss carryforwards and change of ownership

A swap in which creditors acquire more than 50 per cent of the shares within five years can lead to the forfeiture of the company's unused tax losses under the change-of-ownership rule (§ 8c(1) KStG). An acquisition for the purpose of restructuring the business is disregarded, if the conditions of the restructuring clause are met; restructuring means measures aimed at preventing or removing illiquidity or over-indebtedness while preserving the essential operating structures (§ 8c(1a) KStG). Structuring the swap so that the restructuring clause or other exceptions apply can preserve valuable tax assets.

Practical issues for creditors becoming shareholders

Creditors who become shareholders take on new risks and duties. Their remaining loans may become subordinated shareholder loans in a later insolvency, unless the restructuring privilege applies: a creditor that acquires shares in a crisis for the purpose of restructuring is not subject to subordination of its existing and new loans until the company has been sustainably restructured (§ 39(4) sentence 2 InsO). Our insight on shareholder loans in insolvency explains the rules.

Regulatory requirements may also apply: acquiring a stake in a bank, insurer or payment institution requires an owner control procedure, and stakes in companies in sensitive sectors may require foreign investment screening; see our page on foreign investment control.

Lenders, particularly banks, may face internal restrictions on holding equity, so swaps are often structured through holding vehicles, with shareholder agreements regulating governance, exit and drag-along rights. Bondholders can implement swaps through majority decisions under the Bond Act, which allows the conversion or exchange of bonds into shares by qualified majority (§ 5(3) no. 5 SchVG); see our insight on bondholder votes under the SchVG. Merger control may be triggered where a creditor acquires control of a company that meets the turnover thresholds.

Structuring debt to equity swaps step by step

Debt to equity swaps in practice follow a recognisable sequence, whichever legal route is chosen:

1. Restructuring concept: establish the sustainable debt capacity of the business and the amount of debt that must be converted or waived, usually supported by an independent restructuring opinion.
2. Valuation: obtain a valuation of the business and of the claims to be converted, which drives the allocation of equity among creditors and any residual stake for existing shareholders.
3. Route: decide between a consensual capital measure, a StaRUG plan and an insolvency plan, taking into account shareholder cooperation, the need for operational measures and timing.
4. Holding structure: decide whether creditors hold shares directly or through a new holding company, and draft the shareholder agreement, including governance, information rights, transfer restrictions and exit provisions.
5. Approvals: identify merger control, foreign investment, owner control and other regulatory filings, and change-of-control consents under key contracts.
6. Tax: confirm the treatment of the restructuring gain and loss carryforwards and consider a binding ruling.
7. Implementation: execute the capital measures, register them in the commercial register and update the shareholder list or share register.

Change-of-control clauses deserve particular attention. In a consensual swap, a change of control may entitle counterparties to terminate important contracts, licences or financing. In an insolvency plan, measures under § 225a(2) and (3) InsO do not entitle counterparties to withdraw from or terminate contracts with the debtor, and contrary agreements are ineffective (§ 225a(4) InsO), which can be another reason to choose the plan route. Management incentive plans for the post-swap company are often negotiated alongside the swap, because the new owners need to retain the management team that will implement the restructuring.

Valuation, fairness and disputes

Every debt to equity swap rests on a valuation of the company and of the claims. In plan-based swaps, the valuation feeds into the comparative calculation and the assessment of whether shareholders and dissenting creditors receive appropriate value. Shareholders who lose their stake will challenge valuations that appear to understate the company's value, while creditors will challenge valuations that inflate it. Independent valuation reports, transparent assumptions and, where possible, market testing through an investor process strengthen the position of the plan proponents and reduce the scope for later litigation. Our page on distressed M&A covers investor processes.

How TRW & Co helps

We advise lenders, bondholders, distressed investors, companies and shareholders on debt to equity swaps in Germany. We structure consensual swaps and plan-based conversions, draft capital measures and shareholder agreements, coordinate valuation and tax analysis, including § 3a EStG and § 8c KStG, and handle merger control, foreign investment and owner control filings. We also represent shareholders and creditors in disputes over valuation and plan confirmation. This page is general information, not legal advice. To discuss a restructuring, please contact us.