Legally secure convertible loans

Convertible loans have been a popular financing tool for investors and young companies in recent years. Yet there is always uncertainty as to when a convertible loan requires notarial form. Courts and literature do not agree on this either, and a decision by the Federal Court of Justice (BGH) is still not foreseeable. This legal uncertainty entails considerable risks, as in case of doubt the entire contract would be null and void.

Facts

The decision of the Federal Court of Justice is based on the following facts: The plaintiff insolvency administrator asserts claims for reimbursement against the former managing director of the now insolvent limited liability company (GmbH), ("debtor") due to unauthorized payments made after the company became insolvent (Sec. 64 Sentence 1 of the German Limited Liability Companies Act (GmbHG), old version, henceforth Sec. 15b of the German Insolvency Code (InsO)). According to the insolvency administrator, the insolvent GmbH was already overindebted as of January 1, 2016, but the application for insolvency was only filed six months later. The managing director was therefore liable for the payments made in the meantime. In addition, the debtor would also have been insolvent by February 1, 2016 at the latest. This is because the convertible loan granted was invalid in form, so that the loan could have been recalled at any time.

The decision of the Federal Court of Justice of April 25, 2023, Case No. II ZR 96/22

The Federal Court of Justice (BGH) ultimately only had to decide the question of whether the Higher Regional Court of Zweibrücken (OLG) should have allowed the appeal. This would have been the situation, among other things, if the case was of fundamental importance. The BGH denied this, as the question whether the convertible loan was formally invalid or not was not decisive for the judgment of the OLG Zweibrücken (judgment of May 17, 2022 - 8 U 30/19). The OLG Zweibrücken had upheld the claim and justified this by stating that the debtor had already been over-indebted as of January 1, 2016. Although, the OLG Zweibrücken also ruled that the convertible loan granted was invalid in form, this was not relevant for the success of the action. Therefore, the BGH could not allow the appeal and decide on the question when a convertible loan requires notarial form.

Practical advice

Legally, the BGH's decision is not questionable. In practice, however, the situation remains unsatisfactory as it is still unclear which formal requirements must be complied with in case of a convertible loan. As the case shows, this can entail considerable (liability) risks for all parties involved. If the formal requirements are not complied with, the entire contract may be null and void. Thus, the lender would not have a conversion right and the company would have to fear that the loan might be recalled at any time. This is likely to lead to illiquidity and thus to the company’s obligation to file for insolvency. In addition, a convertible loan agreement often contains a so-called qualified subordination agreement. This too would be invalid, resulting in the additional threat of over-indebtedness. Ultimately, this entails a high liability risk for the management. After all, if the invalidity of the form is not recognized, the management will usually not fulfil its obligation to file for insolvency in time.