The convertible loan – off to new beginnings?
Convertible loans have been widely recognized as a reliable and established means of financing for startup companies. A convertible loan is a type of loan that is typically unsecured and includes a provision allowing or obligating the lender to convert the loan claim, along with any accrued interest, into newly issued company shares in the startup, in most cases during a subsequent financing round. Convertible loans are frequently utilized in this particular context as a versatile mechanism for obtaining financing at a reduced expense. The formal prerequisites pertaining to convertible loan agreements, however, have been a topic of contentious discussion.
I. The general technique of a convertible loan
The fundamental aspect of a convertible loan, viewed through a legal lens, is its conversion mechanism. This mechanism entails the issuance of new shares to the lender in a future capital increase, in exchange for the assignment of the loan repayment claim, typically inclusive of interest. The loan repayment claims and interest claims are assigned to the company in a manner that results in the claim becoming void due the identity of the debtor and creditor (confusion). Subsequently, the repayment sums are recorded for each instance in the company’s unrestricted equity reserve, as defined by Section 272(2)(4) Commercial Code.
The determination of the pre-money valuation to be utilized as a basis for conversion is contingent upon a commercial accord, which may involve a computation based on a discount applied to the valuation of a forthcoming financing round of a third-party investor. The conversion mechanism poses a legal question regarding the exclusive entitlement of the lender to exercise the conversion right. This pertains to the lender’s ability to request the issuance of new shares in a subsequent funding round and/or upon the occurrence of a specific temporal event. Alternatively, it raises the issue of whether a conversion obligation should also be imposed. In the scenario of a conversion mandate, the investor is required to assume ownership of newly issued shares in the event of a forthcoming increase in capital. It is commonly accepted in practical scenarios, such as in anticipation of a forthcoming funding cycle, to establish a predetermined minimum investment threshold by a third party. Subsequent to the startup’s successful acquisition of investment from a third party, the investor would be required to undertake the acquisition of new shares in exchange for the assignment of the loan repayment claim. From this perspective, the requirement for conversion can be considered a provision that is favorable to startups. This is because conversion, which results in the cancellation of the loan repayment claim, can be enforced even if the investor is not in agreement with it.
The issue of legal governance pertaining to the investor who acquires shares in the future through conversion arises already at the time of concluding the convertible loan agreement. It is imperative to determine the legal framework that will apply to or in relation to the investor once the investor has taken over the shares. The company, as well as all current shareholders, seek the inclusion of the convertible lender as a party to any present and/or future shareholders’ agreement. It is advisable to establish a regular agreement regarding this matter within the convertible loan agreements.
II. Formal issues – previous status
Due to the flexible and cost-effective nature of convertible loans, there is often a desire among all stakeholders to minimize the administrative burden, particularly with regard to notarizing the convertible loan agreement.
The issue of whether a convertible loan agreement requires notarization has always been a subject of contention in legal literature and case law. Undoubtedly, it is a common occurrence when a convertible loan agreement mandates adherence to a shareholders’ agreement, which in turn includes clauses necessitating notarization, such as a drag along obligation.
The issue of whether there also exists a customary requirement for notarization or certification, or at the very least, an obligation to certify, in cases where a conversion obligation has been stipulated in a convertible loan agreement, specifically with respect to the obligation to acquire shares in a German limited liability company (GmbH), is a matter of debate. The prevailing viewpoint in scholarly literature has been corroborated by reference to a ruling by the Supreme Court of the German Reich (Supreme Court of the German Reich, December 13, 1935 – II 161/35, RGZ 149, 385 (395); Rowedder/Schmidt-Leithoff/Schnorbus Section 55 para. 61; BeckOK GmbHG/Ziemons Section 55 para. 100; Bork/Schäfer/Arnold/Born Section 55 para. 34), while there has been a longstanding belief among many commentators that this assertion is doctrinally flawed (Lutter/Hommelhoff/Bayer, Section 55 para. 33; MüKoGmbHG/Lieder, Section 55 para. 206; Rowedder/Pentz/Schnorbus, Section 55 para. 61; Scholz/Priester/Tebben, Section 55 para. 117; NSH/Servatius, Section 55 para. 40).
In light of the current divergence of perspectives, it would be reasonable, from a legal standpoint, to undertake a (precautionary) notarization of the convertible loan agreement and the certification of the relevant powers of attorney. Conversely, the practice of venture capital transactions frequently neglected the implementation of a preventive notarization process. Additionally, there existed legal frameworks that enabled the circumvention of the obligation to notarize in a legitimate manner. In negotiations, investors and business angels frequently tended to overlook the significance of the specific case details in relation to the crucial matter of the formal validity of the convertible loan agreement.
III. Are the formal issues to be reassessed in light of the case law of Zweibrücken Higher Regional Court?
A reconsideration has been underway since May 2022 regarding this matter, prompted by the decision, note yet final, of Zweibrücken Higher Regional Court (Case 8 U 30/19). The ruling itself holds significant importance, particularly for individuals serving as founding general managers. An insolvency administrator had filed legal action against the former general managers on the grounds of liability claims resulting from a failure to file for insolvency in a timely manner, thereby breaching their duty. As per the liability regime outlined in insolvency law, it can be inferred that the general managers bear unrestricted personal liability. The insolvency administrator predicated the requirement to initiate insolvency proceedings in advance on a convertible loan agreement that was deemed null and void due to its non-notarization. As per the Higher Regional Court’s ruling, the lender possessed an implicit right to demand repayment under the null and void convertible loan agreement from the moment of its execution, thereby resulting in the individual liability of the general managers.
The primary tenets of the ruling that pertain to the formal matter of the case are outlined as follows:
“In the event of a convertible loan agreement entered into with a German limited liability company that provides for a binding conversion obligation in certain cases at the lender’s expense in accordance with a predetermined ratio, the signature of the transferee shall require notarization in accordance with Section 55(1) Limited Liability Companies Act where such transferee is not a member of the company.”
“Where a convertible loan agreement with a unilateral conversion option for the borrower provides for a capital increase that is binding on the company and that amends the Articles of Association in the event that such conversion right is exercised, a duty to notarize the underlying shareholder resolution may be deemed appropriate pursuant to Section 53(2) Limited Liability Companies Act.”
The Higher Regional Court’s decision has resulted in a multitude of comments within the legal commentary and VC practice, including investors and business angels. For certain market participants, it has even led to a shift in their practices, with some opting to notarize convertible loan agreements as a precautionary measure
1. (Analogous) application of Section 55 Limited Liability Companies Act?
The primary assertion of the ruling pertains to a scenario that has previously necessitated the participation of a notary, as per the prevailing view, including by Zweibrücken Higher Regional Court, citing BeckOK GmbHG/Ziemons, 51st ed. as amended on December 01, 2021, Section 55 para. 100; Saenger/Inhester, GmbHG 4th ed. Section 55 para. 48; Krampen/Lietzke, RNotZ 2017, 20, 23, and lawyers’ precautionary evaluation. Specifically, this pertains to instances where a third party outside the company provides a loan while simultaneously imposing a conversion obligation.
The act of a lender committing to assume shares in a forthcoming capital increase carries with it the requirement for a notarized assumption declaration as stipulated in Section 55(1) Limited Liability Companies Act. In light of this, Zweibrücken Higher Regional Court inferred that the convertible loan agreement, which contains similar provisions, must also adhere to notarization requirements in accordance with the principles governing the extension of formal requirements to preliminary agreements. Ultimately, the court fails to establish a definitive differentiation between the necessity of notarization, as indicated in the grounds for the ruling, and the adequacy of certification, as indicated in the secondary headnote.
Zweibrücken Higher Regional Court bases its grounds, among other things, on a decision of Munich Higher Regional Court (23 U 5121/04, NZG 2005, 756). The court’s interpretation of this verdict differs significantly from the views expressed in a substantial portion of the literature.
Munich Higher Regional Court first states that the “formal requirement of Section 55(I) Limited Liability Companies Act [...] [does not have] a warning function for the transferee, but [...] [is intended to] inform the public about the capital basis of the company, to protect legal transactions, creditors, and future shareholders. These purposes [are] not relevant for a preliminary agreement between the shareholders. Therefore, the notion that the obligation to an assumption under Section 55(I) also requires compliance with formal legal requirements [is] not to be followed.”
Upon analyzing this excerpt from Munich Higher Regional Court’s ruling in isolation and in accordance with the formal legal requirement of Section 55(1) Limited Liability Companies Act, scholars and commentators, including those who analyzed Zweibrücken Higher Regional Court’s decision, have dogmatically and definitively determined that a formal stipulation regarding the responsibility to acquire shares cannot be derived from Section 55(1) Limited Liability Companies Act (analogously).
This fails, however, to take into account the further considerations of Munich Higher Regional Court, according to which “in the event of the accession of a new shareholder, [...] a parallelism with the formation phase is obvious.” In the constellation decided by Munich Higher Regional Court, such a case did not exist, which is why Munich Higher Regional Court further states that “[i]n the event of contracts between persons who are already shareholders of the limited liability company [...] similar to voting agreements - including those relating to intended amendments to the Articles of Association - a reason for compliance with a specific form is not apparent.” Munich Higher Regional Court leaves open – and this is probably also how Zweibrücken Higher Regional Court interprets the decision – the issue of whether (analogous) application of Section 55(1) Limited Liability Companies Act is also ruled out where a third party outside the company undertakes to assume shares.
This assertion is supported by persuasive sources in literature that contradict the decision of Zweibrücken Higher Regional Court (cf., for instance, MüKoGmbHG/Lieder, Section 55 para. 206). Thus, it can be inferred that the provision of Section 55(1) Limited Liability Companies Act does not aim to offer personal safeguard in terms of a cooling-off period, even where the entity is acting as an external third party. Moreover, it should be noted that the standard does not serve as a cautionary measure, especially since certification, which is deemed satisfactory under Section 55(1) Limited Liability Companies Act, does not necessitate notarial guidance and counsel. As per its intended function, Section 55(1) Limited Liability Companies Act solely functions to provide information to the general public.
2. Is there a need for notarization under Section 53(2) Limited Liability Companies Act?
Moreover, Zweibrücken Higher Regional Court, while not pertinent to the ruling, addresses the question of whether the convertible loan agreement at issue should have been notarized in accordance with Section 53(2) sentence 1 Limited Liability Companies Act. This is due to the fact that the company, in turn, committed to issuing fresh shares to the convertible lender, thereby agreeing to a conversion right of the convertible lender. Zweibrücken Higher Regional Court presumes a modification to the Articles of Association that necessitates notarization in accordance with Section 53(2) sentence 1 Limited Liability Companies Act.
It can be rightly argued that the notarization requirement would only have an impact on the convertible loan agreement if all shareholders were involved in the agreement and if the agreement included a shareholders’ resolution, as opposed to the scenario evaluated by Zweibrücken Higher Regional Court. In the scenario where a convertible loan agreement is solely between the company and the lender, the need for notarization would primarily pertain to the authorization resolution of the shareholders. This resolution is indisputably necessary for management to finalize the convertible loan agreement. As per the prevailing view, if the convertible loan agreement is drafted appropriately, the responsibility of the shareholders involved in executing the capital increase would not be considered an expected shareholders’ decision. Instead, it would be considered a simple voting agreement, which, as also per Munich Higher Regional Court, can be established without any formalities.
Zweibrücken Higher Regional Court’s stance appears to deviate from the predominant perspective in various areas, despite the court’s citation indicating a desire to align with said perspective. The evaluation of the requirement for notarization in the context of a simple conversion right seems to contradict both customary contractual practice and the prevailing view.
3. Consequence: Convertible loan agreement rendered null and void?
Zweibrücken Higher Regional Court drew a consequential inference from the presumed formal ineffectiveness of convertible loan agreements, which provides a decisive reason for their notarization as a precautionary measure until clarification by the Federal Court of Justice is ultimately provided. Zweibrücken Higher Regional Court applied Section 139 Civil Code, resulting in the full and complete invalidity of the convertible loan agreement. This is in spite of the maintenance clause that is associated with the decision, which is justified by the favorable interest rate that is frequently observed with convertible loans. The convertible loan agreement is indivisible and cannot be fragmented into distinct autonomous agreements or contractual provisions. The loan agreement’s invalidity in accordance with Section 139 Civil Code has a comprehensive impact on the entire agreement. This is because the loan agreement, which offers a favorable interest rate of 2.5%, cannot be viewed in isolation from the conversion provision for the lenders. Consequently, the presumption of invalidity under Section 139 of the Civil Code is applicable.
The viability of this outcome is uncertain when considering the jurisprudence of the Federal Court of Justice. In a legal case with similar circumstances and a challenge under Section 133(1) sentence 1 Insolvency Code, the Federal Court of Justice issued a ruling in February of last year (IX ZR 250/20, NZI 2022, 425), which stated that the determination of insolvency was not obligatory in situations where ineffective convertible loan agreements and their accompanying subordination agreements resulted in an obligation to repay at any time. The legal issue relating to the convertible loan agreement’s lack of validity on account of formal deficiencies had not yet been conclusively resolved by the highest court in the land.
IV. Further questions of form
It is widely accepted among legal experts, in addition to Zweibrücken Higher Regional Court, that a preliminary agreement which includes a requirement for a new shareholder to join an existing or future shareholders’ agreement must be notarized. This is particularly true if the shareholders’ agreement includes provisions that mandate the transfer of shares, such as a drag along clause. It should be noted that this notarization requirement goes beyond the standard notarization mandated by Section 15(4) Limited Liability Companies Act. As previously indicated, it is advisable to adhere to the requirement of entering into a shareholders’ agreement that encompasses adequate regulatory comprehensiveness, and subsequently, notarizing the convertible loan agreement.
The question of whether a lender’s conversion right may be exercised without an accession obligation to a shareholders’ agreement remains unresolved. It is likely that Zweibrücken Higher Regional Court would invoke Section 53(2) Limited Liability Companies Act in this scenario. This is due to the fact that the company has committed to issuing new shares upon the lender’s exercise of the conversion right, thereby incurring an obligation to undergo notarization.
Given the uncertainties consolidated by Zweibrücken Higher Regional Court, it is advisable to notarize the convertible loan agreement as a precautionary measure, despite the fact that such agreements are not required to be notarized based on the aforementioned principles. This measure should be taken until clarification is provided by the Federal Court of Justice. As per the prevailing notarial convention, it is advisable to notarize the lender’s power of attorney for executing the convertible loan agreement as a precautionary measure, in light of Zweibrücken Higher Regional Court’s ruling.
In consideration of the potential liability risks faced by the founding general managers, it is commonly recommended that a notarization of the convertible loan agreement be prioritized over a notarization of the signatures on said agreement. This is due to the lack of foreseeable legal precedent on the matter.
It is desirable that the Federal Court of Justice provides a definitive resolution to the issues of form and overall invalidity in relation to the ongoing appeal proceedings concerning the ruling of Zweibrücken Higher Regional Court (BGH II ZR 69/22) for pragmatic reasons.