Review of Compulsory Subordination of Shareholder Loans and the Current Structure of Turkish Law
There are various financing choices available for companies to enable the building of a healthy and efficient capital structure that will suit and serve them the best. However, the capital structure of a company is not only of utmost importance for the company itself but also for other corporate constituencies and even for the real economy (Berk & DeMarzo, 2017). Therefore, financing tools and capital structures have been studied widely and become subject to a variety of rules and restrictions. One of these financing tools comes in the form of a shareholder loan. Shareholder loans and rules on their subordination are one of the interesting yet controversial issues that reflect the concerns regarding the capital structure both from legal and corporate finance perspectives.
Shareholder loans are provided to the company by its shareholders as debt and not as equity. There are various reasons as to why a shareholder may choose to finance the company through a loan, such as opting for a lower risk than the equity investment, obtaining higher returns through interest payments, or enabling the company to obtain tax benefits. However, as stated above shareholder loans attracted some criticism on whether such loans shall be treated any different than outside debt including its compulsory subordination. The basic idea of the compulsory subordination doctrine is to lower the ranking of shareholder loans below the claims of the outside creditors of the company or to treat it as an equity contribution in case of insolvency. Therefore, compulsory subordination excludes shareholders from equal participation in insolvency with outside creditors of the company. In addition to subordination, compulsory subordination as applied in some jurisdictions provides for restrictions on repayment of the loans and security rights (Verse, 2008).
Compulsory subordination has been studied through both legal and economic analysis by its proponents and opponents. The main arguments on compulsory subordination come from corporate law, insolvency law, and economic perspectives and there is no widely accepted conclusion on the debate. The discussion on compulsory subordination failed to draw enough attention in some countries, whereas in some other countries such as Germany and the US, compulsory subordination gained more support and ended ultimately with its codification. The implementation of compulsory subordination under those jurisdictions differs in terms of the treatments and restrictions as to apply subordination. Some countries, including Turkey and Switzerland however, have discussed subordination and drafted legal rules to this effect but have failed to achieve codification (Türk, 2016).
Besides compulsory subordination, in practice, there are other forms and means of subordination of shareholder loans.Subordination of a claim against a company including those over shareholder loans may take place through a contractual or structural subordination. Contractual subordination of shareholder loans is often included in security packages when a company obtains debt financing. Further, parties enter into assignment or transfer of receivables agreements along with subordination agreements with subordinated creditors in order to provide a stronger position during bankruptcy proceedings.
Under the following sections, legal arguments and rules under different jurisdictions of the compulsory subordination of shareholder loans will be reviewed. After this brief analysis, a general overview of Turkish law in relation to compulsory subordination doctrine will be presented, and the final section will provide for the conclusion.
II. The Overview of Legal Rationale and Different Implementations of Compulsory Subordination
The legal justification in favor of compulsory subordination is derived from the aspects of both corporate law and insolvency law. Corporate law arguments are mainly associated with the principles related to capital requirements, limited liability, and the nature of shareholders as residual claimants. On the other hand, insolvency law arguments are mainly based on the principles for the preservation of going-concern value and fair distribution within creditors. The basis of main legal arguments under corporate and insolvency law and examples of different implementations are briefly reviewed below.
- Corporate Law Perspective
Shareholders, as the owners of a company, provide risk-bearing capital that wipes out first when the company is in financial distress but increases in the upside scenario. This explains the control power and ownership rights granted to shareholders (de Weijs, 2018), almost as if awarded in return to their risk-bearing capital investment. On the other hand, creditors, that are not the owners of the company and lack control over the company, require creditor protection to have their claims protected against shareholders and shareholders’ personal creditors to withdraw or destruct company assets securing creditors’ claims (Armour, Hansmann, Kraakman, & Pargendler, 2017). It is at this point where the main corporate law argument in favor of the subordination of shareholder loans appears. Since shareholders, through providing loans that are not subordinated, become creditors of the company with a fixed claim, it may lead shareholders to avoid providing risk-bearing capital and to back their fixed claims by company assets while still maintaining control over the company, having access to information over the company and minimizing their downside risk (Skeel & Krause-Vilmar, 2006). Therefore, it is argued that compulsory subordination of shareholder loans is necessary to maintain limited liability, to make shareholders bear the financial consequences of their decisions, to reduce the scope of value-decreasing opportunism, and therefore to sustain effective creditor protection. Against the compulsory subordination argument, it is argued that shareholder creditors should rank as any other creditor since the money provided by them is as “green” as other people’s money (de Weijs, 2018).
In many (if not all) jurisdictions, shareholders, as residual claimants, can only receive payments in insolvency after all other creditors are paid since shareholders rank at the bottom for equity claims in insolvency liquidation. However, shareholder loans without subordination enable shareholder-creditors to rank the same with outside creditors in insolvency and their participation dilutes the assets available for outside creditors. Therefore, it is argued that the rules provided by insolvency law such as avoidance or restriction on dividend payments, become inoperative in the absence of compulsory subordination also with an opportunity of claiming repayments from outside creditors through transaction avoidance to have them make payments to shareholders (de Weijs, 2018). The benefits that can be created by shareholder loans and securities provided to shareholders, are therefore argued to be conflicting with the insolvency law principles and it is argued that it may be used as a tool to circumvent the insolvency law principles, and to unfairly favor shareholders.
On the other hand, preventing viable businesses from liquidation through facilitating improved reorganization and rescue opportunities is also an important aspect of insolvency law. Gelter found out that subordination rules may prevent efficient rescue attempts (socially desirable as defined by Gelter) under certain circumstances (Gelter, 2006).This creates the basis for both insolvency law and economic analyses against compulsory subordination. Thus, against compulsory subordination, it is mainly argued that such unfavorable treatment of shareholder loans shall hinder a shareholder’s incentive for rescue finance and therefore prevent efficient rescue attempts leading to unnecessary liquidation of viable businesses. Consequently, it is argued that compulsory subordination, contrary to the argument that seems to favor them, would harm creditors and therefore would not comply with insolvency law principles (de Weijs & Good, 2015).
Some jurisdictions, such as the United States, Germany, Australia, Italy, and Spain, provide for the compulsory subordination of shareholder loans and restrictions on its repayment and security interests whereas some jurisdictions have no rules to subordinate such loans and permit secured shareholder loans such as the United Kingdom and France. In between these two opposite positions, some jurisdictions, such as Switzerland and the Netherlands, apply the compulsory subordination doctrine through their courts in certain circumstances even though their legislative framework does not provide an explicit rule for such (Orval, 2011; Rohde & Spillmann, 2016). This form of treatment ranges from automatic subordination to much more limited subordination of only some shareholder loans under certain circumstances. The applicable rules of the United States and Germany are examined below in brief detail to paint a better picture.
Compulsory subordination doctrine takes two forms under US law, (i) equitable subordination, and (ii) recharacterization (Wheaton, 2015). Recharacterization aims to identify the funds provided by insiders, including shareholders, to the company as equity or debt by questioning whether a legitimate and valid debt exists or not. It deals with whether the funds were provided as capital contribution, questioning whether the status of funds is ambiguous, or whether it is well-documented or not. As to the function of recharacterization, shareholder loans are not subordinated to claims of outside creditors but are treated as equity. Equitable subordination, on the other hand, deals with whether a legitimate creditor including shareholder-creditors has acted inequitably or not (Skeel & Krause-Vilmar, 2006). As a result, a claim of a creditor or a shareholder can be subordinated by the court if creditor acted inequitably. It is also possible to see both the recharacterization and the equitable subordination doctrines to be applied in unison (Scheler et al., 2006).
German law provides one of the most comprehensive treatments on compulsory subordination. Current provisions under German insolvency law provides for the automatic subordination of almost all shareholder loans regardless of whether it is provided or not withdrawn during a financial crisis as opposed to the pre-2008 structure of compulsory subordination under German Law (Verse, 2008). Few exemptions under German law are provided for the loans extended by the shareholders that do not have control in the company and the outside investors who obtained shares in the company as a rescue attempt (Verse, 2008). Two other aspects of German compulsory subordination are the restrictions on the repayment of shareholder loans and the security interests thereof, which is not the case in the US.
III. The Current Structure under Turkish Law
Turkish corporate law and insolvency law do not include compulsory subordination and specific provisions on restrictions on repayment of shareholder loans or secured shareholder loans. Without prejudice to other provisions (such as those specific to the misconduct of board members or affiliated companies), loans provided by shareholders are not treated differently under Turkish corporate laws. Similarly, Turkish insolvency laws do not treat such loans differentlythan other claims. If the shareholder loan is secured, shareholders will have the right to enforce their security interests just like other secured creditors and if it is not secured they will rank pari passu with other junior creditors without any restriction in insolvency proceedings.
In Turkish practice, the subordination of shareholder loans or restrictions on payment and providing security interests for such loans can be established through either contractual arrangements with creditors, structural subordination within group companies, or voluntary subordination under Article 376/3 of the Turkish Commercial Code No. 6102 (the“TCC”). Even though voluntary subordination under Article 376/3 benefits all third parties, it cannot be a substitute for compulsory subordination since it is voluntary but not compulsory that depends on the will of creditors and is in use of any creditor. Similarly, contractual subordination cannot reach the same outcome as compulsory subordination since it only applies to the contracting party and for the loans specified in the contract (Somay, 2018; Zenginpedük & Gürsel, 2019).
- Turkish Corporate Law
TCC was passed in 2011 replacing the previous Commercial Code No. 6762. Two of the new concepts introduced by the TCC were voluntary subordination of creditors’ claims for joint stock companies under Article 376/3 and compulsory subordination of claims of shareholders and relevant parties for limited liability companies under Article 615. However, while voluntary subordination under Article 376/3 is still in force, compulsory subordination under Article 615 never came into effect, being ultimately abolished by the Law No. 6335 enacted days before TCC’s coming into effect (Tekinalp, 2013). The Law No. 6335 did not provide any reason for the revocation of the compulsory subordination rule.
Both of these provisions were inspired by the discussions of Swiss Corporate Law reform and existing rules of German laws (The Grand National Assembly of Turkey, 2008). As per Article 376, in case the company is insolvent, the board of directors has an obligation to notify the court and file for insolvency. The same article provides for an exception to the obligation of the board of directors to file for insolvency through voluntary subordination system in case a creditor or creditors of the company (that could also be shareholder-creditor) subordinate their existing claims to those of all other creditors by a written agreement to the extent that subordinated claims cover the insufficient amount to recover insolvency. Subordination through Article 376/3 can be useful to create a way out from bankruptcy and ease the procedure due to its erga omnes character if creditors, whether shareholders or not, prefer to subordinate their claims. However, it is obvious that voluntary subordination under Article 376/3 is not equivalent to compulsory subordination of shareholder loans and therefore is not a substitute to the compulsory subordination doctrine.
The revoked Article 615 provided for the compulsory subordination of both shareholder loans and loans provided by persons close to shareholders in case (i) those loans are provided when the assets of the company do not cover the registered capital and required legal reserves or (ii) when such loans are provided when the shareholders or persons close to shareholders would be expected to provide equity capital due to financial situation of the company. Article 615 also required the return of the repayment of the loans if such repayments took place within one year before the bankruptcy took place.
Although voluntary and compulsory subordination rules provided under the TCC have common grounds, the rules were codified as to differ substantially from each other. The compulsory subordination rule for limited liability companies, as opposed to voluntary subordination for joint stock companies, mandated automatic subordination of all loans provided by certain parties that are either shareholders or persons close to shareholders and also obliged such parties to return the repayments taking place within a certain time frame. The preamble does not provide the reason for setting different regulations for limited liability companies and joint stock companies. However, scholars, similar to German literature and court decisions, concluded that Article 615 should have applied to joint stock companies based on the legal reasoning of the provision if it had not been revoked (Kayar, 2012). Nevertheless, Article 376/3 applies to limited liability companies through the general provision under Article 633.
While the introduction of compulsory subordination doctrine was supported by some scholars, it was argued that the revoked provision was very problematic and could have led to unintended and counterintuitive impacts if it was kept as is (Türk, 2016). The scope of parties was not defined well and the ambiguity regarding the financial crisis of a company would most probably create various conflicts and consume substantial time and effort of Turkish courts that already had an excessive workload. TCC’s amendment by the Law No 6335 was a result of widespread criticism that the TCC introduces very strict rules that may affect the existing structure of Turkish companies and harm the market.Therefore, a reason for its annulment could also be the economic situation of Turkey in 2012 and the intention not to cause any disincentive for shareholders to invest in companies back then when it was needed.
Turkish insolvency law aims for the protection of assets of the corporate pool and fair distribution within creditors with the highest payoff possible in proportion, out of the debtor’s assets. The Enforcement and Bankruptcy Code No. 2004 (the “EBC”) is designed to include mechanisms to ensure the protection of the rights and interests of creditors prior to and during insolvency. It may be argued that Turkish legislators’ concerns regarding insolvency law and recent amendments to insolvency law are in line with the insolvency law arguments of compulsory subordination including providing efficient creditor protection, fair distribution, and effective participation. However, insolvency law and therefore Turkish insolvency legislation also aims to facilitate rescue attempts when efficient and to protect unnecessary liquidation of viable businesses to sustain higher liquidation value through timely and efficient liquidation. In case compulsory subordination is found to eliminate efficient rescue finance opportunities, it may lead to an undesirable result that would conflict with the insolvency principles, harm creditors and real economy. In line with this theory, compulsory subordination may also be argued to conflict with Turkish insolvency law principles. Nevertheless, as stated above, Turkish insolvency law under current legislation does not treat such loans any different than claims of outside creditors.
The doctrine of compulsory subordination of shareholder loans is a multifaceted subject that attracts both legal and economic review. Arguments in favor of and against subordination provide well-founded aspects from law and corporate finance. Therefore, while some jurisdictions such as Germany embraced the comprehensive stance of automatic subordination, some jurisdictions neglect to uphold such rules.
Turkish law is one of the jurisdictions that does not provide for the compulsory subordination rule for shareholder loans. As stated above, a compulsory subordination rule under Article 615 of the TCC was structured only for limited liability companies, it was revoked even before the law entered into force in Turkey. With that being said, subordination of shareholder loans may take place through voluntary subordination procedure as per Article 376/3 of the TCC. Alternatively, companies may create structural subordination within group companies or creditors may resort to subordination and assignment of shareholder loans receivables through contractual arrangements especially when outside creditors are engaged in financing. Nevertheless, the use of shareholder loans in Turkish practice, like any other jurisdiction, requires a detailed review of Turkish corporate law, tax law, and insolvency law besides the financial analysis. For example, shareholder loans that are not compliant with market conditions will be subject to different accounting treatments. Similarly, such loans require special attention in order not to lead a claim in relation to the misconduct of board members or affiliated companies.
In fact, it is not only limited to Turkish jurisdiction, but each jurisdiction requires a careful review of the relevant laws and corporate practices as to understand the advantages and consequences to finance a company through shareholder loans. While it may be the best financing option for a company, its shareholders or even for other corporate constituencies under a certain jurisdiction, it may bring further issues under another jurisdiction. For example, a shareholder may end up being placed at a lower ranking and lose its security interests in case a compulsory subordination is applicable under the relevant jurisdiction. Likewise, creditors may encounter dilutive effect on their recoveries if the debtor is financed by shareholder loans in case such loans are not subordinated. Accordingly, conditions surrounding and terms governing shareholder loans should be carefully reviewed before and during shareholder loans are extended. January, 2021.
“Bu makale, makalenin yazım tarihi itibarıyla yürürlükte olan mevzuat dikkate alınarak Yazıcı Avukatlık Ortaklığı tarafından hazırlanmıştır. Her bir olaydaki maddi vakalar ve olay özellikleri ile bunların uygulama ve sonuçları farklı olacağından, bu makale yalnızca bilgilendirme amaçlı olarak hazırlanmış olup, bir hukuki görüş veya öneri teşkil etmez ve bu şekilde yorumlanamaz.”
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 Since shareholder loans, due to its debt character, ideally provide a fixed return and interest payments, and such interests payments can be deducted from the taxable income of the company creating a tax shield (Berk & DeMarzo, 2017).
 Even though professional/strong creditors such as banks or other financial institutions may have a great deal of control over the debtor company, ordinary creditors such as trade creditors or small suppliers cannot obtain such a control and adjust their claims. With that said, efficient contractual protection by either professional creditors or individual creditors with relatively small claims, requires creditors to monitor the company efficiently which may pose higher monitoring costs than expected losses. The observations show that debt covenants are under enforced (Squire, 2010).
 In case the face value of debt and the premium are not adjusted well and therefore cannot offset the dilutive effect on creditors’ recoveries, debt dilution and the transfer of wealth increases. In other words, if the shareholder loan is provided with unfair terms, it provides new assets that is lower than the face value of the debt. Therefore, the new assets (being the cash received) cannot neutralize the dilutive effect of the debt on especially for the unsecured creditors (Squire, 2010).
 It should be noted that it is debatable how a rescue attempt can become actually socially desirable or whether it is unrivalled and it should be carefully analyzed separately when a firm is illiquid and when it is insolvent. Therefore, it it requires a great deal of financial analysis to determine whether a rescue attempt was a socially desirable one for a now-bankrupt company together with hindsight bias (Landuyt, 2018).
 The risk to prevent voluntary financing and especially rescue attempts by shareholders was the prevailing argument of the Swiss discussion on subordination rules when the compulsory subordination provision was removed from the draft Swiss corporate law (The Grand National Assembly of Turkey, 2008).
 Subordination can take place through a contractual, structural or equitable subordination. The doctrine reviewed here is equitable subordination.
 The current law resembles the Spanish law on shareholder loans where subordination does not require the crisis or under capitalization of a company (Lutter, 2006). Please also note that German subordination rules, later, become subject to amendments due to the concerns related to the risk of and to mitigate the unforeseeable financial consequences of the COVID-19 pandemic for a limited period.
 US law does not provide for specific rules on repayment of shareholder loans or its security interests. Both the repayment and security interests are dealt with general provisions of preferences and fraudulent transfers (Verse, 2008). With that said, secured shareholder loans may constitute a factor to conclude that the shareholder acted inequitably (de Weijs & Good, 2015).
 Article 376/3 appplies to claims of all creditors of a company therefore this provision enables not only shareholders but also outside creditors of the company to subordinate their claims subject to their will.
 Therefore, subordination will not be enforced by liquidators and such claims will rank with the claims of other unsecured creditors. To provide the same outcome with subordination, parties may enter into assignment or transfer of receivables agreement along with subordination agreement with subordinated creditors.
 Introduction of compulsory subordination of loan capital was discussed during the revisions to Swiss Law of Obligations in 2000 and a draft provision was included under Article 807c of the premilinary draft. However the provision was not included to the law following the discussions(Kayar, 2012).
 As per Article 376, the board of directors must still notify the court of the insolvency and subsequent subordination since the court may still rule for insolvency based on its review of the subordination and the relevant agreement in terms of its validity, authenticity and expediency. Although the preamble of the law refers it as a provision to provide an alternative solution to litigation when the firm is insolvent and states that the board of directors shall apply to the court unless some of the company’s creditors agree to subordinate their claims to those of the company’s other creditors, the wording of the article requires the board to apply to the court for its review.
 The wording of Article 615 states “loans provided by shareholders or persons close to shareholder” however does not define who would be considered as close to shareholders. The ambiguity of such a definition was criticized by scholars.
 The preamble of the TCL states that the introduction of the compulsory subordination rule aims to strengthen the capital buffer of company and refers to voluntary subordination provision as a similar concept. Despite the common grounds that both provision share, the preamble of Article 376 focused on solely saving the viable enterprises from bankruptcy whereas Article 615 was aiming also to provide fairness, prevent expropriation and strengthen the equity position. Finally, the discussion under the preamble emphasizes the strong equity capital and shareholder support for enhancing Turkish market (The Grand National Assembly of Turkey, 2008).
 Article 633 of TCL states that provisions of joint stock companies regarding insolvency and loss of registered capital shall apply mutadis mutandis to limited liability companies.
 Ceker states that Article 615 was annulled due to some complaints, without providing further details (Çeker, 2012).