Simon Landuyt

A Capital Question. Should Shareholder Loans Be Automatically Subordinated

WP 2018-03

Whether or not shareholder loans should be automatically subordinated in bankruptcy is a much discussed topic in corporate and insolvency law. In this article I show that, because of the existence of non-adjusting creditors, shareholder-managers will sometimes have the incentive to take excessive risk. The subordination of shareholder loans forces the shareholder to internalize these costs. On the other hand, subordination of shareholder loans might also deter the undertaking of desirable projects. On balance, it is likely that subordination is efficient and reduces the agency cost of debt. Furthermore, I will show that shareholders should bear more risk because they are better monitors, do not suffer from information asymmetries and have higher expectations of default. Therefore, if shareholders and outside creditors could hypothetically bargain ex ante in a world without transaction costs on the rank of their debt claim, there is not much doubt that they would agree on subordination. Proving that subordination of shareholder loans is inefficient would imply that the subordinated position of equity is inefficient and further shake the concept of legal capital on its foundations.