Inside Debt Financing

Front matter

Alessandro Pomelli

Inside Debt Financing

Theory, Practice, and Regulatory Approaches

PART II PATTERNS OF INSIDE DEBT FINANCING A. Widely-Held Firms and Closely-Held Firms

B. Dominance of Inside Debt Financing over Inside Equity Financing in Closely-Held Firms

. Small, Privately-Owned Firms . Groups of Companies . Leveraged Transactions

Legal versus Contractual Subordination of Inside Debt Financing ammo

. Strategic Interests against Contractual Subordination of Inside Debt Financing

Part III Shareholders’ Incentives And Appetite For Risk

A. Shareholders’ Incentive Structure when a Firm Is Fully Equity-Financed

B. Shareholders’ Incentive Structure when a Levered Firm Is Fully Solvent

C. Shareholders’ Incentive Structure when a Levered Firm Is in the Vicinity of Insolvency

D. Shareholders’ Incentive Structure when a Levered Firm Is Insolvent pas.

PART IV DESIRABILITY OF INSIDE DEBT FINANCING UPON A FIRM’S SOLVENCY, PRE-INSOLVENCY AND INSOLVENCY pag. 75 A. The Impact of Unsecured Inside Debt Financing

on Capital Structure, Insider Incentives and Creditor Interests

when a Firm Is Fully Solvent » 75 B. The Impact of Unsecured Inside Debt Financing

on Capital Structure, Insider Incentives and Creditor Interests

when a Firm Is in the Vicinity of Insolvency > 79 C. The Impact of Unsecured Inside Debt Financing

on Capital Structure, Insider Incentives and Creditor Interests

when a Firm Is Insolvent »> 85 D. The Impact of Secured Inside Debt Financing

on Capital Structure, Insider Incentives and Creditor Interests » 87

Part V Regulatory Approaches

TO INSIDE DEBT FINANCING > 94 A. The No-Subordination Regulatory Approach > 96 1. Core Features of the No-Subordination Approach > 96

2. Advantages and Disadvantages of the No-Subordination Approach > 100 B. The Equitable Subordination Regulatory Approach > 104 1. Core Features of the Equitable Subordination Approach » 104

2. Advantages and Disadvantages of the Equitable Subordination Approach » 117 C. The Automatic Subordination Regulatory Approach » 119 1. Core Features of the Automatic Subordination Approach » 120

2. Advantages and Disadvantages of the Automatic Subordination Approach » 123 D. The Avoidable Preference Rules » 127

Part VI Determinants Of An Efficient And Fair

REGULATORY INTERVENTION ON INSIDE DEBT FINANCING » 133 A. Efficiency and Fairness Objectives » 134 B. Optimal Rules on Unsecured Inside Debt Financing » 135

1. Superiority of Automatic Subordination to both No-Subordination and Equitable Subordination when Inside Debt Financing Is Provided to a Fully Solvent Firm » 136 8

2. Superiority of No-Subordination to both Automatic Subordination and Equitable Subordination when Inside Debt Financing Is Provided to a Firm in the Vicinity of Insolvency

3. Superiority of No-Subordination to both Automatic Subordination and Equitable Subordination when Inside Debt Financing Is Provided to an Insolvent Firm

. Optimal Rules on Secured Inside Debt Financing . Subordination, No-Subordination and the Absolute Priority Rule . Subordination, No-Subordination and the Relative Priority Rule

ASC)

Subordination, No-Subordination and Debtor-in-Possession Financing

G. Optimal Avoidable Preference Rules

H. The Notion of Insider for Purposes of Subordination of Inside Debt Financing and Avoidance of Preferences

PART VII A NOVEL TIME-PHASED, INFORMATION-FORCING SUBORDINATION APPROACH TO INSIDE DEBT FINANCING AND THE ACCOMPANYING AVOIDABLE PREFERENCE RULES

A. The Contours of a Time-Phased, Information-Forcing Subordination Approach

B. The Treatment To Be Reserved for Secured Inside Debt Financing

C. The Avoidable Preference Rules Needed in Support of a Time-Phased, Information-Forcing Subordination Approach

D. The Benefits of a Time-Phased, Information-Forcing Subordination Approach

E. The Costs of a Time-Phased, Information-Forcing Subordination Approach

F. Comparing This Novel Approach with Alternative Solutions CONCLUSION

REFERENCES

147 149 152 154

156 157

161 166

173 178

LA COLLANA

Ubi societas, ibi jus. Questo antico adagio romano dimostra oggi tutta la sua validita nell’indicarci quanto sia cruciale, per la scienza e per l’agire pratico, collegare fra loro i cambiamenti sociali studiati dalla sociologia e il diritto che cerca di dare loro una regolazione normativa. I contatti e l'influenza reciproca tra diritto e sociologia stanno crescendo di continuo ed i docenti dell’una come dell’altra disciplina sono scientificamente persuasi della loro scelta. L’auspicio è che il dipartimento di sociologia e diritto dell'economia possa esercitare un influsso non trascurabile su alcuni campi della ricerca e della riflessione scientifica di settore, talora soddisfatti del loro status quo (con un atteggiamento spesso isolazionista), talora troppo ancorati alla distinzione tra conoscenza dei principi astratti e conoscenza e fruizione dei fatti e delle pratiche sociali. Già da tempo sono emerse connessioni e mediazioni tra principi e realtà in una proficua reciproca fertilizzazione che è il contrassegno essenziale della posizione culturale del dipartimento; vale a dire una concezione della conoscenza che non è puro e semplice rispecchiamento di una realtà statica fuori ed indipendentemente dall’uomo-cittadino ma attività, non solo teorica, essa stessa aspetto della realtà in trasformazione. È così che la conoscenza dei nessi reali, nella dialettica fra le diverse forze umane e le forme di società, assume una sua dignità autonoma, caratteristica del dipartimento. Contro ogni assolutizzazione del metodo di ogni scienza particolare, contro ogni restrizione degli orizzonti e l’impoverimento contenutistico di certa scienza ufficiale. Ciò non toglie che il diritto e la sociologia possano rivendicare la diversità dei metodi di indagine e degli strumenti conoscitivi propri ma al contempo comporta che nella sussidiarietà reciproca possano ‘vivere’ all’interno dei contesti socio-economici imprimendo il loro rispettivo impulso.

Entrambi possono estroflettere le proprie forze per riconoscere e concorrere a superare le necessità delle collettività ed i loro impulsi indifferibili. Si pensi ad esempio alle materie di studio come l’autorità e la famiglia, l’ impresa e la società, il lavoro e Peconomia, l'imposizione fiscale e la solidarietà sociale, la società attiva e la società acquiescente, l'industria e l’ambiente con i relativi contrasti, il potere della comunità e quello del singolo, il sistema bancario-creditizio e le relative connessioni.

Oggi sembra stiano per cadere o per lo meno oscillano pericolosamente i presupposti di ogni legge eppure la legge risulta una condizione cronica della società contemporanea, dando luogo a situazioni talora paradossali talora sfuggenti all’interno delle quali l’uomo continua a vivere. Sembra essere messo in discussione il legame della legge con il territorio, ma al contempo il legame ritorna quasi in un moto perpetuo sicché il diritto continua a irradiarsi con ordini, condizionamenti, decisioni mentre la società tenderebbe a sottrarsene o a rovesciarli, perché la legge pretende una sorta di eternità dei principi che la sottendono mentre la società non vorrebbe essere sottratta ai flussi del tempo con intenzioni infuturanti progettuali autonome. È questa una delle tipiche occasioni in cui scienze sociologiche e giuridiche consentono di affrontare ‘insieme’ e contemporaneamente nuovi campi di possibilità costruttive, in una molteplicità ordinata che assicura la non contraddittorietà logica della possibilità della sua costruzione. Il diritto e la sociologia non sono ricavabili uno dall’altra ma possono riscontrarsi coincidenze proficue nell’equilibrio continuo delle procedure di libera scelta, pensando simultaneamente gli apparenti opposti, ordine-arbitrarietà, possibilità-necessità, affermazione-negazione. Costituiscono l’uno l’altrimenti dell’altra e al contempo la prossimità dell’altra al primo, senza mai sentirsi identici, pur integralmente affidati al lavoro di restaurazione degli istituti. Dispersioni e disaggregazioni possono assillarli, essendo entrambi essenza di se stessi, ciò che rende raro equivocarli, ma si influenzano reciprocamente nell’esposizione con cui si fanno conoscere e con cui sono stati.

Entrambi superano l’astratta separazione tra tempo vero e tempo apparente e sono dediti al presente per comprenderlo e sostanziarlo, abbracciando lavita in sé con la chiarezza che ne divide e ne rapporta le diverse dimensioni.

Sono discipline che realizzano ‘il possibile’, oltre ogni errante radice, nell’idea del dover essere della pienezza del presente e quindi entrambe contengono principi universali disincarnati da ogni terra e da ogni luogo, liberi dalla crescente instabilità del termine stesso di Stato.

Gli studiosi del dipartimento conoscono la necessità delle domande e la difficoltà frequente delle risposte, ma il domandare e il rispondere sono per loro elementi di una stessa dimensione e quotidiana abitudine di assumerli come un unico contesto.

Domanda e risposta sono due termini incommensurabili, e gli studiosi del dipartimento lo sanno, perciò sono attenti a non sprofondare nella dimensione della domanda, quando è riconosciuta priva di scopo e perciò inutile, avendo come fine la verità in quanto problema. Così non percorrono vie di fuga, auspicando che la verità prenda forma, se non oggi, un’altra volta, con la pazienza di ottenerla.

È così che il dipartimento di sociologia e diritto dell'economia può essere inteso come labirinto protettivo degli studiosi rivolti al possibile delle risposte, anche se spesso si celano.

Ed è il luogo dell’ascesa di giovani intraprendenti che con le loro intuizioni creano una grande realtà, né impaludata né burocratica, vero riferimento in una globalità sempre più frammentata, in attesa del futuro, con coraggio morale in tempi squilibrati e storti di società subalterne e dilatate.

Sociologia e diritto dell'economia si sono accostate luna all’altro nell’ambito di un nuovo dipartimento per la specifica funzione morale e sociale delle discipline e del ruolo dei loro studiosi. L’idea del ‘compito’ delle due discipline è stata centrale per il loro accostamento; tanto da sembrare strettamente legata e finanche suggerita da un idea morale della società e del sistema giuridico. A questa idea si è affiancata poi la volontà di una intensa attività pubblica e di una altrettanto viva produzione scientifica.

L’accostamento delle due discipline può rappresentare l'opportunità di possibili novità nel metodo o nella attualità delle ricerche che sono gli clementi che intendono caratterizzare la Collana, aperta ai lavori anche di sperimentazione, o nella messa a fuoco del proprium di ogni disciplina, tutti considerati come compito e come responsabilità di ogni studioso. È questa la risposta a studi mistificatori e sedicenti scientifici di alcuni anni passati che enunciavano il crollo di tutti i principi e di tutte le regole. Questa Collana ha una funzione ordinante, regolatrice e costruttiva nel nostro sistema sociale, economico e giuridico, e vuole essere espressione di un sistema di valori economici, giuridici e sociali subito associati al concetto di persona umana senza restringere l’orizzonte scientifico ad una sola epoca storica. È così che le cose possono ‘svelare’ la loro esistenza a chi le interroga seriamente, visitandole più volte, senza tuttavia svelare del tutto da dove vengono.

Risulta chiaro che la Collana contiene due punti di vista, entrambi necessari, nella comprensione della realtà, ma differenti e vuole superare le difficoltà o le perplessità che un loro avvicinamento ha più volte suscitato, soprattutto per la diffidenza di alcuni studiosi, nonostante siano coscienti della ormai imprescindibile natura interdisciplinare della ricerca, che si tratti di interdisciplinarietà interna o esterna; anche perché soltanto così si evita sicuramente che ogni scienza rifletta esclusivamente su se stessa e sul proprio ruolo e non prenda in considerazione riflessi, relazioni, interferenze che non possono non stimolare.

La Collana del dipartimento costituisce perciò il punto d'incontro speculativo tra le culture degli studiosi afferenti alla struttura e ha l'ambizione di avvalorare i loro apporti dediti al ritrovamento del senso vero della realtà; così ad esempio il giurista va oltre i classici confini dell’interpretazione della legge che non ne esauriscono obbligatoriamente il compito scientifico e il sociologo va oltre i confini delle regole sociali vigenti in una certa collettività, analizzandone il senso, le funzioni e le finalità di cambiamento della collettività stessa.

Risulta così che le due discipline, diritto e sociologia, possono affrontare nuovi argomenti tra scienza e politica, sottolineando la centralità del concreto rispetto all’astratto in una concludenza armoniosa.

INTRODUCTION

A regulatory intervention affecting the distribution of legal entitlements, for it to be warranted, must bear the burden of proving that in its absence market forces would fail to allocate the entitlements in a socially desirable way.! A cause of market failure in the efficient allocation of entitlements by private arrangements entered into by market participants is negative externalities, that is, costs imposed on defenceless third parties. Rules and doctrines mandating subordination of the debt raised from a firm’s insiders? to the debt owed outside creditors in a firm’ bankruptcy, which cause insiders’ debt claims to be paid only after outside creditors’ claims have been paid in full, are conceived to remedy distortions in the market for the internal financing of companies and thereby prevent harm to non-insider creditors.

Debt financing from a firm’s insiders is a common source of funding for many firms.’ Insiders routinely provide liquidity to their firm by making

1. A widely accepted idea which traces back to the seminal work of Ronald Coase. See Ronald J. Coase, The Problem of Social Cost, 3 JOURNAL OF Law & ECONOMICS 1 (1960).

2. Unless otherwise specified in the text, by “insiders” I mean controlling shareholders, directors and executive officers.

3. The debt I refer to hereinafter consists of claims originating from the voluntary extension of credit to the firm. The source of such debt claims may be a lending agreement, the purchase of debt securities (bonds, debentures, notes) or a transaction on credit whereby payment to the insider in exchange for goods or services provided to the firm is deferred. Regardless of the transactional form, the substance is that of money consensually advanced to the firm to fund its activities. Therefore, the notion of debt claim herein referred to includes debt claims arising from neither involuntary transactions such as a tort nor voluntary transactions such as the payment to the owner-manager of compensation consisting of firm-issued debt instruments or pension and deferred compensation arrangements. The exclusion of debt from the subordination remedy advocated in this work when originated in connection with compensation arrangements meant for owner-managers does not imply that turning it into subordinated debt would be per se undesirable. The benefits of awarding subordinated debt to executives at banks has already been highlighted by others. See Frederick Tung, Pay for Banker Performance: Structuring Executive Compensation

IS loans. They do so whether the firm is solvent or financially distressed. When the firm is solvent, insiders may extend credit to fund operations and growth opportunities. When the firm is financially troubled, insiders may be willing to provide emergency liquidity in the form of debt in order to avert bankruptcy and finance a turnaround.

Corporate finance and agency theory predict that, once the minimum legal capital requirements applicable to a company, if any,‘ are met, the company’s insiders will prefer inside debt to inside equity to satisfy any further financing needs of the firm. By choosing debt rather than equity the firm owners mitigate their risk of loss in the event of bankruptcy while not compromising the overall expected return on their investments. The insiders’ predilection for debt over equity derives from the order of priorities in insolvency, according to which the estate assets must first be used to pay off liabilities, with equity interests

Jor Risk Regulation, 105 NORTHWESTERN UNIVERSITY Law REVIEW 1205 (2011). The same benefits would admittedly arise if subordinated debt were allocated to executives at nonfinancial firms. In holding subordinated debt whatever the source, management would have a weaker incentive to side with shareholder appetite for excessive risk-taking. The subordinated debt held by management would be first in line to lose value as a result of policies transferring wealth from debtholders to equityholders. While enjoying no equity-like upside from risky business, it would be side-by-side with equity in suffering all the downside. But imposing undifferentiated subordination on all debt instruments awarded as compensation would likely lead management to object to this form of compensation in many instances. And forcing nonfinancial companies, let alone closely-held nonfinancial companies, to compensate management wholly or partly with subordinated debt is unrealistic. On top of these considerations, this book is limits itself to considering debt financing, and debt financing in its conventional meaning occurs when a firm sells debt instruments to obtain inflows of capital on competitive terms to fund its operations or when a firm purchases goods or services on credit to defer cash outlays.

4. The controversial usefulness of minimum legal capital requirements, which may chill entrepreneurship whichever equity threshold they set without ensuring financial solvency whichever equity threshold they set, has led some jurisdictions to keep them so low as to look like nothing more than window dressing and has convinced other jurisdictions to abandon them altogether. For instance, state corporate laws across the United States no longer provide for minimum legal capital requirements, which were dropped at the turn of the 20" century. See, e.g., James W. Hurst, THE LEGITIMACY OF THE BUSINESS CORPORATION IN THE Law OF THE UNITED STATES, 1780-1970, 53 (1970). European Union corporate law still imposes minimum equity, but it does so only with regard to public corporations and sets the minimum threshold at 25,000 euros regardless of the debt-to-equity ratio, with no European Union Member State corporate laws departing largely from such minimum. Besides, neither the state corporate laws of the United States nor European Union corporate law provide for a duty to adequately capitalize a corporation. See Jonathan M. Landers, 4 Unified Approach to Parent, Subsidiary, and Affiliate Questions in Bankruptcy, 42 UNIVERSITY OF CHICAGO Law REVIEW 589, 592 (1975) (the United States); Peter O. Mülbert, A Synthetic View of Different Concepts of Creditor Protection, or: A High-Level Framework for Corporate Creditor Protection, 7 EUROPEAN BUSINESS ORGANIZATION Law REVIEW 357, 392-94 (2006) (the European Union).

solely entitled to the leftover. In light of such a priority scheme, should the company enter bankruptcy, equityholders likely see their equity stake entirely wiped out. Conversely, debt claims may still entertain the hope to recover some cents on the dollar, however small such hope may be. Therefore, corporate insiders have a strong incentive to allocate resources to the firm in the form of debt as opposed to equity.

Yet, allowing insider creditors to rank ona par with outside creditors prejudices the recovery rate of the latter if the firm ultimately does enter bankruptcy, with the magnitude of the harmful effects for the outside creditor class correlated with the severity of a company’s financial troubles and the size of the inside debt relative to the outside debt. Additionally, if the debt advances made by the insiders were used to pursue excessively risky business strategies or prolong the life of a floundering company in the expectation of an unlikely recovery, the eventual deepening of the financial imbalance would diminish the chances of reimbursing the outside creditors’ claims even further. It is therefore widely believed that making the firm insiders’ debt claims junior to all the other outside creditors’ claims would help deter advances from the insiders opportunistically designed to serve their private interests at the outside creditors’ expense.’

While subordination of inside debt might deter strategic insider lending, the prospect for insiders of recovering a higher value in bankruptcy by choosing debt financing as opposed to equity financing may become critical for the rescue of a firm in financial dire straits. When the firm is financially distressed, insider financing may prove the only readily available source of funding.‘

5. See Kathleen Kinney, Equitable Subordination of Shareholder Debt to Trade Creditors: A Reexamination, 61 BOSTON UNIVERSITY Law REVIEW 433 (1981) (claiming that if shareholders fail to adequately capitalize a corporation, their creditor claims should be subordinated to those of the trade creditors upon bankruptcy); Leonard J. Long, Automatic Subordination as Incentive for Insider Creditors’ Prudential Investing, 13 JOURNAL OF LAW & COMMERCE 97, 118 (1993) (arguing that automatic subordination of insiders’ creditor claims “could serve as a potentially useful tool to encourage the proper level of investment in closely-held and financially troubled enterprises”); Simon Landuyt, 4 Capital Question, Should Shareholder Loans Be Automatically Subordinated? (University of Ghent Financial Law Institute Working Paper Series, Working Paper no. 03, 2018), www.law.ugent.be/fli/wps/paf/ WP2018-03 (contending that subordination of inside debt would force shareholder-managers to internalize the costs of their excessive risk-taking); Rolef J. de Weijs, Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning against Creditors by Upholding the Debt-Equity Divide, 2 EUROPEAN COMPANY AND FINANCIAL Law REVIEW 403, 415-25 (2018) (noting that without subordination shareholders would give preference to debt over equity financing and shareholder-creditors would inefficiently combine control power over the firm with a disproportionate protection against the risk of loss).

6. See James H.M. Sprayregen, Jonathan Friedland & James R. Mayer, Recharacterization from Debt to Equity: Lenders Beware, 22 AMERICAN BANKRUPTCY INSTITUTE JOURNAL

But insiders unlikely are blind to the escalating risk of loss on any additional investment in the firm. Therefore, depriving them of the possibility to advance loans having the same priority enjoyed by outside debts might have a chilling

30, 31 (November 2003) (“Often, a company in financial distress may find its best avenue for additional funds to be from insiders who already have a vested interest in the company”); Matthew Nozemack, Making Sense Out of Bankruptcy Courts’ Recharacterization of Claims: Why Not Use § 510(c) Equitable Subordination?, 56 WASHINGTON & LEE LAW REVIEW 689, 715 (1999) (“Often an insider is the only source of funds for a struggling company); James M. Wilton & William A. McGee, The Past and Future of Debt Recharacterization, 74 BUSINESS LAWYER 91, 104 (2019) “[F]or an insolvent company, insiders are often the only source of credit”). In sharing these concerns, some United States’ federal circuits and state courts have been wary of attempts to force insiders into judicially-determined financing schemes, as such attempts might discourage the provision of liquidity essential for a firm’s survival at a time when nobody else stands ready to financially support the firm. See In re Mid-Town Produce Terminal, Inc., 599 FEDERAL REPORTER (SECOND SERIES) 389, 392 (United States Court of Appeals for the 10% Circuit, 1979) (“We are unwilling to find a dominant shareholder may not loan money to a corporation in which he is the principal owner and himself become a secured creditor. To hold the debt may be subordinated on that basis alone would discourage owners from trying to salvage a business, and require all contributions to be made in the form of equity capital. We do not think that is desirable as social policy, nor required by the cases.”); Sender v.

Bronze Group, Ltd. (In re Hedged-Investments Associates ), 380 FEDERAL REPORTER (THIRD SERIES) 1292, 1299, nt. 1 (United States Court of Appeals for the 10% Circuit, 2004) (“[E] xcessive suspicion about loans made by owners and insiders of struggling enterprises would discourage legitimate efforts to keep a flagging business afloat.”); Redmond v. Jenkins (In re Alternate Fuels, Inc.), 789 FEDERAL REPORTER (THIRD SERIES) 1139 (United States Court of Appeals for the 10" Circuit, 2015) (“We have been careful not to ‘discourage owners from trying to salvage a business’ by requiring ‘all contributions to be made in the form of equity capital.” quoting In re Mid-Town Produce Terminal, Inc., 599 FEDERAL REPORTER (SECOND SERIES) at 392); Fairchild Dornier GmbH v. Official Committee of Unsecured Creditors (In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc.), 453 FEDERAL REPORTER (THIRD SERIES) 225, 234 (United States Court of Appeals for the 4* Circuit, 2006) (“In many cases, an insider will be the only party willing to make a loan to a struggling business, and recharacterization should not be used to discourage good-faith loans.”); Braas Systems, Inc. v. WMR Partners (In re Octagon Roofing), 157 BANKRUPTCY REPORTER 852, 858 (United States District Court for the Northern District of Illinois, 1993) (“Any other analysis would discourage loans from insiders to companies facing financial difficulty and that would be unfortunate because it is the shareholders who are most likely to have the motivation to salvage a foundering company”); Robson v. Smith, 777 PACIFIC REPORTER (SECOND SERIES) 659, 663 (Supreme Court of Alaska, 1989) (“A corporation in [financial difficulty] needs to be able to rely on those most interested in its survival. Directors and shareholders may be the only persons willing to assist the corporation in such a position”); In re Mader’s Store for Men, Inc., 77 WISCONSIN REPORTER (SECOND SERIES) 578, 609 (Wisconsin Supreme Court, 1977) (“Where a corporation is once provided with a reasonably adequate fund of stated capital but subsequently requires additional funds, the stockholders may advance those funds as a loan in an attempt to enable the corporation to continue in business, and, provided no inequitable conduct is shown, the stockholders may participate with other creditors in the distribution of the insolvent estate.”).

effect on efforts to work out plans preventing financially flagging companies from entering bankruptcy. Legal strategies aimed at relegating an insider’s debt claim to the back of the claim repayment line in bankruptcy might have this unfortunate side effect.’

In light of the many arguments advocating for subordination or no-subordination of insiders’ debt claims, we are confronted with a subordination dilemma. The conflicting views on the desirability of inside debt as a source of financing for firms have unsurprisingly led to radically different regulatory approaches. Europe alone provides a sample of many of them. European Union (“EU”) law encourages new financing and interim financing in connection with restructuring plans of financially-distressed firms,’ but remains silent on pre-petition debt financing from a firm’s insiders.” In the absence of any specific EU law, a few current and former EU Member States refrain from adopting ad hoc remedies to cope with allegedly opportunistic insider loans and choose to rely on general rules on directorial liability for misconduct and equity capital maintenance. In stark contrast, other prominent EU jurisdictions take a harsh

7. See Hilary A. Goehausen, You Said You Were Going to Do What to My Loan — The Inequitable Doctrine of Recharacterization, 4 DEPAUL BUSINESS & COMMERCIAL LAW Journa 117, 142 (2005) (“[R]echaracterization has disastrous implications for potential lenders and may spell the end for financially struggling companies.”); Martin Gelter, The Subordination of Shareholder Loans in Bankruptcy, 26 INTERNATIONAL REVIEW OF Law & Economics 478 (2006) (arguing that subordination of shareholder loans as well as their recharacterization as equity might deter efficient rescue attempts); Paul Wallace, Simplifying the Muddled Doctrine of Debt Recharacterization, 86 Mississir1 LAW JOURNAL 184, 199 (2017) (“[F]ear of debt recharacterization may lead to the extinction of companies who rely on insider financing.”); Patricia A. Redmond & Jessica D. Gabel, Not All Loans Are Created Equal: Equitable Subordination and Prepetition Insider Lending After SI Restructuring, 27 AMERICAN BANKRUPTCY INSTITUTE JOURNAL 22 (November 2008) (“Essentially, equitable subordination and recharacterization disincentivize eleventh-hour restoration financing”); Michael R. Tucker, Debt Recharacterization during an Economic Trough: Trashing Historical Tests to Avoid Discouraging Insider Lending, 71 OHIO STATE Law JOURNAL 187 (2010) (opining that recharacterization of inside debt as equity “encourages underinvestment”, thereby increasing the probability of corporate failures in times of credit rationing).

8. See Directive (EU) 2019/1023 of the European Parliament and of the Council of 20 June 2019 on preventive restructuring frameworks, on discharge of debt and disqualifications, and on measures to increase the efficiency of procedures concerning restructuring, insolvency and discharge of debt, and amending Directive (EU) 2017/1132 (Directive on restructuring and insolvency).

9. Although the Report of the High Level Group of Company Law Experts had entertained the possibility of having insiders’ claims subordinated as part of a more modern European regime for creditor protection (see High Level Group of Company Law Experts, REPORT ON A MODERN REGULATORY FRAMEWORK FOR COMPANY Law IN EUROPE 86 (2002)), sucha suggestion was never acted upon at the EU level.

stance by providing for the automatic subordination of insider loans for the benefit of all external creditors and regardless of the financial conditions of the firm, a broad notion of insider, as well as tight preference rules for the avoidance of preferential payments to a company’s related parties. In between these two extremes there lie countries providing for equitable subordination of inside debt if the financing was provided to an overleveraged or insolvent company." Once we broaden the scope of a comparative assessment of regulatory choices by including the United States (“US”) and other jurisdictions from around the world, we may appreciate even further how diverse the regulatory approaches to inside debt financing might be.

Much has been written with regard to the benefits and costs of inside debt financing from the perspective of social efficiency. On the contrary, the literature is surprisingly sparse when it comes to highlighting in what corporate contexts insider loans figure prominently and what effects inside debt has on a firm’s capital structure, insider behavior and creditor interests once the financial conditions of the company are taken into account. This work aims to fill a gap in the existing literature in that it illustrates in what settings and under what conditions inside debt financing is mostly used and how the effects inside debt generates on insiders’ incentives and creditors’ interests vary as a company moves from a condition of full solvency to one of insolvency. But the goal is even more ambitious. After comparing existing and potential regulatory approaches to insider lending and highlighting their respective pros and cons, this book sketches a novel regulatory remedy to dealing with insider loans, which in essence recommends automatic subordination of insiders’ debt claims if originated while the company was fully solvent and, somehow counterintuitively, no-subordination of insiders’ debt claims if originated while the company was financially distressed, in the latter case provided that adequate disclosure of the debt financing was made. This book also proposes the use of stringent avoidable preference rules targeting insiders so as to avoid that the subordination remedy might be circumvented.

The premise on which this work is built is that firm value is not indifferent

10. Interestingly, Europe seems to be almost evenly split between jurisdictions that provide for specific rules on subordination of insiders’ debt claims and jurisdictions that do not, with the latter representing only a slight majority. There is however no clear pattern underlying this divide. Some countries whose corporate finance practices as well as corporate and bankruptcy laws have much in common take different approaches to inside debt financing, whereas other countries with large differences in corporate culture and corporate and insolvency regimes converge on similar if not identical rules on inside lending. The only certainty notably is that the number of European countries embracing some form of legal subordination of insider loans has increased over the past few years.

to a company’s capital structure, as any given choice of capital structure has repercussions on type and size of agency costs, which in turn reduce firm value. Different regulatory options as to the ranking of debt claims of a firm’s owners in bankruptcy vary in their impact on the latter’s ex ante financing decisions, the resulting capital structure and the ensuing agency relationship between the firm and its external constituencies. A regulatory intervention should therefore aim at setting the proper incentives for the insiders to take financing decisions that, by putting in place a balanced capital structure and alleviating the shareholder-creditor agency problem, prove instrumental in maximizing firm value"! and ensuring fairness.