Invalid subordination clauses

When do profit participation rights constitute deposit-taking business?

In the case in question, the claimant had acquired 62 profit participation rights, each worth 4,000 euros. He argued that the agreed qualified subordination clause was invalid. Without a valid subordination agreement, he claimed, there was an unconditional right to repayment. Such a financing model constituted a deposit-taking business within the meaning of Section 1 of the German Banking Act (KWG) and required authorisation from BaFin pursuant to Section 32 KWG.

In the court’s view, the subordination clause used did not satisfy the requirements of the transparency principle (Section 307(1) of the German Civil Code (BGB)). In particular,

• the economic risks for investors had not been sufficiently explained,
• the provisions for investors had not been made sufficiently comprehensible, and
• the implications of the pre-insolvency enforcement bar had been presented in an unclear manner.

The subordination clause was therefore invalid. The remainder of the contract remained in force in accordance with Section 306(1) of the German Civil Code (BGB).

Why is this decision so significant?

Subordination agreements in profit participation rights, as general terms and conditions, are subject to a review of their content under Sections 305 et seq. of the German Civil Code (BGB). They must not only be formulated transparently, but must also stand up to a review of their substantive appropriateness.

In the absence of a valid subordination clause, the financing model may be classified as a deposit-taking business requiring authorisation. If this is operated without a banking licence, it constitutes a breach of Sections 32 and 54 of the German Banking Act (KWG). At the same time, this may constitute a breach of a protective statute within the meaning of Section 823(2) of the German Civil Code (BGB). Investors may consequently have claims for damages against

• the issuer,
• managing directors,
• platform operators and
• intermediaries

Furthermore, the unauthorised operation of a deposit-taking business is punishable under Section 54 of the German Banking Act (KWG).

What are the practical implications?

For investors
Investors should have existing profit-sharing agreements reviewed. If the subordination clause lacks transparency, claims for damages may arise against companies and their directors and officers.

For companies
Companies should urgently review their contractual arrangements. Invalid subordination clauses may have implications for

• accounting,
• a potential obligation to recognise liabilities,
• the over-indebtedness test, and
• insolvency law issues

Tax implications should also be taken into account.

For managing directors
Managing directors should have existing financing agreements reviewed with regard to their personal liability. Depending on the risk profile, it is also advisable to consult with the D&O insurer.

Key points in brief

• Invalid subordination clauses can render profit participation rights an unauthorised deposit scheme.
• Investors may, under certain circumstances, be able to claim damages against issuers, directors and intermediaries.
• Companies should have their standard contract templates and financing structures reviewed by legal counsel as soon as possible.