20.3 Conversion of debt into shares

When shares are issued the person receiving the shares accepts a contribution obligation. If this issuance of shares is intended as a strengthening of the assets of a company this contribution must be real. The amount to be contributed must be made available to the company. The law recognises two main types of contribution on shares: contribution of money and contribution in kind. A contribution on a share must be in money to the extent that no other kind of contribution has been agreed upon (Article 2:80a/2:191a Dutch Civil Code). The conversion of a debt into share capital amounts to settlement of the contribution obligation through set-off under Article 6:127 (and following clauses) of the Dutch Civil Code. It has been argued that where shares are issued on the conversion of an existing debt owed to a (future) shareholder this should be seen as the contribution of the debt which the shareholder is owed by the company to which the rules applying to a contribution in kind are applicable. Some writers adopt a halfway standpoint and consider contribution through set-off as a special form to which the rules concerning contribution in kind are not applicable.

In economic terms, contribution of the claim that a shareholder has on the company and set-off of this claim against the contribution obligation have the same result. However, there are real differences in legal terms, with different legal consequences. Contribution of a debt forms a contribution in kind. The rules concerning set-off are not applicable because a contribution of debt is made; but rules governing admixture (vermenging) are, because the capacity of the creditor and that of the debtor are com-bined in one person. Set-off is regulated relatively broadly in law but the Dutch Civil Code only has one article concerning admixture of the debt claim and the opposite debt (Article 6:161 Dutch Civil Code). Set-off and admixture are different legal concepts which have different consequences on the basis of their separate legal rules. One difference in results is that where a debt owed by the company to the shareholder is contributed, this debt ceases to exist through the admixture, but a claim held by the company over the shareholder due to his/her obligation to make a contribution on the shares remains. The ‘contribution theory’ is unsatisfactory for contractual law reasons alone. The conversion of debt into shares through set-off is a form of contribution in money. Legislation history teaches us this in so many words, but it is also the most obvious conclusion. Set-off is a manner in which monetary debts can be satisfied. A contribution obligation on the part of the shareholder exists once shares are accepted. This is a monetary debt to the extent that no other form of contribution has been agreed. Set-off is simply a manner of payment here, which does not affect or remove the initial obligation on the part of the shareholder: that of contribution on shares of money.

Set-off is governed by Articles 6:127-141 of the Dutch Civil Code and serves both as a method of payment and one of security. Section 12 of Book 6 (set-off) contains regulatory provisions. Parties can agree that certain parts of the legal regulations shall not apply, they can agree to extra conditions, or even to exclude the entitlement to set-off altogether. I distinguish between five forms of set-off with contribution obligation: (1) set-off by the company, (2) set-off by the shareholder with the consent of the company, (3) the agreement between the company and the shareholder to pure set-off with integral application of the legal regulation, (4) the agreement to set-off which in part deviates from the legal regulation but still takes place between the shareholder and the company, and (5) an agreement for extra-legal set-off, being an agreement external to the relationship between the shareholder and the company, whereby it is agreed that a certain obligation owed by the company to a third party is cancelled in return for a contribution obligation being accepted by the shareholder. The last of these is actually not a form of set-off in the legal sense of the word but involves a transfer in lieu of payment (inbetalinggeving) as covered by Article 6:45 of the Dutch Civil Code. For as far as any deviation from the legal rules can be seen as being to the disadvantage of the company a part of the amount to be set-off equal to the amount of the disadvantage is not to be considered as a contribution.

Set-off may be made in respect of an issue of shares which takes place after the company has been formed. The claim which the shareholder has against the company may have arisen after or prior to the incorporation of the company which has then been ratified by the company (Article 2:93/203 paragraph 1 of the Dutch Civil Code). Regarding set-off with respect to shares which were placed at incorporation the distinction is made between set-off which takes place after incorporation and set-off at incorporation. Prior to incorporation of the company a founder/future shareholder can make a loan to a legal person in formation. After incorporation the company can ratify the loan agreement. Regarding a BV, for which the law does not proscribe any special rules with respect to fully paid up shares on incorporation, there is in principle no objection to set-off with a contribution obligation on the shares placed at incorporation. A set-off of this sort will occur immediately after incorporation of the company because first ratification of the money lending agreement is required, and this ratification can only occur after incorporation. On the incorporation of a BV or NV shares which are placed cannot become fully paid on incorporation by virtue of set-off with an agreement entered into prior to the incorporation. With regards to the capital of a company, Article 2:93/203 paragraph 4 of the Dutch Civil Code states that in the deed of incorporation the founders of the company can only bind the company to issue shares and accept contributions paid up on those shares. At the moment of incorporation there is no actual contribution but a monetary loan, incurred for the benefit of the NV/BV which is in the process of being incorporated (NV/BV ‘in oprichting’ or ‘i.o.’). Ratification of this loan and set-off against a contribution on incorporation falls outside the scope of Article 2:93/203 paragraph 4. It is possible that a monetary loan to a BV i.o. or an NV i.o. by the founder, for incorporation, be reclassified as funds made available for payment on the shares. Set-off transactions with respect to funds which are placed in a bank account in the name of the NV i.o. or the BV i.o. can also take place prior to incorporation; on incorporation the relevant funds are then accepted as payment on shares. In Article 2:94c paragraph 1, sub-paragraph a of the Dutch Civil Code the phrase ‘including debt-claims which are to be set-off’ may be ignored.

A distinction can be drawn between the size and the value of the debt-claim. The size of the debt-claim refers to the nominal value of the claim derived from the relationship between the claim and the original consideration. The value of the claim is related to the creditworthiness of the debtor and the likelihood of repayment. Sometimes, for reasons of structuring, the value of the claim is chosen as the contribution on shares, sometimes it is the size of the claim. Article 6:129 paragraph 3 of the Dutch Civil Code determines that, if a currency value calculation is necessary to determine the effect of a set-off of money debts then such a calculation must be made on the same bases as if mutual payment had occurred on the day of the set-off. The day of the set-off therefore counts as the day of payment. This must be seen as the day of contribution within the meaning of Book 2 of the Dutch Civil Code. Co-shareholders can be disadvantaged if one of the shareholders wishes to set-off his/her contribution obligation with an existing debt-claim. On the one hand because the payment capacity of the company is not directly increased by issuance to that one shareholder, and on the other hand because set-off of a debt-claim, certainly if this is of lower value than the amount against which it is set-off, actually disadvantages the shareholders. The decision to make such an issuance can be contrary to the requirements of fairness and reasonableness and cooperation of the company with such a set-off can lead to directors liability. When setting-off a debt-claim instead of a payment in cash would lead to company creditors not being paid because of insufficient cash, these are disadvantaged by the setting-off. Moreover, it may be that banks demand that shareholders convert their debt-claims into capital before additional financing is provided or existing financial terms extended. Conversion of debt-claims into capital reduces the payment obligations of the company and increases its solvency. Anyone with a limited right over shares held by other shareholders may also be disadvantaged by conversion. In the first instance such a person would not have any direct redress against the company unless it has been contractually agreed that the company should refrain from transactions which may disadvantage holders of limited rights. Conversion can also be at the disadvantage of anyone who has acted as guarantor for the company or is ultimately liable for the debts of the company. In this manner their interests are in line with those of the company and indirectly in line with the interest of its creditors. The statutory regulations concerning set-off will apply, including during bankruptcy, moratory of payment and any application of a debt restructuring scheme, in so far as Articles 53-55, 234-235, 307 and 313 FW do not deviate there from. The possibilities for set-off are extended in such cases because on the side of the company no appeal can be made to Article 6:136 of the Dutch Civil Code. I do not see any objection to the structuring of debt-claims so as to enable the shareholder to meet his/ her debt under the contribution obligation by set-off or to enable a third party to meet a shareholder’s contribution obligation by set-off. In every such case, the company must consent or agree to the set-off. The board must not give its consent if other shareholders, creditors or third parties are unreasonably disadvantaged.

Shares can also be converted into debt by means of a capital reduction. There may be both good and less good reasons for doing so. A number of indicators can be identified which point towards unlawfulness vis-à-vis the company, co-shareholders and/or creditors, or improper performance of the directors. Put into the form of questions, these are: (a) Is the loan entered under normal business, market-conforming terms, both in terms of interest rates, repayment obligations and collateral? (b) Will the position of existing creditors be worse under the new arrangement, and if so, to what extent? (c) Are all shareholders treated equally? (d) If not, are there any good reasons for this? (e) Will this mean the company is in danger of not being able to meet its payment obligations or can this be foreseen? (f) Is there any suggestion of a conflict of interest between a director and the company? (g) Are shares being issued shortly before the capital reduction at the expense of a legal or other, non- distributable, reserve? (h) Was the company able to satisfy the debt-claim of the shareholder by means of the capital reduction?

Set-off with the contribution obligation of a debt-claim from a shareholder on the company which is the subject of a right of usufruct can be considered as a method of collection of the claim. Collection can, unless otherwise specified at the establishment of the usufruct, be done by the usufructuary and by the main proprietor (the shareholder) only with the consent of the usufructuary or if authorised by the subdistrict court. The rules on substitution set out in Article 3:213 of the Dutch Civil Code do not mean that in this situation the shares will be subject to usufruct. A shareholder/pledgor can only set-off a debt-claim on the company which is pledged with the contribution obligation if he/she has the permission of the pledgee or authorisation from the subdistrict court. If a pledged debt-claim is settled with a payment obligation on shares it does not follow that a pledge is established on the basis of the statutory rules on substitution set out in Article 3:246 paragraph 5 of the Dutch Civil Code.

There are various possible combinations of a company’s assets with components of its debts, commonly referred to as ‘guarantee capital’, ‘liability capital’ or ‘resilience capital’. What form such combination takes dictates to some degree what priority it has when ranked against other components of the company’s debt. Debt which is identified as guarantee equity can be subdivided into subordinate loans and convertible loans. Deferred income, deferred tax assets and other provisions are seen as equity. For the answer to the question of whether for guarantee capital it is its asset-character or its debt-character which prevails, how it is entered on the balance sheet gives an indi-cation but is not in itself decisive whether it is a (re)payment obligation or a provision (voorziening). A subordinate loan is a loan with respect to which it is agreed in an agreement between the lender and the borrower that the debt-claim which the lender has will have a rank lower than other, or all other, debts owed by the borrower than that which it would be granted in law (Article 3:277 paragraph 2 of the Dutch Civil Code). A subordination does not necessarily mean that the debt-claim may not be the subject of set-off. It is the intention that convertible loans are to be converted into share capital at a given moment, which takes the form of an issuance of shares to the creditor and a set-off of payment obligations with a subordinated loan. The conditions and timing for any possible conversion of the loan, sometimes in tranches, will be set out and agreed to in the financing/credit documentation. The company gives its consent to the con-version under the agreed conditions, in advance. Shares can also be issued at the expense of deferred income. This does not involve a set-off of the payment obligation with a company debt, but the issuance of shares from a reserve and therefore at the expense of the company’s assets. With regards to other provisions, a distinction can be drawn between provisions made which are of a costs-nature and those which are of a debt-nature. Provisions with a costs-character are reserves and can be converted into share capital where shares are issued at the expense of such provision/reserve. Pro-visions form part of a company’s debt. The law does not provide any opportunity for the set-off of a payment obligation against such provisions.

The right to a share in a company’s profits can take a number of different forms. There are no legal regulations determining profit-rights. The recognition of profit-rights requires a basis in the articles. Profit-rights can be converted into shares by means of a sale/purchase of the profit-rights and the set-off of the payment obligation with the consideration from the company. The consideration for sale/purchase of profit-rights can be seen as a distribution under Article 2:105/216 of the Dutch Civil Code. Shares issued for profit-rights can be paid for by the retention (set-off) of dividends or of other distributions on shares.

A convertible bond is a financing instrument which can form a bridge between risk- limiting and risk-carrying assets. Conversion can transform debt into assets. The convertible bond brings together the contractual conversion moment and the assertion of the right to subscribe for shares at a single point, namely the issue. If at the agreed moment for conversion no company no conditional resolution to issue shares is passed or no right to subscribe for shares exists then the conversion cannot take place. Simi-larly, if the agreement between the bond holder and the company does not allow such a conversion then an issuance of shares cannot take place.

The notary plays a crucial role in the conversion process: in the designing of provisions for that purpose in the articles, checking whether the rules concerning minority protection are being taken into consideration, and by keeping an eye out for the interests of third parties. Legal developments benefit from notaries who combine a high degree of professionalism, a good feel for relations, creativity and a clear under-standing of the limits of what is possible and permissible. It’s not a profession for the faint hearted.