Turkey has become the focus of international financial investors, and has witnessed a sharp increase in M & A transactions, mainly in the form of joint ventures and buyouts, in recent years. A common way for private equity firms to structure a deal (share deal) is through a leveraged buyout transaction (an "LBO").
The key for such a transaction is the "leveraging" of a limited amount of private equity by using a large amount of external capital, usually bank debt. The system requires that the lender (bank) finds sufficient security for the loan. A special purpose vehicle (an "SPV"), which is usually established and serves as the borrower of the loan, and as the buyer of the shares of the target company (the "Target Company"), generally provides only a limited amount of the capital. Therefore, the acquisition debt of the SPV is secured by using the shares, assets and cash flow of the Target Company.
Such assistance of a company to a third party to purchase its own shares (financial assistance) was, until recently, not prohibited in Turkey, making an LBO transaction a preferred method of acquisition.
Rules and Restrictions on Financial Assistance in Turkey
In an effort to modernize its company laws, and to be in line with the EU acquis communautaire, a completely revised new Turkish Commercial Code (the "New TCC") entered into force on July 1st, 2012.
One of the significant changes, among others, was the introduction of the restriction on financial assistance. According to Article 380 of the New TCC, which, as it appears, applies only to Turkish joint stock companies (anonim şirket), a company may not advance funds, nor make loans, nor provide security, with a view to acquire its shares through a third party. Any such transaction is prohibited and is considered null and void. However, two exemptions are permitted: (i) Transactions performed by banks or financial institutions – provided that these transactions are performed in the normal course of business – and (ii) advances, loans and security provided to the company's employees, or its parent or sister company's employees, in order to acquire the shares of the company. Nevertheless, even those exceptional transactions would be deemed null and void, if they have the effect of reducing the statutory legal reserves of the company as required by the New TCC.
The new provision reflects almost literally Article 23 of the Council Directive 77/91/ECC, dated December 13th, 1976 (the "Second Company Law Directive"), which itself, in view of strengthening capital maintenance rules, introduced a general ban on financial assistance given by public companies, in Europe. In 2006, in an effort to make acquisitions more flexible and to foster the young European LBO markets, Directive 2006/68/EC (the "2006 Directive") amended the Second Company Law Directive by lifting the general ban on financial assistance under certain conditions, while keeping the capital maintenance rules to protect creditors and shareholder rights in place. In particular, financial assistance shall be allowed if a loan or advance given by the company is at arm's length, the general meeting of shareholders approved the transaction, a report about the transaction was submitted for the register for publication, and the aggregate financial assistance at no time results in the reduction of the net assets below the amount of the company's stated share capital.
The new restriction on financial assistance in Turkey has been subject to various discussions and criticisms among scholars and legal practitioners, even before the New TCC came into force. The main point of criticism is that the legislator did not take the liberalization brought by the 2006 Directive into consideration, leaving Turkey behind the actual development of company law in Europe. Furthermore, the provision does not distinguish between public and private companies, and is seemingly intended to set a broad and strict regime of financial assistance, leaving little or no room for interpretation.
The new restriction, as a direct result, appears to put an end to LBO transactions that are based on the financial assistance model. On the date of this publication, there is no related secondary legislation, nor has the new provision been tested before the courts. Thus, legal practitioners may only rely on the wording of the provision, and may take into account the legislator's assumed intention. It is speculated whether the shortfall of consideration of the relaxation brought by the 2006 Directive was intended, or is a result of negligence, since the New TCC was drafted in large part prior to the passing of the 2006 Directive. In any case, the restriction changed the way LBO transactions used to be handled in Turkey, and in view of the actual strict regime, new ways of structuring may need to be developed.
Legal Situation and Best Practices in Germany
It has been one of the predominant practices of the Turkish legislator to examine best practices of other countries and, if convenient, to implement them in Turkey, sometimes by customizing them to local needs, and at times, adopting them completely. In this regard, German commercial and company law principles found their way into the early version of the Turkish Commercial Code, and it is not surprising that this also stood as the model for many changes brought by the New TCC. Given a similar legal environment in terms of financial assistance, the German company law system provides an adequate source for comparison. A closer look at the existing legal situation and best practices may, therefore, inspire possible solutions.
German Corporate Law Principles with Regard to Financial Assistance
Without prejudice to any tax implications, which are not discussed in this article, from a German perspective, the loan and security structure, including the level of involvement for the Target Company, largely depends on the limitations provided for by the principle rules on the maintenance of capital, financial assistance in the context of acquiring its own shares, and shareholder liability for endangering a company's continued existence.
Principle of Maintenance of Capital
Germany had already adopted the Second Company Law Directive in 1978, and provisions regarding the maintenance of share capital can be found in the German Stock Companies Act (Aktiengesetz) (the "AktG"), as well as the German Limited Liability Companies Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung )(the "GmbHG"). For German joint stock companies, Article 71a of the AktG was introduced, restricting financial assistance. German limited liability companies are not directly restricted in giving financial assistance. However, the general principles of capital maintenance may still lead to an indirect restriction. Pursuant to Article 57 of the AktG, and Article 30 of the GmbHG, any payment or other financial advantage by a joint stock company, or limited liability company, respectively, to its direct or indirect shareholders, as well as to affiliates of such shareholders that are not subsidiaries of the company, is prohibited if such payment results in the company's net assets falling short of the amount of its stated share capital. The rationale of the introduction of the capital maintenance rules is that a limitation of liability of the shareholders shall only be granted if and to the extent that the equity contribution promised by the shareholders has been validly contributed to the company, and not been repaid to the shareholders.
The prohibition of a repayment of share capital under the capital maintenance rules is interpreted broadly. It applies not only to payments, but to all kinds of benefits with a financial or commercial value, including upstream guarantees, and the granting of other security charges. As a general rule, any financial assistance by a company to its direct or indirect shareholder (or affiliates thereof) must be limited to the amount by which the net assets exceed the registered share capital of the company.
In addition, the transfer of funds to a direct or indirect shareholder (or an affiliate thereof), whether by way of upstream loan or repayment of a downstream loan, may conflict with the rules and principles on the so-called acts endangering the existence of the company (existenzvernichtender Eingriff), i.e., the prohibition to transfer assets to a shareholder, if such transfer could deprive the company of its ability to properly fulfill its obligations towards creditors when due.
In this regard, the prohibition to repay capital to the company's shareholders, and the general prohibition to purchase its own shares, serves this basic principle of capital maintenance.
Finally, Article 71a of the AktG expressively prohibits a joint stock company, whether public or private, from giving assistance to a third party by advancing funds, providing loans or guarantees, in view of the acquisition of its own shares. Any transaction in violation of this restriction is considered null and void.
Having said this, it can be stated that in the context of financial assistance, German corporate law also provides a strict regime.
Domination and Profit and Loss Transfer Agreements
On the other hand, and with the aim to create fiscal unity among group companies and to achieve tax optimization, pursuant to a so-called domination agreement, or a profit and loss transfer agreement between the group's entities, the controlling company is, in principle, entitled to instruct the subsidiary to effectuate certain acts even if they have a negative impact on the controlled entity, or to oblige the controlled company to upstream its profits respectively (cf. Articles 291 and 308 of the AktG).
With respect to domination entered into with a joint stock company as a controlled entity, Article 291 (3) of the AktG expressively states that the relevant capital maintenance rules (in particular, Article 57 (1) of the AktG) do not apply to payments made upon valid instructions under the domination agreement. The reason for this is that the controlled company and its creditors are protected by different means, in particular, by the obligation of the controlling company to compensate any annual net loss of the controlled entity occurring during the term of the domination agreement (Article 302 of the AktG).
The obligation to compensate for any loss incurred by the controlled entity significantly reduces the insolvency risk of the controlled entity, which justifies a relaxation of the otherwise strict capital maintenance rules.
In 2008, two laws entered into force adopting the 2006 Directive, bringing important company law reforms to Germany. In line with the 2006 Directive, an exception has been introduced to Article 71a of the AktG, permitting financial assistance (as well as so-called cash pooling systems) if a domination or profit and loss transfer agreement has been concluded between the SPV and the Target Company, according to which the Target Company is left under the control of the SPV, and/or obliged to upstream funds. Thus, groups of companies that sign domination or profit and loss transfer agreements for tax optimization purposes are excluded from the scope of financial assistance restriction. It must be noted, however, that this only applies to groups of companies having executed such an agreement, wherein the parent company controls at least 75% of the Target Company. Otherwise, controlled groups of companies, or de facto groups of companies, do not per se benefit from this rule.
In these conditions, the underlying agreements for the loans given by the subsidiary to the parent company must comply with certain conditions, such as audit, approval by the general meeting of shareholders, a minimum term of five years and registration with the Commercial Register. In any sense, losses must be absorbed by the dominant company and, generally speaking, the existence of the Target Company should not foreseeably be endangered. The latter is not the case if the Target Company has a fully valuable counterclaim for the return of the transferred funds, and if the repayment claim appears to be fully realizable.
Aside from the above-noted possibility to apply domination or profit and loss transfer agreements, within the German regime of financial assistance and capital maintenance, an LBO transaction where the beneficial shareholder itself has only a small amount of equity, can only be feasible if the Target Company provides sufficient funds, so as to not experience financial difficulties. Otherwise, the transaction will, in most cases, lead to a violation of the capital maintenance rules, making the transaction null and void, and triggering the liability of shareholders and the board members of the Target Company.
In order to circumvent the restrictions, other alternatives of structuring an LBO deal have been developed.
One of the solutions discussed is to convert the joint stock company into a limited liability company, which may, however, not be feasible, and is questionable from a tax point of view.
Among the main solutions in legal practice are: (i) Merger of the SPV and the Target Company; (ii) The merger of liabilities and security in one hand; and (iii) The conclusion of a domination and profit and loss transfer agreement between the involved companies, as already noted above.
Upstream Merger/ Downstream Merger
In one of the first steps of a merger, the SPV acquires the shares of the Target Company, and then, with the second step, the Target Company merges with the SPV. In a so-called upstream merger, the Target Company merges into the SPV, gets absorbed by it, and by losing its legal personality, all assets of the Target Company are transferred to the SPV, and the latter owns the securities granted for its own liabilities. If, however, the SPV merges into the Target Company, the transaction is called a downstream merger, resulting in a factual debt pushdown with the debt made on SPV level ending up at the merged Target Company.
In a merger of the SPV and the Target Company, the capital maintenance rules are generally not relevant, since after the merger, the remaining company is considered to have granted securities for its own liabilities, and not for those of a third party. It is, therefore, not considered an illegal circumvention of the German capital maintenance rules, but a legal way of structuring it. This view is supported by the comprehensive protection that the shareholders and creditors are provided with in a merger transaction according to the German Merger Act (Umwandlungsgesetz). Furthermore, according to Article 71 (1) number 5 of the AktG, it is accepted that a company can acquire its own shares in case of a universal succession, a provision that is explicitly intended to serve the purpose of a merger. The only exception is made if, in a downstream merger, the result of the remaining equity is negative, leaving the remaining company with less capital equity than prior to the merger, which would then be considered to be an indirect violation of the capital maintenance rules. The choice of which form of merger is convenient is mainly determined for tax reasons.
Merging Liabilities and Security in One Hand
Instead of merging the SPV and the Target Company, it is also common practice that the Target Company assumes the debt of the SPV through an agreement. In order not to be prohibited by the capital maintenance, as well as financial assistance rules, an assumption of debt can only be executed if a domination or profit and loss transfer agreement is in place. In this case, the debt is assumed by the Target Company and accounted for at its own level.
Applicable Solutions for Turkey?
With regard to the merger concept, it could be argued that a merger would present an unlawful circumvention of Article 380 of the New TCC.
Against such a view one may argue that in a merger, as it is the case in Germany according to the German Merger Act, the minority shareholders, as well as the creditors, are afforded sufficient legal protection, leaving the application of Article 380 of the New TCC obsolete. It may be added that as discussed above, concerning mergers in Germany, and parallel to Article 71 (1) number 5 of the AktG, the New TCC also accepts that a company by way of universal succession may acquire its own shares, cf. Article 382 (1) (b) of the New TCC. With the same reasoning, it could be concluded that in Turkey, as well, a merger as a means of restructuring a company should be allowed.
As far as the domination or profit and loss transfer agreements within a group of companies are concerned, it can be stated that in Turkey, with the New TCC, the concept of "group of companies" has been introduced (see Art. 195 et seq. of the New TCC), which was modelled on the German group companies law (Konzernrecht), regulated in the German AktG, and on the European law on corporate groups. According to the motives of the legislator, the introduction was made with the intention to create mechanisms to protect shareholders and creditors, and to prevent the abuse of the controlling company. With the introduction of Article 198 (3) of the New TCC which regulates that domination agreements must be registered with the Commercial Registry, the legitimacy of domination agreements and contract-based group of companies has been acknowledged. As a general principle, equal to the German system, the New TCC's approach is based on three elements, as well: The prohibition to exercise abusive control over a subsidiary, exception to the prohibition in the case of compensation of losses, and the liability of the dominant company and its board members for non–compensation. Unlike the German AktG, Article 202 of the New TCC enumerates examples of disadvantageous transactions, including the transfer of funds and the provision of guarantees. As per Article 203 of the New TCC, in the event of full control (100%), the dominant company may give instructions regarding the management of the controlled entity, even if this may cause losses, provided that it is a requirement of the policy of the group of companies. In this case, the responsibility of the board members and managers shall not be triggered; however, recourse may be achieved by creditors claiming the responsibility of the parent company and its board in case of incurred damages.
As it has been demonstrated and explicitly intended by the Turkish legislator, the new group of companies' regime has been set up as a protection system with regard to an abusive control of a parent company. Safeguards, such as transparency, reporting obligations, approval by the general meeting of shareholders, publication requirements, as well as enhanced liabilities, lead to a comprehensive protection of (minority) shareholders, as well as creditors.
It is, however, questionable whether domination by agreement as legally foreseen under Article 198 (3) of the New TCC also leads to the effect that the upstream of funds from the controlled company to the controlling company can be covered by these provisions. Even assuming that this may be the case, due to the fact that Article 380 of the New TCC does not provide for an explicit legal exception of the prohibition of financial assistance in these cases, it can be concluded that this was not intended by the Turkish legislator.
Conclusion
Financial assistance provided by a joint stock company is legally allowed in Germany if certain conditions are met; in particular, if (i) the share capital is duly secured and maintained, and the existence of the Target Company is not endangered, and (ii) a domination and profit and loss transfer agreement has been concluded.
Practical alternatives that have been "engineered" to satisfy the objectives of an LBO transaction in Germany are, besides the conversion of the Target Company into a limited liability company, the execution of an upstream or downstream merger, or the debt assumption by the Target Company through a merger of liabilities and security in its hand, in the context of domination, or a profit and loss transfer agreement.
Although the New TCC introduced a group of companies' regime based on the German model, and allows domination agreements between group companies, it differs from the German model as a connection with the general financial assistance restriction rule and domination agreements has not been established. Besides, German rules provide for an exception if the parent company controls at least 75% of the Target Company; whereas, the New TCC introduces only limited exceptions to liability principles in the event of 100% ownership. This seems to be a missed opportunity, since safeguards for the protection of shareholders and creditors within the group of companies' concept are in place under the New TCC. Hence, the application of Article 380 of the New TCC would not be necessary for financial assistance within a contractual group of companies, which could pave the way for a legally permitted financial assistance as it is already the case in Europe.
For the time being and in the absence of the flexibilities introduced by the 2006 Directive, the only applicable solution in Turkey seems to be a merger of the SPV and the Target Company, or a conversion of the Target Company into a limited liability company. As discussed above, it is questionable whether these solutions present an unlawful circumvention of Article 380 of the New TCC. Further, tax considerations will also be decisive.
It remains to be seen, from the Turkish legislator's point of view, or by interpretation of the courts applying the new law, whether there are ways to implement the law without disregarding the fact that these types of structured transactions are indeed necessary in today's business and investment climate. Meanwhile, private equity funds and banks, as well as their advisors, may need to carefully consider how to structure upcoming deals.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
