The Turkish Commercial Code (the "TCC") gives particular importance to the protection of capital in joint stock corporations ("JSCs") and limited liability partnerships ("LLPs"). The TCC determines mandatory measures to be adopted by these companies' relevant bodies in the event of capital loss. Article 376 of the TCC governs over-indebtedness and technical bankruptcy ("Technical Bankruptcy"). Article 376 distinguishes between three different levels of capital inadequacy and sets forth specific corporate remedies for each. It is crucial to take right the steps on time, because Technical Bankruptcy is one of the legal grounds for dissolution of companies. Companies' board members and managers may be subject to legal and criminal liability, if they fail to fulfill their obligations under Article 376 as well as the Execution and Bankruptcy Law (the "EBL").
A. "Financial Insolvency" Concept
Article 376 of the TCC governs over-indebtedness, Technical Bankruptcy and their consequences:
(i) Under Article 376/1 of the TCC, if the company's board of directors (the "BoD") sees from the previous year's annual balance sheet that 1/2 of the company's share capital and statutory reserves have eroded, then the BoD must call the general assembly of shareholders ("GAS") immediately for an extraordinary meeting and to prepare a proposal for strengthening the company's financial status, to be submitted to the GAS's approval. There is no legal requirement for the GAS to comply with the BoD's suggestions or to take any other specific actions.
(ii) Under Article 376/2, if the BoD sees that 2/3 of the company's share capital and statutory reserves have eroded, the BoD must immediately call for an extraordinary meeting of the GAS and present a proposal for remedial measures, in order to improve the company's share capital status. At this extraordinary meeting, the GAS must resolve on either:
- completing the eroded portion of the share capital through a cash injection, in order to replenish the share capital to its original level; or
- proceeding with the amount equal to 1/3 of the share capital.
If the GAS fails to adopt any of the above mentioned resolutions at the GAS meeting or if a meeting is not convened at all, the company would be deemed dissolved pursuant to the TCC and the EBL.
(iii) In addition to the above, if there are significant signs that the company is over- indebted (e.g. according to the results of the year-end balance sheet or any other financial tables), the BoD must prepare an "interim" balance sheet, where the value of the company's current assets is recalculated at fair (current) market value (i.e., not on the book value). If the interim balance sheet indicates that the company's assets are not sufficient to cover its debts, the BoD must notify the competent commercial court and file for bankruptcy ("Financial Insolvency").
It is important to distinguish between separate Technical Bankruptcy and Financial Insolvency, since their consequences are different. Insolvency can be defined as a debtor's inability to cover its debts, while bankruptcy is a status to be determined by commercial courts, which announces the company's inability to cover its debts by its assets. A company may be bankrupt under several circumstances. Insolvency is one of the grounds for bankruptcy. A company is deemed insolvent if its assets are not sufficient to cover its liabilities, or if the company is in significant financial difficulty in making timely payments of its debts.
On the other hand, in practice, many Turkish companies lose their share capital or become financially insolvent due to different reasons and it is quite uncommon in practice to be declared bankrupt just because of Financial Insolvency under the balance sheet. A dissolution/bankruptcy is a significant risk when the company runs into cash flow problems and creditors are not satisfied. It is worth emphasizing that without remedying Financial Insolvency, a company would not be able to increase its share capital, to make solid financial decisions and to make long term financial plans.
B. Recovery Methods
As explained above, JSCs and LLPs can face Technical Bankruptcy or Financial Insolvency upon erosion of their share capital or if their statutory reserves reach the said thresholds. In these circumstances, the BoD/managers must act immediately, in order to strengthen the company's financial status.
There are several recovery methods such as (i) injection of cash to the company as "loss remedy fund" or (ii) capital increase in order to resolve the insolvency problem. However, these methods also bring together certain financial and tax implications.
i. Loss Remedy Fund
The shareholders/partners may inject cash to the company to replenish the company's capital funds, through creating a special fund, called the "loss remedy fund" (zarar telafi fonu). The shareholder/partner can inject, via loss the remedy fund, in an amount that covers Technical Bankruptcy threshold. Moreover, if the amount injected by the shareholder/partner exceeds the sum of the accumulated losses plus 1/3 of the paid-in capital, tax authorities will deem the exceeding portion as an income of the company.
ii. Capital Increase
The TCC does not explicitly govern capital increase methods in the event of Financial Insolvency. That said, a capital increase may be conducted either through a cash contribution or conversion of the shareholder/partner loans into share capital.
In light of the above, while incorporating a capital company, the initial share capital must be carefully determined, based on the profit and loss projections of the company. This will help avoid Technical Bankruptcy or a similar situation at the early stages of the company's operations. Regardless of the amount of the initial share capital, the company's financial position should also be closely followed and any injection of loans or equity should be arranged, preferably before the company falls in any insolvency situation.
© Kolcuoğlu Demirkan Koçaklı Attorneys at Law 2015
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