Leveraged Buyouts Within The Context Of Financial Assistance Ban
In General
Article 380 of Turkish Commercial Code numbered 6102[1] (“TCC”) bans the legal transactions of a joint stock company that are intended to finance the purchase of its own shares by third parties, or supporting third parties, by granting loans or providing security for the acquisition of its own shares (“financial assistance ban”). This provision is regulated just after art. 379 that regulates the company’s purchase or pledge of its own shares. TCC art. 379 prohibits the acquisition or acceptance of a pledge of a company of its own shares that exceeds ten percent of the registered or issued capital. The ban regulated under art. 380 of the TCC is an extension of this article. The law maker determines financial assistance, such as a company’s buy back of its own shares.
The ban brought by TCC art. 380 bears importance with respect to the leveraged buyout method that is used in large-scale share purchase transactions. In a leveraged buyout, the financing used in the purchase of the target company is ultimately met using the capital and income of the target company. The financial assistance ban set forth in the TCC prohibits leveraged buyout transactions. This newsletter article examines the financial assistance ban that closely concerns investors, and the effect of this ban on leveraged buyouts.
The Concept of Leveraged Buyout
Leveraged buyout is an important financing method used in company acquisitions. In this method, loans that are granted to the purchaser by credit institutions for the purchase of the shares of the target company are repaid by the income of the acquired target company. The term “leveraged buyout” reflects the financial aspect of such method. Provided that the company’s net assets and the total proceeds procured through the utilization of foreign debts in company activities are higher than the debt interest to be paid by the company, and the difference between these will constitute the profit. Accordingly, when the proportion of debt increases, the proceeds of the capital subscribed by the shareholder increases proportionately, as well[2]. This effect is described as the leverage effect.
One of the most important principles of the joint stock company law is the preservation of the capital. Since the ultimate financial source in leveraged buyout transactions is the capital of the target company, the exercise of this method is restricted in different laws. Accordingly, the TCC in art. 380, based on the Second Company Law Directive of European Union (“Directive 77/91/EC” or “Second Directive”)[3], sets forth a provision that bans leveraged buyout transactions.
Purpose of the Financial Assistance Ban
The roots of the financial assistance ban leans on English law. In England, specifically after the First World War, share purchases were made through leveraged buyouts by using the resources of the target companies, and many companies declared bankruptcy in the economic crises of 1920-1921. As a result, a company’s provision to finance the acquisition of its own shares has been considered as dangerous, and a rule prohibiting such financial assistance has been added to English Company Law. Following England’s entry into the European Union, such law has been included in the Second Directive.
Art. 23 of the Second Directive anticipated that the company may not provide advances, loans or security to a third party with a view to acquire its shares by a third party. This prohibition did not apply to the legal transactions in the ordinary course of business of credit and finance institutions, and to the legal transactions in which the company provides advance funds, loans and security to its own employees in order for them to acquire the shares of the company.
Art. 23 includes a strict regulation, and has been subject to criticisms due to its restriction on financing possibilities. Accordingly, in 2006, the Second Directive was amended by directive numbered 2006/68/EEC[4]. This amendment sets forth that the companies may lend financial assistance provided that (i) the advance, loan or security provision transactions are concluded on an arm’s length basis, (ii) a detailed written report on the credibility of the person who is party to the transaction is prepared by the board of directors, (iii) the general assembly of the company approves the report of the board of directors with a two-thirds majority, and the report is registered with, and announced by, the trade registry, and (iv) the financial assistance granted does not cause diminution of authorized share capital and non-distributable reserves of the company.
However, the TCC was enacted with the aim to harmonize with the European Union, and took into consideration the provision of the Second Directive that was in force prior to 2006. Article 380 of the TCC did not include the provision that amended directive numbered 2006/68/EEC that enables financial assistance under certain conditions. Within this context, the provision included in Turkish law is stricter than the current provision of the European Union, and does not allow leveraged buyout transactions, except for the two limited exceptions as foreseen under the law.
Financial Assistance Ban regulated under TCC Art. 380
Pursuant to Art. 380/1 of the TCC, the legal transactions where the target company provides advances, loans, or securities to a third party so that its shares can be acquired will be deemed null and void. As stated in the justification of the article, the broad interpretation of the expression “advances, loans or security” is due to ratio legis, and any type of financial assistance that may serve in the acquisition of the target company’s shares, could conceivably fall under the scope of Art. 380. Such transactions would result in the loss of the company capital in any event, whether such risk actually materializes or not is irrelevant[5].
In order to consider a financial assistance ban, firstly, the shares of a joint stock company must be purchased. The shares to be acquired must be the shares issued by the “target company” that is to provide the financial assistance. If the company providing financial assistance and the company that is issuing the shares to be acquired are not the same, this ban would not be applied. As stated in the justification of the article, it is not required that the share purchase takes place before the advance, loan, or security is granted; the mutual purpose attained afterwards is in the scope of the provision, as well. Therefore, the time of the financing does not bear any importance. Accordingly, if the financing provided after the share purchase is not included within the scope of the article, the article may easily become entangled. The important point to consider is the purpose of the transaction. In order to apply the ban, the primary purpose of the financial assistance must be the procurement of the share acquisition. In other words, for instance, the company’s shares should be acquired by the money lent by such company, or the company should provide a guarantee if the party that is acquiring the shares of the company takes a loan from a third party. However, a written agreement between the parties is not required in order to consider such purpose. Implicit agreements suffice with respect to art. 380 of the TCC.
The type of security provided by a company is unimportant with respect to the ban, the security may be in cash, in kind, or individual security; however, this ban does not prevent the acquirer from providing the acquired shares as a guarantee to the credit institutions, or placing a pledge over such shares.
Different from TCC art. 379 (the share transfers and pledges exceeding ten percent of the capital), TCC art. 380 does not foresee any threshold with respect to the amount of shares to be acquired. The ban shall be valid regardless of the amount of shares acquired by the third party that is financed by the target company. In addition, in order to apply this provision, the transaction should be concluded with a third party. The term “third party” is interpreted broadly, and includes the shareholders, the persons in management, and the board of directors, as well.
The legal consequence of the violation of art. 380 of the TCC is that the financial assistance transaction is rendered void. Where financial assistance is concerned, there are two transactions – one being the acquisition of the shares, and the other one being the financial assistance for the payment of the share price. When the purpose of the ban is considered, it may be concluded that the voided transaction is the financial assistance. The validity of the share purchase transaction is dependent of its own conditions and is not affected by this ban. Furthermore, art. 385 of the New TCC foresees the obligation of the disposing of shares purchased in violation of articles 379. 380 and 381 that govern company share buybacks, rather than rendering such transactions invalid (void). This wording is inclined to be interpreted that share purchases, which are in violation of art. 380, may be realized. Therefore, the only transaction that is invalid is the financing transaction.
The doctrine differentiates between the consequences of the financial assistance ban with respect to the promissory transactions and disposal transactions. The dominant view accepts that only promissory transactions are invalid and that disposal transactions are valid. However, even if the validity of disposal transactions are accepted, the action performed is required to be returned. For instance, if the company became a guarantor to a bank credit obtained in order for its shares to be purchased by a third party, this guarantee agreement would be invalid, and the responsibility of the company may not be claimed.
Exceptions to the Financial Assistance Ban
TCC Art. 380 provides two exceptions to the financial assistance ban. The first exception governs the day-to-day transactions that are overseen by credit and finance institutions. The financial assistance ban will not apply where the financing provided by the credit and finance institutions are used in the acquisition of their own shares. In other words, the financing provided by the target company from the credit and finance institutions for the acquisition of its own shares is beyond the scope of this exception. Accordingly, if the credit institution is not the company whose shares are acquired, TCC art. 380 would lose its meaning, in a market where the majority of the sources of financing are composed of banks.
Similarly, the ban does not apply to legal transactions, wherein a company provides advances, loans, and securities to its own employees for the acquisition of the company’s shares. The justification of the article specifies that this exception is recognized in order to provide convenience for the company’s employees in acquiring the shares of the company and its affiliates. However, this exception would not be applied for the senior executives of the company. Otherwise, a management buyout, which is one of the sub-types of leveraged buyouts, will be allowed, and the ban regulated under Art. 380 will be eliminated.
In order for the abovementioned exceptions to be applied, transactions may not reduce company reserves, and must comply with the provisions of art. 519 and art. 520 regarding the disbursement and separation of the reserves.
Conclusion
The financial assistance prohibition regulated under the TCC bans the transactions of a company intended at financing the acquisition of its own shares by third parties, or supporting third parties by granting loans or providing security. By virtue of the amendment in 2006, this ban, which is regulated under the Second Directive of the European Union, has been softened, and assistance to third parties is enabled under certain conditions. Consequently, leveraged buyouts are allowed under EU law, under certain conditions. However, art. 380 of the TCC did not incorporate such regulation and prohibited the application of leveraged buyouts, a financing method used in acquisitions. However, in order to harmonize the amendment with the Second Directive, and to overcome financing issues in mergers and acquisitions, thus encouraging such transactions, it is suggested that an amendment similar to the Second Directive be made to art. 380 of the TCC, and the strict ban is thereby softened.
[1] Published in the Official Gazette dated 14 February 2011 and numbered 27846 and entered into force on 1 July 2012.
[2] Gül Okutan Nilsson, Anonim Şirketlerin Kendi Hisselerini İktisabı Bağlamında Finansal Yardım Yasağı, Anonim Şirketler Ve Sermaye Piyasası Hukukunda Güncel Gelişmeler Türk – Alman Uluslararası Sempozyumu, August 2011, p. 91.
[3] Second Council Directive 77/91/EEC dated 13 December 1976.
[4] Directive 2006/68/EC of the European Parliament and of the Council dated 6 September 2006.
[5] Veliye Yanlı, Şirketin Kendi Paylarını Edinmesinde Finansal Destek Yasağı, Banka ve Ticaret Hukuku Dergisi, December 2012, p. 31.
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