Capital Maintenance. I. Scenario

7 Capital Maintenance MICHAŁ Z˙ UREK AND KAMIL SZMID Main topics: capital maintenance rules; challenge to a decision to pay dividends; and disguised ...
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7 Capital Maintenance MICHAŁ Z˙ UREK AND KAMIL SZMID

Main topics: capital maintenance rules; challenge to a decision to pay dividends; and disguised distributions. Related topics: piercing the corporate veil (see chapter six, above); non-payment of dividends (see chapter eight, below); abuse of shareholders’ rights (see chapter nine, below); enforcement of directors’ duties (see chapter 10, below).

I. Scenario Builpod (the Company) is a limited liability company which manufactures steel structures for the construction industry. The Company purchases steel from a local steel producer named Steel Factory, whereas other raw materials are delivered by MultiSteel (its 90 per cent shareholder). Current commitments of the Company to Steel Factory for delivered steel to date amount to €150,000. The Company’s assets consist of its premises, production line and leased vehicles. The Company has recently experienced a sudden decrease in demand for its products due to the collapse of the real estate market. It has failed to meet the financial commitments which it owes to Steel Factory. The management board of the Company prepared its annual accounts as at 31 December 2011. These showed that the Company had incurred a loss of €100,000 in the previous financial year. This could be contrasted with the financial years ended 31 December 2009 and 31 December 2010, where the Company had made profits of €180,000 and €20,000, respectively, which had not been distributed to shareholders as dividends. The balance sheet of the Company as at 31 December 2011 was as follows. Assets

Liabilities

Fixed assets

800,000

Issued share capital

Current assets

200,000

Current liabilities

200,000

Non-current liabilities

200,000

Net profit (loss) for the period Accumulated profits brought forward Total

1,000,000

Total

500,000

(–100,000) 200,000 1,000,000

The shareholders’ meeting held on 30 June 2012 passed a resolution approving the distribution of a dividend in the amount of €50,000. The management paid out the dividend in early July 2012. In August, the Company ordered technical equipment worth €120,000

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from MultiSteel and duly paid the purchase price. It turns out that the market value of these goods had been overestimated by €60,000. Steel Factory sued the Company for payment of its outstanding invoices (€150,000). However, Steel Factory’s proceedings against the Company were ineffective and its claim remained unsatisfied. Steel Factory seeks to challenge (i) the dividend distribution and (ii) the payment to MultiSteel. Advise Steel Factory on how to proceed and whether it has a reasonable prospect of success.

II. Case Studies

A. Poland (i) Assessment of the Dividend Distribution The primary authority for deciding whether a dividend should be paid out of the annual distributable profits of a limited liability company rests with the shareholders of that company. A shareholder has the right to be paid a dividend if the articles of association entitle him or her to participate (up to a certain proportion) in the profits generated by the company in each of its financial years or, in the absence of such a provision in the articles of association, if the payment of the dividend is approved by the shareholders in general meeting.1 According to Article 191, section 1 of the Polish Commercial Companies Code 2001 (CCC), a shareholder is entitled to participate in the profits posted in the company’s financial accounts where this is sanctioned in terms of a resolution of the shareholders in general meeting. a. Conditions Imposed on the Making of a Distribution The distribution process involves the management board preparing the Company’s accounts within three months of the financial year end. The Company’s accounts must be approved by an ‘ordinary’ meeting of the shareholders and such meeting must be convened no later than six months after the financial year end. The shareholders are not bound to follow the management board’s recommendations of the amount to be distributed as a dividend and they may pass a resolution which differs from that proposal. Nevertheless, the shareholders are unable to approve the distribution of an amount by way of dividend which exceeds that provided for by the CCC. The facts of the hypothetical case do not suggest any apparent procedural transgressions, since the accounts were prepared, the ordinary shareholders’ meeting was convened and the statutory deadline of six months was met. b. Distributable Amounts Article 192 of the CCC provides for an earned surplus test in terms of which the amount distributable amongst the shareholders of a company in each financial year cannot exceed the result of the following calculation: first, the profit for the financial year is increased by

1 A Szajkowski in S Sołtysin´ski, A Szuman´ski, A Szajkowski and J Szwaja (eds), Commentary—Kodeks Spółek Handlowych. Komentarz (Warsaw, LexisNexis, 2002) 303; A Opalski, Kapitał zakładowy, zysk, umorzenie (Warsaw, LexisNexis, 2002) 114.

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(i) undistributed profits from previous years and (ii) sums drawn from supplementary and reserve capital accounts which may be distributed (ie distributable reserves) and have been created out of profits from previous years. Second, this amount must be reduced by (i) uncovered losses,2 (ii) own shares,3 and (iii) any amounts generated from profits in past financial years which by virtue of the CCC or the company’s articles of association must be allocated to the supplementary or reserve capital accounts.4 Consequently, a dividend can be declared if net profits, profits carried forward and funds created out of profits (+) are higher than the Company’s losses, including losses carried forward and other accounting items which operate to decrease the distributable profit (–).5 When applied to the facts of the hypothetical case, the above test results in the following calculation: €200,000 (retained earnings) less €100,000 (loss in the previous financial year), which is equivalent to €100,000 in earned surplus which can be distributed. The loss incurred during the previous financial year does not impair the feasibility of the distribution,6 nor does the fact that the Company had outstanding invoices payable to Steel Factory immediately prior to the distribution. The balance sheet as at 31 December 2011 disclosed current assets of €200,000 against current liabilities of €200,000, resulting in a 1:1 ratio, which may indicate a somewhat inadequate level of cashflow on the part of the Company. The circumstances may imply that the Company is experiencing significant financial hardship; however, this does not preclude a lawful distribution of dividends so long as the requirements of the test in Article 192 of the CCC are met, ie the equation stipulated above is positive.

2 This is a reference to the losses carried forward from previous financial years, including losses incurred in the relevant financial year, since the most authoritative opinion directs that the incurring of losses in the relevant financial year does not preclude the making of a dividend payment. 3 This is a reference to shares purchased by the company (Art 19 of the Second Company Law Directive, ie Directive 77/91/EEC of 13 December 1976 on coordination of safeguards which, for the protection of the interests of members and others, are required by Member States of companies within the meaning of the second paragraph of Art 58 of the Treaty, in respect of the formation of public limited liability companies and the maintenance and alteration of their capital, with a view to making such safeguards equivalent ([1977] OJ L026/1–13) (as amended by Directive 2006/68/EC). The reason why ‘own shares’ decrease the amount available for distribution is that they must be recorded in the company’s balance sheet under a separate heading as part of the company’s undistributable capital reserves and are represented as a negative value (CCC, Art 200, para 2). Until this undistributable capital redemption reserve is extinguished or redeemed, it is treated as a loss which limits the sums to be distributed. 4 This is a reference to that part of the previous year’s profits of the company which must be capitalised as an undistributable reserve by virtue of the CCC or the company’s articles of association. The CCC provides that the following reserves cannot be distributed: — sums standing in the asset revaluation reserve of the company (Accountancy Act, Art 31, s 5); — sums standing in the share premium reserve; and — sums standing in particular capital reserves under the articles of association of the company for purposes other than the payment of a dividend (eg expected losses in previous financial years). There are also provisions which apply to public companies that require that at least 8% of its profits for a given financial year are transferred to supplementary capital accounts until such capital reaches at least one-third of the share capital so that losses can be financed. 5 Such regulation of limited liability appears to be based on Art 15(a) of the Second Company Law Directive (n 4). 6 See eg A Szuman´ski in W Pyzioł, A Szuman´ski and I Weiss (eds), Prawo spółek (Bydgoszcz, Branta 2002) 640; I Komarnicki, Prawo akcjonariusza do udziału w zysku (Warsaw, CH Beck, 2007) 97–99; A Opalski, ‘Dywidenda po nowelizacji kodeksu spółek handlowych’ (2004) Prawo Spółek 2–7. This seems to confirm the permissibility of the dividend distribution. For a different view, see S Sołtysin´ski in S Sołtysin´ski, A Szuman´ski, A Szajkowski and J Szwaja (eds), CodeKodeksu Spółek Handlowych. Komentarz (Warsaw, LexisNexis, 2002) 306.

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After the distribution of €50,000 as a dividend, the balance sheet of the Company would be as follows. Assets

Liabilities

Fixed assets

800,000

Issued share capital

500,000

Current assets

150,000

Current liabilities

200,000

Non-current liabilities

200,000

Earned surplus Total

950,000

Total

50,000 950,000

The capital maintenance rules which dictate the maximum dividend payable entail consideration of the structure of the shareholders’ equity only and overlook the structure of the Company’s assets and liabilities. Thus, the financial liquidity and cashflow position of the Company are factors which are irrelevant for the purposes of dividend distribution. The only remedy available which is based on the argument that the dividend resulted in a reduction of the Company’s cashflow position would be an action which sought to revoke the shareholders’ resolution approving the distribution on the basis that it was invalid. It could be challenged under Article 249 of the CCC as being (i) contrary to best practice and (ii) prejudicial to the Company’s interests.7 However, the right to bring an action is vested only in the shareholders and the members of the Company’s governing bodies (ie the members of the management board or supervisory board), which means that Steel Factory would be unable to challenge such a shareholders’ resolution. Therefore, up to a maximum of €100,000 could be lawfully distributed as a dividend by the Company in accordance with the provisions of the CCC. The conclusion is that the dividend distribution will be legally effective and any challenge is unlikely to be successful.

(ii) Disguised Distribution When the Company and MultiSteel concluded the contract to buy technical equipment at a price which was €60,000 higher than the market price, the Company was in fact using the contract as a means of diverting its profits to the parent company, ie it made a so-called disguised profit payment. In Polish law, the prohibition on making hidden distributions is set out expressiv verbis in Article 355, section 3 of CCC as follows: Any payment or remuneration for services or other activities undertaken for the benefit of the company by its founders or shareholders, or by companies or cooperatives affiliated therewith or in a relationship of subordination or dominance thereto, must not exceed the usual amount of payment or remuneration adopted in business dealings.

Thus, the law requires the market price to be adopted in any dealings between the shareholders and a public company. Although this provision has no counterpart in the provisions devoted to private limited liability companies, the disguised payment prohibition also applies to such companies by virtue of the numerus clausus principle of statutory payments which are made from company assets for the benefit of its shareholders.8 According to this

7 8

Komarnicki (n 6) 167. Opalski (n 1) 71; K Oplustil, ‘Gloss to the Supreme Court Judgment’, 16 April 2004, I CK 537/03.

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principle, no transfers of property between shareholders and the Company can be made in the absence of valid legal grounds.9 In addition, one must consider whether or not the payment amounts to a breach of the rules which prohibit the depletion of the Company’s legal capital. In accordance with that prohibition, shareholders are not entitled to draw profits from the Company if that leads to its net assets being reduced below the value of its share capital (Article 189, section 2 of the CCC). This provision is designed to protect the creditors of a limited liability company by ensuring that the company is unable to dispose of assets equivalent to the amount of its share capital for the benefit of its shareholders. Therefore, any payment to the shareholders is possible only if the share capital is covered, ie that there are sufficient assets unconnected to company commitments which are at the very least equivalent to the value of the share capital. Some legal commentators argue that the prohibition does not apply to claims arising from civil law contracts concluded between shareholders and the company, since it refers only to payments associated with the corporate relationship,10 but de lege lata it seems that there is no adequate normative basis for making such a distinction. In the instant case, as a result of the transaction which involved MultiSteel ordering technical equipment, the Company reduced the value of its current assets by €60,000 (the difference between the purchase price and the actual value of the goods) to €890,000 (950,000 – 60,000 = 890,000). Since the liabilities of the Company equated to €400,000, the coverage of the share capital was reduced to €490,000 (890,000 – 400,000). The result is that the payment breaches the coverage of share capital (€500,000) and, thereby, the principle which requires share capital to be preserved (Article 189, section 2 of the CCC). This can be illustrated by making the necessary modifications to the balance sheet of the Company as follows. Assets Fixed assets

Liabilities Issued share capital

500,000

Current assets

800,000 30,000

Current liabilities

200,000

Goods

60,000

Non-current liabilities

200,000

Earned surplus Total

890,000

50,000

Loss on the goods

–60,000

Total

890,000

A legal transaction which constitutes a disguised payment to shareholders or which breaches the prohibition against the depletion of the coverage of the share capital is void on the basis that it circumvents the civil law (Civil Code, Article 58, section 1, in conjunction with Article 191 of the CCC) or as being contrary to company law (CCC, Article 189, section 2). A payment made in breach of the law also renders the beneficiaries of the disguised payment (the shareholders) and members of the Company’s governing bodies (on the basis that they negligently permitted the payment to be made) duly liable to reimburse the benefits they have received in contravention of the law (CCC, Article 198). 9

Cf the judgment of the Appeals Court in Białystok, 21 February 2006, I Aca 629/05. W Jurewicz, ‘W sprawie interpretacji art. 14 § 3 i art. 189 § 2 k.s.h.’ (2003) 7 Review Przegla˛d Prawa Handlowego 24. 10

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The claim for reimbursement against the shareholders and management members vests in the Company. However, this claim does not vest in the creditors. Consequently, in light of the above regulations, the creditors of the Company have no right to claim directly from the shareholders.

(iii) Liability of the Parent Company for the Liabilities of the Subsidiary Company In the instant case, it is necessary to examine whether the disguised distribution of the assets of the Company (which impeded the Company’s ability to meet its financial commitments) to the parent company justifies the creditor in seeking financial recourse against the assets of the parent company under laws which regulate corporate groups. The Polish rules which regulate corporate groups which are set out in Article 7 of the CCC require certain agreements concluded between the parent company and the subsidiary company to be registered with the Companies Register, namely those agreements providing for (i) the management of the subsidiary company by the parent company and (ii) the transfer of profits from the subsidiary company to the parent company.11 Polish law does not define what is meant by a ‘profit transfer agreement’. However, legal commentators have advanced the following interpretation: (i)

a profit transfer agreement covers any contract or arrangement which entails the shifting of a part of the costs incurred by the parent company onto the subsidiary,12 such as a service agreement involving the payment of remuneration to the parent that cannot be justified on a commercial basis—for example, when an independent objective evaluation shows that the remuneration paid by the subsidiary to the parent does not equate to the monetary value of the services provided by the parent company;13 and (ii) a profit transfer agreement extends only to those agreements which set out the extent of the parent company’s specific rights of participation in the annual net profits of the subsidiary (shown in the annual financial report).14

11 CCC, Art 7, ss 1, 2 and 3: ‘Where a parent company and a subsidiary company conclude a contract which controls the management of the subsidiary company or the transfer of such subsidiary company’s profit, an extract from such contract, containing the provisions which determine the scope of liability of the parent company for (i) any losses sustained by the subsidiary company as a result of the parent company’s failure to properly perform any of its obligations under the contract and (ii) the obligations and liabilities of the subsidiary company towards its creditors, shall be registered in the public company file of the subsidiary company held by the Polish Companies Register. If the contract does not regulate or exclude the liabilities of the parent company referred to in paragraph 1, such agreement shall nonetheless also be subject to registration. The management board of the parent company or the subsidiary company, or the member of the management board managing the affairs of the parent company or the subsidiary company shall notify the registration court of the circumstances subject to disclosure under paragraphs 1 and 2. If such notification is not made within three weeks from the date when the contract was concluded, it shall result in the nullity of the provisions which limit or exclude the liability of the parent company for the debts or obligations of the subsidiary company or its creditors. 12 See Szuman´ski (n 1) 94. 13 See R Kwas ´nicki, ‘Umowy holdingowe w prawie prywatnym oraz podatkowym’ (2005) 4 Radca Prawny 44–55. 14 See T Sójka, ‘Umowa przewiduja˛ca odprowadzanie zysku przez spółke˛ akcyjna˛ a zasada utrzymania kapitału zakła˛dowego’ in M Cejmer, J Napierała and T Sójka (eds), Europejskie Prawo Spółek (Krakow, Zakamycze, 2005); K Wojtyczek, ‘Dopuszczalnos´c´ zawierania tzw. umów holdingowych w s´wietle przepisów kodeksu spółek handlowych’ (2002) 5 LawPrawo Spółek 35; I Ge˛bala, ‘Cywilnoprawny charakter umowy, której przedmiotem jest przekazywanie zysku w s´wietle regulacji art. 7 § 1 kodeksu spółek handlowych’ (2008) 10 (210) Rejent 125–38.

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It would appear that the provisions of Article 7 of the CCC concerning the transfer of profits agreements do not cover disguised payments, which involve the subsidiary company undertaking activities at a fictitious or inflated price (transfer pricing). Moreover, the facts of the case are devoid of any factors that would enable the one-off sale agreement to be classified as what is known as a ‘holding agreement’.15 In particular, the sale agreement does not contain any provisions which involve the parent company (1) assuming the losses or long-term obligations (for example, its distribution functions) of the subsidiary company or (2) dictating the operating or cashflow policies and principles to be applied throughout the corporate group. Furthermore, in order to be valid, the holding agreement (the agreement providing the transfer of profit) must be approved by a resolution passed by the shareholders’ meeting. In the case at hand, whilst no holding agreement has been entered into, MultiSteel as the majority shareholder of the Company controls 90 per cent of the votes at the Company’s shareholders’ general meeting. Thus, we are dealing with a de facto holding situation. The question is whether MultiSteel as the majority shareholder of the Company may be held to account for the Company’s liabilities in these circumstances in the absence of a formally concluded holding agreement. The academic legal literature is dominated by the traditional concepts of autonomy and the separate legal personality of a limited company, which is treated as negating the potential for any liability on the part of the parent company for the obligations or liabilities of the subsidiary company, whether it be a contractual or de facto holding relationship.16 The aforementioned Article 7.3 of the CCC does not provide sufficient grounds for the courts to pierce the veil of incorporation to render MultiSteel liable for the debts and/or liabilities of the Company.17 Some writers favour a blunter interpretation, whereby Article 7 establishes a presumption of liability on the part of the parent company, but only in respect of contractual holding agreements.18 Polish company and commercial law does not de lega lata treat a corporate group as a single economic unit. This can be contrasted with Polish tax, accounting and/or competition law. Many legal commentators argue that the legal position should be changed and have formulated proposals which would provide a creditor with a direct claim against a parent company in the event that a subsidiary company failed to satisfy its obligations due to the former’s wish to harm the latter’s creditors.19

(iv) The Potential for the Creditors of the Company to Successfully Recover Payments from the Members of the Management Board Article 299 of CCC directs that the members of the management board will be jointly and severally liable for the obligations of the company if recourse against that company has proved ineffective. The board members may extricate themselves from such liability by

15 The term ‘holding agreement’ is referred to by legal commentators as a collective expression for agreements specified in Art 7 of the CCC; see T Staranowicz, ‘Regulacja prawna holdingu w k.s.h.’ (2003) 3 RadcaPrawny 87. 16 M Romanowski, ‘W sprawie potrzeby nowej regulacji prawa grup kapitałowych w Polsce’ (2008) 7 Przegla˛d Prawa Handlowego 4–12. 17 T Targosz, ‘Art. 7 k.s.h.—czy rzeczywis´cie zala˛z ˙ ek regulacji prawa holdingowego?’ (2003) 1 Rejent 130; A Karolak, ‘Prawne mechanizmy ochrony spółki córki oraz jej wirzycieli w strukturze holdingowej’ (2001) 5 LawPrawo Spółek 2–12; see also Sójka (n 14) 247. 18 See eg Szuman´ski (n 1) 94. 19 M Romanowski, ‘Wnioski dla prawa polskiego wynikaja˛ce z uregulowan ´ prawa grup kapitałowych w wybranych systemach prawnych pan´stw UE, Japonii i USA’ (2008) 2 LawStudia Prawa Prywatnego 23.

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demonstrating that: (1) a petition for declaration of bankruptcy of the company was filed or composition proceedings with the creditors were instituted in time; (2) that the failure to file a petition for declaration of bankruptcy or institute composition proceedings with the creditors was not attributable to their own fault; or (3) the creditors suffered no loss notwithstanding the fact that (i) no petition for declaration of bankruptcy was filed or (ii) no composition proceedings were instituted. Therefore, an effective method of Steel Factory pursuing its claim for payment of €150,000 may be grounded in the personal and joint and several liability of the members of the management board of the Company for the Company’s liabilities. The existence of personal liability on the part of the members of the management board of the Company does not stem from the illegality of the non-payment of Steel Factory’s outstanding invoices of €150,000. Instead, it stems from the ineffectiveness of enforcement against the Company and, like the concept of piercing the veil, this liability is connected to the Company’s financial situation.20

(v) Conclusions The Company could distribute a dividend in the amount of €50,000. However, the payment for the technical equipment which leads to the depletion of the share capital is prohibited by Article 189 of the CCC, which results in the transaction being treated as null and void. Nevertheless, the creditor (Steel Factory) has no legal right to file an action directly against MultiSteel—creditor protection and the protection of a company’s assets fall within the framework of the relationship between the Company and its creditors, since Polish company law has not developed the concept of piercing the corporate veil. Instead, Steel Factory has the right to sue the members of the management board of the Company for payment of the outstanding invoices of €150,000, which is the prevailing manner of protecting creditor interests in corporate relationships under Polish law.

B. France (i) Introduction In France, a large company such as Builpod would probably be structured as a simplified joint-stock limited company (Société par actions simplifiée (SAS)) or a public limited company (Société anonyme (SA)) rather than as a limited liability company (Société à responsabilité limitée (SARL)). However, the applicable rules are similar. In the case of an SARL, the authority to decide whether a dividend should be paid out of the annual distributable profits belongs to the shareholders’ general meeting.21 The situation is identical in the case of an SA.22 The board of directors proposes an amount and the decision is made by the shareholders. In an SAS, the situation is also identical, since Article L 227-9 al. 2 of the Commercial Code provides that decisions on the annual accounts have to be taken by a collective decision of the shareholders. In addition, the provisions of the Commercial Code on the ability of a company to pay a dividend and the limits on the amount that

20 21 22

M Litwin´ska-Werner, ‘Naduz˙ ycie formy spółki’ (2007) 3(4) Studia Prawa Prywatnego 81–102. Commercial Code, Art L 232-11. Commercial Code, Art L 232-11.

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can be paid are included in the same provisions of the Commercial Code, particularly Article L 232-12, which applies to the SARL, the SA and the SAS.

(ii) Assessment of the Dividend Distribution a. Principles Applicable to the Amount that Can Be Distributed under French Company Law French law applies the principle of intangibility of capital (principe de fixité ou d’intangibilité du capital social). Therefore, no dividends can be distributed from the issued capital. The financial liquidity and cashflow position of the company are irrelevant to determining whether a distribution of a dividend is lawful or not. Article L 232-11 of the Commercial Code indicates what can be used to pay the dividends: The distributable profit consists of the profit for the period, less the losses brought forward, plus the sums carried forward pursuant to the law or the memorandum and articles of association, plus the profit brought forward. The general meeting may, moreover, decide to distribute sums taken from the reserves available to it. In which case, the shareholders’ decision must expressly indicate the reserve from which such sums are to be taken. The dividends are nevertheless taken primarily from the distributable profit for the period. Unless there has been a share capital reduction, no distribution can be made to the shareholders when the share capital is, or would thereby become, lower than the amount of the capital plus the reserves which the law (statutory reserves) or the memorandum and articles of association require in order for a distribution to take place. Any revaluation reverse is not distributable. It may be wholly or partly incorporated into the capital.

In substance, this article provides that the amounts which can be distributed under French company law are as follows: (a) the profit from the company’s financial year; and (b) the company’s accumulated profits shown in a distributable reserve (réserves). According to Article L 232-11 al. 3 of the Commercial Code, the statutory reserve (réserve légale) cannot be distributed. A company must set aside at least five per cent of its income from its profits as statutory reserve each year as long as the statutory reserve does not represent 10 per cent of its issued capital.23 The statutory reserve is not distributable. In the Company’s case, there does not seem to be any statutory reserve. However, it is assumed that the amount of €500,000 of issued share capital also includes the statutory reserve since, like the issued capital, it cannot be distributed. One final issue is not dealt with by Article L 232-11, namely whether additional paid-in capital (prime d’émission) can be distributed or not as the case may be. There are conflicting views amongst authors as to whether the additional paid-in capital is profit or a form of capital. The French Cour de cassation took the latter view in a decision reached in 1952.24 However, since additional paid-in-capital is not treated as issued capital, the French courts adopt the position that it is not subject to the principle of intangibility of capital. Therefore, it can also be distributed. In the Company’s case, there is no indication that there is any additional paid-in-capital.

23

Commercial Code, Art L 232-10. Cass Com (Cour de cassation, Commercial Chamber), 9 July 1952, JCP G 1953, II, 7742 with a note by Bastian. 24

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The distribution of a dividend in violation of these rules may be punished criminally as a fictitious dividend.25 The managers of an SARL may be held criminally liable in such a case.26 The same applies to the CEO, the directors27 and senior executive officers (Directeurs généraux délégués)28 of an SA, as well as to their equivalents in an SAS.29 Turning to the potential civil liability, the distribution of an illegal dividend may be treated as a nullity. The French Commercial Code provides that, in the case of a decision by the ordinary shareholders’ meeting (SA) or an ordinary decision of the shareholders (SAS and SARL), ‘The nullity of acts or deliberations … may result only from the breach of a mandatory provision of this Title [Title on Common provisions applying to commercial companies] or of the acts governing contracts’.30 Article L 232-11 of the Commercial Code is a mandatory provision. Therefore, when it is breached, the sanction is the nullification of the dividend payment. The legal action seeking a declaration that the dividend is a nullity may be brought by any interested person, including a creditor. The shareholders must also reimburse the fictitious dividend to the company if they were aware that the dividend was fictitious or they ought to have been aware of this.31 This disgorgement action can be raised by the company or a creditor.32 Turning to the Company’s situation, during the 2012 shareholders’ general meeting, which approved the 2011 accounts, the Company voted in favour of the distribution of a dividend of €50,000 which was paid in early July 2012. Since the 2012 shareholders’ meeting deals with the 2011 fiscal year, no loss was incurred and the payment of the dividend (€50,000) is valid since it is less than the accumulated profits (€200,000). Under French company law, the fact that the shareholders decided to distribute a dividend during a calendar year in which they incurred losses is irrelevant, since the possibility of distributing a dividend depends on whether the financial statements regarding the previous financial year allowed for such a distribution. The Company made profits in 2009 and 2010 well in excess (€200,000) and a loss of €100,000 in 2011, which means that there was a remaining €100,000 distributable for the 2011 financial year. This is more than the amount of the dividend (€50,000) distributed for the 2011 financial year. Therefore, the payment of the €50,000 dividend in 2011 or in 2012 is valid and Steel Factory cannot challenge the decision.

(iii) Disguised Distribution In August 2012, the Company ordered technical equipment worth €120,000 from MultiSteel, its 90 per cent shareholder, and duly paid the purchase price. It turns out that the market value of these goods had been overestimated by 50 per cent. The fact that the Company overpaid by 50 per cent for the technical equipment could be considered to be a disguised distribution. However, under French company law, there is no specific rule or case law on disguised distributions such as imbalanced transactions. Only tax law deals

25 26 27 28 29 30 31 32

Commercial Code, Art L 232-11 al 3. Commercial Code, Art L 241-3 2°. Commercial Code, Art L 242-6 1°. Commercial Code, Art L 248-1. Commercial Code, Art L 244-1. Commercial Code, Art L 235-1. Commercial Code, Art L 232-17. J Hémard, F Terré and P Mabilat, Sociétés commerciales, vol 3 (Paris, Dalloz, 1978) n° 532.

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with a disguised distribution (distribution camouflée de dividendes). Therefore, the fact that the issued capital would be impaired by the loss due to the overpayment will not jeopardise the payment of the €50,000 dividend. The situation would be dealt with in France through the application of the rules on conflicted/related transactions (conventions réglementées). Under French company law, in the case of an SARL, contracts such as a purchase of equipment entered into between a company and a manager or any shareholder (regardless of the amount held) are not subject to any requirement for prior authorisation but only to ex post approval by the shareholders.33 The situation is the same in the case of the simplified joint-stock company (SAS).34 In both cases, there is an exemption from approval for contracts which are common and entered into under normal terms and conditions. It is likely that the purchase was a current operation of the Company since it is common for a company manufacturing steel structures to acquire technical equipment. However, the contract was not entered into under normal terms and conditions since the price paid to the majority shareholder was inflated. Therefore, the procedure on related parties transactions ought to have been applied. However, the fact that the procedure has not been followed cannot be sanctioned by the nullity of the act. An action for damages could be initiated by the minority shareholders against the directors. In the case of a joint-stock company (SA), contracts such as a purchase of equipment entered into between the company and a director or a shareholder holding more than 10 per cent of the voting rights are subject to the prior authorisation of the board.35 Agreements are then subject to the ex post approval of the general meeting of the shareholders36 and any interested directors are prohibited from voting.37 These provisions do not also apply to agreements relating to current operations entered into under normal terms and conditions.38 With regard to the purchase of the equipment at an inflated price by the subsidiary, there was an obligation to have a board resolution since the contract is concluded both with a shareholder holding more than 10 per cent of the voting rights who is also probably a director of the Company. Therefore, the procedure relating to conflicted transactions ought to have been applied. If MultiSteel participated in the vote or the authorisation was not given by the board of directors, the transaction can be treated as void if it has a detrimental effect upon the Company. Indeed, this appears to have been the case. However, disinterested shareholders can avoid the nullity by ratifying through a vote.39 In the Company’s case, it is doubtful whether the disinterested shareholders would approve such a transaction. However, even if there was a defect in the procedure, a creditor such as Steel Factory cannot raise a legal action to invalidate the purchase contract since the procedure on related parties transactions of the Commercial Code, and especially the requirement to have an ex ante authorisation by the board of directors, was established in order to protect the

33 34 35 36 37 38 39

Commercial Code, Art L 223-19. Commercial Code, Art L 227-10. Commercial Code, Art L 225-38. Commercial Code, Art L 225-41. Commercial Code, Art L 225-40. Commercial Code, Art L 225-39. CA Paris (Court of Appeal of Paris), 18 December 1990, Bull Joly, 604.

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shareholders rather than the creditors.40 Therefore, as in the case of an SA and an SARL, the only remedy is an action for damages, which could only be initiated by the minority shareholders against the directors. Although not a shareholder, Steel Factory could consider suing the directors for damages on the grounds that they did not follow the procedure on related parties transactions of the Commercial Code or that the overpayment for the assets was detrimental to the interests of the Company’s creditors. However, with regard to the former legal ground, it is very unlikely that a creditor would be recognised as having the requisite standing in a French court to sue the directors for damages in respect of a breach of the rules on conflicted transactions, since a creditor is barred from raising legal proceedings to invalidate the purchase contract. On the second legal ground, Steel Factory would also be unable to secure damages from the directors. The rationale for this is that French company law dictates that only the company itself can be sued and not the individual managers (SARL) or directors (SA and SAS). When the managers or the directors act in their official capacity as directors, they are shielded from liability towards third parties as long as they acted within the scope of their functions. The French Cour de cassation is very reluctant to find directors personally liable towards third parties for acting outside the scope of their responsibilities (faute séparable des fonctions). There must be intentional fault of a specific gravity which cannot be linked to the individual’s functions or responsibilities as a director. Taking into account that it is a very rare case where such fault has been found by the Cour de cassation,41 it is highly probable that MultiSteel, as a manager or director, would be shielded from personal liability.

(iv) Liability of the Parent Company for the Financial Obligations of the Subsidiary Company The French courts recognise the possibility of piercing the corporate veil. However, the conditions attached are very restrictive. There are two possible grounds for piercing the corporate veil. None of them would apply to the Company’s situation. The first is the concept of the fictitious company (société fictive).42 If a company is fictitious, its debts can be attributed to the parent company. This concept implies that the fictitious company does not exist because there is no real activity, there are no regular operations of the company or there was no real willingness on the part of the shareholders to create a company. The courts tend to apply different criteria in order to declare a company fictitious, with no one factor being essential. In the Company’s case, the Company is clearly a real company with operations, a majority shareholder and minority shareholders. Therefore, the scope for Steel Factory to successfully pierce the corporate veil on this basis is non-existent.

40

Cass Com (Cour de cassation, Commercial Chamber), 15 March 1994, RJDA 5/94 n° 541. See eg Cass Com (Cour de cassation, Commercial Chamber), 20 May 2003 (Madame SEUSSE c/ Société Sati), Revue des sociétés 2003, 479 with a note by JF Barbiéri, D 2003, Jur 2623, with a note by B Dondero and AJ 1502, with an observation by A Lienhard, RTD com 2003, 523, with an observation by J-P Chazal and Y Reinhard and 741, with an observation by C Champaud and D Danet, RTD civ 2003, 509, with an observation by P Jourdain. 42 Eg Cass Com (Cour de cassation, Commercial Chamber), 18 November 1986, D 1987, som 73 and 9 June 2009, Revue des sociétés 2009, 781. 41

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The second ground for the corporate veil to be pierced is the commingling of assets (confusion de patrimoine).43 If there is a commingling of assets, the debts of the subsidiary can be attributed to the parent company. This concept applies in the case of bankruptcy proceedings. The French courts are generally unenthusiastic when it comes to acceptance of the commingling of assets ground. Here again, the existence of an imbalanced transaction is not enough for a French court to pierce the corporate veil.

(v) Summary and Conclusions The French Commercial Code and the French courts are relatively liberal when it comes to the payment of dividends. In addition, there is no such concept as a disguised distribution. Therefore, in the hypothetical case, the creditor would enjoy little protection in France.

C. Germany44 (i) Introduction The annual accounts of a German limited company (GmbH) are to be drafted according to the relevant rules of the German Commercial Code (see GmbHG, § 42). Thereafter, the accounts and, if required, the auditor’s report have to be sent to the shareholders for approval, who also decide on the distribution of profits (GmbHG, §§ 42a, 46(1)). The amount of profits which may be distributed is specified in § 29 of the GmbHG: the shareholders are entitled to the annual net profit (plus the undistributed profits less the uncovered losses from the previous years), insofar as this amount has not been transferred to the supplementary or reserve capital accounts. Profits can also be distributed from the supplementary or reserve capital accounts. These rules are very similar to those in Polish law. Thus, the distribution of profits in the hypothetical case was in compliance with § 29 of the GmbHG. A further limitation is that the assets of the company which are required for the maintenance of the share capital may not be distributed to the shareholders (GmbHG, § 30). It is therefore necessary to calculate whether the value of the Company’s assets less its liabilities and distributed profits is not less than the issued share capital. In this case, €1,000,000 less €400,000 and €100,000 is €500,000, which is equivalent to the Company’s issued share capital. If the resolution of the general meeting to distribute profits had been unlawful, this could not have been challenged by a creditor. Conversely, any shareholder could raise an action for the avoidance of a resolution of the general meeting.45 Since the relevant criteria for a challenge are not specified in the GmbHG, the courts use the relevant rules of the law on public companies (AktG, §§ 241–49) by analogy. However, the strict time limit of one month (AktG, § 246(1)) is only regarded as a guide in order to determine whether an action has been filed within a reasonable period.46

43 B Grelon and C Dessus-Larrivé, ‘La confusion de patrimoine au sein d’un groupe’ (2006) Revue des sociétés 281. 44 Abbreviated statutes: AktG = Law on Joint-Stock Companies (Aktiengesetz); GmbHG (Law on Private Limited Companies); InsO (Insolvency Code). 45 It will only be in extreme cases that a decision of the general meeting will be regarded as void. 46 BGH (German Federal Supreme Court), BGHZ 101, 113, 117; 111, 224, 226; W Zöllner in Baumbach & Hueck’s GmbHG 19th edn (Munich, Beck, 2010) Anh nach § 47, para 145.

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(ii) Disguised Distributions Like Polish law, German law has a concept of ‘disguised distributions’. German public companies are strictly prohibited from making such distributions (AktG, §§ 57 and 58(5)). The German law on private companies on this issue is not codified. However, here too, disguised distributions are unlawful under certain requirements. First, one is required to establish whether there is a ‘disguised distribution’. This is a reference to any payment made to a shareholder (not being a formal distribution of profits) without adequate consideration. A typical example is the sale of goods to a shareholder below the market price.47 There are four reasons why such distributions may be unlawful.48 First, assets required for the maintenance of share capital may not be distributed to the shareholders (GmbH, § 30). This is calculated in the same way as under Polish law. Second, in the absence of shareholder agreement, disguised distributions violate the principle of equal treatment of the shareholders. Third, such distributions may involve a breach of fiduciary duties. There may be cases where undervalue transactions can be justified by the business judgment rule.49 However, if the beneficiary is a related party, there is little doubt that the directors are in breach of their duty of loyalty to the company.50 Fourth, if the other shareholders do not approve of the distribution, this also entails the infringement of the powers of the general meeting, since the general meeting is usually entitled to decide about the distribution of profits (see above). Thus, in the present case, the disguised distribution is unlawful for a variety of reasons. Creditors of public companies can enforce violations of capital maintenance law if recourse against the company proved ineffective and insolvency proceedings have not yet been initiated (AktG, § 62(2)). In some cases, they can also enforce general breaches of directors’ duties.51 Similar provisions do not exist for private companies, and the predominant view rejects the drawing of any analogy.52 Thus, the enforcement of disguised distributions also lies with the company itself.53 Since creditor protection is most relevant in the insolvency of a company, it is also worth mentioning that in this case the insolvency administrator (InsO, § 148(1)) represents the company on behalf of the interests of the creditors. The Polish solution indicates that the law on groups of companies may be relevant in the present case. In the German law on public companies, the law on groups of companies is codified in detail (AktG, §§ 291–338). However, no such rules exist for private companies and the predominant view also rejects drawing any analogy. Instead, one must consider whether there has been a violation of fiduciary duties among the shareholders.54 This can be enforced by the shareholders themselves,55 but not the creditors of the company.

47 BGH (German Federal Supreme Court), NJW 1987, 1194; G Hueck and L Fastrich in Baumbach & Hueck’s GmbHG (n 46) § 29, paras 68–69. 48 Hueck and Fastrich in Baumbach & Hueck’s GmbHG (n 46), paras 71–76. 49 See ch 2 at II C, above. 50 For this duty, see ch 3 at II D, above. 51 See ch 6 at II C, above. 52 See eg Hueck and Fastrich (n 47) § 31, paras 6, 31 and 43. 53 For the possibilities of shareholder actions, see eg ch 10 at II D, below. 54 See, eg Zöllner, above n 46, Schlussanhang para 79. 55 See, eg ch 10 at II D below.

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D. Italy56 According to Article 2478-bis of the CC, an Srl’s financial statements must be prepared in accordance with the rules applicable to Spas and must be presented to the shareholders for their approval within 120 days (or 180 days in particular situations) of the financial year end. As part of this process, the shareholders must also decide on the distribution of profits. In addition, Article 2478-bis, paragraph 5 of the CC stipulates that only profits that have been ‘really attained’ and that are indicated in the financial statements can be distributed amongst the shareholders. Finally, Article 2478-bis, paragraph 6 of the CC provides that any dividends distributed in violation of the rules provided by the Civil Code do not need to be repaid if the shareholders received these profits in good faith and on the basis of financial statements that mentioned these profits and were approved by the shareholders. In terms of the Italian rules on the preparation of a company’s financial statements, the Company would be allowed to distribute €50,000, as indicated in the hypothetical case. In fact, the balance sheet of the Company indicates that the value of the Company’s assets less its liabilities—and less its share capital—generated an ‘accumulated profits brought forward’ of €200,000, which was eroded only in part by the loss of €100,000 incurred during the previous financial year. In brief, in Italy the Company would be entitled to distribute a maximum of €100,000. However, it should be stressed that Italian law would require a part of the accumulated profits to be allocated to a capital account called the ‘legal reserve’. According to Article 2430 of the CC, the legal reserve is created by setting aside at least five per cent of the Company’s annual net profits until this reserve has reached 20 per cent of the issued share capital.57 This reserve cannot be distributed amongst the shareholders. Considering that the Company’s balance sheet indicates that it has €200,000 of ‘accumulated profits brought forward’, a minimum of €10,000 of these profits would have been attributed to the ‘legal reserve’, meaning that only a distribution of €90,000 would have been permitted. Another important issue is the date on which it was decided to distribute the dividend. If the resolution approving the financial statements and the distribution of the profits is taken as 30 June 2012, it would have been decided 182 days after the Company’s financial year end. Thus, the resolution would have been taken in violation of Article 2478-bis of the CC. However, for several reasons, Steel Factory would not be allowed to challenge the validity of the profit distribution: first, it is unclear whether the approval of the financial statements after 120–80 days would put at risk the validity of a late resolution;58 second, Article 2478-bis, paragraph 6 of the CC would protect the shareholders that received payments in good faith; and, third, even if the resolution were invalid, it is unlikely that a third party, particularly in the hypothetical case, would have standing to challenge the resolution.59 With regard to the transaction between the Company and MultiSteel in respect of the transfer of the technical equipment, Steel Factory may have several remedies. However, none are based on the rules on capital maintenance or directly relate to the problem of disguised distributions. 56 Abbreviations: CC = Italian Civil Code (codice civile); Spa = joint-stock company (Società per azioni); Srl = private limited company (Società a responsibilità limitata). 57 Generally, on the legal reserve in Italian law, see P Balzarini, ‘Commento sub art. 2430’ in P Marchetti, LA Bianchi, F Ghezzi and M Notari (eds), Commentario alla Riforma delle società. Obbligazioni. Bilancio (Milan, Giuffrè-Egea, 2006) 617 ff. 58 D Corrado, ‘Commento sub art. 2434-bis’ in Marchetti et al (eds) (n 57) 659–62. 59 Cf Corrado (n 58) 681 ff.

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Article 2475-ter, paragraph 1 of the CC on the conflict of interest of directors may form the basis of an action for damages pursuant to Article 2476 of the CC. However, it is unclear whether creditors may file a direct action against directors of an Srl.60 In addition, even if in some cases the conflict of interest may make the transaction voidable, the plain wording of Article 2475-ter of the CC grants only the company the right to challenge the validity of the agreement. Since the Company is arguably subject to the ‘direction and coordination’ of MultiSteel, a second remedy available to Steel Factory would be an action pursuant to Article 2497 of the CC.61 According to this provision, any companies and entities entrusted to carry out the direction and coordination of another company who act in their own interests or in the interests of other parties are directly liable for losses suffered by the shareholders of the companies subject to such direction and coordination, or by the creditors of those companies for the losses caused to the integrity of the corporate assets. It is important to highlight, however, that such liability is excluded if, among other things and in light of the impact and effect of the direction and coordination, no loss is suffered by the company. Thus, it would be necessary to know if, in general, the activity of direction and coordination carried out by MultiSteel was detrimental to the Company. In conclusion, the distribution of profits may not be challenged by Steel Factory. On the other hand, the transaction between the Company and MultiSteel may result in an award of damages for Steel Factory, both directly for a violation of the rules on the direction and coordination of companies or indirectly for a violation of the rules on the conflict of interests of the directors.

E. Spain (i) Introduction In Spain, the annual accounts of the Sociedad de Responsabilidad Limitada (SL) have to be prepared in accordance with the rules set out in Articles 253–84 of the Ley de Sociedades de Capital (LSC).62 Directors are required to formulate the annual accounts within three months after the end of the financial year (LSC, Article 253.1) and the general shareholders’ meeting must meet within the first six months of the company’s financial year in order to approve the annual accounts of the previous financial year (LSC, Article 164.1).63 After the general shareholders’ meeting is called, any shareholder should be afforded the opportunity to obtain the annual accounts and the auditor’s report from the company (LSC, Article 272.2). The general meeting must then decide on the approval of the annual accounts (LSC, Article 272.1), as well as the dividends to be distributed to shareholders (LSC, Article 273).

60

Cf ch 6 at II D, above. Cf ch 10 at II E, below. 62 Real Decreto Legislativo 1/2010, de 2 de julio, por el que se aprueba el texto refundido de la Ley de Sociedades de Capital (LSC). Before the passing of the LSC, both types of companies were regulated in separate Acts—the Real Decreto Legislativo 1564/1989, de 22 de diciembre, por el que se aprueba el texto refundido de la Ley de Sociedades Anónimas (for SAs) and the Ley 2/1995, de 23 de marzo, de Sociedades de Responsabilidad Limitada (for SLs). 63 Unless otherwise specified in the bylaws, the financial year end of a company is the 31 December in each calendar year (LSC, Art 26). 61

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In accordance with the LSC, once the formalities required by the law or the company’s bylaws (for example, the constitution of capital reserves) have been attended to, dividends may be distributed, either from the company’s profits or distributable capital reserves, but not from statutory capital reserves (LSC, Article 273.2). An additional requirement is that the distribution of dividends must not result in the company’s net asset value being lower than its issued share capital (LSC, Article 273.2).64 Indeed, if there are losses from previous financial years that result in the net asset value being lower than the issued share capital, then profits must be applied to cover such losses (LSC, Article 273.2). If the Company’s general shareholders’ meeting approves the annual accounts corresponding to the year 2011 in June 2012 and decides to distribute a dividend of €50,000, then the Company’s net asset value would be €650,000 (ie €500,000 plus €200,000 minus €50,000); €650,000 is higher than the Company’s issued share capital (€500,000). Therefore, the distribution of the dividends would be in accordance with Spanish company law. It is important to note that there is a legal requirement that 10 per cent of a company’s annual profits in each financial year must be allocated to the statutory capital reserve until this reaches at least 20 per cent of the issued share capital of the company (LSC, Article 274.1); it is assumed that such undistributable reserve is included in the amount corresponding to the Company’s issued share capital in the hypothetical case.

(ii) Disguised Distributions Spanish law does not directly address the concept of disguised distributions by specific legal provisions. Nevertheless, scholars have recognised the existence of the phenomenon, which may have different purposes, ranging from the generation of tax savings for the company to the attribution of advantages to certain shareholders.65 The payment made by the Company to MultiSteel, its 90 per cent shareholder, concerning a purchase above market value can be considered a disloyal and discriminatory disguised distribution since a majority shareholder has benefited and the other shareholders have been excluded. Such types of disguised dividends, which are explained in the case of chapter 10, below, may involve the violation of certain duties by the directors of the Company and by MultiSteel towards the Company. Moreover, disguised dividends that bring the net worth of the company below the share capital are considered to be a fraud on creditors.66 The purchase of assets by the Company from MultiSteel at a price above the market value reduces the Company’s net asset value by €60,000, thus reducing it to €590,000 (€500,000 plus €200,000 less €50,000 and €60,000). Since €590,000 is above the Company’s issued share capital valued at €500,000, the capital maintenance rules are not breached. However, it is interesting to note the consequences of a distribution which defraud a company’s creditors. Whilst some scholars take the view that such transactions are null and void, imposing an obligation on the benefited shareholders in restitution, most jurisprudential and doctrinal analyses do not advocate the nullity of the transaction as a mechanism for the protection

64

See F Sánchez Calero, Principios de Derecho Mercantil 15th edn (Navarre, Thomson-Aranzadi, 2010) 306. The most comprehensive study on disguised distributions and, notably, on disguised dividends in Spain is developed by B Bago Oria, Dividendos encubiertos. El reparto oculto del beneficio en sociedades anónimas y limitadas (Cizur Menor (Navarre), Civitas, 2010). A treatment of the different reasons behind disguised dividends is set out at 87–93. 66 See eg Bago Oria (n 65) 96–102, 109, 112–13 and 121. 65

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of creditors.67 It is also worth stressing the point that creditors will tend to seek amounts owed to them rather than the nullity of the transactions giving effect to the distribution of disguised dividends.68 This can be attributed to the fact that the latter remedy would simply repatriate the assets back to the company, whereas the main purpose of the creditors is to ensure that the amounts owing to them are paid.69 There are circumstances where there may be compliance with capital maintenance rules, but where nonetheless there has been a fraud on the creditors, for example, where disguised dividends are aimed at committing fraud on creditors and executed prior to an insolvency situation—these dividends may indeed be challenged and judicially revoked afterwards.70 Another possibility for creditors affected by fraud is to file a revocatory action (Civil Code (CC), Article 1111), which is however limited to those circumstances where the creditor cannot retrieve amounts in any other way (CC, Article 1291) and when the debtor does not have any other goods for the payment of the debt.71

F. Finland (i) Introduction The annual accounts of a Finnish limited liability company must be drafted in accordance with chapter 8 of the Companies Act (CA) and the Accounting Act.72 The distribution of assets must be based on the latest set of adopted financial statements (CA, chapter 13, section 3). The annual accounts must be adopted by the general meeting which is to be held within six months from the end of the financial period (CA, chapter 5, section 3(1) and (2)). The financial statements, annual report and, if required, the auditor’s report must be made available to the shareholders at its head office or on the company’s website for at least one week before the meeting. Upon request, the documents must be sent to a shareholder (CA, chapter 5, section 21(1)). The general meeting decides about the distribution of profits and is generally bound by the board’s proposal. Therefore, the general meeting can only decide to distribute larger amounts if so required by the articles of association (CA, chapter 13, section 6(1)).

(ii) Distributable Amounts Only distributable reserves of the company may be distributed as dividends (CA, chapter 13, section 1(1), paragraph 1). The issued share capital, the fair value reserve and the revaluation reserves of the company are treated as undistributable reserves under the Accounting Act (CA, chapter 8, section 1(1)). If the company wishes to decrease its share capital, the Trade Registrar must be informed. The creditors are notified and can oppose the proposal by a written statement to the Trade Registrar (CA, chapter 14, section 4). Distributable reserves are comprised of other reserves and profits of the company from the current and previous financial years, from which losses are deducted. This amount may be distributed

67 68 69 70 71 72

See eg Bago Oria (n 65) 150. See eg Bago Oria (n 65) 150. See eg Bago Oria (n 65) 150–51. See eg Bago Oria (n 65) 118–20. See eg Bago Oria (n 65) 120. Kirjanpitolaki (1336/1997).

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unless otherwise provided by the articles of association. At first glance, therefore, it seems that €100,000 (accumulated profits (€200,000) less loss (€100,000)) would be distributable. However, a solvency test must be undertaken prior to any distribution. Assets cannot be distributed if doing so would render the company insolvent in accordance with the information available (and information that should be available) at the time of the decision (CA, chapter 13, section 2). This means that the creditors must be paid before the shareholders. Solvency is not defined in the CA. According to the Act 758/1991 relating to the obligations of companies in the case of bankruptcy,73 a debtor is insolvent where the debtor is not able to pay his or her debts when they become due and this is not a temporary situation. In the hypothetical case, the Company has failed to meet its financial commitments to Steel Factory (€150,000) on more than a temporary basis. The case scenario does not reveal when the market collapsed and the severe difficulties experienced by the Company in meeting its financial commitments started. For the purposes of the hypothetical case, let us assume that it was before the general meeting in June 2012 that the Company’s difficulties started and also that this led to the insolvency of the Company. Therefore, the general meeting’s decision to distribute €50,000 as dividends out of (to simplify) €100,000 of distributable reserves was made when it was known or ought to have been known that the distribution might lead to insolvency. The decision therefore falls foul of the requirements in chapter 13, section 2 of the CA. The dividends distributed to the shareholders in July must therefore be refunded, with interest, if the shareholder in question knew or should have known that the distribution was unlawful (CA, chapter 13, section 4). The unlawful distribution of assets also constitutes a criminal offence (CA, chapter 25, section 1(1)).

(iii) Steel Factory’s Options However, Steel Factory as a creditor is not in a position to challenge the dividend distribution and demand a refund based on the CA. Furthermore, whether or not the distribution of assets is unlawful is often difficult to decide in practice. Let us assume that the scenario is as clear as described above. Here, Steel Factory has basically two options: (1) to sue the Company based on breach of contract and demand a court order for precautionary measures (injunction)—Steel Factory would not be successful in enforcing its claim, presumably due to the Company’s insolvency; and (2) to hold the directors and/or the shareholders personally liable in damages based on chapter 22 of the CA. Shareholders who deliberately or negligently contribute to the unlawful distribution are liable in damages to a creditor (CA, chapter 22, section 2). The board of directors are obliged not to enforce unlawful decisions made by the general meeting (CA, chapter 6, section 2), and having done so they are liable in damages to creditors (CA, chapter 22, section 1(2), with a reversed burden of proof). Naturally, the directors should not have proposed an unlawful distribution in the first place and are liable to the creditors in damages if they indeed put such a proposition forward to the general meeting. Steel Factory must establish causation between its loss and the unlawful distribution. Furthermore, Steel Factory can also bring forward a claim for damages in conjunction with possible criminal proceedings. The damages may in that case also be based on the Tort Liability Act,74 under which damages

73 74

Laki takaisinsaannista konkurssipesään (758/1991), s 4. Vahingonkorvauslaki (412/1974), s 5(1).

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can be granted for economic loss arising from punishable acts if the directors’ conduct is considered particularly reprehensible.

(iv) Disguised Distributions Turning now to the Company’s purchase of equipment from the majority shareholder MultiSteel, the transaction was seemingly designed to make a loss. No sound business reasons for the decision have been presented. Such transactions are unlawful by virtue of chapter 13, section 1(3) of the CA irrespective of whether the recipient is a shareholder.75 Therefore, even without the solvency test, the assets (overpriced) must be refunded (CA, chapter 13, section 4). The recipient, MultiSteel, having a 90 per cent share of the Company, cannot argue that it was not aware of the unlawfulness.76 The transaction constitutes a disguised distribution. Thus, the transaction is also a breach of the principle of equal treatment of shareholders enshrined in chapter 1, section 7 of the CA and might as such be invalid by virtue of chapter 6, section 28 of the CA. Distributable reserves can be distributed as agreed by all shareholders in contravention of chapter 13, section 1 of the CA, unless otherwise provided by the articles of association (CA, chapter 13, section 6(4)). However, this does not apply where the board fails to secure the consent of the minority shareholders. Nevertheless, even so, the present transaction would fall under chapter 13, section 2 of the CA in the circumstances described above and would fail to pass the solvency test. Steel Factory’s options are the same as described above. As the Company is apparently insolvent, Steel Factory’s best option would be to raise proceedings against the directors for damages. Here, the shareholders were not formally involved in the decision-making. It can be assumed, however, that the majority shareholder (MultiSteel) to whom the disguised dividends were paid has contributed to the unlawful decision and therefore is liable in damages.

G. Latvia (i) Dividend Payments By virtue of sections 174, 179 and 180 of the Commercial Code, the annual accounts of a Latvian limited liability company (sabiedrı¯ba ar ierobežotu atbildı¯bu (SIA)) must be prepared at the end of each business year and submitted to the general meeting of shareholders and the supervisory board, if the latter has been formed, together with a proposal by the board of directors on the application of the profits, if any.77 The distribution of profits to the shareholders is done in accordance with section 161 of the Commercial Code by way of the payment of dividends. In terms of section 161(4) of the Commercial Code, dividends may not be determined, calculated and paid out if the

75 Undervalue sales, overpriced purchases and loans taken with interest rates higher than average are all examples of transactions that prima facie lack sound business reasons and therefore violate the fiduciary duties of the directors. 76 Only a party who knew or should have known about the unlawfulness is under an obligation to reimburse. 77 Likums ‘Komerclikums’, Latvijas Ve ¯stnesis 158/160 (2069/2071), 13 April 2000. An English translation of the Act is available at www.fktk.lv/en/law/financial_instruments_market/laws.

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annual accounts reveal that the own funds of the company are less than the total amount of the company’s issued share capital. There is nothing to suggest that this requirement has not been complied with.

(ii) Payment to MultiSteel However, the purchase from and payment to MultiSteel may have contravened the rule on the equal treatment of shareholders in section 161(2) of the Commercial Code, whereby dividends must be paid to shareholders in proportion to the total of the par value of the shares owned by them. If the payment to the shareholder MultiSteel is viewed as a disguised payment of dividends, the result would be that such payment to MultiSteel would have been to the exclusion of the other shareholders. Furthermore, section 161(5) of the Commercial Code may have been violated, which provides that dividends are to be determined and calculated only once a year: if the payment to MultiSteel is seen as a disguised payment to a shareholder, this payout and the normal payout by way of the statutory procedure would have occurred twice during 2012. In addition, the payment has not complied with the requirement that payments must be based on a resolution passed by the meeting of shareholders in terms of sections 161(2) and (5), 180(4) and 210(5) of the Commercial Code: the decision to order and pay for goods from MultiSteel was taken by the management and not by the meeting of shareholders. Whilst it may be debated whether the above rules on the procedure for the payment of dividends have been complied with, the payment by the Company to MultiSteel has clearly violated the statutory prohibition on unjustified dividend payments to shareholders: section 182(1) of the Commercial Code prohibits any payments to shareholders, other than by way of dividend payments or in the event of a reduction of share capital. The law expressly prescribes a presumption that a purchase by a company from a shareholder at a price higher than usual is unjustified and therefore prohibited in terms of section 182(2) of the Commercial Code. Whether prices for goods are ‘higher than usual’ depends on the respective current market prices of goods of equal quality, but also requires an overall assessment of the consequences of the transaction for the purchasing company. In the absence of any evidence of benefits accruing to the Company, the purchase of goods from MultiSteel at a price 50 per cent above the current market price would be viewed as being within the scope of conduct prohibited by the law and would therefore constitute an unjustified payment. Unjustified payments to shareholders, as well as dividends paid out in contravention of the rules on the payment of dividends, result in an obligation to return payments to the Company by virtue of section 162(1) and (2) of the Commercial Code. The Company’s claim for reimbursement here is not available to third parties: the wording of the Commercial Code and the location of the provision within the section of the Commercial Code which deals exclusively with relations between the shareholders and the company leaves no room for its application to non-shareholders by way of an extrapolative interpretation. The payment must be returned, but in order for Steel Factory to force the Company to make such a claim against MultiSteel, a separate statutory entitlement would be required, which is not available. Therefore, Steel Factory has no legal grounds to challenge the payment to MultiSteel.

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H. The UK78 (i) Introduction The provisions of company law which regulate the payment of dividends79 of a private limited company are found in the common law capital maintenance principle,80 Part 23 of the CA 2006 (CA 2006, sections 829–53)81 and regulations 30 to 35 of the Model Articles.82 Like Polish law, the primary authority for deciding whether a dividend should be paid out of the annual distributable profits of a limited liability company rests with the shareholders of that company. Model Article 30(1) and (2) directs that a company may by ordinary resolution of its shareholders declare dividends, but a dividend must not be declared unless the directors have made a recommendation as to its amount and a dividend must not exceed the amount recommended by the directors. The directors have the power to recommend to shareholders what part of the profits available for distribution shall be carried to reserve or otherwise be set aside or be carried forward, and what part shall be made available for dividend. There is no requirement for a private limited company to hold a general meeting of its shareholders to approve the company’s annual accounts. Regulation 30(4) of the Model Articles directs that dividends of a private limited company are paid by reference to each shareholder’s holding of shares on the date of the resolution or decision to declare or pay it.83 However, this is subject to anything to the contrary stipulated in the articles, for example, where the articles direct that account will be taken of the shares of members which are not fully paid up.84

(ii) Payment of €50,000 as a Dividend Section 829 of the CA 2006 defines a ‘distribution’ as every description of distribution of a company’s assets to its members, whether in cash or otherwise, subject to certain exceptions. Most importantly, section 830 of the CA 2006 stipulates that a company may only make a distribution out of profits available for the purpose. A company’s profits available for distribution are its accumulated, realised profits, so far as they are not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as they are not previously written off in a reduction or reorganisation of capital duly made. Section 853(4) of the CA 2006 directs that references to ‘realised profits’ and ‘realised losses’ are to such profits or losses of the company as fall to be treated as realised in accordance with principles generally accepted at the time when the accounts are prepared, with respect to the determination for accounting purposes of realised profits or losses. Thus, whether

78 Abbreviations: CA 2006 (the Companies Act 2006); Model Articles (Model articles of association of private companies limited by shares (in reg 2 of and sch 1 to the Companies (Model Articles) Regulations 2008, SI 2008/3229), private companies limited by guarantee (in reg 3 of and sch 2 to the Companies (Model Articles) Regulations 2008, SI 2008/3229) and public limited companies (in reg 4 of and sch 3 to the Companies (Model Articles) Regulations 2008, SI 2008/3229). 79 Also referred to as ‘distributions’. 80 This is the rule in Trevor v Whitworth (1887) 12 App Cas 409 (HL) 423 (Lord Watson) that a company’s share capital should not be returned to shareholders, except in the limited circumstances sanctioned by the CA 2006. 81 CA 2006, s 851(1) clarifies that pt 23 of the CA 2006 operates in parallel with, and does not supersede, the common rules which regulate the payment of dividends. 82 See eg Model Articles, regs 30–35 of sch 1. 83 See also Birch v Cropper (1889) LR 14 App Cas 525 (HL). 84 Hoggan v Tharsis Sulphur and Copper Co (1882) 9 R 1191.

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a realised profit or loss exists is ascertained mainly in accordance with generally accepted accounting principles (GAAP),85 which are referred to as Financial Reporting Standards (FRS) and Statements of Standard Accounting Practice (SSAP) duly promulgated by the UK Accounting Standards Board.86 The relevant FRS is FRS 18. This stipulates that profits are to be treated as realised only when realised in the form of cash or of other assets, the ultimate cash realisation of which can be assessed with reasonable certainty.87 Moreover, the Institute of Chartered Accountants in England and Wales (ICAEW) and the Institute of Chartered Accountants in Scotland (ICAS), which are the professional accountancy bodies in the UK, have issued detailed technical guidance on realised profits and losses in terms of section 830 of the CA 2006.88 Sections 836 and 837 of the CA 2006 stipulate that whether a distribution may be made is determined by reference to the company’s profits, losses, assets, liabilities, provisions, share capital and reserves (including undistributable reserves), duly based on the company’s last annual accounts, ie the company’s individual accounts that were last circulated to members of the company in accordance with section 423 of the CA 2006.89 Since the Company is not a plc, the financial liquidity, cashflow and net asset position90 of the Company are factors which are irrelevant for the purposes of dividend distribution in the case of private limited companies.91 This is in stark contrast to the Polish solution. For the purposes of this UK solution, it is assumed that: (i) the retained earnings of €100,000 qualify as realised profits (rather than unrealised profits) in terms of ICAEW/ ICAS TECH 02/10; (ii) the loss of €100,000 is a realised loss (rather than an unrealised loss); (iii) there has been no significant deterioration in the financial position of the Company since the annual accounts date of 31 December 2011;92 (iv) the directors of the Company have recommended the payment of €50,000 as a dividend; and (v) the dividend has been approved by the shareholders by ordinary resolution93 in accordance with Regulation 30 of the Model Articles. When applied to the facts of the case, like the Polish solution, the UK test results in the equivalent of €100,000 in earned surplus which can be distributed by the Company. Neither the loss of €100,000 incurred during the previous financial year nor the fact that the Company had outstanding invoices payable to Steel Factory immediately prior to the distribution functions to impair the lawfulness of the distribution. Therefore, up to a maximum of €100,000 could be lawfully distributed as a dividend by the Company, the dividend distribution of €50,000 will be legally effective and any challenge by Steel Factory

85

Gallagher v Jones [1994] Ch 107 (CA). See www.frc.org.uk/asb/about. 87 See FRS 18, 16 at para 28 (www.frc.org.uk/Our-Work/Publications/ASB/FRS-18-Accounting-Policies.aspx). 88 See paras 3.–3.15 at pp 23–27 of TECH 02/10 at www.icaew.com/en/about-icaew/what-we-do/technicalreleases/~/media/Files/Technical/technical-releases/legal-and-regulatory/TECH-02-10-Guidance-on-realisedand-distributable-profits-under-the-Companies-Act-2006.ashx (‘TECH 02/10’). 89 Accounts are drawn up in accordance with GAAP. See CA 2006, ss 395 and 396. 90 In other words, the aggregate of the Company’s assets less the aggregate of its liabilities. 91 In terms of s 831(1) and (2) of the CA 2006, it is impermissible for a plc to pay a dividend (a) if the aggregate of its assets less the aggregate of its liabilities (referred to as its ‘net assets’) is less than the aggregate of its called-up share capital and undistributable reserves and (b) if, and to the extent that the distribution does not reduce the amount of those assets to less than that aggregate. 92 Cf the Finnish solution to this case at II F, above. If this assumption were incorrect, the payment of the dividend might breach the common law capital maintenance principle. 93 The hypothetical case specifically confirms this. 86

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would be unsuccessful. Indeed, once the dividend has been paid, the remaining €50,000 may be distributed in the same financial year.

(iii) Disguised Distributions Like Polish law and German law, UK law has a concept of ‘disguised distributions’, ie that where distributions/dividends are paid otherwise than out of profits available for distribution, this will represent a breach of the statutory rules in section 830 of the CA 2006.94 Moreover, if a distribution is made by the Company to a shareholder such as MultiSteel otherwise than out of distributable profits or outside the course of a winding-up or a formal reduction of capital, that payment will be unlawful and will breach the common law capital maintenance principle enunciated in Trevor v Whitworth.95 These statutory and common law rules are designed to protect creditors from being leap-frogged in the queue for receiving value. It is submitted that the conclusion of the contract between the Company and MultiSteel amounted to a diversion of profits to the parent company and could be potentially described as a disguised distribution, since more than adequate consideration was given in exchange. Whether a transaction amounts to a disguised distribution to shareholders is a question of substance rather than form.96 Where an arm’s length and good faith transaction between a company and a shareholder has proved with hindsight to have been detrimental to the company, the court must inquire into the true purpose and substance of the impugned transaction by investigating all the relevant facts, which might include the states of mind of those orchestrating the corporate activity. However, sometimes the states of mind of the directors will be irrelevant, and what they did was enough by itself to establish the unlawful character of the transaction, however well-meaning the directors who negotiated the transaction were. If the court concludes that there was a genuine arm’s length transaction, then it would stand even if it might appear with hindsight to have been a bad bargain for the company; however, if it was an improper attempt to extract value by the pretence of an arm’s length sale, it would be held to be unlawful.97 Here, the state of knowledge or intention on the part of the Company or its directors is unclear from the facts of the hypothetical case. However, if one assumes that there was subjective knowledge or intention on the part of the directors of the Company that the assets were acquired by the Company from MultiSteel at overvalue, then there is a strong argument that the distribution was (a) a disguised return of capital to the extent that the overpayment was not covered by distributable profits and (b) an unlawful distribution in breach of the rules in section 830 of the CA 2006 and the common law capital maintenance principle. As noted 94 See E Ferran, Principles of Corporate Finance Law (Oxford, Oxford University Press, 2008) 243–45 and 260–62; and E Micheler, ‘Disguised Returns of Capital—An Arm’s Length Approach’ (2010) 69 Cambridge Law Journal 151. 95 Trevor v Whitworth (1887) 12 App Cass 409 (HL) 423 (Lord Watson). 96 Aveling Barford v Perion (1989) 5 BCC 677; MacPherson v European Strategic Bureau Ltd [2002] 2 BCC 39; Progress Property Co Ltd v Moorgarth Group Ltd [2010] UKSC 55, [2011] 1 WLR 1. Interestingly, most of the cases where it has been argued that there has been a disguised distribution have involved the sale of assets by a company at undervalue, rather than the situation in the hypothetical case which concerns the acquisition of assets by the Company from a shareholder at overvalue. However, it is submitted that the principles are the same, ie whether the Company has sufficient distributable profits to cover the extent of the underpayment or overpayment, as the case may be. 97 Progress Property Co Ltd v Moorgarth Group Ltd [2011] 1 WLR 1, 10–11 (Lord Walker).

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above, only €50,00098 remained distributable as a dividend subsequent to the payment of the dividend of €50,000 in June 2012. Since the acquisition of the technical equipment from MultiSteel was overvalued by €60,000, this leaves a deficit of €10,000. The €10,000 shortfall would be treated as an unlawful distribution which depletes the capital base of the Company in contravention of Part 23 of the CA 2006 and the common law rules.99 Where there has been a distribution in contravention of section 830 of the CA 2006 and there is sufficient evidence to demonstrate that MultiSteel knew or had reasonable grounds for believing that it was made in contravention of section 830 of the CA 2006, section 847 of the CA 2006 directs that shareholders such as MultiSteel will be liable to repay it (or that part of it, as the case may be) to the Company.100 However, the difficulty for Steel Factory is that section 847 of the CA 2006 only gives the Company the right to seek recovery. It does not give a creditor such as Steel Factory the right to raise legal proceedings to compel MultiSteel to repay the Company in respect of the disguised distribution of €10,000. For that reason, Steel Factory will have no right to sue MultiSteel in terms of section 847 of the CA 2006. Furthermore, in light of the cases of Flitcroft’s Case,101 Bairstow v Queens Moat Houses plc102 and Re Marini Ltd,103 a director who knowingly and deliberately authorises the payment of an unlawful dividend will be liable to account for the unlawful dividend to the extent that it is not covered by undistributable reserves, since this will be treated as a breach of section 171 or 174 of the CA 2006. However, once again, since Steel Factory is a creditor of the Company, the duties of the directors in sections 171 and 174 of the CA 2006 are owed to the Company only.104 As the Company is not insolvent or on the verge of insolvency, it is submitted that it is unlikely that Steel Factory would be successful in any action it raised against the directors of the Company, since no duty is owed directly by the directors to the Company’s creditors.105 Finally, it should be noted that the Polish solution indicates that the law on groups of companies may be relevant in the present case. However, no equivalent exists in UK company law and the law on piercing the corporate veil would be of no assistance to Steel Factory for the same reasons identified in the UK solution in chapter six, above.

98 In other words, realised profits, less realised losses, less any dividend paid in the same financial accounting year (€200,000 – €100,000 – €50,000 = €50,000). 99 As noted above, since the Company is not a plc, its net asset position is irrelevant for the purposes of calculating the lawful dividend distribution and s 831 of the CA 2006 does not apply, on which, see the example provided in Ferran (n 94) 250-51. 100 In the case of It’s A Wrap (UK) Ltd (In Liquidation) v Gula [2006] EWCA Civ 544, [2006] BCC 626 (CA), the Court of Appeal ruled that a shareholder such as MultiSteel would be disentitled from claiming that it was not liable to return a distribution to the Company on the grounds that it did not know of the restrictions on the making of distributions in the CA 2006 and the consequences of those rules when properly applied to the facts. 101 Re Exchange Banking Co, Flitcroft’s Case (1882) LR 21 Ch D 519 (CA). 102 Bairstow v Queens Moat Houses plc [2000] BCC 1025 (QB) 1033–34 (Nelson J). Nelson J’s judgment was appealed to the Court of Appeal, but it was dismissed; see Bairstow v Queens Moat Houses plc [2001] EWCA Civ 712, [2002] BCC 91 (CA). 103 Re Marini Ltd [2003] EWHC 334 (Ch), [2004] BCC 172 (Ch). 104 See CA 2006, s 170(1). 105 See eg the UK solution in ch 6 at II H, above.

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(iv) Summary and Conclusion The dividend of €50,000 paid by the Company is lawful and Steel Factory would be unsuccessful if it attempted to challenge it. Furthermore, although the value of €10,000 of the overpayment of €60,000 to MultiSteel amounts to an unlawful and disguised distribution by the Company in contravention of Part 23 of the CA 2006 and the common law capital maintenance principle, if Steel Factory was minded to sue MultiSteel or the directors of the Company, it is submitted that both claims would have no reasonable prospect of success.

I. The US (i) Appropriateness of the Dividend In the US, corporate dividends are determined by the board of directors of a corporation, not by the shareholders.106 The board of directors of a corporation may declare a dividend on shares of capital stock out of the corporation’s ‘surplus’.107 Surplus is defined as ‘the net assets of the corporation over the amount so determined to be capital’. A company’s net assets are the ‘amount by which total assets exceed total liabilities’.108 The capital mentioned in the definition of surplus, often called ‘legal capital’, refers to the amount by which the stock value exceeds the aggregate par values of capital stock. In cases such as the hypothetical problem where no par value is assigned to the stock, the board of directors must state the amount of legal capital (called ‘stated capital’) or all the money in the no-par issuance will be deemed legal capital. Assuming that the Company never provided a stated capital for the no-par issuance, the dividend paid still passes Delaware’s ‘impairment of capital’ test. The Company’s net assets in 2011 were €600,000. If the entire value of the issuance (€500,000) were considered legal capital, this still leaves a residue of €100,000 which the Company may employ to pay dividends. Even if the Company’s financial statements showed negative ‘net assets’, the board of directors of the Company would be given some latitude in the calculation of the ‘surplus’ available for distribution to shareholders. In the US, directors are given: Reasonable latitude to depart from the balance sheet to calculate surplus, so long as they evaluate assets and liabilities in good faith, on the basis of acceptable data, by methods that they reasonably believe reflect present values, and arrive at a determination of the surplus that is not so far off the mark as to constitute actual or constructive fraud.109

Consequently, even if the Company’s distribution was slightly in excess of €100,000, the court would be likely to find that the directors had reasonable latitude to distribute the dividend. Despite the wide latitude granted to the board of directors with regard to dividends, the board of directors does not have unlimited discretion in this area. If the board of directors commits any ‘wilful or negligent violation’ in the declaration or payment of dividends, the

106 107 108 109

See eg Delaware General Corporation Law (DGCL), § 173. DGCL, § 170(a). DGCL, § 154. Klang v Smith’s Food & Drug Centers, Inc, 702 A 2d 150 (Del 1997).

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directors individually are jointly and severally liable to the corporation and ‘to the creditors in the event of dissolution or insolvency’.110 If the Company were a limited liability company (LLC) rather than a closely held corporation, it would not be possible to make ‘distributions’ of the sort described in the hypothetical case if ‘at the time of the distribution, after giving effect to the distribution, all liabilities of the limited liability company … exceed the fair value of the assets of the limited liability company’.111 Even if this occurred in the hypothetical case, however, this statute ‘creates a corporate cause of action against LLC members who improperly receive a distribution of those assets’. However, it does not create a cause of action for a third party like Steel Factory.112

(ii) Payment to MultiSteel In Delaware, there is no company law that directly addresses ‘disguised distributions’. Further, there is no company law requiring all transactions between shareholders and the corporation or members and the LLC to be at market price. Notwithstanding this statutory silence, the Delaware courts would be reluctant to uphold a conflict-of-interest transaction that is ‘unfair’. Generally speaking, shareholders have standing to challenge such transactions via fiduciary duty litigation, but the creditors of the Company would not have any standing to bring such a lawsuit. Another avenue—independent of company law—that Steel Factory could pursue against the Company is to try to recover the payment to MultiSteel through Delaware’s fraudulent transfer statute.113 Under this statute, a transfer of assets by an insolvent corporation to a third party with actual intent to delay the creditor’s ability to collect or without receiving reasonably equivalent value for the exchange may be voidable at the instance of one of the corporation’s creditors.114 If Steel Factory could demonstrate that the Company was insolvent at the time of the transfer and that the Company did not receive reasonably equivalent value for its consideration, Steel Factory may be able to nullify the transaction entirely.

J. Japan Under the Companies Act 2005 (CA) in Japan, a company may distribute dividends of any surplus to its shareholders.115 Whenever a company intends to distribute dividends of surplus, it must decide to do so by resolution of a shareholders’ general meeting. At the shareholders’ general meeting, the type and total book value of the dividend, the arrangements for the payment of the dividend to the shareholders and the date on which the distribution of the dividend of the surplus takes effect should all be decided.116 The amount of the surplus is basically calculated by subtracting the aggregate of the company’s

110 111 112 113 114 115 116

DGCL, § 174. Delaware Limited Liability Company Act (DLLCA), § 18-607(a). Pepsi-Cola Bot Co of Salisbury, Md v Handy, 2000 WL 364199 (Del Ch 15 March 2000). See eg Del Code, Ann 13, §§ 1301–12. Del Code, Ann 13, § 1304. CA, Art 453. CA, Art 454(1).

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liabilities, stated capital and reserves from the amount of assets and the book value of treasury shares.117 The Company may distribute dividends up to the amount of the surplus calculated under Article 446(1) of the CA. The total book value of the sums to be delivered to shareholders may not exceed ‘the distributable amount’.118 If the Company pays dividends in excess of the distributable amount, the payment is illegal and is in breach of Article 461 of the CA. If the dividend paid is illegal on the basis that it exceeds the distributable amount, a shareholder in receipt of such dividends is obliged to pay to the Company the equivalent of the book value of the dividend.119 A creditor of the Company is also entitled to require a shareholder who received the dividend to pay the Company the money equivalent to the book value of the dividend.120 If the payment of the dividend is made in violation of the law, shareholders who received the dividend, and directors and officers who were involved in the illegal payment of the dividend are jointly and severally liable to reimburse to the Company an amount equivalent to the book value of the dividend.121 If the director made the payment to the Company under Article 462(1) of the CA, he or she may claim against any shareholder who received the dividend. However, if the shareholder did not recognise the fact that the dividend payment exceeded the distributable amount, the director or officer who made the payment to the Company may not claim against such shareholder.122 Some commentators argue that in such a case, the payment of the dividend is not invalid because Article 463(1) of the CA refers to the payment of ‘the amount deliverable on the date on which the said act took effect’. However, such a view would lead to uncertainty since the validity of the payment would depend on the knowledge of the shareholder. Thus, the prevailing theory stresses that all transactions relating to the payment of the dividend become invalid if the payment made was in excess of the distributable amount. So, in the hypothetical case, Steel Factory may take an action to pursue the liability of the directors of the Company and MultiSteel and to require them to repay the relevant sums to the Company.

III. Conclusion A. Introduction The case solutions illustrate how the jurisdictions examined address the issue of creditor protection of a company in financial difficulties where distributions are made to shareholders and assets are transferred at undervalue.

117 118 119 120 121 122

CA, Art 446. CA, Art 461(2). CA, Art 462(1). CA, Art 463(2). Ibid. CA, Art 463(1).

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B. Distributions Each of the jurisdictions imposes restrictions on distributions, ie each of them provides for the maximum permissible amount of a company’s equity which can be paid to shareholders as a dividend. The restrictions vary from the traditional concept of nominal capital maintenance ‘via accounting-based profit distribution restrictions’,123 which are typical for continental Europe, to the solvency-based model. In the first model, distributions must not be made which are in breach of legal capital requirements, ie the nominal value of the issued share capital and amounts treated as capital either by statute, case law or the company’s charter.124 The most common method of restricting distributions under this model stems from the application of the so-called ‘balance sheet surplus test’. According to this test, the distribution is made out of the surplus of the company’s net assets (aggregate assets less aggregate liabilities) over the legal capital. Interestingly, the balance sheet surplus test seems to be followed both by common law countries (as inferred from the US solution) and civil law jurisdictions (as in Italy or Latvia). The two most significant weaknesses of this test which the hypothetical case amply demonstrates are that (i) it is based only upon the historical financial situation of the company, since the limits on distributions are derived from the company’s balance sheet in the previous set of financial statements, and (ii) it fails to take into account the nature and structure of the company’s equity capital and consequently its liquidity and cashflow position. For example, in the present case, although the Company may have a large portfolio of fixed assets but no cash to discharge its due contractual obligations, it would nevertheless have the ability to make a dividend distribution. Moreover, the distributions regime based on the ‘balance sheet surplus test’ requires reliable regulations to determine the calculation of the balance sheet and for the purposes of simplicity we have assumed that the conventions on the calculation of the balance sheet would show the same values in each jurisdiction. Nevertheless, the same regulations would be much less protective in jurisdictions which apply more liberal accounting principles. The advantage of this system is that it is clear and it is a relatively straightforward way of controlling distributable amounts ex ante. In some jurisdictions, the ‘earned surplus test’ is applied, according to which a distribution may be made only out of the company’s profits available for that purpose, which is further defined either by law or soft law (as in the UK). The application of the earned surplus test leads to similar results to the ‘balance sheet surplus test’—for example, in the hypothetical case, the distribution of the dividend is legal in every analysed jurisdiction, except for Finland. Meanwhile, a solvency-based model assumes that a distribution cannot be made if payment would lead to the company’s insolvency. The main example is Finnish law, which requires a solvency test to be exercised prior to the distribution. In terms of Finnish law, assets cannot be distributed if this would render the company insolvent according to the information available (and information that ought to be available) at the time of the

123 C Kuhner, ‘The Future of Creditor Protection through Capital Maintenance Rules in European Company Law’ in M Lutter (ed), Legal Capital in Europe, ECFR Special Volume 1 (Berlin, de Gruyter, 2006) 341–64. 124 For example, the threshold for statutory reserves in French and Italian law is 5% of the company’s annual profit which is accumulated until the statutory reserves reach 10% or 20% of the share capital and in Finland restricted capital includes revaluation reserves.

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decision. In the UK, soft law precludes the company’s assets from being distributed to shareholders where there has been ‘significant deterioration in the financial position of the Company since the annual accounts date’. Other jurisdictions do not have rules which would address dividend distributions where a company is in financial distress. In consequence, financial liquidity appears to be a largely irrelevant factor in respect of dividend distribution in most of the analysed jurisdictions.

C. Disguised Distributions The jurisdictions examined employ a variety of strategies to address related party transactions and the transfer of assets at undervalue (tunnelling of profits) to the detriment of creditors. Nevertheless, certain patterns can be traced in the solutions to the hypothetical case: (i) those which prohibit directly or indirectly disguised distributions, for example, Germany, the UK, Finland, Poland and Latvia; (ii) those which do not specifically regulate disguised distributions but provide other remedies for imbalanced transactions, for example, Italy and France; and (iii) those which allow for distributions of assets at undervalue, for example, the US. German law defines a disguised distribution as a payment to a shareholder (not being a formal distribution of profits) without adequate consideration. The definition in the UK is more lenient insofar as it allows a distribution to be made so long as it is paid out of distributable profits, to the extent that any overpayment which falls outside distributable profits would be treated as unlawful. Rules on disguised distributions are either specifically addressed by statute or case law (for example, Latvian law, which prescribes that an acquisition by a company from a shareholder at a price higher than usual is presumed to be unjustified and therefore prohibited, or Finnish law, which provides that any transaction designed to make a loss for the company is unlawful), or derived from the rules on capital maintenance or the principle of equal treatment of shareholders of a private company (as in Germany and Poland) in the jurisprudence or academic literature. French and Italian law lack any rules on undervalue transactions with shareholders, but they employ rules on disclosure and authorisation in terms of which transactions with shareholders (above certain thresholds) need to be authorised by the corporate bodies. At the other extreme, we have the US solution, where there is no requirement for the transaction between the shareholders and the company to be struck at the market price. However, there is the possibility that the transaction may be challenged via fiduciary duty litigation. When it comes to an assessment of the practical effectiveness of all the above rules, it is of the utmost importance that the creditor Steel Factory can bring an action in order to challenge the illegal transfer of assets (dividend payment or undervalue transaction) and retrieve those assets for the company. Interestingly, we find that in none of the jurisdictions examined, except for Japan, would the creditors enjoy standing to raise an action in court designed to recover illegally transferred assets. Instead, we find that the above rules are aimed at protecting either the company or minority shareholders, as opposed to the creditors. The hypothetical case involved a limited liability company. Therefore, the first important issue was the distinction between a full publicly held corporation and a privately held one.125 The Polish limited liability company is one example of such a privately held

125 This issue was considered by many of the authors of the solutions in the context of the discussion on the liability of directors towards creditors.

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corporation with important characteristics usually attributable to a partnership. The other example under Polish law would be a joint-stock company (corporation) whose shares are not listed on the Stock Exchange (a closed joint-stock company). Indeed, it can be seen that different legal forms of closed and public corporations existed in the jurisdictions examined. A functional argument can be made that the legislature should distinguish between companies with a dispersed shareholding structure where the management board (or the board of directors in a one-tier model system) exerts more control over the company’s affairs than that undertaken in the case of privately held companies and companies with a concentrated shareholding structure when it comes to drawing up the rules on the liability of directors towards creditors. However, we have not identified any commonly applied distinction between public and closed corporations, with the exception of Germany. As mentioned above, certain patterns can be traced in the solutions to the hypothetical case. These patterns of legal thought underlie the different legal rules. We have identified five groups of provisions relating to undervalue transactions, which basically lead to functionally similar results. For example, the first pattern of legal thought is that if the company’s assets are illegally pumped out of the company (either by the directors or shareholders), they continue to be treated as a part of the company’s property. Thus, the creditors of the company have the right to satisfy their claims thereon and reach these assets, despite the fact that title to the assets vests in a third party. However, the protection afforded to the creditors is different from that available in the case of a security in rem, since the creditor may not only satisfy its claims by calling on the former assets of the company but may also reach the personal assets of the ‘wrongdoer’ (as in the case of the application of the piercing the corporate veil doctrine or the damages-based liability of the directors towards creditors for a breach of fiduciary duties). The question of whether the protection of the creditors is stronger than that which could be obtained under contract (for example, under a security in rem contract) remains open since a company’s creditors are not entitled to any priority of claims over the assets of the wrongdoer. Therefore, these strategies for retrieving the company’s debts may be used only as supplementary to capital maintenance rules. The rules regarding the payment of dividends, including the concept of disguised dividends in Poland, France, Germany, Finland, Latvia and the US, are often designed to ensure the equal treatment of shareholders (see the Polish, German and Spanish solutions). As a result, these strategies are typically treated as constituting rights in favour of the company and its shareholders and are of little assistance to the creditors. The remaining legal patterns are: duties of directors (either fiduciary or those contrary to law) (Germany, the UK and, possibly, the US); the liability of a parent company under the piercing the corporate veil doctrine or the law on group company holding relationships (Poland, Italy, Germany, the UK and the US); and fraudulent conveyance laws (the US and Poland). One of the important questions addressed by the hypothetical case was whether creditors can invoke the rules on the duties of directors (management board members) and sue the directors in respect of a breach of these rules. In France, although damages are theoretically available because the directors failed to follow the proper procedure, it is very doubtful that a creditor would be recognised as having standing to sue the directors (of both public and closed companies) for damages in a French court in respect of losses suffered as a result of a breach of the rules on conflicted transactions. Moreover, the creditor would not be entitled to nullify the contract and the directors acting in their official capacity would be shielded from liability towards third parties as long as they acted within the scope of their functions. This can be contrasted with German law. Whilst directors duties are not owed to creditors in the

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case of private companies, in the case of public companies, creditors are entitled to enforce a breach of capital maintenance rules if recourse against the company proved to be ineffective and insolvency proceedings have not yet been opened (AktG, paragraph 62(2)).126 Furthermore, in certain circumstances, the creditors may also enforce general breaches of directors’ duties.127 Thus, it could be inferred that the mandatory law on public companies in Germany provides for greater responsibilities of directors towards creditors on the ground that the creditors are the ‘real’ owners of the company and the agency costs associated with separation of ownership and control are greater. This suggests that there is no need for special directors’ duties towards creditors in the case of privately held companies, since the controlling shareholder may often also be the chairman of the board and chief executive of the company. Thus, imposing a stringent fiduciary duty on directors would be fruitless if they commonly act as both shareholders and directors simultaneously and are able to manipulate matters acting in the capacity of a director in order to advance their own interests as a shareholder. On the other hand, the German example is striking because it enables creditors to have recourse directly against the director of the stock corporation, even though insolvency proceedings have not been initiated and irrespective of whether the company is on the verge of insolvency or not. Spanish law also permits a creditor recourse against a shareholder where a transaction entered into by the company and a shareholder amounts to a disguised dividend. In such a case, the creditor will be entitled to sue the shareholder directly on the basis that the disguised dividend is a fraud on the creditors. If established, the doctrine of fraud on the creditors imposes an obligation of restitution on the shareholder who has benefited from the transaction. The remaining jurisdictions base a creditor’s rights of recourse upon the solvency test in the context of a claim for a breach of a director’s fiduciary duties. For example, under Finnish law, the creditors can demand damages from the directors if the company is insolvent. The transfer of assets at undervalue is unlawful by virtue of law.128 Latvia and Italy do not recognise fiduciary duties owed by directors towards creditors. In the UK, the common law courts have adopted the position that the duty to take account of creditors’ interests is owed by directors to the company—rather than directly to the creditors129—when

126 AktG, § 62(1): ‘Shareholders shall repay the stock corporation for any benefits they have received from the stock corporation contrary to the provisions of this Act. If such amounts were received in the form of dividends, the obligation to repay such amounts to the stock corporation shall arise only if the shareholders knew, or due to negligence did not know, that they were not entitled to receipt thereof. (2) Claims of the stock corporation may also be asserted by the stock corporation’s creditors if they are unable to obtain satisfaction from the stock corporation. If insolvency proceedings have been instituted over the stock corporation’s assets, the receiver or the trustee shall exercise the rights of the stock corporation’s creditors against the shareholders during the course of the insolvency proceedings.’ This provision could constitute the basis for an action against a director if he or she has obtained an unlawful benefit as a shareholder of the stock corporation. 127 Other breaches of directors’ duties of care may only be enforced by the creditors if recourse against the company proved ineffective and there was a gross violation of directors’ duties (AktG, § 93(5)). This enables direct recourse against the director irrespective of whether he or she is a shareholder of the company or not. 128 The transaction was seemingly designed to make a loss and no sound business reasons have been advanced in favour of the decision. 129 Yukong Line Ltd of Korea v Rendsburg Investments Corp of Liberia [1998] 1 WLR 294 (QB); West Mercia Safetywear Ltd v Dodd (1988) 4 BCC 30 (CA); Re Halt Garage (1964) Ltd [1982] 3 All ER 1016 (Ch); Kuwait Asia Bank EC v National Mutual Life Nominees Ltd [1991] 1 AC 187 (PC).

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a company is insolvent or nearing insolvency.130 The end result is that a creditor is denied standing to sue in respect of a breach of directors’ duties and only a future liquidator of a company would have title to sue the director. Under US law, although the conflict transaction will be treated as unfair, creditors will not have standing to bring a lawsuit.131 We have also grouped liability on the basis of the piercing the corporate veil doctrine and the techniques imposing liability on the parent company for the subsidiary in the same category, which can be referred to as the ‘guarantee strategy’. This category is different because the creditor’s right of recourse against the third party does not depend on whether the company is successful or effective in seeking recourse against the third party, akin to liability under the fiduciary duties (the German solution is an example). To take the Polish example of Article 7 of Commercial Companies Code, it seems that this parent company liability can be created in a contract both as a subsidiary liability (which is effective only if recourse against the principal proves to be ineffective) and as a joint and several liability. The provision stipulates that an agreement must contain the scope of liability of the parent company. The same also appears to be true under Article 2497 of the Italian Civil Code, when the company is subject to the direction and coordination of a third party.132 In their operation, both the Polish example of Article 7 of the CCC and the Italian Article 2497 of the CC closely resemble the piercing the corporate veil doctrine. In turn, German law differentiates between the limited liability company and the stock corporation. Although the mechanism and legal provisions appear to be completely different, the pattern is similar. Therefore, the strategy is to govern the situation where a dominant shareholder administers the company through either a formal transfer of profits agreement (the Polish example) or in disregard of corporate governance principles (the piercing the corporate veil doctrine). For example, under UK law, if the company is a mere façade concealing the true facts or has been formed to evade existing legal obligations, the court will pierce the corporate veil. However, it seems that the application of the piercing the corporate veil doctrine possesses certain defects when compared to liability under group company holding law. Besides the fact that in the case of the application of the piercing the corporate veil doctrine (as in other ‘guarantee strategy’ examples) no priority will be given over assets of

130 Whether a company is on the verge of insolvency is an issue for objective assessment and directors must take independent financial and legal advice to confirm the position. In such circumstances, the duty to have regard to the interests of the company’s creditors arises because it is the creditor’s position in the company’s liquidation that will be affected by the director’s actions. Since the director’s duty to take into account the interests of creditors when the company is insolvent or nearing insolvency is owed to the company rather than directly to the creditors, it is only indirectly through a liquidator acting on behalf of the company that the creditors’ interests are represented. 131 The question continues to be debatable in the US. For example, in Credit Lyonnais Bank Nederland v Pathe Communications Corp (1991) 17 Delaware Journal of Corporate Law 1099 (not reported in A 2d), the Court of Chancery opined that when a corporation is ‘in the vicinity of insolvency’, its directors should not consider the shareholders’ welfare alone, but should consider the welfare of the community of interests that constitute the corporation. In another case (Geyer v Ingersoll Publications Co, No 12, 406 1992 Del Ch Lewis 132 (Del Ch 18 June 1992), the Court of Chancery ruled that directors owe a direct duty to manage the corporation on behalf of creditors when the corporation is insolvent but not yet in bankruptcy. However, how far fiduciary duties should protect creditors in circumstances of near-insolvency remains a hot topic. See eg HTC Hu, ‘Risk, Time, and Fiduciary Principles in Corporate Investment’ (1990) 38 UCLA Law Review 277; and L Lin, ‘Shift of Fiduciary Duty upon Corporate Insolvency: Proper Scope of Directors’ Duty to Creditors’ (1993) 46 Vanderbilt Law Review 1485. 132 According to this provision, the companies and entities which, carrying out direction and coordination, act in their own interest or in the interest of other parties are directly liable for the damages suffered by the shareholders of the companies subject to direction and coordination, or by the creditor of these companies for the damages caused to the integrity of the corporate assets.

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the company where they have been commingled with the personal assets of shareholders, creditors will also be confronted by obstacles by virtue of the burden of proof. Therefore, it would appear that capital maintenance rules and directors’ fiduciary duties towards creditors (Germany) better serve the purposes of creditor protection in comparison to the piercing the corporate veil doctrine. On the other hand, some jurisdictions (such as the US and Spain) provide for the so-called claw-back rules or the Actio Pauliana, which afford creditors a remedy where debtors transfer their assets to third parties or prefer certain creditors over others in the period leading up to the company’s insolvency. These doctrines allow creditors to rescind transactions at undervalue if corporate assets are diverted near insolvency. This doctrine is particularly important in the US, where there are no capital maintenance rules.