Private Equity and Financial Assistance: a dangerous pairing.

“Financial Assistance” is considered as the assistance given by a company for the purchase of its shares or those of its holding companies. Why should be considered as “dangerous”?

Until well into 2010 there was virtually no Private Equity without financial assistance. In fact, financial assistance was an intrinsic part of the business model. So much so that the risk of incurring prohibition of financial assistance wasn’t even part of the contingencies arising from the Due Diligence process.

The origin of the concept of “financial assistance” is found in English law, specifically in section 45 of the Companies Act of 1929, which was then regulated by different national legislations (Germany, France, Italy) and, at the level of the European Union, in Article 23 of the Second Directive 77/91 / EEC.

In the United States, Private equity funds are formed and operated to avoid regulation under the Investment Company Act 1940. In order to avoid regulation, Private equity funds have to meet one of the exemptions from regulation under the Investment Company Act for an issuer and are expected to meet the “accredited investor” definition of Regulation D.

In Spain, this Directive entered into the Spanish legal system by Law 19/ July 25,1989 (RCL 1989, 1660), Partial Amendment and Adaptation of Commercial Legislation to the Directives of the EEC, now being included in the Capital Companies Act (hereinafter “LSC) in article 143.2 LSC for limited liability companies (LLC) and in article 150 CCA for limited companies (LC).

Financial assistance consists of all those legal businesses that, directly or indirectly, involve the use of the company’s resources to facilitate the acquisition of their own shares/ participations.

This prohibition seeks to protect a series of interests, such as the integrity of the capital, which seeks to guarantee the initial correspondence between capital and company’s assets and, therefore, preserve the interests of the partners and creditors, in the face of asset changes in the Target company, with respect to the principle of parity of treatment between shareholders and partners, abuse of political rights, etc.

This was established in the Supreme Court Judgment no. 413/2012 of July 2 RJ 2012/10124: “This tries to avoid the risk that the acquisition of shares is financed from the equity of the company itself whose capital is represented in them. The prohibition is inspired by the idea that it constitutes an anomalous use of company’s assets to apply it to the acquisition of the actions of the financier or of which is its dominant society”; (…) prevent the solvency of the company from being compromised; put a stop to possible abuses by managers and administrators and avoid it being used for a speculative purpose.” It continues, saying that “The doctrine aims, among other objectives, to defend the integrity of share capital understood as a figure set in the statutes that operates as a retention figure in the balance sheet of a static accounting system, so that the same is integrated by external contributions to the company itself and does not circumvent the prohibition of acquiring its own shares by financing its acquisition by third parties.”

Regarding the differences existing according to the type of company, in the first place, in the case of a limited liability company, the financial assistance for the acquisition of its shares or those issued by another company group is prohibited, while in the public limited company reference is made to the company’s own shares, and only to those issued by the parent company.

Second, while in a limited liability company there are no exceptions to the prohibition, in a PLC:

  • It will not apply to businesses aimed at providing the company’s staff with the acquisition of the shares of the company itself, or of participations or shares of any other company belonging to the same group (Art. 150.2 LSC).
  • Nor with regards to operations carried out by banks or other credit entities in the scope of ordinary operations of their corporate purpose that are borne by the company’s free assets. In these cases, the obligation to create a Reserve is established in the liabilities of the balance sheet equal to the credits recorded.

 

The ban on financial assistance and Leveraged Buy Out operations

As we said in the introduction, it was quite common that in leveraged acquisitions or Leveraged Buy Outs (LBO) of companies, funders sought to guarantee the operation by establishing real rights over the shares/ units or the most relevant assets of the Target company or of subsidiaries of the same. However, these guarantees would clearly constitute a breach of the financial assistance prohibition.

We then had several possible ways to comply with the law, among which we highlight:

  • Acquisition of all the assets of the company, instead of its shares/ participations.
  • Leveraged merger of article 35 of the Structural Modifications Act: the most common in this type of company acquisitions is to first establish a Newco that obtains financing to acquire the shares/ participations of the Target Subsequently, Newco will merge with the Target, so that the assets of the target company become guarantors of the financial debt. As requirements of this type of merger, we must bear in mind that the norm establishes that the debt must have been contracted in the three immediately previous years and that the report of the administrators on the merger project will be mandatory, and must establish the reasons that would have justified the merger operation (other than the evasion of the financial assistance ban) and whether or not financial assistance existed [1].

 

What are the consequences of non-compliance with the prohibition?

In case of non-compliance with this prohibition, we must comply with the pecuniary sanctions provided in Art. 157 LSC. This also establishes that the administrators of the infringing company and, where appropriate, those of the parent company that have induced the commission of the infringement, will be considered responsible for the infringement. However, the LSC does not expressly contemplate which are the effects that derive from the breach of the prohibition.

Part of the doctrine has solved the problem through the application of Art. 6.3 Civil Code, which establishes the nullification of full right for acts contrary to peremptory and prohibitive norms. The jurisprudence in this regard establishes that “its non-compliance could cause, in accordance with Article 6.3 of the Civil Code (LEG 1889, 27), the radical nullification of the business affected by the prohibition.” The question that arises then is what act would be nullified? The business for which financial assistance has been provided (the loan or credit granted, for example)? Or the business of acquiring the shares or participations?

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