venture capital

Venture capital and financial assistance: an ordered pair

Up well into 2010, there was practically no Venture Capital without financial assistance. It was in fact an intrinsic part of the business model. To such an extent that the risk of incurring in the prohibition of financial assistance was no longer part of the picture of contingencies that derived from the Due Diligence process.

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

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In Spain, this Directive was transposed into Spanish law by Law 19/1989, of 25 July (RCL 1989, 1660), on Partial Reform and Adaptation of Commercial Legislation to EEC Directives. It is now included in the Companies Act (hereinafter “LSC”) in Article 143.2 LSC for limited liability companies (S.L.) and Article 150 LSC for public limited companies (S.A.).

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

This prohibition seeks to protect a series of interests, such as the integrity of the capital, which aims to guarantee the initial correspondence between capital and corporate assets and, therefore, to preserve the interests of the partners and creditors, in the event of asset alterations in the Target Company; compliance with the principle of parity of treatment between shareholders or partners; the abusive use of political rights, etc.

This is established in Supreme Court Ruling No. 413/2012 of 2 July RJ 2012/10124:

“seeks to avoid the risk that the acquisition of shares is financed from the assets of the company whose capital is represented in those shares. The prohibition is inspired by the idea that it constitutes an anomalous use of corporate assets to apply it to the acquisition of shares of the financing company or of its parent company” ; (…) to prevent the solvency of the company’s assets from being put at risk; to put a stop to possible abuses by managers and administrators and to prevent it from being used for speculative purposes”.

It continues to say in this sentence that:

“the doctrine points, among others, to the defense of the integrity of the share capital understood as a figure fixed in the articles of association that operates as a retention figure in the balance sheet of a static accounting system, so that it is integrated by external contributions to the company itself and that the prohibition of acquiring one’s own shares by financing their acquisition by third parties is not circumvented”.

Regarding the differences existing according to the type of company, firstly, in the case of an S.L., attendance for the acquisition of its shares or those issued by another group company is prohibited, while in the case of S.A., reference is made to own shares and only to those issued by the parent company.

Secondly, while there are no exceptions to the prohibition in S.L.’s, there are two exceptions in S.A.’s:

  1. It shall not apply to businesses intended to make it easier for company personnel to acquire the company’s own shares or shares in any other company belonging to the same group (Art. 150.2 LSC).
  2. Nor to the transactions carried out by banks and other credit institutions within the scope of the ordinary transactions inherent to their corporate purpose, that are paid for out of the company’s unrestricted assets. In these cases, the obligation to create a reserve on the liabilities side of the balance sheet equal to the recorded credits is established.

The prohibition of financial assistance and the operations of LBO

As we said in the introduction, it was quite usual that in leveraged buyouts or LBOs, the financing entities sought to guarantee the operation by establishing rights in rem over the shares/participations or over the most relevant assets of the Target company itself or of its subsidiaries. However, such guarantees would clearly constitute a breach of the prohibition on financial assistance.

There were several possible ways to comply with the law at that time, among which we can highlight:

  1. Acquisition of all the company’s assets, instead of its shares/participations.
  2. Leveraged merger under Section 35 of the Structural Amendments Act: The most common practice in this type of acquisition of companies is to first establish a Newco which obtains the financing to acquire the shares/equity of the Target company. Subsequently, Newco will be merged with the Target company, so that the assets of the Target company become the guarantors of the financial debt. The requirements for this type of merger are that the debt must have been incurred in the three immediately preceding years and that the directors’ report on the draft terms of the merger must be mandatory, setting out the reasons that would have justified the merger (other than the avoidance of the prohibition on financial assistance) and whether or not there was any financial assistance[1].

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

In case of breach of this prohibition, we shall have to comply with the financial penalties provided for in Article 157 LSC. It further provides that the directors of the offending company and, where appropriate, those of the parent company who have induced the infringement shall be held liable for the infringement. However, the LSC does not expressly contemplate which are the effects of non-compliance with the prohibition.

Part of the doctrine has solved the problem by applying Article 6.3 of the Civil Code, which establishes the nullity of acts contrary to mandatory and prohibitive norms. The case law in this regard states that “failure to comply with them may cause, in accordance with Article 6.3 of the Civil Code (LEG 1889, 27), the radical nullity of the business affected by the prohibition”. Therefore, the question that arises is which act would be void? 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?

If this article has been of interest, we also suggest you to read the following article published on our website:

Financial Assistance

[1] Provincial Court of La Rioja (Section 1), Judgement no. 288/2008 of 17 October AC 2009/140.
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