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KPMG Deutsche Treuhand-Gesellschaft Aktiengesellschaft WirtschaftsprüfungsgesellschaftKlingelhöferstraße 1810785 BerlinGermany

Georg LanfermannT +49 30 2068-1262F +49 1802 [email protected]

The information contained herein is of a general nature and is not intended to address the circumstances ofany particular individual or entity. Although we endeavor to provide accurate and timely information, therecan be no guarantee that such information is accurate as of the date it is received or that it will continue tobe accurate in the future. No one should act on such information without appropriate professional adviceafter a thorough examination of the particular situation.

2008 KPMG Deutsche Treuhand-GesellschaftAktiengesellschaft Wirtschaftsprüfungs-gesellschaft, a member firm of the KPMG net-work of independent member firms affiliatedwith KPMG International, a Swiss Cooperative.Printed in Germany. KPMG and the KPMG logoare registered trademarks of KPMG International.

Contract

ETD/2006/IM

/F2/71K

PM

GFeasibility

Study

onC

apitalMaintenance

–M

ainR

eport

Contract ETD/2006/ IM/F2/71Feasibility study on an alternative to the capital maintenance regime established by the Second Company Law Directive77/91/EEC of 13 December 1976 and an examination of the impact on profit distribution of the new EU-accounting regime

Main Report

kpmg.com

Contact

KPMG Deutsche Treuhand-Gesellschaft Aktiengesellschaft WirtschaftsprüfungsgesellschaftKlingelhöferstraße 1810785 BerlinGermany

Georg LanfermannT +49 30 2068-1262F +49 1802 [email protected]

The information contained herein is of a general nature and is not intended to address the circumstances ofany particular individual or entity. Although we endeavor to provide accurate and timely information, therecan be no guarantee that such information is accurate as of the date it is received or that it will continue tobe accurate in the future. No one should act on such information without appropriate professional adviceafter a thorough examination of the particular situation.

2008 KPMG Deutsche Treuhand-GesellschaftAktiengesellschaft Wirtschaftsprüfungs-gesellschaft, a member firm of the KPMG net-work of independent member firms affiliatedwith KPMG International, a Swiss Cooperative.Printed in Germany. KPMG and the KPMG logoare registered trademarks of KPMG International.

Contract

ETD/2006/IM

/F2/71K

PM

GFeasibility

Study

onC

apitalMaintenance

–M

ainR

eport

Contract ETD/2006/ IM/F2/71Feasibility study on an alternative to the capital maintenance regime established by the Second Company Law Directive77/91/EEC of 13 December 1976 and an examination of the impact on profit distribution of the new EU-accounting regime

Main Report

KPMG Feasibility Study on Capital Maintenance – Main Report

I

Summary of contents

Main Report Pages 1 Executive summary 1 2 Introduction 13 3 Basic elements of capital regimes 17

4 Alternatives to the current regime of capital regime 25

4.1 Comparative analysis – situation in the European Union 25

4.1.1 France 25 4.1.2 Germany 50 4.1.3 Poland 76 4.1.4 Sweden 97 4.1.5 United Kingdom 117 4.1.6 Conclusions 143

4.2 Comparative analysis – situation in non-EU countries 155

4.2.1 USA – MBCA 155 4.2.2 USA – Delaware 161 4.2.3 USA California 183 4.2.4 Canada 201 4.2.5 Australia 217 4.2.6 New Zealand 236 4.2.7 Conclusions 256

4.3 Alternative regimes proposed by literature 269

4.3.1 High Level Group 269 4.3.2 Rickford Group 280 4.3.3 Lutter Group 294 4.3.4 Dutch Group 297 4.3.5 Conclusion 306

4.4 Conclusion on comparative analysis 311

5 Impacts of IFRS on profit distribution 315

6 Introduction of new regime 395

6.1 Introduction 395 6.2 Legal capital 396 6.3 True no-par value shares 410

KPMG Feasibility Study on Capital Maintenance - Main Report

II

Annexes – Part 1 Pages 1 Sample methodology 1 2 Key questionnaires 5

2.1 CFO questionnaire 5 2.2 IFRS questionnaire 8

3 Legal annexes 45

3.1 EU legal annexes 45 3.2 Non-EU legal annexes 176

4 Private companies 310

Annexes – Part 2 Pages 1 Legal questionnaires 1

1.1 EU legal questionnaire 1 1.2 non-EU legal questionnaire 44

2 Cost questionnaires 85

2.1 EU countries 85 2.2 non-EU countries 194

Annexes Part 1 and Part 2 can be found in two separate binders.


III

Table of contents Summary of content I - II Table of content III - IX List of abbreviations X - XI Table of figures XII - XV 1 Executive summary 1 2 Introduction 13

2.1 Area of EU company law under examination 13 2.2 Scope of the study 13 2.3 Methodological approach 14

3 Basics elements of capital regimes 17

3.1 Introduction 17 3.2 Statutory basis of the capital protection system 17

3.2.1 Provisions on the structure and acquisition of equity capital 17 3.2.2 Provisions in distributions 20 3.2.3 Provisions for the maintenance of contributed capital 21

3.3 Approach to the economic analysis 22 3.4 Considerations regarding the protection of shareholders and creditors 24

4 Alternatives to the current capital regime 25

4.1 Comparative analysis – situation in the European Union 25

4.1.1 France 25 4.1.1.1 Structure of capital and shares 25 4.1.1.2 Capital increase 29 4.1.1.3 Distribution 36 4.1.1.4 Capital maintenance 42 4.1.1.4.1 Acquisition by the company of its of own shares 42 4.1.1.4.2 Capital reduction 45 4.1.1.4.3 Withdrawal of shares 46 4.1.1.4.4 Financial assistance 47 4.1.1.4.5 Serious loss of half of the subscribed capital 47 4.1.1.4.6 Contractual self protection 48


IV

4.1.1.5 Insolvency 49

4.1.2 Germany 50

4.1.2.1 Structure of capital and shares 50 4.1.2.2 Capital increase 55 4.1.2.3 Distribution 62 4.1.2.4 Capital maintenance 68 4.2.1.4.1 Acquisition by the company of its of own shares 68 4.1.2.4.2 Capital reduction 71 4.1.2.4.3 Withdrawal of shares 72 4.1.2.4.4 Financial assistance 73 4.1.2.4.5 Serious loss of half of the subscribed capital 73 4.1.2.4.6 Contractual self protection 74 4.1.2.5 Insolvency 75

4.1.3 Poland 76

4.1.3.1 Structure of capital and shares 76 4.1.3.2 Capital increase 80 4.1.3.3 Distribution 85 4.1.3.4 Capital maintenance 90 4.1.3.4.1 Acquisition by the company of its own shares 90 4.1.3.4.2 Capital reduction 92 4.1.3.4.3 Withdrawal of shares 93 4.1.3.4.4 Financial assistance 94 4.1.3.4.5 Serious loss of half of the subscribed capital 94 4.1.3.4.6 Contractual self-protection 95 4.1.3.5 Insolvency 96

4.1.4 Sweden 97

4.1.4.1 Structure of capital and shares 97 4.1.4.2 Capital increase 101 4.1.4.3 Distribution 105 4.1.4.4 Capital maintenance 110 4.1.4.4.1 Acquisition by the company of its of own shares 111 4.1.4.4.2 Capital reduction 113 4.1.4.4.3 Withdrawal of shares 114 4.1.4.4.4 Financial assistance 114 4.1.4.4.5 Serious loss of half of the subscribed capital 114 4.1.4.4.6 Contractual self protection 115 4.1.4.5 Insolvency 116

4.1.5 United Kingdom 117

4.1.5.1 Structure of capital and shares 117 4.1.5.2 Capital increase 121 4.1.5.3 Distributions 126 4.1.5.4 Capital maintenance 134 4.1.5.4.1 Acquisition of own shares 135


V

4.1.5.4.2 Capital reduction 138 4.1.5.4.3 Redeemable shares 139 4.1.5.4.4 Financial assistance 140 4.1.5.4.5 Serious loss of half of the subscribed capital 140 4.1.5.4.6 Contractual self protection 141 4.1.5.5 Insolvency 142

4.1.6 Conclusions for the five EU Member States 143

4.2 Comparative analysis – situation in non-EU countries 155

4.2.1 USA – MBCA 155

4.2.1.1 Introduction 155 4.2.1.2 Capital formation 156 4.2.1.3 Capital maintenance 157

4.2.2 USA – Delaware 161

4.2.2.1 Structure of capital and shares 161 4.2.2.2 Capital increase 164 4.2.2.3 Distribution 167 4.2.2.4 Capital maintenance 174 4.2.2.4.1 Acquisition by the company of its own shares 175 4.2.2.4.2 Capital reduction 178 4.2.2.4.3 Share redemption 178 4.2.2.4.4 Financial assistance 179 4.2.2.4.5 Serious loss of half of the subscribed capital 180 4.2.2.4.6 Contractual self protection 180 4.2.2.5 Insolvency 182

4.2.3 USA – California 183

4.2.3.1 Structure of capital and shares 183 4.2.3.2 Capital increase 184 4.2.3.3 Distribution 187 4.2.3.4 Capital maintenance 193 4.2.3.4.1 Acquisition of own shares 194 4.2.3.4.2 Capital decrease 196 4.2.3.4.3 Share redemption 196 4.2.3.4.4 Financial assistance 198 4.2.3.4.5 Serious loss of half of the subscribed capital 198 4.2.3.4.6 Contractual self protection 198 4.2.3.5 Insolvency 199

4.2.4 Canada 201

4.2.4.1 Structure of capital and shares 201 4.2.4.2 Capital increase 204 4.2.4.3 Distribution 206 4.2.4.4 Capital maintenance 211


VI

4.2.4.4.1 Acquisition of own shares 211 4.2.4.4.2 Capital decrease 212 4.2.4.4.3 Share redemption 213 4.2.4.4.4 Financial assistance 214 4.2.4.4.5 Serious loss of half of the subscribed capital 214 4.2.4.4.6 Contractual self protection 214 4.2.4.5 Insolvency 215

4.2.5 Australia 217

4.2.5.1 Structure of capital and shares 217 4.2.5.2 Capital increase 219 4.2.5.3 Distribution 222 4.2.5.4 Capital maintenance 228 4.2.5.4.1 Acquisition of own shares 228 4.2.5.4.2 Capital decrease 230 4.2.5.4.3 Share redemption 231 4.2.5.4.4 Financial assistance 232 4.2.5.4.5 Serious loss of half of the subscribed capital 233 4.2.5.4.6 Contractual self protection 233 4.2.5.5 Insolvency 234

4.2.6 New Zealand 236

4.2.6.1 Structure of capital and shares 236 4.2.6.2 Capital increase 238 4.2.6.3 Distribution 241 4.2.6.4 Capital maintenance 249 4.2.6.4.1 Acquisition by a company of its own shares 249 4.2.6.4.2 Capital reduction 251 4.2.6.4.3 Share redemption 251 4.2.6.4.4 Financial assistance 253 4.2.6.4.5 Serious loss of half of the subscribed capital 253 4.2.6.4.6 Contractual self protection 254 4.2.6.5 Insolvency 254

4.2.7 Conclusions for the four non-EU countries 256

4.3 Alternative regimes proposed by literature 269

4.3.1 High Level Group 269

4.3.1.1 The proposal 269 4.3.1.1.1 Outline 269 4.3.1.1.2 Necessary amendments to the 2nd CLD 269 4.3.1.1.3 Distributions 271 4.3.1.2 Economic analysis 275

4.3.2 Rickford Group 280

4.3.2.1 The Proposal 280


VII

4.3.2.1.1 Outline 280 4.3.2.1.2 Necessary amendments to the 2nd CLD 280 4.3.2.1.3 Distributions 282 4.3.2.2 Economic analysis 288

4.3.3 Lutter Group 294


4.3.4 Dutch Group 297


4.3.5 Conclusion on regimes proposed by literature 306

4.4 Conclusions on comparative analysis 311

5 Impacts of IFRS on profit distribution 315

5.1 Introduction 315

5.2 Overview on 27 EU Member States – part I 317

5.2.1 Introduction 317 5.2.2 Determination of distributable profits 318

5.2.2.1 Application of IFRS in the European Union 318 5.2.2.2 Determination of distributable profits based on IFRS 319 5.2.2.3 Deviations between national accounting rules and IFRS 322

5.2.3 Specific areas of accounting 326

5.2.3.1 Investment property 326 5.2.3.2 Post-employment benefits 327 5.2.3.3 Financial instruments 330

5.2.4 Conclusion on overview of 27 EU Member States 332

5.3 Detailed country analysis - part II 335 5.3.1 France 335


VIII

5.3.1.1 Introduction 335 5.3.1.2 Investment property 335 5.3.1.3 Employee benefits 335 5.3.1.4 Financial instruments - including hedging 336

5.3.2 Germany 341

5.3.2.1 Introduction 341 5.3.2.2 Investment property 341 5.3.2.3 Defined benefit plans (DBP) 344 5.3.2.4 Financial instruments 346

5.3.3 Poland 352


5.3.4 Sweden 362


5.3.5 United Kingdom 372

5.3.5.1 Overview of UK legal position on distributable profits 372 5.3.5.2 Investment property 378 5.3.5.3 Defined benefit schemes 379 5.3.5.4 Financial instruments 383

5.3.6 Conclusions on detailed analysis for selected EU Member States 392

6 Introduction of a new regime 395

6.1 Introduction 395 6.2 Legal capital 396

6.2.1 Amendments to the 2nd CLD’s basic model of legal capital 396

6.2.1.1 Overview 396 6.2.1.2 Model 1A – “Company option” 397 6.2.1.3 Model 1B – “Regulator option” 399 6.2.1.4 Model 2 – “IFRS solvency add-on“ 400 6.2.1.5 Model 3 – “On equal terms“ 401 6.2.1.6 Model 4 – “Solvency test predominance“ 402


IX

6.2.2 Capital maintenance in groups of companies 404

6.2.2.1 Overview 404 6.2.2.2 Model 1 – “Do nothing” 405 6.2.2.3 Model 2 – “Add-on” 405 6.2.2.4 Model 3 – “Pure consolidated view” 405

6.2.3 Design of the solvency test 407

6.2.3.1 Overview 407 6.2.3.2 Model 1 – “Leave it to the companies” 408 6.2.3.3 Model 2 – “Current ratios” 409 6.2.3.4 Model 3 – “Short-term projection” 409 6.2.3.5 Model 4 – “Mid-term projection” 409

6.3 True no-par value shares 410

6.3.1 Introduction 410

6.3.2 Concepts for the introduction of true no-par value shares 411

6.3.2.1 Model 1: Protection of all proceeds from share issues 411 6.3.2.2 Model 2: Variable capital 417 6.3.2.3 Model 3: Mixed Model 419 6.3.2.4 Model 4: Solvency test 420 6.3.2.5 Model 5: Solvency margin 422 6.3.2.6 Conclusion 422


X

List of abbreviations

AASB = Australian Accounting Standards Board ABL = Aktiebolagslagen (Swedish Companies Act) AG = Advocate General AGM = Annual General Meeting (of company shareholders) AktG = Aktiengesetz (German Stock Corporation Act) AMF = Autorités des Marchés Financiers Art. = Article ASIC = Australian Securities and Investments Commission ASX = Australian Stock Exchange B.C.C. = British Company Cases BaFin = Bundesanstalt für Finanzdienstleistungsaufsicht

(German Federal Financial Supervisory Authority) BALO = Bulletin des Annonces Légales Obligatoires BIA = Bankruptcy and Insolvency Act (Canada) BODACC = Bulletin Officiel des Annonces Civiles et Commerciales CA (1) = Companies Act (United Kingdom) CA (2) = Corporations Act 2001 (Australia) CA (3) = Companies Act 1993 (New Zealand) CAC = Cotation Assistée en Continu CBCA = Canada Business Corporations Act CCAA = Companies' Creditors Arrangement Act (Canada) CCC (1) = Commercial Companies Code (Poland) CCC (2) = California Corporations Code CEO = Chief Executive Officer CFO = Chief Financial Officer CLD = Company Law Directive DAX = Deutscher Aktienindex (German Stock Index) EBIT = Earnings before Interest and Taxes EBITDA = Earnings before Interest, Tax, Depreciation and Amortisation ER = English Reports EU = European Union FRS = Financial Reporting Standard (United Kingdom) FTSE = Financial Times Stock Exchange (United Kingdom) FY = Financial year GAAP = Generally Accepted Accounting Principles GBP = United Kingdom Pound (currency) GDP = Gross Domestic Product HGB = Handelsgesetzbuch (German Commercial Code) i.e. = id est (that is) IAS = International Accounting Standard IASB = International Accounting Standards Board ICAEW = Institute of Chartered Accountants in England and Wales ICAS = Institute of Chartered Accountants of Scotland IFRS = International Financial Reporting Standards IPO = Initial public offering IRL = Polish Insolvency and Rehabilitation Act J.C.P. = Journal of Consumer Policy LBO = Leveraged buy-outs


XI

Ltd = Limited M&A = Mergers and Acquisitions MBCA = Model Business Corporation Act (United States) MidCap = Middle capitalisation NA = No answer NZD = New Zealand Dollar NZX = New Zealand Stock Exchange PCG = Plan comptable général (General Accounting Plan) PLC = Public Limited Company (United Kingdom) PLN = Polish Zloty New (Polish currency) S&P = Standard and Poor's S.A. = Société Anonyme SEC = Securities and Exchange Commission SEK = Swedish Krona (Swedish currency) SME = Small and medium-sized enterprises TECH = Technical Release from the Business Law Committee of the ICAEW TSX = Toronto Stock Exchange UFTA = Uniform Fraudulent Transfer Act (California) UK = United Kingdom US = United States WIG = Warszawski Indeks Giełdowy (Warsaw Stock Exchange Index)


XII

Table of figures Number Title Page

2-1 KPMG methodological approach 15 4.1.1-1 Ratio of subscribed capital to market capitalisation (France) 26 4.1.1-2 CFO survey results: necessity of subscribed capital (France) 27 4.1.1-3 CFO survey results: level of subscribed capital (France) 28 4.1.1-4 Ratio of subscribed capital to total shareholder’s capital (France) 28 4.1.1-5 CFO survey results: attitudes towards increases of subscribed capital (France) 29 4.1.1-6 Process for ordinary capital increase (France) 33 4.1.1-7 Process for authorised capital increase (France) 34 4.1.1-8 Process for the injection of contributions (France) 35 4.1.1-9 Process of dividend distributions (France) 38 4.1.1-10 Determinants for the distribution of dividends in the holding company (France) 39 4.1.1-11 Important deterrents when considering the level of profit distribution (France) 39 4.1.1-12 Determinants for the distribution of dividends by the subsidiaries (France) 40 4.1.1-13 Process for the acquisition of own shares (France) 44 4.1.2-1 Ratio of subscribed capital to market capitalisation (Germany) 52 4.1.2-2 CFO survey results: necessity of subscribed capital (Germany) 52 4.1.2-3 CFO survey results: level of subscribed capital (Germany) 53 4.1.2-4 Ratio of subscribed capital to total shareholder’s equity (Germany) 54

4.1.2-5 CFO survey results: attitudes towards increases of subscribed capital (Germany) 54

4.1.2-6 Process of an ordinary capital increase (Germany) 58 4.1.2-7 Process of the authorised capital increase 59 4.1.2-8 Process for the injection of contributions (Germany) 61 4.1.2-9 Due process for distributing profits (Germany) 64

4.1.2-10 Determinants for the distribution of dividends in the holding company (Germany) 65

4.1.2-11 Important deterrents when considering the level of profit distribution (Germany) 65

4.1.2-12 Determinants for the distribution of dividends by the subsidiaries (Germany) 66 4.1.2-13 Process for the acquisition of own shares (Germany) 69 4.1.3-1 Ratio of subscribed capital to market capitalisation (Poland) 77 4.1.3-2 CFO survey results: necessity of subscribed capital (Poland) 78 4.1.3-3 CFO survey results: level of subscribed capital (Poland) 78 4.1.3-4 Ratio of subscribed capital to total shareholder’s equity (Poland) 79 4.1.3-5 CFO survey results: attitudes towards increases of subscribed capital (Poland) 79 4.1.3-6 Process for ordinary capital increase (Poland) 83 4.1.3-7 Process for authorised capital increase (Poland) 84 4.1.3-8 Process for the injection of contributions (Poland) 84 4.1.3-9 Due process for distributing profits (Poland) 86 4.1.3-10 Determinants for the distribution of dividends in the holding company (Poland) 87 4.1.3-11 Important deterrents when considering the level of profit distribution (Poland) 88 4.1.3-12 Determinants for the distribution of dividends by the subsidiaries (Poland) 88 4.1.3-13 Process for the acquisition of own shares (Poland) 91 4.1.4-1 Common Stock – Market Capitalisation (Sweden) 99 4.1.4-2 CFO survey results: necessity of subscribed capital (Sweden) 99 4.1.4-3 CFO survey results: level of subscribed capital (Sweden) 100


XIII

4.1.4-4 Ratio of common stock to total shareholder’s equity (Sweden) 100 4.1.4-5 CFO survey results: attitudes towards increases of subscribed capital (Sweden) 101 4.1.4-6 Due process for distributing profits (Sweden) 107

4.1.4-7 Determinants for the distribution of dividends in the holding company (Sweden) 108

4.1.4-8 Important deterrents when considering the level of profit distribution (Sweden) 109 4.1.4-9 Determinants for the distribution of dividends by the subsidiaries (Sweden) 109 4.1.4-10 Process for the acquisition of own shares (Sweden) 112 4.1.5-1 Ratio of subscribed capital to market capitalisation (United Kingdom) 118 4.1.5-2 CFO survey results: necessity of subscribed capital (United Kingdom) 119 4.1.5-3 CFO survey results: level of subscribed capital (United Kingdom) 120 4.1.5-4 Ratio of subscribed capital to total shareholder’s equity (United Kingdom) 120

4.1.5-5 CFO survey results: attitudes towards increases of subscribed capital (United Kingdom) 121

4.1.5-6 Process for ordinary capital increase (United Kingdom) 124 4.1.5-7 Process for the injection of contributions (United Kingdom) 126 4.1.5-8 Due process for distributing profits (United Kingdom) 130 4.1.5-9 Process of dividend distribution authorised by the directors (United Kingdom) 130 4.1.5-10 Process of dividend distribution declared by the shareholders (United Kingdom) 130

4.1.5-11 Determinants for the distribution of dividends in the holding company (United Kingdom) 131

4.1.5-12 Important deterrents when considering the level of profit distribution (United Kingdom) 132

4.1.5-13 Determinants for the distribution of dividends by the subsidiaries (United Kingdom) 132

4.1.5-14 Process for the acquisition of own shares (United Kingdom) 136 4.1.6-1 Minimum subscribed capital in the five EU Member States 145 4.1.6-2 Importance of subscribed capital (EU comparison) 145

4.1.6-3 Ratio of subscribed capital to shareholders equity (average for 5 EU Member States) 146

4.1.6-4 Permissibility to distribute premiums in the five EU Member States 146 4.1.6-5 Characteristics of balance sheet tests and solvency tests (EU comparison) 149 4.1.6-6 Deterrents to distributions (EU comparison) 149 4.1.6-7 Determinants of distribution for holding companies (EU comparison) 150 4.1.6-8 Determinants of distributions by subsidiaries (EU comparison) 151 4.1.6-9 Conditions for the repurchasing of own shares (5 EU Member States) 152 4.1.6-10 Incremental costs for the five EU Member States 153 4.2.2-1 Ratio of share capital to market capitalisation (USA) 163 4.2.2-2 Ratio of share capital to total shareholder’s equity (USA) 164 4.2.2-3 Process of capital increase (USA-Delaware) 166 4.2.2-4 Process of injection of contributions (USA-Delaware) 166 4.2.2-5 Due process for distributing profits (USA-Delaware) 169 4.2.2-6 Determinants for the distribution of dividends in the holding company (USA) 179 4.2.2-7 Important deterrents when considering the level of profit distribution (USA) 171 4.2.2-8 Determinants for the distribution of dividends by the subsidiaries (USA) 171 4.2.2-9 Process of acquisition of own shares (USA-Delaware) 176 4.2.3-1 Process for capital increase (USA-California) 186 4.2.3-2 Process for the injection of contribution (USA-California) 186 4.2.3-3 Due process for distributing profits (USA-California) 191 4.2.3-4 Process for the acquisition of own shares (USA-California) 195 4.2.4-1 Ratio of share capital to market capitalisation (Canada) 203


XIV

4.2.4-2 Ratio of share capital to total shareholder’s equity (Canada) 204 4.2.4-3 Due process for distributing profits (Canada) 208 4.2.4-4 Determinants for the distribution of dividends in the holding company (Canada) 208 4.2.4-5 Important deterrents when considering the level of profit distribution (Canada) 209 4.2.4-6 Determinants for the distribution of dividends by the subsidiaries (Canada) 209 4.2.5-1 Ratio of share capital to market capitalisation (Australia) 218 4.2.5-2 Ratio of share capital to total shareholder’s equity (Australia) 219 4.2.5-3 Process for capital increase (Australia) 220 4.2.5-4 Process for the injection of contributions (Australia) 221 4.2.5-5 Due process for distributing profits (Australia) 225

4.2.5-6 Determinants for the distribution of dividends in the holding company (Australia) 225

4.2.5-7 Important deterrents when considering the level of profit distribution (Australia) 226

4.2.5-8 Determinants for the distribution of dividends by the subsidiaries (Australia) 226 4.2.6-1 Ratio of share capital to market capitalisation (New Zealand) 237 4.2.6-2 Ratio of share capital to total shareholder’s equity (New Zealand) 238 4.2.6-3 Process for the capital increase (New Zealand) 240 4.2.6-4 Process for the injection of contribution (New Zealand) 240 4.2.6-5 Due process for distributing profits (New Zealand) 244

4.2.6-6 Determinants for the distribution of dividends in the holding company (New Zealand) 246

4.2.6-7 Important deterrents when considering the level of profit distribution (New Zealand) 246

4.2.6-8 Determinants for the distribution of dividends by the subsidiaries (New Zealand) 247

4.2.7-1 Overview on capital regimes in the four non-EU countries 257 4.2.7-2 Characteristics of balance sheet tests and solvency tests (non-EU countries) 261

4.2.7-3 CFO survey results: solvency tests and dividend determination (non-EU countries) 263

4.2.7-4 CFO survey results: accounting standards and profit distribution (non-EU countries) 264

4.2.7-5 Determinants of dividends for holding companies (non-EU countries) 264 4.2.7-6 Determinants of dividends for subsidiaries (non-EU countries) 265 4.2.7-7 Conditions for the repurchasing of own shares (5 non-EU jurisdictions) 265 4.2.7-8 Deterrent for profit distributions (non-EU countries) 267 4.2.7-9 Summary of incremental cost for the five non-EU jurisdictions 268 4.3.5-1 Estimated incremental burdens of theoretical models 310 4.4-1 Incremental costs in the five EU Member States 311 4.4-2 Incremental costs for the five non-EU jurisdictions 312 4.4-3 Comparison of the average EU and non-EU incremental costs 312

4.4-4 Comparison of the average EU incremental costs with estimated incremental burdens of theoretical models 314

5.2-1 Mandatory and permitted application of IFRS 318

5.2-2 Survey on 27 EU Member States: profit distribution based on IFRS, modification requirements 319

5.2-3 Survey on 27 Member States: average deviation of IFRS from national GAAP 323 5.2-4 Survey by IFRS standard: average deviation from national GAAP 324 5.2-5 Survey by IFRS standard: impact on equity 325

5.2-6 Survey for 27 EU Member States: accounting method under a post employment benefit plan 328


XV

5.2-7 Relevance of parameters to calculate a post-employment benefit obligation 329 5.2-8 Method of recognition of actuarial gains or losses 330 5.2-9 Accounting treatment for non-derivative financial instruments 331 5.2-10 Recognition and measurement of derivative financial instruments 331 5.2-11 Forms of hedge accounting 332 5.3-1 Example deferred taxes (UK) 381 6.2-1 Five Approaches for amendments to the basic model of the 2nd CLD 397 6.2-2 CFO survey results: accounting framework and profit distribution 398

6.2-3 CFO survey results: determinants for dividend distributions by holding companies 404

6.2-4 Three approaches concerning dividend distributions in groups of companies 405 6.2-5 CFO survey results: use of liquidity tests 407 6.2-6 Four approaches concerning the design of solvency tests 408


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1 Executive summary The guiding objective of this study is to evaluate the feasibility of an alternative to the current regime of legal capital established by the 2nd Company Law Directive (CLD) and to examine the impacts of International Financial Reporting Standards (IFRS) on profit distribution. The study is intended to help the European Commission to evaluate whether an alternative regime would better support the efficiency and competitiveness of EU businesses. A particular challenge for the capital regime as currently embedded in the 2nd CLD is the introduction of IFRS in the European Union. Under the IAS Regulation (1606/2002), EU Member States may permit or require companies to use IFRS for their individual financial statements. This instantly raises the question whether IFRS as an accounting framework is adequate to be used as the basis for profit distribution under the current capital regime of the 2nd CLD when IFRS are not primarily designed for this purpose. The decision on the introduction of an alternative to the current regime is a highly complex task. Several disciplines on which alternative regimes may have an effect or influence, will need due consideration. This primarily concerns the areas of company law and accountancy. Furthermore, certain aspects of insolvency and securities legislation or taxation may also come into play. For specific industries, such as the banking and insurance sector, certain regulations e.g. Basel II or Solvency II may also affect the capital regimes of the companies concerned. This study focuses on the core aspects of company law and accountancy as relevant for any company falling under the 2nd CLD, not making specific considerations for a particular industry. Taking into account the impact of IFRS on the current capital regime of the 2nd CLD, the study examines the feasibility of an alternative system by way of measuring the administrative burdens for EU businesses. Overall, the cost analysis of the existing models adopted in the five EU Member States and five non-EU jurisdictions has shown that the compliance costs related to the capital regimes in all jurisdictions are generally not overly burdensome as by average they do not exceed €30,000 for a specific process. Comparative synthesis tables can be found in section 4.4 of this study report. A first conclusion of the study is that the reduction of compliance costs is unlikely to be a motivation for the transition to an alternative, solvency-based system. Concerning the accounting aspects, EU Member States may require or permit the use of IFRS for individual accounts. As a consequence, IFRS individual accounts could also be used as a basis for profit distribution subject to Member States’ legislation. This is currently the case in 17 of the 27 EU Member States. The practice on how IFRS are applied for distribution purposes shows a mixed picture throughout these 17 EU Member States. In 7 of these 17 Member States, the IFRS accounting profits are modified for distribution purposes. The basic modification consists in declaring certain “unrealised” profits resulting from IFRS individual financial statements as non-distributable. Comparative cost analysis of capital regimes in selected EU/non-EU jurisdictions and in literature Based on a legal analysis, the study conducts an economic analysis of the capital regimes of five EU Member States (France, Germany, Poland, Sweden and the United Kingdom) and of four non-EU countries (the USA, Canada, Australia and New Zealand) [for the legal analysis see Annexes - part 1, section 3]. Furthermore, four models which can be found in the literature (High Level Group, Rickford Group, Lutter Group and Dutch Group) are analysed. The aim of this economic analysis is the identification of the administrative costs, i.e. the


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incremental burdens linked to company law provisions concerning the capital regimes in existence and the proposed models in the literature. The comparison of the administrative costs of different regimes may allow assessing whether a certain capital regime is more advantageous than another for EU companies from a cost perspective. In order to obtain comparable data throughout the various jurisdictions with different economic levels, we have employed standardised cost rates of €100/€70 per hour for the main cost factor of the provisions, the internal man hours spent on compliance. The basis for the economic analysis formed in-depth interviews with high-ranking representatives of 35 companies of different sizes in the five EU and the four non-EU countries. The interviews were complemented by the results of a CFO questionnaire sent out to 3,578 companies in these countries; thereof 157 companies have responded to the questionnaire which represents 4.39 percent of the 3,578 companies [for the CFO questionnaire, see Annexes - part 1, section 2.1]. Administrative costs in five EU Member States A main building block of the current capital regime of the European Union is the concept of a subscribed capital which is protected from distributions. The concept of subscribed capital is extended to the 2nd CLD’s approach to capital maintenance, which provides restrictions on share repurchases, capital reductions, the withdrawal of shares and financial assistance. Another building block is the use of balance sheet test to determine any distribution under the 2nd CLD. The balance sheet profit is the profit realised for the financial year after setting off losses and profits brought forward as well as sums in mandatory and optional reserves. The accounting framework from which the realised profits are derived is either national GAAP harmonised to a certain degree by the 4th CLD or IFRS. A third building block of the current regime of the 2nd CLD is the decision making authority of the general meeting concerning all matters relating to an amendment of the subscribed capital or fundamental decisions concerning transactions linked to capital maintenance issues. The legal analysis of the company law regime adopted in five EU Member States showed that all of them closely follow the 2nd CLD. However, in some EU Member States there are a few significant additional protective measures in national legislation which partly concern profit distribution. This is the case, for instance, for national provisions concerning the protection of premiums and of certain reserves from distributions; the prohibition of transactions with shareholders that are not conducted at “arm’s length”; the necessity of resolutions by the general meeting to distribute profits; different quorums for general meetings and additional rules regarding sanctions. In implementing the 2nd CLD, the five EU Member States have set minimum subscribed capital requirements which in all cases exceed the minimum of €25,000 required by the 2nd CLD and extend up to €225,000 for French listed companies [see section 4.1.6]. In company practice, the subscribed capital regularly exceeds the minimum amounts by far. However, the interviews conducted with EU companies indicated that the practical relevance of the subscribed capital for the assessment of the viability of a company is seen as low. The companies as well as their peers like banks, rating agencies and analysts rather refer to other equity figures such as “net equity” and “market capitalisation”. A comparison of the ratio of subscribed capital to the total shareholders’ equity for the companies on the main stock exchange indices of the five EU Member States showed that due to the low percentage of subscribed capital, equity financing is not largely dependant on it and that there should be sufficient equity base for adequate distributions. In this context, it must be noted that the results of the CFO questionnaire underpin that the majority of the responding CFOs in all five EU Member States do currently not particularly question the distribution restrictions implied


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by the concept of legal capital. The majority of the responding CFOs considered the subscribed capital to be necessary for equity financing and, in their opinion the subscribed capital does not constitute a barrier to the distribution of excess capital. The general dividend policies of the companies interviewed differentiate from company to company as they depend on their individual circumstances. The level of dividends as such is a “political decision” of the parent company with a view to the share price. This includes aspects like dividend continuity or sending certain signals to the capital market. The starting point for the consideration of potential dividend levels is usually the consolidated financial statements and the cash flow situation of the group. The results of the interviews in this respect have been validated by the results of the CFO questionnaire. From an economic perspective, the reference to the group situation shows that the legal profit distribution concept which is based on the single legal entity, receives less consideration when discussing the actual level of dividends. In general, all five EU Member States follow the requirements of the 2nd CLD in restricting profit distributions. The results of the CFO questionnaire showed that the responding CFOs considered legal requirements concerning distributions as well as possible violations of insolvency law as important deterrents regarding excessive levels of dividend payments; i.e. payments which endanger the viability of a company. Other market-led solutions such as bank covenants and rating agencies’ requirements play a less significant role. To bring the parent company’s financial situation in line with the group perspective, a large part of the companies interviewed steer the profit and cash flow situation of the parent company. This is mostly done in a structured planning process over several years. This can entail significant costs for companies. However, as this process is mainly undertaken to achieve tax optimisation for intra-group distributions, we have disregarded the associated costs as incremental burdens stemming from company law. Altogether, we have tried to assemble the administrative costs associated with key processes concerning compliance with the provisions of the implemented 2nd CLD. These processes included capital increases and profit distributions as well as certain aspects of capital maintenance such as the acquisition by the company of its own shares, capital reductions and redemption/withdrawal of shares. We have mainly been able to retrieve meaningful data for capital increases, profit distributions and acquisition by the company of its own shares as companies are regularly using these processes. The average costs for each process do not exceed €30,000. For capital reductions and the redemption/withdrawal of shares, there are no meaningful data as the sampled companies have not made use of these processes. For contractual self-protection such as covenants, we have found the use of such instruments but have not received associated cost data. Furthermore, we have not found that compliance costs vary according to the size of the company, in general. In total, we conclude that the administrative costs concerning the 2nd CLD company law requirements are generally low for companies interviewed throughout the five EU Member States [for details please refer to section 4.1.6 of this study report]; more significant costs arise outside the area of the core company law requirements, specifically with regard to securities legislation (e.g. capital increases; acquisition by the company of its own shares). In view of the most recent changes to the 2nd CLD in 2006, we have not been in a position to verify the cost implications of these measures as they have not yet been applied by the EU companies interviewed.


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In addition, we have analysed the situation of private companies in four of the five EU Member States (Sweden has no separate legal form). In essence, the legal requirements related to the capital regime of private companies are less restrictive than the regime for the companies falling under the 2nd CLD [For an overview and further details, please refer to Annexes – part 1, section 4]. Private companies maintain the capital as contributions can usually not be distributed, although there is a trend at least to lower the amounts or de facto abolish the minimum capital. Capital increases and decreases require a resolution by the shareholder meeting. The basis for profit distributions are usually the net accounting profits as shown in the annual financial statements; the UK deviates by referring to “realised profits”, an approach also applied to UK companies falling under the 2nd CLD. The repurchase of own shares is generally not restricted, except for the UK where basically the same rules as for public companies apply. Administrative costs in four non-EU countries The four non-EU countries show different alternatives to the capital regime used in the EU. We have examined two US state laws (Delaware and California), the Canadian federal legislation as well as the company laws of Australia and New Zealand [for an overview see section 4.2.7]. Furthermore, we have outlined the provisions of the US Model Business Corporation Act (MBCA) which is a guideline for the company laws of a significant number of US states [see section 4.2.1]. With the exception of Delaware, none of the non-EU jurisdictions prescribe a subscribed capital or a minimum capital. In Delaware, the traditional capital system continues to be applied although it does not play an important role in practice. Because Delaware corporations usually issue shares with a very low par value (e.g. US$ 0.01 and less), capital is negligibly low. As with EU companies, the equity figures “net equity” and “market capitalisation” are much more important to the companies interviewed. Instead, the emphasis has shifted to increased testing procedures for dividend payments and other kinds of distributions such as the repurchase of the company’s own shares. This is achieved through various solvency and balance sheet tests. In some of the jurisdictions considered, the performance of the balance sheet test is based on audited consolidated accounts for legal or practical considerations (e.g. for the United States US GAAP). The results of the CFO questionnaire indicate that the responding CFOs of non-EU companies are satisfied with the concept of a balance sheet test and that they consider their audited accounts as a good starting point to determine the level of dividends. On the other hand, the majority of the responding CFOs, with the exception of Australia, believes that a solvency test taking into account future cash-flows better determines the ability to actually pay dividends than a balance sheet test. In the non-EU countries, the distribution decision lies with the board of directors which has full discretion in this respect. The assessment by the company’s management about the adequate level of dividend payments results, as in the EU Member States, is a “political” decision driven by a share price objective. Aspects such as dividend continuity and other signalling effects to the capital market play a role. Again, these companies regularly refer to their consolidated accounts and cash flow position as a starting point for such considerations. This is reconfirmed by the results of the CFO questionnaire. One interesting fact in this context, however, is that the responding CFOs in the considered non-EU countries rank the issue of the compliance with covenants much higher than their EU counterparts.


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One common feature of the non-EU capital regimes is that the increased responsibility of the board in this regard translates into a fiduciary duty or personal liability. Particularly in the United States, directors may also be subject to fraudulent transfer legislation. As for EU Member States, we have tried to track the administrative costs associated with key processes for the non-EU jurisdictions. These processes included capital increases and profit distributions as well as certain aspects of capital maintenance such as the repurchase of shares, capital reductions, redemption/withdrawal of shares. We have been able to retrieve meaningful data only for capital increases, profit distributions and repurchase of shares as companies regularly use such processes. The average cost for each operation does not exceed €25,000. For capital reductions and the redemption/withdrawal of shares, there is no meaningful data available as companies have not made use of these options. With respect to contractual self-protection such as covenants, we found significant compliance costs amounting on average up to €90,000. However, the costs relating to covenants mainly depend on individual circumstances, especially how covenants are negotiated. Furthermore, we have not found that compliance costs vary depending on the size of the company, in general. However, it should be noted that the non-EU companies interviewed were all in good financial health. The compliance effort may, in these models, significantly increase once a company enters into a more difficult financial situation because the management assessment to justify a dividend payment would become much more detailed. In total, we conclude that the administrative costs are also generally low for companies interviewed throughout the five non-EU jurisdictions [for details please refer to section 4.2.7 of this study report]; as market-led solutions, namely covenants, play a more prominent role, additional costs may arise in this respect. More significant costs rather arise outside the area of the core company law requirements, specifically with regard to securities legislation (e.g. capital increases; repurchase of shares). Administrative costs of four models in the literature All four proposals in literature (High Level Group, Rickford Group, Lutter Group, Dutch Group) consider possible changes to the current regime of profit distributions in the EU. These proposals vary from partial to full scale reform of the 2nd CLD capital regime. All systems differ as to how this affects the overall set-up of the capital regime. The Lutter Group proposal [see section 4.3.3] to a large extent maintains the current system of the 2nd CLD and only changes provisions on the distribution of profits to accommodate the use of IFRS in the individual financial statements. To this end, the Lutter Group proposes a solvency test, in addition to the balance sheet test already foreseen by the 2nd CLD. The other three models (High Level Group, Rickford Group, Dutch Group) discuss a fundamental change to the current capital regime by abolishing the concept of legal capital in favour of distribution testing by means of additional solvency tests. The latter goes hand-in-hand with the transition from a par value concept of shares to a true no-par value share concept. The High Level Group [see section 4.3.1] and the Dutch Group [see section 4.3.4] require the companies to meet both the balance sheet test as well as the solvency test. The High Level Group additionally discusses the introduction of a solvency margin. The Rickford Group [see section 4.3.2] ultimately only requires that a solvency test must be met to allow for distributions.


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The solvency margin proposed by the High Level Group is an instrument which can only be used in the context of a balance sheet test and may replace the concept of a fixed legal capital. It ensures that the assets, after the distribution, exceed the liabilities by a certain margin. In this respect, it is decisive to determine an appropriate margin level to avoid excessive restrictions for companies to distribute dividends. In California, which is the only jurisdiction under consideration which embeds a solvency margin in law, the margin only needs to be met if a company does not have sufficient retained earnings for a distribution. We have not encountered any practical case of a California incorporated company where such a margin test has been actually performed. The economic effects of these models are not fully clear, as they leave the most burdensome administrative aspects of the 2nd CLD intact. This specifically concerns the preparation of the general meeting in the case of capital increases, dividend distributions and the repurchase of shares. This is the reason why we have used the EU average administrative cost as a starting point for cost considerations. Presumably, this would also be true for capital reductions and redemptions/withdrawals. However, as specified above, we have not been able to gather reliable EU data in this regard. All four models are, in differing degrees, incomplete in their suggestions on how to exactly conduct changes to the 2nd CLD. One important example is the impact of different designs of solvency tests. The existing gaps in these models partly allow for a wide interpretation and can immensely influence the associated burdens for the companies concerned. For the High Level Group, it seems relatively easy to comply as a reference to current balance sheet ratios is proposed (current assets/current liabilities). For the Rickford and Lutter Group, cash-flow projections are required. The Dutch Group leaves the design completely open. Except for the reference to current ratios, we have not encountered a formalised detailed application of any of these design approaches in the five non-EU jurisdictions. Therefore, we have not been in a position to build on this experience and, thus, have not attempted to estimate the costs associated with the different formats of the solvency tests [see section 4.3.5]. Result of the comparative cost analysis Overall, the cost analysis of the existing models in the five EU Member States and four non-EU countries has shown that the administrative costs of company law in this regard for the companies in all jurisdictions are generally not overly burdensome as by average they do not exceed €30,000 in a specific process. The comparative synthesis tables can be found in section 4.4 of this study report. Thus, such considerations do not seem to play a decisive role in determining whether the transition to an alternative system would actually benefit EU businesses by lowering administrative burdens. However, administrative burdens can be of significant relevance when considering the implementation of certain measures in a jurisdiction. This is especially true for the design of solvency tests. Moreover, we have considered qualitative aspects of shareholder and creditor protection within each model. Both the EU and non-EU jurisdictions have certain shareholder and creditor protection instruments in place. In particular, the EU jurisdictions generally require the involvement of the general meeting concerning capital measures, whereas non-EU jurisdictions more often rely on the board of directors to take decisions in this respect.


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Impacts of IFRS on profit distribution The primary objective under which the IFRS are developed is the decision usefulness of the information provided to the users of the financial statements. Accounting standards developed under the IASB Conceptual Framework are not intended to serve as a basis for a distribution policy which aims at warranting the future viability of a company. IFRS typically make use of different measurement models, but rely in some areas to a large extent on fair value measurements. As a consequence, re-measurements due to changes in relevant market prices or equivalent measurement references result in recognition of (unrealised) profit/losses or have a direct effect on equity. In this context there is a debate as to whether the 2nd CLD in its current format is sufficiently prepared for this challenge. Although the European Union has only introduced IFRS as a mandatory accounting framework for the consolidated accounts of publicly traded companies, EU Member States may require or permit the use of IFRS for individual accounts. As a consequence, IFRS individual accounts may also be used as a basis for profit distribution subject to Member States’ legislation. This is currently the case already in at least 17 of the 27 EU Member States1. In 7 of these 17 Member States2, the net income presented under IFRS is modified for distribution purposes. The main objective of suchc modifications is to eliminate “unrealised” profits/losses from IFRS individual financial statements from the basis for distributions. Concerning the impact of the transition from national accounting rules to IFRS, the analysis shows that it cannot be generally assumed that the application of IFRS will result in a major increase in profits or in equity. However, as specific circumstances at each company prevail, situations may arise where the transition may show major impacts. In this context, it must be kept in mind that when comparing different accounting frameworks, any difference impacting accounting profits in one period will usually be reversed in a later period. The analysis of the largest deviations of IFRS from national accounting rules for all 27 EU Member States [see section 5.2] showed that the following standards are mainly concerned: IAS 19 (Employee benefits), IAS 29 (Reporting in Hyperinflationary Economies), IAS 39 (Financial Instruments: Recognition and Measurement), IAS 40 (Investment Property), IFRS 2 (Share-based Payments), IFRS 3 (Business Combinations) and IFRS 5 (Non-current Assets Held For Sale and Discontinued Operations). As a general rule, these are mainly accounting standards which require or permit fair value measurements. Assessed by EU Member State, the perceived deviation of IFRS standards from national accounting rules ranged between 1.6 and 3.8 on a scale between 1 (identical) and 5 (dissimilar). For example, investment properties may be carried at fair value with an immediate impact on profit or loss or immediately on equity. The accounting for defined benefit plans shows differences in the methods of accounting and parameters utilised. Moreover, actuarial gains or losses may not be recorded immediately. Accounting for financial instruments is a complex task for derivative and non-derivative financial instruments. In several jurisdictions, the fair value measurement of certain financial instruments is permitted or required.

1 Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, Greece, Ireland, Italy, Latvia, Lithuania, Malta, Netherlands, Poland, Portugal, Slovakia, Slovenia and United Kingdom.. 2 Denmark, Greece, Ireland, Italy, Malta, Netherlands and United Kingdom..


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In this context, however, it must be noted that the degree of deviation is, by essence, determined by the national interpretation of the realisation principle as embedded in the 4th CLD. The differing degrees of deviation reveal a lack of harmonisation of the interpretation of basic accounting principles of the 4th CLD throughout the European Union. Under a national accounting framework which is guided by the idea of decision usefulness the realisation principle is differently interpreted than under an accounting framework which emphasises the idea of prudence, e.g. German GAAP. This is one of the main reasons why there is no clear-cut answer regarding the total effects of a transition to IFRS for the European Union as a whole. The last part of the IFRS analysis [see section 5.3] concerns a detailed comparison of national accounting rules’ effects in the five EU Member States on distributable profits with IFRS in distinct areas, namely investment properties, defined benefit pension plans and financial instruments. These accounting areas showed a lack of European harmonisation as the national accounting rules differ widely. The analysis of the current legislative practices in the five EU Member States concerning the interaction of national accounting frameworks under 4th CLD and the distribution model of the 2nd CLD has revealed certain options for a single company to deal with excessive distributions. A balancing element can be introduced at different levels. A first option is the emphasis on prudence in the basic principles of an accounting framework, e.g. in Germany. This option is, however, not relevant for IFRS. As a second option, a reassessment of what profits are distributable or of what should be restricted, may also take place outside the core financial accounting process. In particular, in the UK there is a differentiation between accounting profits under UK GAAP and realised profits for distribution purposes; the UK institutes ICAEW and ICAS have developed authoritative accounting guidance in this respect. Certain accounting treatments are revised by means of an authoritative guidance of the Institutes ICAEW/ICAS and determined as “realised” profits/losses. For further details on the authoritative guidance, please refer to section 5.3.5 of this study report. Under such an approach, certain accounting treatments of IFRS would need to be assessed as unduly influencing the distribution capacity of the companies concerned. Companies are only affected if they use these specific accounting treatments. Experience from the interviews with UK companies shows a mixed picture: some UK companies were not at all affected and others suffered from the administrative burdens associated with these provisions [see section 4.1.5]. In Sweden, the management has to observe a “prudence rule” in addition to the balance sheet testing based on the 2nd CLD; Swedish company law obliges the management of Swedish companies to specifically review the financial situation of the company and, in a group situation, also of the group. This relates not only to the accounting results but also to the cash flow situation. Interviews with Swedish companies pointed to a moderate compliance effort in this regard. The “prudence rule” could also be applied to the determination of distributable profits based on IFRS individual accounts. Both the UK and Swedish approaches go beyond a simple consideration of accounting frameworks and are rather embedded in company law. Even though the direct use of IFRS for profit distribution purposes potentially allows for excessive distributions, it must be acknowledged that IFRS as such may not necessarily cause problems for companies in their capacity to distribute profits. For example, the experience with the Polish companies interviewed did not point to major problems in the use of IFRS for


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distribution purposes. However, they were not subject to excessive fair value measurements compared to a historical cost approach. They only reported issues concerning the transition to IFRS with regard to the treatment of hyperinflationary effects [see section 4.1.3]. To this end, potentially critical situations did not arise with the Polish companies interviewed. Assuming that IFRS represents a uniform accounting framework throughout the European Union, it could be argued that any solution concerning the flexibility for the use of IFRS would need to be determined at EU level, also in view of warranting a comparable minimum protection to creditors in all EU Member States. Another argument for an EU solution could be that any further reaching reform which alters the current capital regime of the 2nd CLD would at least require European consensus. On the other hand, it could be argued that individual EU Member States may be best positioned to individually determine the necessary changes to their national company law framework to achieve the flexibility in an effective and efficient manner, especially when the capital regime as embedded in the 2nd CLD remains untouched. Finally, it must be noted that IFRS are still developing and it seems that the development tends – although not finally decided - towards an increasing use of fair values as a measurement basis. Such element should be kept in mind within the debate as to how IFRS accounting profits should be relevant for profit distribution and whether modifications – such as the introduction of non-distributable profits or reserves or additional solvency requirements – ought to be permitted or required at EU or Member-State level. Introduction of a new regime As part of this study project, we have been specifically asked to explain the effects of the introduction of a new regime. To this end, the study elaborates an array of options on how the system of the 2nd CLD could be adjusted in order to introduce an alternative to the current regime. This elaboration is based on capital regimes already existing in EU and non-EU practice as well as the models in literature. The presentation of these options is designed to find a competitive solution which will not overburden EU companies. However, this study is not intended to recommend a single model to be implemented as an alternative. The determination of such a model is the task of the institutions of the European Union in their role as legislator. At the same time, such consideration will need to include shareholder and creditor protection aspects. To achieve flexibility regarding the implications of the use of IFRS for distribution purposes, it is intended to present the different degrees of reform to the 2nd CLD structured into different dimensions which provide basic lines of thinking. The dimensions discussed are possible amendments to the basic model of legal capital of the 2nd CLD and the design of solvency tests. Finally, there is a discussion concerning the introduction of true no-par value shares. The potential amendments to the basic model of legal capital range from a limited change to the distribution rules via the introduction of a specific fiduciary duty in company law up to a full-scale reform of the 2nd CLD with the abolition of legal capital and the predominance of solvency tests in determining dividend levels [see also section 6.2.1].


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Reform of the basic model of capital Model 1a “Company option” – Based on a general fiduciary duty to be embedded in company law, the board of directors could decide whether the balance sheet test prepared under a certain accounting framework such as IFRS is adequate to present the basis for distribution. If necessary, the board is entitled to make adjustments in view of a realised profit for distribution purposes. The exercise of the fiduciary duty should also include a duty to review whether the current or prospective cash flow situation allows for such distributions. Such approaches can be found in the current practice of Delaware corporations and in Sweden, where a separate “prudence rule” is introduced in company law. Such fiduciary duty could be introduced at the EU or only Member State level. Model 1b “Regulator option” – A central authority determines mandatory adjustments for certain accounting treatments under a specific accounting framework such as IFRS as they are considered as not adequate for distribution purposes. Such an approach can be currently found in the United Kingdom where the Institutes ICAEW and ICAS have issued various pieces of authoritative accounting guidance. Mandatory adjustments could be determined either at EU or Member State level. Model 2 “IFRS solvency add-on” – An additional mandatory solvency test is introduced for all EU companies using IFRS for their individual financial statements. The remaining elements of the 2nd CLD are kept intact. This approach is favoured by the Lutter Group. Such an approach requires the introduction of a solvency test format at EU or only Member State level. Model 3 “On equal terms” – A full scale reform abolishes the legal capital of a company and introduces a two-stage distribution test consisting of a balance sheet and solvency test which have the same importance as they must both be met. This basic approach is suggested by the High Level and the Dutch Group. An additional protective element could be a solvency margin as discussed by the High Level Group. Concerning the balance sheet test, the buffer of the legal capital of at least €25,000 would either fall away or be replaced by a solvency margin. The solvency test is introduced as a balancing element. Model 4 “Solvency test predominance” – Again, a full scale reform abolishes the concept of legal capital. Within a two-stage distribution test, a solvency test must be met in any case. The balance sheet test does not constitute any restriction on distributions as long as the solvency test is met. In essence, this approach reflects the proposal of the Rickford Group. As a consequence, distributions based on a negative balance sheet test would be permitted if the cash situation allowed for this. The design of solvency tests is for nearly all potential changes to the basic model of capital a crucial feature of a reform of the 2nd CLD. It determines to a large extent the economic burdens associated for companies. To this end, the options range from a fiduciary duty for directors to adequately determine the format of a solvency test up to a prescribed mid-term projection of future cash flows up to five years taking into account further future commitments [see also section 6.2.3]. The responsibility of the directors for this solvency assessment could be demonstrated to the general public via a solvency certificate. In this context, it must be noted that we have not included as another option a solvency test based on a long-term projection period. The reason for this is the fact that experience from the interviews conducted in all nine EU and non-EU countries has shown that reliable forecasts cannot usually be produced for time periods exceeding five years.


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Solvency test models Model 1 “Leave it to the companies” – A general fiduciary duty could require the board of directors of a company must justify a distribution from a cash flow perspective. As it is not exactly prescribed how the solvency test will have to be performed, companies can flexibly adapt the method to their financial situation. A company in good financial health with a comfortable cash position will not need to perform detailed testing in this regard; a company in financial distress may have to intensify its efforts in this regard. This approach has been particularly found with Delaware corporations. Model 2 “Current ratios” – A comparison of current assets to current liabilities based on audited financial statements could be an easy way of fulfilling this requirement. This has been suggested by the High Level Group. It does not take account of a prospective look into the future where certain obligations may already be known. Model 3 “Short-term projection” – A short term projection would cover at least the next twelve months of a company’s life. Another important element is the inclusion of longer term commitments. This is the basic approach of the Rickford and Lutter Group where the Lutter Group would also see a two year period as appropriate for the detailed analysis. Model 4 “Mid-term projection” – A mid term approach would cover the next three to five years of a company’s life and would also include longer term commitments. The projection period stretches to the boundaries of the current company’s practices and ability to project cash flows in most cases. Finally, possible ways are considered for the introduction of no-par value shares which do not refer to a nominal or fractional value [see also section 6.3]. The 2nd CLD at present only recognises par value shares and shares with an accountable par. The options discussed are solutions which keep the current 2nd CLD mainly intact up to solutions which require a fundamental reform as they allow that the proceeds contributed could be generally used for distributions if specific tests like the solvency test or margin do not prevent this. True no-par value shares Model 1 "Protection of all proceeds from share issues" – This model maintains, as far as possible, the provisions of the 2nd CLD and places all proceeds from the issuance of shares under protection under a new balance sheet item “equity capital” similar to that applicable to subscribed capital. Amendments would be necessary apart from the abolition of the prohibition on below par issues in particular because of the total binding of the proceeds from the share issues. However, it should be noted that this solution would, in some EU Member States, represent a considerably more onerous solution than the present one. The reason is that it is admissible in certain EU Member States that premiums be used to cover losses. This possibility would be lost if premiums were bound under the item “equity capital”. Model 2 "Variable capital" - This model is characterised by the fact that the proceeds of the share issue are not completely contributed to a protected equity capital item but to an only partially protected reserve. In this model most of the provisions of the 2nd CLD could remain intact. Amendments apart from the abolition of the prohibition on below par issues would be necessary in particular because of the different binding of the proceeds from the share issues. Furthermore, it should be noted that the reserves can be – under certain circumstances - reduced to zero.


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Model 3 "Mixed model" - According to the mixed model, subscribed capital is formed on the foundation of the company, and the proceeds of the share issue are entered as such, until the minimum capital or a higher amount prescribed by the statutes is reached. Above that figure, the issue proceeds are no longer treated as subscribed capital but can be entered as reserves. This model leads to the necessity to have various procedures in place depending on whether the proceeds of the share issue are attributed to, or should be removed from, the subscribed capital or the reserves. Amendments to the 2nd CLD are – in addition to the introduction of the abovementioned different procedures and the abolition of the prohibition on below par issues – necessary as also this model leads to changes in the binding of the proceeds of the share issue. Furthermore, it should be noted that in this model less of the proceeds could flow to the subscribed capital than under the 2nd CLD. Models 4 and 5 "Total abolition of legal capital" – These two models protect the proceeds of the share issue not by the prevention of distributions but by admitting its distribution under certain conditions, namely a balance sheet and/or solvency test or solvency margins. As, in this model, no-par value shares would be in a completely different environment, a full revision of the 2nd CLD would be necessary in practice, although this would not be due to the introduction of no-par value shares as such.


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2 Introduction 2.1 Area of EU company law under examination The existing 2nd EU Company Law Directive (2nd CLD)3 imposes minimum capital requirements on public limited liability companies and contains a range of detailed provisions aimed at protecting shareholders and creditors. They apply inter alia to the formation stage, profit distributions to shareholders, acquisitions of own shares as well as to increases and reductions in capital. This Directive has currently been subject to a legislative process at EU level (Directive 2006/68/EU dated 6 September 2006) in order to implement simplification measures aiming at facilitating certain capital related measures. These simplification measures were to a large extent triggered by the SLIM report of 1999. Beyond this recently completed limited reform of the existing 2nd CLD, the Report of the High Level Group of Company Law Experts of 2002 additionally called for the introduction of an alternative regime which would not be based on the concept of legal capital but rather on a solvency test. However, the High Level Group could at the time not establish whether the current rules on capital formation and maintenance represent a disadvantage for EU public companies. A study regarding the feasibility of such an alternative regime was embedded in the European Commission’s Action Plan for Corporate Governance and Company Law of 2003 as a medium term measure. The introduction of IFRS in the EU in 2002 (IAS regulation) created a new challenge for the concept of the existing capital maintenance rules of the 2nd Company Law Directive. The IASB framework does not relate to a specific concept of capital maintenance. Underlying IFRS accounting concepts – especially the fair value based revaluations – cause doubts whether distributable reserves and profits can be used for dividend payments. A new development constitutes the inclusion of the 2nd CLD in the European Commission’s simplification efforts of company law for small and medium-sized entities (SMEs). In the general context of Better Regulation, the European Commission has decided to simplify the regulatory environment for European businesses, in co-operation with the European Parliament and the Member States. A Commission Communication (COM (2007) 394) dated July 2007 postulates that “at least a review of that system should be considered in order to give companies more flexibility in the field of distributions to their shareholders.” This study report is supposed to provide additional information that should facilitate the Commission’s assessment in this regard. 2.2 Scope of the study KPMG Deutsche Treuhand-Gesellschaft Aktiengesellschaft Wirtschaftsprüfungsgesellschaft (KPMG DTG) has been contracted by the European Commission to conduct a study project whose overall objective is to evaluate the feasibility of an alternative to the current regime of minimum capital established by the 2nd Company Law Directive (Contract ETD/2006/IM/F2/71). This alternative regime could be established at the option of EU Member States.

3 Second Council Directive 77/91/EEC of 13 December 1976.


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This study is intended to help the European Commission to evaluate whether an alternative regime better supports the efficiency and competitiveness of EU businesses and whether creditors´ and shareholders´ protection could be fully maintained. To support the European Commission’s evaluation, the study assesses selected existing capital regimes inside and outside the European Union. For the European Union, the current legal capital regime in five EU Member States is subject to assessment, namely: • France • Germany • Sweden • Poland • United Kingdom After a thorough examination of the legal basis, the Member States’ regimes and practices are examined under cost aspects. Specific focus of the study project was the degree of burdens of the existing legal capital regimes for European stock corporations as well as the protection of shareholders and creditors. Furthermore, the study covers alternative approaches as in existence in other non-EU countries as well as concepts in literature. This examination is not exclusively bound to solvency based regimes. The examination of alternative regimes as in existence in other non-EU countries comprises the following countries: • USA – Delaware • USA – California • Canada • Australia • New Zealand The concepts in literature concern the following four models: • High-Level Group • Rickford Group • Lutter Group • Dutch Group A second part of the study deals with the impacts of the new IFRS accounting regime on the current profit distribution scheme. In order to support the European Commission’s assessment of the current situation, the study provides information on the financial statements to be used in the determination of profits and the status of convergence of national GAAP to IFRS for all 27 EU Member States. Furthermore, the study gives specific information for the five EU Member States with regard to the effect of national GAAP on distributable profits compared with IFRS in three specific areas, namely financial instruments, defined benefit pension plans and investment properties. 2.3 Methodological approach The methodological approach chosen by KPMG DTG for conducting this study is specifically tailored to address the objective of the study: evaluation of the feasibility of an alternative to the current regime of minimum capital.


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The basis for any economic consideration of the issue of capital regime is a proper legal analysis of the underlying legislation. A sound understanding of the legal framework in EU and non-EU countries allows a comparison of the practices in companies concerned and gives way to an analysis of the costs linked to practical processes existing in these companies. Figure 2 – 1: KPMG methodological approach

Phase 1 Preparatory legal analysis KPMG DTG

local KPMG member firm or

external law firm

Phase 2 Economic analysis KPMG DTG

local KPMG member firm

local companies

Phase 3 Wrap-up

The study researches the relevant legal issues in the jurisdictions under consideration. For Phase 1, two separate legal questionnaires were developed, one for the five EU Member States (France, Germany, Sweden, Poland and the United Kingdom) and another one for the four non-EU countries (USA (State laws of Delaware, California), Canada, Australia, New Zealand). Both questionnaires have been submitted to the European Commission for comment. Overall, the preparation of the legal questionnaires has proven to be very demanding in order to achieve a satisfying level of conformity between EU and non-EU countries. The EU legal questionnaire required a high level of describing elements in order to present EU requirements in a way that they are easily accessible at local level and to also be able to identify the local elements that may be overly burdensome to local stock corporations. Overall, for the EU countries 525 pages of individually prepared documentation have been received; for the non-EU countries 404 pages. Due to the complexity of the legal subject, there was an intense iterative review and consultation process with the participating KPMG member firms or external law firms in these countries. An aggregated description of the individual capital regimes can be found in Annexes Part 1 of the study report. In Annexes Part 1, the study also examines in which of the five EU Member States the principles of the 2nd CLD are applied to private companies. Subsequently, cost questionnaires were developed on the basis of the answers to the legal questionnaires. The German cost questionnaire was subject to a „test run” with a German blue chip company in April 2007. The individually prepared EU and non-EU cost questionnaires amount can be found in Annexes Part 2 of the study report. To finally assess the practical cost implications, companies of different sizes were selected for in-depth interviews (for the detailed methodology for the selection of companies, please refer to Annexes Part 1 of the study report). In the execution phase from July to September 2007,


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each of the 34 companies in nine countries was interviewed in-depth for 1 to ½ hours about their practices concerning capital formation and maintenance and the related burdens. These interviews were mainly conducted on-site in these countries with few exceptions where interviews took place via telephone. The aggregated results of these interviews can be found in the main body of the study report. Furthermore, a “CFO questionnaire” was prepared to collect data on a wider statistical basis (e.g. typical amount of subscribed capital or relation of subscribed capital to premium). This questionnaire has been sent to 3,578 companies in the nine countries under consideration. The questionnaire itself is very much focussed on a small number of questions to make it easy for companies to respond to it and, thus, achieve a higher response rate. A copy of this questionnaire can be found in Annexes Part 1 of the study report. Concerning the impact of IFRS on distributable profits, the European Commission clarified in October 2006 the required level of the analysis in this regard. In particular, the European Commission asked to provide the following information in the course of the study:

− Complete list of Member States containing information on which financial statements required or permitted to be used in the determination of distributable profits.

− Complete list of Member States which are converging national GAAP to IFRS and

the progress on convergence, for the three areas listed below.

− Comparison of five Member States (DE, FR, PL, SW, UK) national GAAP effect on distributable profits compared with IFRS in three specific areas: investment properties; defined benefit pension plans; and financial instruments.

Based on these requirements, a 38-page IFRS questionnaire was developed and submitted to local KPMG member firms in the 27 EU Member States. This IFRS questionnaire is divided into two parts. Part I is directed towards KPMG member firms in all 27 EU Member States. It analyses the use of IFRS within Europe and provides an indication of the stage of convergence between national GAAP and IFRS primarily based on three subjects. Part II of the analysis is only directed to the core five EU countries of the study project (France, Germany, Poland, Sweden and United Kingdom). The objective of this part of the analysis is to determine whether there is a tendency towards increased equity/anticipated profits under IFRS compared with local GAAP or vice versa. Based on the results of the survey on burdens for companies and IFRS impacts on profit distribution, the study identifies a range of approaches to capital regimes showing the cost/benefit and timing effects of introducing alternatives to the current capital regime as embedded in the 2nd CLD. These approaches encompass solvency-based and the current capital-based systems. Regarding no-par-value shares, the study analyses from a legal point of view the nature of no-par-value shares and examines the necessary changes to the current 2nd CLD.


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3 Basics elements of capital regimes 3.1 Introduction This study project looks at a variety of different capital regimes in altogether nine countries and analyses alternative models currently only existing in literature. All these systems may differ in their outset, however, there are certain common basic elements which all these systems incorporate and which may show different formats in the various countries and theoretical models under consideration. Below we try to define these elements which serve in our analysis as a common denominator to show similarities or deviations of these systems and to demonstrate their consequences. Firstly, it must be stated that for all systems of public companies reviewed in the European Union and non-EU countries, it is characteristic that the personal liability of shareholders for the debts of the company is excluded. In fact only the company as a legal person is liable for its debts and recourse in case of liability and the basis for credit are solely the assets of the company which it has acquired initially on its formation and later through its economic activity, for example in the course of capital increases4. It is therefore understood as self-evident in all systems reviewed that the basis for the formation of set equity is the obligation of the shareholders to pay-in their contributions. Only whoever pays-in a contribution can be a shareholder. It is also inherent in all systems that the equity capital built up cannot be returned to the shareholders without restriction, although the degree of protection differs greatly as between the EU models and the non-EU models. Ultimately, there are regulations which permit distribution to the shareholders, for example, in the form of dividends, only under certain conditions everywhere. In all states, calculations are conducted to determine whether assets may be distributed, differences, however, being evident in the methods of calculation and the parameters on which they are based. Apart from these fundamentals, which are responsible for the paying-in of contributions, the maintenance of the contributions and the distribution of the company's assets, there are further issues which must be referred to for the assessment of the efficiency of the systems employed. A particular concern of the study is the ascertainment of the burdens for the public companies affected, which have to apply these regulations. For these companies, the aspect of legal certainty and the liability and other risks of sanctions associated with the regulations play a special part, which ultimately determines their application in this respect. The company view alone does not lead to efficiency from the shareholders' and creditors' point of view. Their concerns or level of protection is intended to be illustrated separately. 3.2 Statutory basis of the capital protection system 3.2.1 Provisions on the structure and acquisition of equity capital Regulations on the structure of equity capital are the first basic elements of the models reviewed as it determines how the company may use the equity capital. The second basic elements are regulations on the acquisition of equity capital. Distinction in that respect has to be made between the formation and the capital increase, which are based, in the models reviewed, on the same regulatory approach. In practice, the capital increase is far more important, so that this aspect will constitute the emphasis regarding capital acquisition in the later examination.

4 cf. Lutter, Kapital, p. 40.


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3.2.1.1 Structure of capital All legal systems reviewed contain provisions on the question of how the company may use equity capital acquired by contribution, in particular, whether it is regarded as a bound asset not capable of distribution or not. In the European model, public companies must be in a position to dispose over a stated capital. The amount of the subscribed capital (minimum or higher amount) is characterised in that it is subject to special regulations as to binding and therefore, in its function as a cushion against losses, may not be distributed to the shareholders. In addition, there is the possibility that the company acquires additional capital through the premium i.e. the obligation of the shareholders to pay an amount above the nominal or accountable par value of their shares. This is also bound, in the EU and non-EU countries reviewed, even if less strictly than the subscribed capital. In addition, the assets of the company are also sometimes additionally bound, for example, the distribution of assets of the company to the shareholders is admissible only under a resolution on the distribution of profits. It is also characteristic for the European Union system that the subscribed capital is divided into nominal value shares or non-genuine no-par value shares. It is also significant in this context that according to the European Union model, a connection between the subscribed capital as reference amount and the number of shares exists. In the case of no-par value shares, their total is the subscribed capital. In the case of non-genuine no-par value shares, each share can, by division, be attributed an amount in the subscribed capital. In most of the third states, a subscribed capital is no longer prescribed. The funds paid-in by the shareholders is recorded as a prescribed equity capital item e.g. referred to as "share capital", "contributed capital" or simply "capital". These funds are not per se bound, but in most of the countries reviewed, be reduced practically to zero, if adequate assets are present to pay debts due. Usually, in these states, no-par value shares are used. There are also non-EU countries in which the subscribed capital exists and is, in principle, protected against distribution. Usually, in these countries the members of the board of directors can freely determine the portion of the sale proceeds to be shown as subscribed capital. In the cases in which nominal value shares are issued, this may not be less that the total of the nominal value capital. The amount exceeding the nominal value, constitutes a "surplus" which is available for distribution. If shares with a very low nominal value are issued (e.g. $0.001), the resulting amount not eligible for distribution is negligibly small. In the case of no-par value shares also permitted, it may even be zero 3.2.1.2 Formation Formation concerns the attribution of a certain amount of capital to the company, and this takes place by contributions. This element is found in all legal systems although with differences in the determination of the contributions to be made and the binding of the contributed assets. Capital to be contributed In all models reviewed, the founders may, in the course of the formation, determine the amount of the capital which the company should have, in the statutes of the company. In the


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EU model, a certain minimum amount in the form a subscribed capital must be achieved. In the non-EU countries, a minimum capital is not prescribed, although there are, in some cases, principles according to which the company must be adequately capitalised for the scope of business it is to conduct. Ensuring the contribution of equity capital A further basic element of all systems on the formation of equity capital is the obligation of the shareholders to pay-in contributions to the company, in order to become shareholders in that company and participate in it. There are also usually additional safeguards intended to ensure that the capital of the company actually reaches the company. Among the most important are: Minimum amount Provisions concerned with the amount of the contribution are found in all models. In the EU model, a certain sum to be subscribed and undertaken is compulsory, the total of such sums corresponds to the subscribed capital (prohibition on the issue of shares below par). The subscribed capital is, for this purpose, divided into nominal value shares and non-genuine no-par value shares. In view of the contribution of premia, there are provisions in the EU Member States which assume full payment of contributions. In the models without nominal value which exist in some of the third states, the amount determined by the founders must be

subscribed and undertaken. In these systems, division into nominal value is not provided for. Objects capable of being contributed A basic principle of all models is a provision as to what objects are capable of being contributed. All models have in common that cash and in kind contributions may be made, although in many non-EU models, the contribution of services is admissible, in others this is not the case. Protection against over-valuation The models reviewed have provisions to protect against over-valuation of contributions. In the EU model, as well as an internal audit of contributions in kind by the company's organs, an audit by an expert is provided for. Individual states sometimes demand more, for example, an audit by the register court. In the third states, it is a matter for the members of the board of directors – in exercise of a certain duty of care – to determine the value of the contribution. An examination by the third party is voluntary. Sanctions Finally, there are penalties in all EU Members States reviewed for improper contribution. 3.2.1.3 Capital increases In a capital increase, equity capital is contributed at a later date. In the models reviewed, the same basic provisions as in the case of formation are found, supplemented, however, by provisions which take account of the special features of the capital increase.


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Contribution A special element in comparison to the formation is firstly, that in the case of the acquisition of capital by a capital increase, it is necessary in all models hat the amount of the capital or the number of shares to be increased, is fixed and that either the shareholders directly or through a prior authorisation, agree to the capital increase. In some third states models, authorisations in the statutes, which can permit capital increases without mentioning a minimum amount or a minimum period, are adequate. Pre-emption rights Another special element is the pre-emption right, which enables a shareholder to participate in a capital increase in proportion to the number of shares he already holds. The details of the pre-emption right vary. While in the EU Member States it is mandatorily prescribed for capital increases in cash, it can, in the third states, be granted only on the basis of the statutes. The amount of the pre-emption right and the possibility of its being excluded, differ as between individual legal systems. 3.2.2 Provisions in distributions In all systems reviewed, it is admissible to determine the amount of the company's assets and to derive therefrom distributions to the shareholders and other entitled persons. The EU provisions differ in detail from the third state provisions on the question of how the distributable assets are to be calculated and determined. Based on statutory provisions, private contractual protection covenants are found in varying degrees. Provisions on the calculation of the distributable amount A crucial basis element of any capital system is the provisions on the calculation of the distributable amount. The EU and non-EU models differ considerably in this respect. The EU model relies on the distribution of a profit on audited individual accounts, calculated according to the accountancy regulations in the Accountancy Directive. Only the freely available profit for the current accounting period and that accumulated from previous years may be distributed. The third states usually work with two or more test procedures to determine the distributable amount. Two levels can be distinguished, in principle. The starting point is usually a method of calculation relying on current profit and retained earnings. Sometimes distributions from the surplus (excess of net assets over subscribed capital) are possible. In many legal systems, distributions de lege lata are, in addition, even admissible if the company thereafter has almost no or even negative capital. These accountancy tests are partially applicable by law to balance sheets to be prepared according to binding accountancy systems (e.g. US GAAP, New Zealand GAAP). In part, it is also deemed to be admissible to deviate from accountancy on the basis of historical acquisition and manufacturing costs and to use other accountancy methods, provided that these are reasonable in the circumstances. Differences also arise on the questions of whether and to what extent specific group situations are mandatorily to be taken into account. On a second level, the determination of the distributable amount is to be conducted in the non-EU countries reviewed by a solvency test, which is sometimes applied by law, and


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sometimes under judgements. It varies in detail. In principle, distributions are prohibited if the company by the distribution would no longer be in a position to pay debts becoming due in the normal course of its business. Provisions on determining the distributable amount The countries reviewed also provide regulations concerned with which organ proposes the amount for distribution and whether and to what extent the consent of the shareholders is required. There are differences precisely on the involvement of the general meeting. Return of payments received without justification/liability If payments are made in breach of the distribution procedure, the various legal systems have provisions for their repayment and on liability of the organ members involved. Contractual self-protection Apart from the statutory protection mechanisms, creditors secure themselves also on a contractual basis. In the third states, the model of contractual self protection, by which usually major creditors secure themselves directly or indirectly against improper distribution of assets, is especially developed. 3.2.3 Provisions for the maintenance of contributed capital Also among the fundamentals of the models reviewed are provisions on the maintenance of the contributed capital. Apart from the questions of whether the EU basic capital system is applicable or not, the legal systems reviewed see certain – similar – transactions forms as "dangerous" and therefore to be protected, although differences in detail remain. Apart from the common features, some legal systems have other protection mechanisms. Acquisition of the company's own shares The acquisition by the company of its own shares, by which shareholders receive repayment of their contributions, is regulated in all legal systems reviewed. Again the methods differ. While in the European Union, the maintenance of net assets (assets less liabilities) and the approval of the general meeting is relied on, in non-EU countries share repurchase is equated mostly with other forms of distribution and subjected to the regulations. The countries reviewed maintain provisions on redemption or cancellation of shares acquired. Financial assistance Financial assistance which prohibits public companies from granting loans or other support to purchase their shares, is dealt with mainly in the EU Member States. In the non-EU countries, such provisions are only occasionally found. Capital reduction Capital reduction plays a part only in the states which provide for stated capital. In the other states, in particular the non-EU countries, the contribution paid for shares is reduced by other methods, either by a reduction of the number of shares or by distributions although certain restrictions on distributions have to be observed.


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Reduction in the number of shares The reduction in the number of shares and the refund of capital associated therewith displays a number of sub-groups, variously represented in the legal systems reviewed. Distinction has to be made between the obligatory redemption of shares, redeemable shares, amortisation and the cancellation of the company's own shares held by it. Fraudulent transfers Provisions on “fraudulent transfers” are regarded in the various third states as an important element of protection of the company and its creditors. The provisions which apply during the subsistence of the company or, above all, on the insolvency of the company, declare transactions to be invalid for example, in which the debtor acts with the intention of prejudicing creditors or which lead to only inadequate assets being left in the company. 3.3 Approach to the economic analysis The determination of the burdens on the company constitutes a significant assessment criterion of the efficiency of the existing provisions. Significant criteria which influence the burdens are the legal certainly associated with the provisions and the associated liability and penalty provisions. The economic analysis always follows a prior legal analysis of the relevant capital protection system. The prior legal analysis is intended to contribute to identifying the important parameters for a company and rendering in particular the chronological order of legal processes transparent (cf. Annex 2: Legal Questionnaire EU and non-EU). Of their nature, the economic analyses constitute a comparison of burdens created by various regulations for the relevant company. In the analyses of burdens, the "incremental cost" of a regulation for the company is relied on. Only such costs are regarded as relevant which usually arise for the company due to the specific regulation in company law. This includes internal costs for personnel (highly qualified, lowly qualified), but also external advisory costs and administrative charges. For the purposes of this study it is not usually adequate to restrict oneself to the purely publication costs as the burden of capital protection regulations refers mainly to internal processes. A restriction to publication costs would be therefore misleading. The advantages of regulation arise ultimately from the comparison of a regulation with other possible regulations for the same situation. The information received for costs of high / low qualified personnel were generally collected by man hours. To allow for comparability between jurisdictions with different levels of welfare, we have applied standardised hourly rates (fully loaded) of €100 per hour for highly qualified personnel and €70 per hour for low qualified personnel. The average internal hours spent by companies on incremental burdens due to company law provisions is subsequently multiplied by these hourly rates. The information received for other costs were generally given in expenses per year. As these regularly did not constitute the main incremental cost factor for companies concerned, these amounts are only converted to Euro amounts with the exchange rates as of 09/15/2006. Because of the relatively small total economic impact, we have not taken the effort to subject them adaptations to reflect different levels of welfare in the various countries.


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The "incremental cost" is determined in interviews with selected companies. A few companies which are intensively questioned, are concentrated on. The approx. 1 ½ hours interviews are conducted with high-ranking company representatives (CEO, CFO or head of the legal department, Treasury or Accounting). The exact costs of the compliance with the legal processes that are subject to this study are not specifically recorded in the day-today business of companies. Therefore, the information from the company itself relies to a large extent to estimates on the basis of best knowledge (for more exact presentation of the selection of companies or the questioning technique cf. Annexes 1 and 2 of the Study). With regard to equity capital provision, the structure of the capital and the shares is considered. It should be ascertained in each case whether the present structure causes special burdens for the company. The significance of protected equity capital, in particular subscribed capital play an important part in the financing of the company. On this, the question is asked whether the subscribed capital is necessary for the financing of the company or whether the bound amount is too high and could better be invested elsewhere. On the other hand, whether the amount of subscribed capital could alone be adequate for financing the company or whether there is usually other financing requirement, is also considered. Finally, the structure of the shares is examined. The main question is whether the present structure is relevant in assessing the viability of a company. The efficiency of the company formation, as an historical event, is not specifically taken care of in the economic analysis. Particular emphasis in the economic analysis is placed on the distribution process, which forms the central subject of all present reform efforts on capital protection. The internal regulations on distribution amounts and their determinants from the company's point of view are examined. An economic analysis encompasses the costs to comply with the statutory restrictions on distributions. Finally, the other distribution process costs are ascertained. With regard to possible changes in the system, the existence of certain conditions e.g. the practice of budgeting of cash-flows are investigated. Here the attempt is also made to ascertain the use of "covenants", i.e. contractual provisions with influence on the capacity of companies to distribute and to estimate their burden for the company. With regard to capital increases, the associated burdens for the company are intended to be ascertained. The incremental expenses of the necessary company law steps will be considered. In as far as possible the expense of company law requirements due to capital market law requirements will also be looked at (e.g. for the preparation of prospectuses), in order to clarify the significance of company law regulations in this context. The subject matter of the analysis is regulations for maintenance of capital and the subjects of "own shares" "financial assistance", "capital reduction/ withdrawal of shares". With regard to "own shares", the expense of the regulations for the company will be examined. Here also comparisons can, as far as possible, be made with the costs of the capital market regulation of "own shares", in order to assess their significance. Financial assistance will usually be more difficult to investigate because the liberalisation of EU legislative provisions in this respect took place only in 2006. "Capital reduction/ withdrawal of shares" will first be examined as to its use and the costs, as far as existing, estimated. In addition, the relevance of continuous monitoring of information obligations on the loss of stated capital and the continuous relevance of the insolvency provisions will be considered.


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3.4 Considerations regarding the protection of shareholders and creditors The various models examined also display provisions characterised by more or less protection of shareholders and creditors. They are also to be considered because more regulation with higher expense can also result in higher protection of shareholders and creditors. Examples for such regulations are the auditing obligations of contributions in kind by an expert third party, the obligation to obtain shareholder approval for a capital increase and to acquire the company's own shares, the granting of pre-emption rights, publication obligations, auditing obligations of annual accounts, distributions and the implementation of the principle of equality between shareholders.


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4 Alternatives to the current capital regime 4.1 Comparative analysis - situation in the European Union 4.1.1 France 4.1.1.1 Structure of capital and shares

4.1.1.1.1 Legal framework With respect to the means of equity financing by shareholders French law is based on the subscribed capital and on share premiums. With respect to the structure of shares French law differentiates between shares with a nominal value and shares with an accountable par. Structure of capital Subscribed capital Under French law the share capital must be at least €225,000 in listed public companies and at least €37,000 in other public companies. Above this minimum amount, the shareholders are entitled to freely fix the share capital. The share capital must be higher than €225,000 or may be lower than €37,000 in the case of some regulated activities, such as insurance or press publishing. In the stage of formation the French Commercial Code does not use the possibility of fixing authorised capital. This possibility only exists in case of an increase in share capital. Premiums Under French law it is possible to use share premiums at the stage of formation but this possibility is hardly used in practice. The premiums must be accounted on the liabilities side under the section: subscribed capital (“capital social”), account 104 (Article 441/10 PCG). However, the premiums can be distributed to the shareholders or be used in any other manner (Cass. Com. 09.07.1952, J.C.P. 1953, II, 7742). Premium distribution may be decided by shareholders’ resolution in general meetings. In the event of the liquidation of the company, no individual has a right to premiums paid by him; the premiums remain in the liquidation surplus and can be thus distributed to any shareholder without distinction. Protection of the public company`s assets The share capital may not be returned to shareholders except for cases in which the capital is decreased (see. under 4.1.2.3.2). Premiums may be returned to the shareholders under the conditions mentioned above. Furthermore French law limits to transactions can follow from the company's corporate objects ("objet social") or from the prohibition on misuse of the company's funds ("abus de biens sociaux"). Structure of shares According to the provisions of the 2nd CLD the French Commercial Code French law offers shares with a nominal value (par value shares) or, alternatively, shares with an accountable par. Under French law, shares with a nominal value must represent a certain numeric amount


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which is the amount of the contribution which has been/must be paid on the subscribed capital. On the contrary shares with an accountable par do not dispose of such a numeric amount. These shares represent the same fraction of the subscribed capital as all shares with an accountable par participate in the subscribed capital with the same amount. As these shares are linked to the subscribed capital, they are in fact notional no-par value shares. 4.1.1.1.2 Economic analysis Practical relevance of subscribed capital and structure of shares for an assessment of the viability of a company The responses from the French companies interviewed showed a mixed reaction to the concept of minimum legal capital and par value. The concept of minimum legal capital was considered to be more important for SMEs and for start-ups. In this context, it can be seen as a sign of seriousness concerning the foundation of the company. Two companies interviewed explicitly stated that for listed companies it was not perceived to be important due its minimal amounts. Instead the net equity figures were of much higher relevance. To verify the statement for listed companies, we have additionally performed an analysis of certain ratios concerning subscribed capital for the main French stock exchange index CAC 40: Figure 4.1.1-1: Ratio of subscribed capital to market capitalisation (France)

France: Subscribed Capital to Market Capitalisation

47%

25%

14%

8%

6%

< 5%5% - 10%10% - 20 %20% - 30%> 30%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of September 2006 For 47 percent of the CAC 40 companies the subscribed represents less than 5 percent of their market capitalisation. Thus, the overall importance of subscribed capital figure seems to be marginal for listed companies. Concerning the concept of par value, the picture was mixed. Three companies considered the “par value” to be relevant as it was part of the legal set-up which guarantees the minimum capital of companies. Two other companies stated that the “par value” concept was of little use to their companies.


27

One company specifically stated that the legal framework should rather allow for measures that the share price would not become “too high”. This particular statement alluded to measures that possibly lower the stock price, e.g. stock splits which are easier to be contemplated under a “no-par value regime”. The respective attitudes were not linked to the size of the companies and were rather motivated by personal opinions of the persons interviewed. Restriction for distribution The results from the CFO questionnaire sent to 287 French public companies showed that there is no uniform assessment by French companies concerning the distribution restrictions implied by the concept of legal capital. Figure 4.1.1-2: CFO survey results: necessity of subscribed capital (France)

"In general, we do not consider stated/subscribed capital to be necessary; it

unnecessarily reduces our company's flexibility to distribute excess capital."

38%

63%

TrueFalse

Source: CFO questionnaire, September 2007 The responses to the CFO questionnaire did not deliver a clear statement in faour or against legal capital. While 63 percent of the respondents considered the existence of subscribed capital to be necessary, this view was opposed by 38 percent of the respondents.


28

However, according to the respondents to the CFO questionnaire there does not seem to be any interest in excessive restrictions to distributions: Figure 4.1.1-3:CFO survey results: level of subscribed capital (France)

"The company's management considers it advantageous to increase the level of

stated/subscribed capital to the highest possible extent because it should not serve

for distributions."

13%

88%

TrueFalse

Source: CFO questionnaire, September 2007 A clear majority of 88 percent of the respondents rejected the idea to increase the level of subscribed capital to the highest extent possible to avoid distributions. Role of the subscribed capital in equity financing For CAC 40 companies, the ratio of subscribed capital to total shareholder’s equity shows that for 64 percent of the CAC 40 companies the subscribed equity portion stays under 20 percent of total shareholder’s equity. Figure 4.1.1-4: Ratio of subscribed capital to total shareholder`s capital (France)

France: Subscribed Capital to Total Shareholder's Capital

25%

25%14%

14%

22%< 5%5% - 10%10% - 20 %20% - 30%> 30%

Source: One source: Subscribed capital for the FY 2005, shareholder’s equity (consolidated) for the FY 2005


29

This underpins that the equity financing is not largely dependant on the subscribed capital and that there is a sufficient equity base in the CAC 40 companies and their subsidiaries to allow for adequate distributions. The existence of a subscribed capital does seem to be a stumble block for the CAC 40 companies in their approach to equity financing and distribution policy from a group perspective. The following answers to the CFO questionnaire concerned the attitude of companies regarding capital increases: Figure 4.1.1-5: CFO survey results: Attitudes towards increases of subscribed capital (France)

"Our company intends to keep its maximum flexibility and will try to minimise the portion allocated to stated/subscribed capital to the amount strictly necessary for legal or other

reasons."

63%

38%True False

Source: CFO Questionnaire, September 2007 63 percent of the respondents stated that they usually try to keep the level of subscribed capital to the minimum amount necessary. 38 percent of the respondents opposed this view. These responses show that companies are generally not interested in a dominant role of subscribed capital in equity financing. Subsequent formations We have not received any information on subsequent formations as these provisions are not relevant to the French companies interviewed. 4.1.1.2 Capital increase 4.1.1.2.1 Legal framework In accordance with the 2nd CLD French law differentiates between different forms of capital increase and mechanisms which ensure that the subscribed capital is contributed to the company. Increase in capital Under French law one can distinguish between ordinary capital increases and increases by authorised capital and also special forms of capital increase.


30

Ordinary capital increase For an ordinary capital increase an extraordinary general meeting may decide an immediate or possible capital increase, on the basis of a report from the board of directors or the management board. However, it is general practice to convene, when needed, such an extraordinary general meeting at the same venue and date as the annual general meeting. The extraordinary general meeting has a quorum when first convened only if the shareholders present or represented hold at least one quarter of the voting shares and, if reconvened, one fifth of the voting shares. Failing this, the second meeting may be postponed to a date not later than two months after the date originally scheduled. In non-listed public companies, the memorandum and statutes may require higher quorums. The resolution on the capital increase must be passed by a majority of two thirds of the votes held by the shareholders present or represented. After completion of tax registration formalities, the decision to increase the share capital shall be published as follows: legal announcement in a gazette; filing with the Registry of Commerce and Companies of the following documents within one month from the date of the said general meeting: • two copies duly signed and certified by the legal representative, of the general meeting’s

minutes deciding or authorising the increase in share capital; • where applicable, two copies of the minutes of the board of directors’ or management

board’s decision to implement the capital increase, • two copies of the depository’s certificate, • two copies duly signed and certified by the legal representative, of the general meeting’s

minutes deciding on the necessary amendment to the statutes, • two copies of the amended statutes and notice of the amendment to the Companies and

Commercial Registry, publication in BODACC. Authorised capital Under French law, the extraordinary general meeting may delegate its competence to decide on a capital increase to the board of directors or the management board. In order to do so, the extraordinary general meeting sets the period during which that authorisation may be used, up to a maximum of twenty-six months, and the overall maximum amount for that increase. The board of directors or the management board must use the authorisation within the twenty-six-month period and implement the increase in share capital within five years from the date on which the authorising resolution was passed. Other forms of capital increase Furthermore French law provides for the following special kinds of increases in capital. Firstly, the capital can be increased by capitalisation of reserves. Alternatively, the share capital may also be increased for example by means of the exercise of stock options as an effect of a successful takeover bid or of a demerger, by way of exercising a right attached to transferable securities giving access to the capital, including, if applicable, payment of the corresponding sums.


31

Contributions of premiums In accordance with the 2nd CLD, French law allows to use share premiums in the context of the increase in capital. The share premium must be fully paid-up on subscription. The share premium amount is decided either by the extraordinary general meeting or the management board/supervisory board if the extraordinary general meeting has delegated its competence to decide on the terms of the increase in capital. Mechanisms to ensure the contribution of capital Subscription of shares The French Commercial Code is based on the principle that the share capital must be subscribed in full. If the subscribed capital is less than the share capital, the company may be annulled. Newly issued shares must be fully paid up within 5 years. Public Companies are prohibited to subscribe their own shares, either directly or through a person acting in his own name but on the company’s behalf. In accordance with the 2nd CLD, the French Commercial Code prescribes that shares may not be issued at a price lower than their nominal value or accountable par. If the capital is increased, it is necessary to amend the statutes as well, the contribution (i.e. date of the decision to increase the share capital and the amount of the increase in share capital), as well as the share capital (i.e. new amount of the capital and new total number of shares). Contributable assets / paying in Under French law, capital increases can be performed by contributions in cash and in kind. Any immoveable or moveable asset (whether tangible or intangible) whose monetary value can be assessed and whose ownership or possession is transferable can become a contribution in kind. Only commercially exploitable assets can be contributed to commercial companies. A contribution can be made in ownership, possession or usufruct. In the case of cash contributions at least one-fourth of the nominal value of any shares subscribed in cash must be paid-up upon subscription and, where applicable, the entire amount of any issue premium. The balance must be paid-up, in one or several instalments, within the 5 years following the day on which the capital increase becomes final. Protection against over-valuation In the event of a contribution in kind or of the granting of special advantages, one or several Contribution Appraisers (“commissaires aux apports”) must be appointed by court order. The Contribution Appraiser’s report must be kept available to the shareholders at the registered office, for at least 8 days before the date of the extraordinary general meeting. If the general meeting approves the valuation of the contributions and the granting of special advantages, it then formally acknowledges the completion of the capital increase. If, on the other hand, the general meeting reduces the valuation of the contributions or the benefit of any special advantages granted, then these modifications must be expressly approved by the contributors, the beneficiaries or their duly authorised representatives, failing which the capital increase cannot be implemented. Also with respect to mergers, French law requires the appointment of an Expert Appraiser (a “commissaire à la fusion” and a “commissaire aux apports,” who may be the same person but who nonetheless has two separate assignments and must draw up two separate reports).


32

Sanctions Shareholders are not bound by the valuation determined by the expert appraiser. However if the valuation is not based on serious arguments, shareholders of a limited liability company (such as société anonyme, société à responsabilité limitée and société par actions simplifiée) could be sued for a fraudulent increase in the contribution (Article L.241-3-1 of the French Commercial Code). Furthermore, the managers and shareholders of limited liability companies who subscribed for the capital increase can be jointly liable for 5 years, if the amount retained is different from the valuation made by the expert appraiser (Article L.223-33 paragraph 2 of the French Commercial Code). Pre-emption rights French law provides a preferential right to shareholders to subscribe capital increases based on contributions in cash in proportion to the value of their shares. Such a pre-emption right does not exist if the capital increase results from a contribution in kind. This pre-emption right does not exist if the capital increase results from a contribution in kind. To enable shareholders to exercise their rights, the company must also comply with certain publication formalities, which may vary depending on whether the company makes a public offering or not: for non-listed public companies: registered letter with acknowledgement of receipt sent to the shareholders 14 days before the planned date for the close of the subscription; for listed public companies or in case the shares are not all registered: publication in the BALO 14 days before the planned date for the close of the subscription. Pre-emption rights are attached to either ordinary or preference shares. The general meeting which decides or authorises a capital increase may remove the preferential subscription right for the total capital increase or one or more tranches thereof. To do so, the general meeting must be informed by a report from the board of directors or the management board and a special report from the statutory auditor. The exclusion of the pre-emption right is only valid for an 18-month period; thus the issue of new shares must be implemented in this period of time. If the general meeting has merely approved the capital increase, and authorised the board of directors or the management board to implement it, the authorisation also covers the exclusion of the pre-emption right under the same voting and majority conditions. In addition, a complementary report, which includes the aforementioned information, must be issued by the board of directors to the general meeting. A second report from the statutory auditor will be handed over to the board of directors or the management board at the time of the implementation of the increase. 4.1.1.2.2 Economic analysis The practice of handling capital increases in the French companies interviewed was again quite surprising. The different ways for increasing their capital showed the pattern that these French companies nearly all preferred authorised capital over an ordinary share capital increase with one exception where a company increased its capital during its initial public offering (IPO).


33

Ordinary capital increase The first “traditional” way of increasing capital is the ordinary capital increase where the company’s management proposes a shareholder resolution with an immediate capital increase. Practical steps Under French stock corporation law, the following chronological order of practical steps would be necessary for such an ordinary capital increase: Figure 4.1.1-6: Process for ordinary capital increase (France)

Ordinary capital increase

Step 1 Proposal of the board on how the company should be financed (amount of subscribed capital, amount of premiums)

Step 2 Invitation to shareholders meeting

Step 3 Resolution by shareholders on capital increase and alteration of statutes / Resolution by shareholders on pre-emption rights in case of cash consideration

Step 4 Subscription by shareholders to the increase in share capital: deposit of the amount to the company’s bank account

Step 5 Amending statutes to raise the amount of subscribed capital Step 6 Tax registration Step 7 Legal announcement in a legal gazette Step 8 Filing with the Clerk of the Commercial Court of legal documentation Step 9 Modifying publication to the Companies and Commercial Registry

Step 10 Publication in BODACC (Bulletin Officiel des Annonces Civiles et Commerciales)

Step 11 Up-dating of the corporate registries Analysis None of the French companies interviewed have recently conducted an ordinary capital increase. One exception was mentioned by a company that had conducted its initial public offering (IPO) several years ago. However, we were not able to obtain specific data on this “ordinary” capital increase. Authorised capital A much more common way of increasing the capital of the French companies interviewed is a way by which an extraordinary general meeting may delegate its competence to decide on a capital increase to the board of directors or the managing board within the period twenty-six months. This possibility is used by all French companies interviewed and is in most of the French companies interviewed a longer standing tradition.


34

Practical steps To fix authorised capital, the following chronological order of legal steps has to be adhered to: Figure 4.1.1-7: Process for authorised capital increase (France)

Authorised capital increase


Step 2

Decision by shareholders’ meeting on the principle of the increase in capital, and delegate powers to the board the decide or not the realisation of the increase in capital; Resolution by shareholders on pre-emption rights in case of cash consideration

Step 3 Decision of the board to use the delegation and to increase the capital Step 4 Amending statutes to raise the amount of subscribed capital Step 5 Tax registration Step 6 Filing with the Clerk of the Commercial Court of legal documentation Step 7 Modifying publication to the Companies and Commercial Registry

Step 8 Publication in BODACC (Bulletin Officiel des Annonces Civiles et Commerciales)

Step 9 Up-dating of the corporate registries Analysis In practice, all French companies interviewed have used the opportunity to create an authorised capital. Three of the companies interviewed have actually used this possibility. The proposal for the shareholder assembly, to introduce or prolong the authorised capital. As it mainly a repetitive shareholder resolution every five years, the company reuses and updates the documentation used in the previous authorisation process. According to the estimates received the use of internal resources amounts from 3 to 24 hours depending on the individual circumstances as well as culture and organisation of the company. The effort required does not seem to be linked to the size (market capitalisation) of the company. Mostly, the legal aspects are dealt with on an in-house basis. Outside legal advice was widely used but only to reconfirm the correctness of the inhouse work performed. The external legal costs associated with the proposal are partly covered by general service agreements with the law firms and if there were separately charged ranged in the area of several thousand euros. Again, this seems to be very much linked to the individual circumstances of the company. We specifically asked in what format the extraordinary shareholder assembly was convened. We were reassured that the extraordinary shareholder assembly would regularly follow an ordinary shareholder meeting and, thus, the fact of an extraordinary meeting would not constitute an additional burden for the companies concerned. The board’s decision to use the authorisation may require very different levels of preparation which again are not linked to the size of the company and rather have to do with individual circumstances and culture of the company. The effort described varied from 1 hour to 20 hours of highly qualified personnel. The same is true for the amendment of the statutes of the company ranging in between 0.1 to 5 hours of highly qualified personnel.


35

Steps 5 to 9 (publication) are partly handled in-house and partly by outside service providers, notably so called “formalistes” who professionally take care of filing matters with public institutions or partly also banks concerning the update of corporate registries. Internal efforts amount to about 10 hours of which 5 hours may be of lower qualification. The costs for the external handling of filing matters are estimated around €1,000. The banking fee amounts to several thousand euros. In the French environment, companies did not volunteer information concerning the effort required for compliance with the securities market legislation (costs for prospectuses etc.). Incremental Costs HighQ LowQ Other Costs Hours spent 9.1 to 54 5 - Hourly rate €100 €70 - €910 to €5,400 €350 €11,000 Total costs €12,260 to €16,750 Mechanisms to ensure the contribution of capital - contributions-in-kind Practical steps Regarding contributions in cash or in kind which can be injected during a capital increase the following steps have to be taken under French law in a chronological order: Figure 4.1.1-8: Process for the injection of contributions (France)

Injection of contributions

Step 1 Monitoring if assets to be contributed are capable of economic assessment Step 2 Monitoring if the designated amount is paid in the foreseen time frame Step 3 Performance of valuation process with respect to contributions in kind

Step 4

Appointment of an expert “contribution appraiser” in charge of appraising the value of the assets to be contributed. The appointment is made by the President of the Commercial Court located in the same district as the registered offices of the company increasing its share capital.

Step 5 Drafting and signing of a contribution agreement, which is to set out the terms and conditions, the valuation and the remuneration of the contribution of assets.

Step 6

Publication of report: the contribution appraiser’s report must be kept available to the shareholders at the registered office for at least 8 days before the scheduled date of the Shareholder’s Meeting. Within the same 8-day period, it must also be filed with the Clerk of the Commercial Court located in the same district as the registered office of the Company.

Step 7

Holding of a Shareholders’ Meeting which will: - approve the valuation and remuneration of the contribution in kind - approve the terms of the contribution agreement - decide on the capital increase and the modification of the statutes.

Step 8 Modification of the statutes


36

Analysis In the course of our interviews, we have only encountered two cases in which a company had made use of contributions-in-kind when acquiring another company in return for stocks. However, these companies were not in a position to provide us with detailed data on the burdens associated with these acquisitions. We were explained that the preparation of these acquisitions required significant effort including the necessary documentation and publications. Several formal requirements were handled by “formalistes”, the professional care-takers for filing purposes. Another important aspect was the cost for the valuation of the contribution-in-kind by an external expert. However, we did not receive specific data on the associated internal and external cost for this exercise. We only received general comments that the cost depended on the complexity of the assets to be contributed. Contributions-in-cash are much easier to handle. 4.1.1.2.3 Protection of shareholders and creditors Regarding the provisions on capital increase one can draw the following conclusions under the aspect of shareholder and creditor protection. Firstly, it should be noted that the requirement that the shareholders have to agree to the ordinary capital increase has clearly a shareholder protective character. Furthermore, the provisions on authorised capital contain elements which are shareholder protective as the authorisation must be given by the extraordinary general meeting. Also the fact that the authorisation period is limited to twenty-sixth months and the amount which can be covered by the authorisation are shareholder protective. In this respect French law contains further protective provisions, as it prescribes the registration of the shareholders’ resolution to increase the capital, the registration and publication of the increase in capital and the registration and publication of the amendment of the statutes. To ensure that an equal treatment in contributions takes place French law prescribes the drawing up of a report by an independent expert in case of contributions in kind to protect shareholders before over-evaluations and its consequences. Under the aspect of shareholder protection the mandatory pre-emption rights are furthermore of importance as they prevent from dilution. Insofar it should be noted that under French law, these provisions protect the shareholders only in the case of contributions in cash. 4.1.1.3 Distribution 4.1.1.3.1 Legal framework French provisions on distributions differentiate between provisions dealing with the calculation of the distributable amount, the determination of the amount to be distributed and the consequences of incorrect distributions. Calculation of the distributable amount Under French law, the provisions of Article 15-1 of the 2nd CLD are implemented in the French Commercial Code. Accordingly, the distributable amount is the net after-tax profit; minus any negative retained earnings or allocations to legal or statutory reserves; plus any positive retained earnings; plus distributable reserves if the general meeting so decides (distributable profits are first taken from the profit; if some distributable profits are taken from


37

the distributable reserves, the decision of the general meeting shall expressly mention from which distributable reserves these amounts are taken). Except in case of a reduction in share capital, no distribution can be made to shareholders when the net equity is or would be, after the distribution, less than the amount of the share capital plus legal or statutory reserves that are not distributable. The French Commercial Code aquires that every year five percent of the financial year’s earnings less any losses brought forward have to be allocated to a reserve fund referred to as “the legal reserve” until the legal reserve reaches ten percent of the subscribed capital or a higher percentage if so provided by the company’s statutes. However, the share premium is not part of the legal reserve and therefore can be distributed. Connection to accounting rules The balance sheet profit is determined with reference to the annual accounts which must be drawn up in accordance with national GAAP. The annual accounts must be audited except where the public company is considered to be small. Determination of the distributable amount – responsibilies In France, a dividend distribution falls within the exclusive competence of the annual general meeting which approves the annual accounts, upon proposal of the company’s governing body (i.e. board of directors, president). The general meeting can only decide on the dividend distribution after having approved the annual accounts of the relevant financial year and having acknowledged the amount the distributable profits. The majority required is that for the ordinary general meeting (majority of the votes). Minutes of the general meeting approving the annual accounts and allocating the result (i.e. dividend distribution) shall be filed with the competent Commercial Court as well as the annual accounts. These documents are then publicly available at the Commercial Court. Sanctions French law provides for different instruments for the case that the distribution was not in line with the aforementioned provisions. First of all shareholders can challenge improper decisions of general meetings before the competent Commercial Court. It is often the case that majority shareholders systematically vote that the profit made by the company not be distributed but rather allocated to reserves. In such cases, minority shareholders may petition the relevant court in order for such a decision to be considered as an abuse of majority. Nevertheless, case law requires proof of such an abuse of majority: for this purpose, it has to be proved that such a decision to allocate profit to reserves is contrary to the company’s general interest and only in the majority shareholders’ interest. But in some cases, the court has sanctioned penalised such decisions, which were considered as an abuse of majority. Any dividend distribution/interim dividend distribution din breach of the rules provided in Article L.232-11/L.232-12 of the French Commercial Code constitutes a “false dividend distribution” which is subject to specific penalties i.e., a five-year imprisonment and a fine of €375,000 and to civil damages. Shareholders are obliged if the distribution took place in violation of the before mentioned rules to return to the company any payment received if the recipients knew about the irregular nature of the distribution. Furthermore the managers, the directors or the presidents are liable


38

in criminal law in case of distribution of “dividend fictifs” (five year imprisonment and a fine up to €375,000). Furthermore, they, as well as the statutory auditors, may have to pay civil damages if they were aware of the irregular distribution and if they had not revealed it to the general meeting. 4.1.1.3.2 Economic analysis Overall, French companies considered the French legislation concerning dividend distribution as easy to comply with. The reference to the accounting profit derived from the annual accounts provides a high degree of legal certainty which gives the French companies interviewed comfort. Practical steps The distribution of the balance sheet profits requires the following practical steps which are of importance for the cost analysis. By chronological order, the series of practical steps comprises: Figure 4.1.1-9: Process of dividend distributions (France)

Process for dividend distributions

Step 1 Closing of the FY / Use of company’s annual accounts

Step 2 Monitoring of distributions made / monitoring of the provisions determining the distributable amount

Step 3 Calling of a board of directors’ meeting

Step 4 Board of directors’ meeting (that notably calculate the distributable profit according to the legal constraints mentioned above)

Step 5 Certification of the annual accounts by th1e statutory auditor and issuance of its general report

Step 6 Calling of the annual shareholders’ meeting

Step 7 Annual shareholders’ meeting (and filing of the corresponding Minutes and of the annual accounts to the Clerk of the Commercial Court)

Step 8 Payment of the dividend within a maximum period of nine months after the closing of the FY

Analysis Calculation of the distributable amount From an economic point of view, the establishment of the dividend proposal typically involves the CFO and CEO and other selected high ranking company representatives preceded by preparations in the company’s administration (treasury, tax and/or accounting departments). The level of dividends is also a political decision concerning the attractiveness of the shares to investors. The dividend proposal is subsequently subject to a discussion in the company’s management board before it is handed over to the supervisory board. The intensiveness of the discussion in the management and supervisory board depends on the specific importance of dividend levels for the performance of the shares of the company.


39

The point of reference for the determination of the distributable amount is the consolidated financial statements of the company. The individual financial statements which are the legally decisive set of accounts are also considered but more with a view concerning possible constraints for envisaged distributions. Other aspects like dividend continuity and certain signals to the capital market via the level of dividends are also important aspects for the French companies interviewed. The results of a CFO questionnaire sent to French companies listed on main indices reconfirm this: Figure 4.1.1-10: Determinants for the distribution of dividends in the holding company (France)

"What are the determinants for the distribution of dividends by your holding company?"

1,862,002,71

3,50

2,14

4,25

2,122,15

3,063,64

2,964,22

1

2

3

4

5

Fin. performance(group accounts)

Financialperformance(individual

accounts of theparent company)

Dividendcont inuity

Signalling device Credit rat ingconsiderat ions

Tax rules

Determinants

Impo

rtan

ce

France

EU Average

Source: CFO Questionnaire, September 2007 However, concerning the importance of the current legal restrictions on profit distribution, the CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market led solutions like rating agencies’ requirements or bank covenants. Figure 4.1.1-11: Important deterrents when considering the level of profit distribution (France)

"Which of the following deterrents are important for you when you consider the level of profit distributions?"

3,14

1,71

2,43

2,43

3,44

2,16

2,25

2,65

1

2

3

4

5

Distribut ion/Legal capitalrequirements

Rating agencies'requirements

Contractual agreementswith creditors (covenants)

Possible violat ions ofinsolvency law

Deterrents

Impo

rtan

ce

France

EU Average

Source: CFO Questionnaire, September 2007 Depending on the structure of the company, it may be necessary to bring the consolidated view in line with the disposable profits / cash at parent company level. This requires a certain planning effort regarding necessary distributions from subsidiary levels. In this context, tax considerations may also play a certain role in generating profits and cash at parent level. We


40

were not able to obtain specific data on the exact effort required for this. However, as this planning effort may be largely based on tax optimisation any effort in this respect could also be considered non-incremental. Again, the results of a CFO questionnaire sent to French companies listed on main indices show the importance of tax considerations: Figure 4.1.1-12: Determinants for the distribution of dividends by the subsidiaries (France)

"What are the determinants for the distribution of dividends by your subsidiaries?"

2,71

3,29

4,13

2,74

3,144,07

1

2

3

4

5

Demands from the ult imate parent Tax rules Own investment decisions

Determinants

Impo

rtan

ce

France

EU Average

Source: CFO Questionnaire, September 2007 Connection to accounting rules Due to the immediate link to the audited financial statements under French GAAP, the French companies interviewed considered it easy to verify the distributable amount from a legal compliance point of view. There is no specific effort needed in this regard. Determination of the distributable amount The total time spent on this process does amount by average between 10 and 20 hours of highly qualified personnel of the company. Thereof the largest bulk is spent on the establishment of an adequate dividend proposal. The time effort for the distribution proposal by management varies depending on the culture and organisation of the individual company and is typically not linked to certain size criteria. From a legal compliance perspective, the French companies interviewed spent by average regardless of the size of the company about 3 hours of highly qualified personnel to comply with the relevant French restrictions in connection with the distribution proposal. One company with exceptional circumstances (distribution from additionally paid-in capital) had an increased time effort and external legal advice. However, this extraordinary situation did not represent an exceptional increase in cost - even in a borderline situation. In this situation, the time effort tripled and there was a marginal amount of money necessary to receive legal advice on the situation (several thousand euros). The legal compliance effort concerns the preparation of the board of director’s meeting as well as the shareholders’ meeting ranges between 1 and 2 hours of highly qualified personnel. A considerable effort constitutes the actual payment of dividends which is mainly arranged via banks for certain fees. The time effort for highly qualified personnel is rather limited


41

(about 5 hours). The handling cost for banks for the registration of shareholders and the transfer of dividends largely depend on the number of shareholders to the company and can range from several thousand euros to more than €100,000. However, it should be kept in mind for the purpose of this study that the costs for the actual payment of dividends are the result of a negotiation between the bank and the company. It is an effort that would arise under any legal distribution scheme and it cannot be particularly influenced by company law. The companies interviewed do typically not engage external legal advisors in this process and rather use in-house solutions. We have encountered one exception with a company that distributed from its additionally paid in capital; however, costs amounted only to several thousand euros. The remaining other steps were considered to be non-incremental as they were from the companies’ perspective not originating from the compliance with distribution provisions such as the preparation of the accounts, the annual audit and the general preparations for holding the annual general meeting. Regarding the establishment of alternative cash-flow projections to be used in the distribution process all companies interviewed had a very detailed cash flow planning for at least one year. However, this planning is based on internal rules on how to prepare such projections and is clearly linked to the business needs of these companies. The maximum projection period which allowed for serious estimations was considered between three to five years depending on the nature of the business of the company. One specific feature of the French environment that was mentioned to us by one company is a requirement for the company to issue a statement about its future solvency to the worker’s council. A 1984 law imposes on French companies to inform the worker’s council twice a year on the results of a check whether the company is able to meet its liability during the next year. Sanctions Concerning the efforts to comply with provisions concerning incorrect dividend distributions, the French companies interviewed generally considered the risk of liability for company’s management to be low. The reason for this is mainly the very clear cut legal provisions on profit distributions which due to their simplicity provide a high level of legal certainty. However, in one instance mentioned above (profit distribution from additionally paid-in capital) the workload has been labelled as “high”. However, from a wider perspective the compliance can still be considered as minor (17 hours of highly qualified personnel, several thousand euros in legal costs). Related parties In general, there were also no significant issues concerning the question of the monitoring of the relationships with related parties and potential other refluxes of funds to shareholders. In two cases, there was increased attention to this aspect due to the shareholder structure of the company. One company has introduced a special board committee to monitor the relationship with its major shareholder. Another company has a policy that contractual relationships with shareholders owning more than 10 percent of the company’s shares need


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prior board approval. The work effort resulting from this internal requirement amounts to two days (16 hours) of highly qualified personnel. Incremental Costs HighQ LowQ Other Costs Hours spent 16 to 27 - - Hourly rate €100 €70 - €1,600 to €2,700 - - Total costs €1,600 to €2,700 4.1.1.3.3 Protection of shareholders / creditors Under the aspect of shareholder and creditor protection one can draw the following key conclusions from the before mentioned provisions on distributions. Firstly, it should be noted that the clearly formulated legal distribution limitations including in particular the subscribed capital and the legal or statutory reserves as well as the immediate link to the audited financial statements lead to a legal certainty and to a little risk with respect to the liability of board members. Furthermore, these rules can be characterised as creditor protective as they limit the distributable amount by the profits and preserve a certain amount of the equity for the creditors. The obligation that the general meeting has to decide on the allocation of the dividend distributions, which stems from the national legislation, leads to shareholder protection. Also the principle of equal treatment in distributions protects shareholders. In this respect French law contains further protective provisions, as it allows shareholders to challenge resolutions that may lead to incorrect distributions. Also the national provisions prescribing the liability of members of the management board and the supervisory board for losses caused by unlawful distributions are shareholder protective. 4.1.1.4 Capital maintenance French law provides for different instruments dealing with the capital maintenance. Among these are the provisions on the limitation of the acquisition of own shares and the prohibition of financial assistance as well as the provisions on capital decreases, the withdrawal of shares and the serious loss of the subscribed capital and the principles on the prohibition of the misuse of the company’s funds. Furthermore the question arises in how far the contractual self protection is of importance. 4.1.1.4.1 Acquisition by the company of its of own shares 4.1.1.4.1.1 Legal framework French law generally prohibits companies from purchasing or subscribing their own shares, except in the limited cases provided for by law. These exceptional cases cover purchases like in the framework of a capital reduction that is not the result of losses. The repurchased shares must in this case be cancelled immediately; in order to grant shares to the company’s employees, for example, under a profit-sharing plan, a stock option plan or a plan to grant free shares. Furthermore, French law provides for a general authorisation of the acquisition by the company of its own shares. According to this provision, the general meeting of a listed public company can authorise the board of directors to acquire 10% of the company’s capital. The general meeting has to resolve on the purpose, the terms and conditions of the acquisition. The authorisation can be given for a maximum period of 18 months. This authorisation can be used, for example, to improve the financial management of the shareholders’ equity. The


43

relevant information must be notified to the market (general regulations of the Autorités des Marchés Financiers ( i.e., the French securities exchange commission, hereinafter the “AMF” and AMF instructions). The details of the redemption program must be published in one or several newspapers, made available at the issuer’s registered office, and posted on the issuer’s website. A company’s acquisition of its own shares is, moreover, subject to the following conditions: - the purchase must not be made by a person acting on the company’s behalf, - a 10% limit; i.e. the company may not acquire more than 10% of the total number of its

shares, - the shareholders’ equity must be maintained: the company’s purchase of its own shares

must not have the effect of reducing its shareholders’ equity to an amount that is lower than the combined amount of its capital and non-distributable reserves.

Furthermore, the company’s purchase of its own shares must be authorised by the ordinary general meeting. In France, the shares purchased by the company must be registered shares and be paid-up in full. The acquisition by the company of its own shares has the consequence that the voting rights of treasury shares are cancelled. The same applies to the right to dividends and pre-emption rights. Furthermore, it must be noted in this context that the amount of the company’s reserves, not including its legal reserve, must be at least equal to the value of all the shares it holds. In accordance with the 2nd CLD, the French Commercial Code prescribes that any shares held by the company in contravention of the legal provisions must be sold within one year of their acquisition, failing which they must be cancelled. Any corporate officers or executives who, on behalf of the company, have purchased shares issued by it without satisfying the related conditions of purchase, or who have held on to them beyond the deadline for disposing of them, are subject to a €9,000 fine. Under French law it is prohibited for the company from taking a pledge of its own shares, either directly or through persons acting in their own name but on the company’s behalf. Regarding the resale of the company’s own shares French law does not provide specific regulations. Regarding a prospective implementation of the amendments of the 2nd CLD it should be noted that they have not yet been implemented into national law. 4.1.1.4.1.2 Economic analysis In France, the amendments to the 2nd CLD in the year 2006 have not yet been enacted in French legislation (dropping of the 10 percent limit, prolongation of the authorisation by another five years). Thus, the interview results still refer to the current French arrangements for the acquisition of own shares.


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Practical steps To acquire own shares a company has to follow this process: Figure 4.1.1-13: Process for the acquisition of own shares (France)

Acquisition of own shares

Step 1 Proposal of board to acquire own shares Step 2 Calling a shareholders’ meeting Step 3 Ordinary shareholders’ meeting authorising the acquisitions of own shares Step 4 Monitoring of provisions (amount of nominal value, net assets, fully paid in etc) Step 5 Information in the annual accounts and in the annual management report. Analysis All of the French companies interviewed (5 companies) dispose of an authorisation by the shareholders’ assembly to the company’s management to acquire own shares. Four of these companies make use of their authorisation and actually acquire own shares. Authorisations are normally renewed at least every two years within the legally permitted timeframe of 18 months. The relaxation of the revised 2nd CLD will prolong these periods to five years and, thus, will help to lift the burden for companies by less frequent renewals of authorisations. The French companies interviewed buy back shares for mainly two reasons: either for share option programmes or in connection with liquidity programmes to support the trading of the share at the stock exchange. Potential acquisitions may be another reason. Within the legal process, there are several steps that require preparations mainly by the company’s departments responsible for legal matters and for treasury. The first step is the proposal by the management board which takes between 3 and 24 hours of preparation of highly qualified personnel depending on the complexity of the issue. This proposal is regularly an update of pre-existing documents which have been elaborated at the time of the initial introduction. This proposal is regularly prepared in-house and is in some cases checked by an external lawyer. This can be part of a general service agreement with a law firm and is not an extensive effort. The initial elaboration of the documentation and other documents is a costly exercise which may amount to several ten thousand euros of external legal advice. The actual buyback is the most burdensome exercise in the acquisition of own shares. It is mostly done via trading houses/banks for charges amounting to several ten thousand euros. The monitoring of these activities takes by average about 20 hours of highly qualified personnel. The documentation of the buybacks for the securities regulator can amount to 8 hours of highly qualified personnel per month (106 hours per year). However, it is clear that these burdens stem rather from securities regulation than company law. Another step is the preparation of the notes to the accounts to inform about the acquisition of own shares. Depending on the complexity of the buyback activity, the average time effort is 10 hours of highly qualified personnel.


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In general, we have not noticed significant deviations in the work load between different sizes of companies. It rather depends on the level of activity of the company regarding stock buyback programmes. Incremental Costs HighQ LowQ Other Costs Hours spent 33 to 54 - - Hourly rate €100 €70 - €3,300 to €5,400 - €50,000 Total costs €53,300 to €55,400 4.1.1.4.1.3 Protection of shareholders and creditors Under the aspect of shareholder and creditor protection one can draw the following key conclusions from the before mentioned provisions on the acquisition of own shares. Firstly, it should be noted that with respect to the most important case of acquisitions of own shares - the acquisition of own shares on the basis of an authorisation of the general meeting – the shareholders have to authorise the acquisition of own shares by a resolution which can be done for a maximum period of 18 months, what is shareholder and creditor protective. Furthermore, the provisions which limit the amount of own shares which can e acquired (the 10% threshold) and the provision which prescribe that own shares may not be acquired with the subscribed capital and not distributable reserves aim at protecting shareholders and creditors. In the case shares have been purchased different shareholder and creditor protection rules are applicable. Of importance are for example the provisions which prescribe that all rights attached to the acquired shares are suspended. Also of importance is the provision that, when acquired shares are included on the assets’ side of the balance sheet, a reserve of the same amount not available for distribution must be set up and specific information about the acquisition and the reselling of shares must be made. 4.1.1.4.2 Capital reduction 4.1.1.4.2.1 Legal framework The French Commercial Code provides for two kinds of capital reductions: the simplified capital reduction (which is due to losses) and the ordinary capital reduction (which is not due to losses). The reduction in share capital may be implemented either by the reduction of the number of shares or by reduction of their nominal value. The extraordinary general meeting is exclusively competent to decide or authorise the capital reduction. However, the meeting can delegate to the board of directors all its powers to implement the capital reduction. The extraordinary general meeting has a quorum when first convened only if the shareholders present or represented hold at least one quarter of the voting shares and, if reconvened, one fifth of the voting shares. Failing this, the second meeting may be postponed to a date not later than two months after the date originally scheduled. In non-listed public companies, the statutes may require higher quorums. The extraordinary general meeting resolves on the capital reduction with a majority of two thirds of the votes held by the shareholders present or represented. Under French law it is possible to reduce the share capital to €225,000 for a listed public company and €37,000 for a non-listed public company (S.A.).


46

Regarding the ordinary capital reduction, the creditors of the company may notify to the company their objection to the reduction within 20 days after the filing with the Commercial Court of the minutes of the general meeting deciding on the reduction. If the judge of original jurisdiction grants the objection, the capital reduction procedure is immediately halted until sufficient guarantees are provided or until the debts are repaid. If he rejects it, the reduction procedure may recommence and the distribution or repayment of their shares to the shareholders can be made. The simplified capital reductions can only be used to offset losses; the regime is slightly different. The amendments of the 2nd CLD with respect to the burden of proof have not yet been implemented into national law. 4.1.1.4.2.2 Economic analysis Within our sample none of the French companies has neither reduced its capital nor considered to do so. 4.1.1.4.2.3 Protection of shareholders and creditors Regarding the shareholder and creditor protection existing with respect to capital decreases, firstly the requirement that the shareholders have to agree to the capital decrease with a majority of two thirds of the votes held by the shareholders present or represented is of importance. Furthermore the safeguards to the creditors which have under certain circumstances the right to obtain security are creditor protective. 4.1.1.4.3 Withdrawal of shares 4.1.1.4.3.1 Legal framework Regarding the withdrawal of shares French law allows the compulsory withdrawal of shares. Furthermore French law provides for the withdrawal of own shares. Not possible is the issuance of redeemable shares. In accordance with the 2nd CLD, the compulsory withdrawal of shares is only permissible if it is prescribed or authorised by the statutes before the shares to be withdrawn are subscribed for or with the unanimous approval of the shareholders. The statutes must expressly provide the conditions (grounds, competent body, procedure to be followed). These conditions must be objectively determined, and that the value shall be determined, in case of dispute, by an expert. In case the compulsory withdrawal leads to a capital reduction, the capital reduction shall be implemented in accordance with the provisions stated by French law regarding ordinary capital reduction. Shares which have been acquired by the company can be cancelled by means of a reduction in capital. The acquisition, assignment or transfer of the said shares may be effected by any means.


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4.1.1.4.3.2 Economic analysis Within our sample of French companies, we have only encountered one case in which capital decrease provisions have been used to lower the number of shares. It concerned the redemption of own shares. We have not received specific data concerning the redemption of the shares but were reassured that it would be a simple procedure which is normally authorised by the same shareholder’s meeting dealing with the share buyback programme. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.1.1.4.3.3 Shareholder and creditor protection Regarding the withdrawal of shares it is with respect to shareholder and creditor protection firstly of importance that it is only permissible if it the statutes allow it before the shares to be withdrawn are subscribed for or if the shareholders concerned approve the withdrawal if it is made possible by the statutes after the shares have been subscribed. Furthermore in case the compulsory withdrawal leads to capital reduction, the safeguards to creditors are of importance, which correspond to the ones which apply in the case of ordinary capital decreases. 4.1.1.4.4 Financial assistance 4.1.1.4.4.1 Legal framework Under French law a company cannot grant any loans or securities for the purpose of allowing a third party to subscribe or purchase its own shares. This prohibition applies not only to subscriptions or purchases by persons unrelated to the company but also to transactions made by the shareholders themselves. 4.1.1.4.4.2 Economic analysis As the changes to 2nd CLD have not been implemented, there could not have been any practical cases in the course of the interviews with French companies. 4.1.1.4.5. Serious loss of half of the subscribed capital 4.1.1.4.5.1 Legal framework In France, in the event that, because of losses of the company, the net equity becomes lower than one half of the share capital, an extraordinary general meeting must be held in order to decide on whether or not the company should be dissolved. If the shareholders decide not to dissolve the company, it is mandatory that the company bring its net equity to an amount that is at least equal to one half of the share capital before the end of the second financial year following that during which the shareholders’ meeting was held. The decision (whether to dissolve or not) is published in a legal gazette and filed with the Commercial Court.


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4.1.1.4.5.2 Economic analysis The French companies interviewed spent very little time on the monitoring of this provision on the serious loss of subscribed capital. In general, they would see a significant increase in monitoring activity if the financial position of the company showed indications that such a situation could actually occur. The management of the companies interviewed normally use their normal internal reporting and risk management systems to monitor the financial position of the company/group. This would give them sufficient lead time to recognise critical situations. 4.1.1.4.5.3 Shareholder and creditor protection The provisions dealing with the serious loss of the subscribed capital have a shareholder and also creditor protective character as the shareholders meeting gets the possibility to decide on dissolving the company or not. 4.1.1.4.6 Contractual self protection 4.1.1.4.6.1 Legal framework In France there are no specific legal provisions concerned with contractual self protection of creditors which can guarantee the payment to the creditors, except the texts regarding warrantees (pledge, security, etc.). The contractual provisions usually provide that the reimbursement of the loan shall prevail against any other repayment. Other provisions can provide that no security can be taken over the assets of the company at least without the prior approval of the bank. Those kinds of protections can also be provided for in shareholders’ agreements. 4.1.1.4.6.2 Economic analysis Three of the five French companies interviewed have covenant in the format of financial ratios in loan agreements. These covenants do regularly not foresee direct restrictions on profit distributions but refer to certain ratios (e.g. EBIT / financial charges or Equity / net debt). These may indirectly result into restrictions to profit distributions. The existence of such covenants is a matter of negotiation with the respective banks. We did not receive specific data concerning the administrative burden for the companies but we were reassured that the covenant by nature do not present a severe burden. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.1.1.4.6.3 Shareholder and creditor protection Regarding the aspect of creditor protection it should be noted, that covenants are based on private law contracts and that only individual creditors are protected by them.


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4.1.1.5. Insolvency 4.1.1.5.1 Legal framework In France, an insolvency test is required to ascertain if the company is in “cessation des paiements”, that means not able to meet its financial obligations and to pay its current liabilities with its liquid assets. The board must apply this test when the company encounters difficulties in meeting its financial obligations or when the statutory auditors trigger the alert procedure. However, the board can trigger other procedures (“Mandat ad hoc” and “procédure de sauvegarde”) to prevent insolvency before the “cessation des paiements”. The purpose of the "mandat ad hoc" is to obtain an agreement with the company’s main creditors with the help of a person appointed by the court. The “procédure de sauvegarde”, which is the principle reformation of the French reform, is an insolvency procedure available only when the company is not in “cessation des paiements”; it can be initiated only at the debtor’s request The board can be caused to apply the insolvency test after a procedure of alert (“Procedure d’alerte”). This procedure can be triggered either by the statutory auditors, the works council, the minority shareholders or the president of the Commercial Court. The main procedure of alert is that exercised by the statutory auditors. They must alert the board on facts which, according to them, can compromise the continuity of the activity of the company. This alert is given by registered letter addressed to the board and asking for explanations of the situation. If the statutory auditors think that the explanations given or the decisions taken are not sufficient, they draft a special report for the attention of the shareholders convened for the occasion by the board. The statutory auditors shall also inform the president of the Commercial Court of their intentions with regard to the decisions taken by the shareholders. The president of the Commercial Court can decide, if he is of the opinion that the situation (such as information given by the statutory auditors or request of a creditor) threatens the survival of the company, to convene the directors to question them about the situation of the company. 4.1.1.5.2 Economic analysis Like for the provision on the serious loss of subscribed capital the French companies interviewed spent very little time on the monitoring of insolvency triggers. Again, they would generally see a significant increase in monitoring activity if the financial position of the company showed indications that such a situation could actually occur. The management of the companies interviewed normally use their normal internal reporting and risk management systems to monitor the financial position of the company/group. This would give them sufficient lead time to recognise critical situations.


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4.1.2 Germany 4.1.2.1. Structure of capital and shares 4.1.2.1.1 Legal framework With respect to the means of equity financing by shareholders, German law is based on the subscribed capital and on share premiums. Furthermore, additional equity contributions in the form of bonds or by contractual obligation are possible. With respect to the design of shares, German law differentiates between shares with a nominal value and so called notional “no par value shares”. Structure of capital Subscribed capital Under German law, public companies are required to have subscribed capital which has to be entered under equity in the balance sheet and cannot be distributed to shareholders. German law prescribes a minimum subscribed capital of €50,000. Above this minimum amount the founders are entitled to freely fix a higher capital amount which is protected in the same way. Furthermore, the German Stock Corporation Act uses the possibility of fixing authorised capital at the stage of formation. The board of directors can be authorised for a maximum period of five years, starting with the incorporation of the company, to increase the subscribed capital by up to half of the subscribed capital that existed at the time the authorised capital was fixed in the statutes. The subscribed capital can be – in line with the 2nd CLD – increased by an ordinary increase in capital, by an increase in capital which is based on authorised capital or special forms of capital increase, like for instance the nominal increase in capital or the conditional increase in capital. Premiums As mentioned, the other form of equity financing is the use of share premiums which is very common in practice in the context of capital increases but which is already allowed at the stage of formation. Under German law, the term “share premiums” is generally understood as the amount the subscriber of new shares has to pay in excess of the nominal value to the shares. According to the German Commercial Code, share premiums are to be placed in the capital reserve (“Kapitalrücklage”). The capital reserve and the statutory reserve (“gesetzliche Rücklage”) form a “legal reserve fund” so that, in each financial year, five percent of the financial year’s earnings less any losses brought forward have to be placed in the statutory reserve until the statutory reserve and the capital reserves reach ten percent of the subscribed capital or a higher percentage if so prescribed by the company’s statutes. The “legal reserve fund” – and thus the share premium – must not be distributed. It serves in the first place to offset losses which otherwise reduce the subscribed capital. If the combined sum of the capital reserve and the statutory reserve exceeds ten percent of the subscribed capital or the higher percentage prescribed by the company’s statutes, it may also be used for an increase in capital. Protection of the public company’s assets Apart from the principle that subscribed capital cannot be distributed and premiums can only be used under certain circumstances, there is general consensus that the German Stock


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Corporation Act must be understood to the effect that it prohibits any payment to a shareholder out of the corporation’s funds if it is made not in the context of a distribution of the balance sheet profits and is not allowed because of a special statutory regulation. Therefore, the prohibition applies if the payment is made out of the subscribed capital, the statutory reserve or the optional reserve if an effective shareholders’ resolution on the distribution does not exist. Furthermore, it should be noted that the prohibition covers not only patent but also hidden transactions such as dealings with shareholders not at arm’s length. Structure of shares According to the provisions of the 2nd CLD, the German Stock Corporation Act offers shares with a nominal value (par value shares) or, alternatively, so called “notional” no-par value shares. Under German law, shares with a nominal value must describe the amount of the contribution which has been/ must be paid to the subscribed capital. For the German notional no-par value shares, it is characteristic that every no-par value share represents the same fraction of the subscribed capital as that in which all no par value shares participate in the subscribed capital. They are still linked to the subscribed capital. 4.1.2.1.2 Economic Analysis Practical relevance of subscribed capital and structure of shares for an assessment of the viability of a company In general, the German companies interviewed did not see a high degree of practical relevance of the legally imposed subscribed capital concerning the assessment of their viability by outsiders. This also includes the question how the subscribed capital is structured, i.e. whether a legal capital is based on an accountable par. The subscribed capital is not, in their opinion, specifically relevant in the assessment by banks, analysts or rating agencies. For these institutions, other indicators are more relevant for assessing the financial position of the company. According to the results of the interviews conducted, these companies rather look at the figures “net equity” and “market capitalisation” as relevant to determine their equity position and their assessment of their chances to preserve their business or to attract additional capital. It was therefore neither feasible nor useful to extract data on the initial foundation of these companies. To verify this statement, we have additionally performed an analysis of certain ratios concerning subscribed capital for the main German stock exchange index DAX 30:


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Figure 4.1.2-1: Ratio of subscribed capital to market capitalisation (Germany)

Germany: Subscribed Capital to Market Capitalisation

57%

20%

13%

10%

< 5%5% - 10%10% - 20%20% - 30%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of september 2006 Compared to the market capitalisation, the subscribed capital shows even a lower portion. For 57 percent of the DAX companies the subscribed represents less than 5 percent of their market capitalisation. Thus, the overall importance of subscribed capital figure seems to be marginal. Restriction for distribution However, the German companies interviewed did not particularly question the distribution restrictions implied by the concept of legal capital. The latter was also reconfirmed by results from the CFO questionnaire sent to 354 German public companies. Figure 4.1.2-2: CFO survey results: necessity of subscribed capital (Germany)



37%

48%

15%True

False

NA

Source: CFO questionnaire, September 2007


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48 percent of the respondents considered the existence of subscribed capital to be necessary. This view was opposed by 37 percent of the respondents. However, according to the respondents to the CFO questionnaire there is no interest in excessive restrictions to distributions: Figure 4.1.2-3: CFO survey results: level of subscribed capital (Germany)



for distributions."

15%

78%

7%True

False

NA

Source: CFO questionnaire, September 2007 A clear majority of 78 percent of the respondents rejected the idea to increase the level of subscribed capital to the highest extent possible to avoid distributions. Role of the subscribed capital in equity financing The subscribed capital figure as part of the wider equity of the company is necessary for the financing of the company. According to the companies interviewed, the subscribed capital is not sufficient for the equity financing of the operations of the company. For DAX 30 companies, the ratio of subscribed capital to total shareholder’s equity shows that for 87 percent of the DAX 30 companies the subscribed equity portion stays under 20 percent of total shareholder’s equity.


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Figure 4.1.2-4: Ratio of subscribed capital to total shareholder`s equity (Germany)

Germany: Subscribed Capital to Total Shareholder's Equity

23%

30%

34%

10% 3%

< 5%5% - 10%10% - 20%20% - 30%> 30 %

Source: One source: Subscribed capital for the FY 2005, shareholder’s equity (consolidated) for the FY 2005 This underpins that the equity financing is not largely dependant on the subscribed capital and that there is a sufficient equity base in the DAX companies and their subsidiaries to allow for adequate distributions. The existence of a subscribed capital does seem to be a stumble block for the DAX companies in their approach to equity financing and distribution policy from a group perspective. The following answers to the CFO questionnaire concerned the attitude of companies regarding capital increases: Figure 4.1.2-5: CFO survey results: Attitudes towards increases of subscribed capital (Germany)

"Our company intends to keep its maximum flexibility and will try to minimise the

portion allocated to stated/subscribed capital to the amount strictly necessary for

legal or other reasons."

59%26%

15%True

False

NA

Source: CFO Questionnaire, September 2007 59 percent of the respondents stated that they usually try to keep the level of subscribed capital to the minimum amount necessary. Only 26 percent of the respondents opposed this view.


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These responses show that companies are generally not interested in a dominant role of subscribed capital in equity financing. Subsequent formations Concerning subsequent formations, some of the interviewees had recent experiences with the provisions at subsidiary level. These provisions are perceived to be burdensome, as they may require the review of all the contracts with shareholders in order to avoid the applicability of the provisions on subsequent formations. It is felt that there is inadequate attention to the materiality of such transactions in the legal assessment. 4.1.2.2 Capital increase 4.1.2.2.1 Legal framework In accordance with the 2nd CLD, German law differentiates between different forms of capital increase and mechanisms which ensure that the subscribed capital is contributed to the company. Increase in capital Under German law, one can distinguish between ordinary capital increases, increases by using authorised capital, nominal capital increases and, for instance, conditional capital increases. Ordinary capital increase For an ordinary capital increase, by which the subscribed capital is increased, a shareholders’ resolution is required. German law provides that a double majority is required for this resolution: a simple majority of the votes submitted and a majority of ¾ths of the votes attached to the subscribed capital represented in the general meeting (capital majority). The statutes may determine that the capital majority must be lower or greater than ¾ths of the votes attached to the subscribed capital represented. For this purpose, the shareholders must be invited to a general meeting in which the resolution can be passed. This is possible at the annual general meeting. The German Stock Corporation Act requires the publication of both the shareholders’ resolution to increase the capital and the increase in subscribed capital. The board of directors and the chairman of the supervisory board are firstly required to register the shareholders’ resolution and the increase in capital at the register court. The same applies to the amendment of the statutes. The registration of the increase in capital and the amendment of the statutes are then to be published. Authorised capital Under German law, the statutes can contain an authorisation, for a maximum period of five years, to the management board to increase the capital. If the statutes do not contain a sufficient basis for authorised capital, the statutes may be amended to insert such a possibility by shareholders’ resolution passed by a simple majority and a qualified capital majority (see above). Authorised capital is restricted to ½ of the subscribed capital which exists at the time the authorisation to increase the capital is given. To use the authorised capital, the management board has to decide on the capital increase within a maximum period of five years. The management board’s decision to issue new shares is subject to the consent of the supervisory board. The German Stock Corporation Act requires that the increase in capital be


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published. Before the increase in capital is published, it must be registered at the register court. Other forms of capital increase The German Stock Corporation Act also provides for a nominal increase in capital which refers to a process whereby the capital reserve and the profit reserve are converted into subscribed capital, and a conditional increase in capital which refers to a process whereby the capital is increased only to the extent that use of conversion rights or subscription rights which the company grants in respect to new shares, is made. In accordance with the 2nd CLD, the German Stock Corporation Act extends the rules applicable to ordinary increases in capital to the issue of convertible bonds and profit-sharing bonds. Contributions of premiums In accordance with the 2nd CLD, German law allows the use of share premiums in the context of the increase in capital. Share premiums must be placed in the capital reserve and are not, therefore, available for distribution. Mechanisms to ensure the contribution of capital Subscription of shares Under German law, the principle that all shares must be subscribed before the increase in capital is registered, applies. The public company is prohibited from subscribing its own shares and so is any subsidiary and third person acting in his own name but on behalf of the issuing company. In accordance with the 2nd CLD, the German Stock Corporation Act prescribes that shares may not be issued at a price lower than their nominal value or accountable par. The minimum nominal value/ accountable par is – going beyond the provisions of the 2nd CLD – provided for but is relatively low: one Euro. If the capital is increased, the amount of the subscribed capital stated in the statutes must be amended as well as, if applicable, the nominal values of shares, the number of shares of each nominal value or, where there are no-par value shares, their number, the classes of shares and the number of shares of each class of shares. Contributable assets/ paying in Under German law, in the context of capital increases, capital may be contributed in cash or in kind. Cash contributions may be made by legal currency, namely banknotes and coins, or via credit to a company’s or director’s bank account. In cases in which the capital is contributed other than in cash, the consideration must constitute assets capable of economic assessment. Where the capital is increased by consideration in cash, at least 25 percent of the nominal value/ accountable par of the shares must be paid-up , and where shares are issued at a premium, the full premium must be paid in as well. The sum paid in must also be irrevocably at the management’s board free disposal. The management must ensure that the sum has not been returned to shareholders. In cases in which the capital is increased by a consideration other than in cash, the consideration is to be transferred to the company within five years of the time the capital increase is registered, unless – going beyond the provisions of the 2nd CLD - the consideration constitutes rights of use and enjoyment which must have been transferred to the company by the time the capital increase is registered.


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Protection against over-valuation Where the capital is increased by consideration other than in cash, the German Stock Corporation Act requires – in line with the provisions of the 2nd CLD – that the consideration must be valued and a report must be drawn up by independent experts. Where the report reveals that the value of the consideration other than in cash does not correspond to the nominal value/accountable par of shares issued for it, the register court is required to reject the company’s application to register the capital increase. Sanctions According to German law, the register court is required to reject the company’s application to register the increase in capital if it is of the opinion that the value of the consideration is not immaterially lower than the nominal value/accountable par of the shares issued for it. Regarding the liability of the management board and supervisory board, the Stock Corporation Act provides, on the one hand, for criminal sanctions where a member of either board gives incorrect information about the subscription of shares, payment on contributions or contributions in kind. On the other hand, members of either board are also liable in civil law to compensate the company for any damage caused due to incorrect statements about the capital increase. Pre-emption rights The German Stock Corporation Act provides for pre-emption rights in the context of capital increases. German law prescribes that pre-emption rights are not only to be granted on the condition that the capital is increased by consideration in cash but also - beyond the provisions of the 2nd CLD - if the capital is increased by consideration other than in cash. However, in practice capital increases in kind are in general linked with an exclusion of the pre-emption rights. Under German Stock Corporation Law, pre-emption rights may only be excluded by a shareholders’ resolution, in fact the decision may only be made in the resolution to increase the subscribed capital. The resolution requires a simple majority of the votes submitted and a majority of ¾ of the votes attached to the subscribed capital represented in the general meeting. The management board is required to present to the general meeting a report indicating the reasons for the exclusion and justifying the proposed issue price. Because of the heaviness of the intervention and the position of the shareholders protected under constitutional law the Federal Supreme Court held that any restriction of pre-emption rights must be justified by facts. Apart from that German law also provides for the possibility that the pre-emption rights may be excluded in the general meetings’ resolution authorising the board to increase the capital. Furthermore, the statutes and the general meeting may delegate the power to restrict or withdraw pre-emption rights to the management board empowered to decide on the capital increase within the limit of the authorised capital. In all these cases the substantive requirements developed by the Federal Supreme Court do not apply to the full extent: It must only be stated that the exclusion serves a purpose which is in the company’s interest.


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4.1.2.2.2 Economic analysis The practice of handling capital increases in the German companies interviewed was quite surprising. The different ways used for increasing their capital showed the pattern that these German companies all preferred the authorised capital over an ordinary share capital increase. Conditional capital increases are used for the issue of convertible bonds or in connection with stock option programmes but with a different degree of use between companies. Ordinary capital increase The ordinary increase of capital was not used be the interviewed companies because of the possibility to use more flexible forms of capital increase. Practical steps Under the German Stock Corporation Act, the following chronological order of practical steps would be necessary for such an ordinary capital increase: Figure 4.1.2-6: Process of an ordinary capital increase (Germany)


Step 1 Proposal of the board on how the company should be financed (amount of subscribed capital, amount of premiums).

Step 2 Calling of a general meeting

Step 3

Resolution by shareholders on capital increase, if applicable, separate vote of shareholders of each class of shares and amendment of the statutes. Notarial recording of the resolution to amend the statutes, filing with the registrar (§ 130 AktG).

Step 4

Resolution by shareholders on pre-emption rights in case of contributions of cash and in kind –or possible resolution of shareholders that shares are issued to banks or financial institutes with the obligation that they be offered to shareholders of the company (§ 186 (5) AktG).

Step 5 Registration of the shareholders’ resolution to increase the capital (§ 184 AktG), registration and publication of the increase in capital (§§ 188, 190 AktG) and registration and publication of the amendment of the statutes (§ 181 AktG).

Analysis None of the German companies interviewed have recently conducted an ordinary capital increase. The provisions were considered too inflexible as this procedure requires the immediate involvement of the general meeting and, thus, also not considered as a very desirable way of increasing capital. One interviewee also responded that in Germany so called “professional shareholder activists” would see this as a welcome opportunity to bring legal action on doubtful grounds against the annual meeting resolution and, thereby, block the capital increase process with a potential severance payment from the company in mind to drop the proceeding.


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Authorised capital A much more popular way of increasing the capital among the companies interviewed is the possibility of fixing authorised capital in the statutes. This possibility is used by all German companies interviewed and is, in most of the German companies interviewed, a longer standing tradition. Considerable efforts have to be made in connection with the elaboration of the proposal for authorisation. However, the proposal usually only requires an update of already existing documentation as this is usually a repetitive action. Most costs actually stem from securities regulation which is not relevant in terms of incremental costs of compliance with company law provisions. Practical steps To fix authorised capital, the following chronological order of legal steps has to be adhered to: Figure 4.1.2-7: Process of the authorised capital increase (Germany)


Step 1 Proposal of the founders/board on how the company should be financed (amount of subscribed capital, amount of premiums).

Step 2

Fixing authorised capital in the statutes during the stage of formation. If authorisation to increase the capital is not already laid down in the statutes: shareholders’ resolution on the increase in capital, if applicable, separate vote of shareholders of each class of shares, and amendment of the statutes, notarial recording of the resolution, filing with the registrar (§ 130 AktG), registration of the amendment of the statutes (§ 181 (1) AktG) and publication (§ 181 (2) AktG).

Step 3 Decision of the board to increase the capital up to a specific amount with due regard to the restrictions laid down in the statutes/by the shareholders’ resolution, consent of the supervisory board.

Step 4

Resolution by shareholders on pre-emption rights in case of cash consideration or consideration in kind (if not excluded) or possible resolution of shareholders that shares are issued to banks or financial institutes with the obligation to offer them to shareholders of the company (§§ 203 (1), 186 (5) AktG).

Step 5

Determination of the content of the rights attached to the new shares and the conditions of the issue of new shares by the management board if the statutes do not provide otherwise (§ 204 (1) AktG). Consent of the supervisory board (§ 204 (1) s. 2 AktG).

Step 6 Registration and publication of the increase in capital (§§ 203 (1) s. 1, 188 (1), 190 AktG).

Analysis In practice, most German companies interviewed have used the opportunity to create authorised capital. However, only two of the companies interviewed have actually used this possibility. The introduction of authorised capital happens for various reasons linked to the individual strategy of a company’s management. It is also considered as a way of raising additional interest in the potential shareholder community to buy or hold the stock.


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Bearing this in mind, we had the opportunity to gather most data for the first important step, the proposal for the general meeting to introduce or prolong the authorised capital. As it is mainly a repetitive shareholder resolution every five years, the company reuses and updates the documentation used in the previous authorisation process. According to the estimates received, the use of internal resources amounts to between 5 to 40 hours depending on the individual circumstances as well as the culture and organisation of the company. This also includes the subject of pre-emption rights. The effort required is not linked to the size (market capitalisation) of the company. Outside legal advice was only used in a minority of cases. Mostly, the legal aspects are dealt with on an in-house basis. The legal costs associated with the proposal are partly minimal (3 hours for outside lawyers) up to €30,000 for external advice. Again, this is very much linked to the individual circumstances of the company. Significantly, more work and cost is incurred once it is decided to execute the authorised capital and to actually increase the capital. This requires about 80 hours of highly qualified personnel over a time period of several months and, if a prospectus is required, legal and other costs amount to approximately €1,000,000. However, it has to be noted that this burden results from capital market regulation and does not, in essence, stem from company law (2nd CLD or national company law). Again, the workload and costs can vary from company to company depending on the individual circumstances. Incremental Costs HighQ LowQ Other Costs Hours spent 85 to 120 - - Hourly rate €100 €70 - €8,500 to €12,000 - up to €30,000 Total costs €8,500 to €42,000 Conditional capital increase With respect to the conditional increase in capital in the course of the interviews, we have encountered in four cases (more than 50 percent) the use of conditional capital increases. These are mainly used for the issuance of convertible bonds, partly also for stock option programmes for employee participation. In a few cases, we have received data estimates from the companies interviewed for the workload and costs associated with the issuance of convertible bonds, which seem to be significant. The preparation of the decision for the issuance of convertible bonds takes approximately 50 hours of highly qualified personnel and another 27 hours of highly qualified personnel for the negotiation of the terms with the banks. Legal advice in this regard costs about €200,000. However, it should be noted that these burdens for the company are not linked to the provisions of the 2nd CLD. Overall, these burdens may vary from company to company depending on individual circumstances. Mechanisms to ensure the contribution of capital – contributions-in-kind None of the interviewed companies had practical experience with contributions in kind. However, the economic aspects were discussed on the basis of the practical steps in a general way.


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Practical steps The following steps have to be taken under German law to increase capital by contributions in kind: Figure 4.1.2 -8:Process for the injection of contributions (Germany)


Step 1

Where shares are to be issued for a consideration other than in cash, fixing the terms of the resolution to be voted on by shareholders in the general meeting, namely the nominal value of shares or, where there are no-par value shares, the number of shares issued for a consideration other than in cash together with the nature of the consideration and the name of the person providing the consideration (§ 183 (1) s. 1 AktG). Monitoring that the terms of the resolution are laid down in the agenda of the general meeting and are duly published (§ 183 (1) s. 2 AktG).

Step 2 Where shares are issued for a consideration other than in cash, monitoring if assets that serve as consideration are capable of economic assessment.

Step 3

Monitoring if contributions in cash have been paid up to an extent of at least 25 percent of the lowest advanced amount and, where shares are issued at a premium, also the premium at the time the capital increase in registered (§§ 188 (2) s. 1, 36a (1) AktG). Monitoring that the sum paid in is irrevocably at the management board’s free disposal (§§ 188 (2) s. 1, 36a (1) AktG). Monitoring if considerations other than in cash (namely rights of use and enjoyment) have been transferred to the company by the time the capital increase is registered (§§ 188 (2) s. 1, 36a (2) AktG).

Step 4

Performance of valuation process with respect to contributions in kind (valuation of the consideration other than in cash, appointment of independent experts by the local court, drawing up the expert report on consideration other than in cash).

Step 5 Publication of report: Submitting the expert report on the consideration other than in cash to the management board and to the register court.

Step 6

Amendment of the statutes (Stating the subscribed capital in the statutes; if applicable, the nominal values of par value shares and the number of shares of each nominal value or, where there are no-par value shares their number, where there are several classes of shares, the classes of shares and the number of shares of each class).

Step 7

Registration of the shareholders’ resolution to increase the capital (§ 184 AktG), registration and publication of the increase in capital including the fixing of contributions in kind (§§ 188, 190 AktG) and registration and publication of the amendment of the statutes (§ 181 AktG).

Analysis Unfortunately, we have not encountered any practical cases of contributions-in-kind during our interviews with German companies. However, a general opinion was that the most burdensome aspect is the valuation process of the contribution by external experts. This requires, on the one hand, enormous effort to collect relevant data for the valuation and the cost for the outside expert may also be considerable. The actual burden for such kind of valuations largely depends on the complexity of the subject to valuation. This may be a single asset or a highly complex company.


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Protection of shareholders and creditors Regarding the provisions on capital increase, one can draw the following conclusions under the aspect of shareholder and creditor protection. Firstly, it should be noted that the requirement that the shareholders have to agree to the ordinary capital increase as well as to the conditional or nominal capital increase with a qualified majority, clearly has a shareholder protective character. Furthermore, the provisions on authorised capital contain elements which are shareholder protective as the authorisation must be stated in the statutes or, if this is not the case, an amendment of the statutes with qualified majority is necessary. Also the fact that the authorisation period is limited to five years and the amount which can be covered by the authorisation - half of the subscribed capital – are shareholder protective. In this respect, German law contains further protective provisions, as it prescribes the registration of the shareholders’ resolution to increase the capital, the registration and publication of the increase in capital and the registration and publication of the amendment of the statutes. To ensure that equal treatment in contributions takes place, German law prescribes the drawing up of a report by an independent expert in case of contributions in kind to protect shareholders against over-evaluations and their consequences. To prevent circumventions of the provisions, German law prohibits hidden contributions in kind. Under the aspect of shareholder protection, the mandatory pre-emption rights are furthermore of importance as they prevent dilution. It should be noted that under German law, these provisions protect the shareholders not only in the case of contributions in cash but also in the case of contributions in kind. 4.1.2.3 Distribution 4.1.2.3.1 Legal framework German provisions on distributions differentiate between provisions dealing with the calculation of the distributable amount, the determination of the amount to be distributed and the consequences of incorrect distributions. Calculation of the distributable amount In accordance with the provisions of the 2nd CLD under German law only the balance sheet profit may be distributed to the shareholders. The balance sheet profit is the profit for the financial year as shown in the profit and loss account after setting off losses and profits brought forward as well as sums placed into mandatory and optional reserves. The disclosed reserves comprise the capital reserve in which any premiums paid must be placed and the profit reserves. The profit reserves comprise the legal reserve, the reserve for own shares held by the company, statutory reserves and “other profit reserves”. The capital reserve and the statutory reserve form a “legal reserve fund” which is not available for distribution and may not, therefore, be dissolved to this end. Hence, any premiums and a certain part of the financial years’ profit placed into the statutory reserve, may not, in addition to the subscribed capital and the reserve for own shares held, be paid back to shareholders. The statutory reserves and “other profit reserves” are by contrast distributable. However, an amount equal to these reserves is bound in the company as long as these reserves are not dissolved by the management board and the general meeting has not decided on the distribution.


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Connection to accounting rules The balance sheet profit is determined with reference to the annual accounts which must be drawn up in accordance with German accounting rules. The annual accounts must be audited except where the company is considered to be small. Determination of the distributable amount – responsibilities In Germany, the management board is required to submit a proposal on the allocation of the balance sheet profit to the supervisory board. The proposal must comprise the amount to be distributed to shareholders, the amounts to be allocated to profit reserves, the profit brought forward and the balance sheet profit. The supervisory board examines the proposal together with the annual accounts and draws up a report on the examination. The report is then submitted to the management board which is required to call a general meeting and display the report on the examination and the proposal on the balance sheet profit in the company’s premises for inspection by shareholders. The shareholders decide on the allocation of the balance sheet profit by resolution for which a simple majority is required. The shareholders are not bound by the management board’s proposal. However, allocations to profit reserves and carrying profits forward to new accounts is restricted if such measures are not financially necessary. In this case, the amount to be distributed may not fall short of 4 percent of the subscribed capital. The German Stock Corporation Act requires that the shareholders’ resolution on the allocation of the balance sheet profit must fix the amount to be distributed to shareholders, the allocation to profit reserves, the profit brought forward, the balance sheet profit and additional expenses arising from the resolution. The shareholders’ resolution and the management board’s proposal on the allocation of the balance sheet profit must be filed with the registrar and published in the Joint Electronic Register Portal of the Federal States. Regarding the dividend the shareholders receive, the principle of equal treatment is applicable; the shareholders must be paid pro rata. Sanctions German law provides for different instruments for the case that the distribution was not in line with the aforementioned provisions. Firstly, the German Stock Corporation Act allows shareholders to challenge resolutions that may lead to incorrect distributions by bringing an action to set aside the resolution. Furthermore, shareholders are obliged, if distributions took place in violation of the before mentioned rules, to return to the company any payment received contrary to the Stock Corporation Act. Where the payments received constitute dividends, the payments must be returned only if the company proves that those e shareholders knew of the irregularity of the payment or could not, in view of the circumstances, have been unaware of it. The German Stock Corporation Act provides that members of the management board and the supervisory board are liable to compensate the company for losses caused by unlawful distributions. 4.1.2.3.2 Economic Analysis Overall, German companies considered the German legislation on this issue to be very light and easy to comply with. The reference to the accounting profit derived from the annual accounts provides a high degree of legal certainty which is a very desirable feature for German companies interviewed. The companies are more concerned about the elaboration of the dividend proposal by the board. The actual payment may also present a major effort.


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However, the costs are linked to capital market requirements and depend on the number of shareholders. Practical steps Based on the legal analysis, the distribution of the balance sheet profits requires the following practical steps which are the basis for the economic analysis. Figure 4.1.2-9: Due process for distributing profits (Germany)

Due process for distributing profits

Step 1 Drawing up the company’s annual accounts in accordance with national GAAP.

Step 2 Placing sums in mandatory reserves (capital reserve, legal reserve, statutory reserves).

Step 3 The management board determines the balance sheet profit with reference to the annual accounts (§ 170 AktG).

Step 4 The management board submits the annual accounts and the proposal on the allocation of the balance sheet profit to the supervisory board (§ 170 (2) AktG).

Step 5 Audit of annual accounts (§ 316 (1) HGB). The supervisory board examines the accounts and the management board’s proposal on the allocation of the balance sheet profit (§ 171 AktG).

Step 6 The supervisory board draws up a report on the examination of the accounts and the proposal (§ 171 AktG).

Step 7 The supervisory board submits the report on the examination to the management board (§ 171 (3) AktG).

Step 8 Adoption of accounts (normally) by the supervisory board and the management board (§ 172 AktG).

Step 9 Calling a general meeting; displaying the report on the examination and the management board’s proposal on the allocation of the balance sheet profit in the premises of the company for inspection by shareholders (§ 175 AktG).

Step 10 Shareholders’ resolution on the allocation of the balance sheet profit (§§119 (1) no. 2, 174 AktG).

Step 11 Filing of the management board’s proposal on the allocation of the balance sheet profit and the shareholders’ resolution with the registrar, publishing them in the Joint Electronic Register Portal of the Federal States (§ 325 (1) HGB).

Analysis Calculation of the distributable amount From an economic point of view, the establishment of the dividend proposal typically involves the CFO and CEO and other selected high ranking company representatives preceded by preparations in the company’s administration (treasury, tax and/or accounting departments). As the level of dividends is also a political decision concerning the attractiveness of the shares to investors, investor relation experts may also play a significant role in the elaboration of the dividend proposal. The dividend proposal is subsequently subject to a discussion in the company’s management board before it is handed over to the supervisory board. The intensiveness of the discussion in the management and supervisory board depends on the specific importance of dividend levels for the performance of the shares of the company.


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The clear point of reference for the determination of the distributable amount is the consolidated financial statements of the company, not the individual financial statements which are the legally decisive set of accounts. This first assessment is complemented by considerations concerning dividend continuity and return on investment considerations for shareholders. The results of a CFO questionnaire sent to German companies listed on main indices reconfirm this: Figure 4.1.2-10: Determinants for the distribution of dividends in the holding company (Germany)


2,352,41

2,723,37

3,654,33

2,122,15

3,063,64

2,96

4,22

1

2

3

4

5

Fin. performance(group

accounts)



Dividendcont inuity


Tax rules

Determinants

Impo

rtan

ce

Germany

EU Average

Source: CFO Questionnaire, September 2007 However, concerning the importance of the current legal restrictions on profit distribution, the CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market led solutions like rating agencies’ requirements or bank covenants. Figure 4.1.2-11: Important deterrents when considering the level of profit distribution (Germany)


3,48

2,37 2,37

2,63

2,65

2,252,16

3,44

1

2

3

4

5





Deterrents

Impo

rtan

ce

Germany

EU Average

Source: CFO Questionnaire, September 2007 Depending on the structure of the company, it may be necessary to bring the consolidated view in line with the disposable profits / cash at parent company level. This requires a certain planning effort regarding necessary distributions from subsidiary levels. In this context, tax considerations may also play a certain role in generating profits and cash at parent level. We


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were not able to obtain specific data on the exact effort required for this. However, as this planning effort may be largely based on tax optimisation, any effort in this respect could also be considered non-incremental. Again, the results of a CFO questionnaire sent to German companies listed on main indices show the importance of tax considerations: Figure 4.1.2-12: Determinants for the distribution of dividends by the subsidiaries (Germany)


2,74

3,22

4,30

2,743,14

4,07

1

2

3

4

5


Determinants

Impo

rtan

ce

Germany

EU Average

Source: CFO Questionnaire, September 2007 Connection to accounting rules Due to the immediate link to the audited financial statements, the German companies interviewed considered it simple to verify the distributable amount from a legal compliance point of view. There is no specific effort needed in this regard as the preparation and the audit of the annual accounts is not considered as an incremental cost. Determination of the distributable amount From an incremental cost perspective, all German companies interviewed considered step 3, i.e. the proposal on the allocation of balance sheet profits, to be the most time-consuming effort in this legal process. The total time spent on this process amounts to between 10 and 50 hours of highly qualified personnel of the company. Thereof, more than 90 percent is spent on the establishment of an adequate dividend proposal. This time effort for the distribution proposal by management varies depending on the culture and organisation of the individual company and is typically not linked to certain size criteria. The pure legal compliance effort is by average less than 2 hours of highly qualified personnel and, thus, can be considered as negligible. This concerns the specific time needed for the report on the distribution proposal by the supervisory board as well as for the preparation for the general meeting and for the publication in the Joint Electronic Register Portal of the Federal States. The monetary amount to be spent on the publication is also considered minimal and remains below €10,000. The companies interviewed do not generally engage external legal advisors in this process and rather use in-house solutions. We have encountered one exception with a company with very low market capitalisation where this is part of a common external routine check on legal documents.


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The remaining steps were considered to be non-incremental as they did not, from the companies’ perspective, originate from the compliance with distribution provisions such as the preparation of the accounts, the annual audit and the holding of the annual general meeting. Regarding the establishment of alternative cash-flow projections to be used in the distribution process, all companies interviewed had a very detailed cash flow planning for at least one year. However, this planning is based on internal rules on how to prepare such projections and is clearly linked to the business needs of these companies. The maximum projection period which allowed for serious estimations was considered between three to five years, depending on the nature of the business of the company. There was general scepticism concerning the establishment of distinctive rules concerning the elaboration of cash flow projections. The same is true for any outside attestation service by third parties (experts, accountants etc.). Sanctions Concerning the efforts to comply with provisions concerning incorrect dividend distributions, the companies interviewed considered the risk of liability for the company’s management to be low. The reason for this is mainly the very clear cut legal provisions on profit distributions which, due to their simplicity, provide a high level of legal certainty. Related parties There were also no significant issues concerning the question of the monitoring of the relationships with related parties and potential other reflows of funds to shareholders. One respondent also referred to the existence of a specific report on the dependence of shareholders as a protective instrument (“Abhängigkeitsbericht”, § 312 AktG). Incremental Costs HighQ LowQ Other Costs Hours spent 10 to 50 - - Hourly rate €100 €70 - €1,000 to €5,000 - < €10,000 Total costs €1,000 to €15,000 4.1.2.3.3 Protection of shareholders / creditors Under the aspect of shareholder and creditor protection, one can draw the following key conclusions from the above mentioned provisions on distributions. Firstly, it should be noted that the clearly formulated legal distribution limitations, including, in particular, the subscribed capital and the premiums as well as the immediate link to the audited financial statements, lead to a high legal certainty and to little risk with respect to the liability of board members. Furthermore, these rules can be characterised as creditor protective as they limit the distributable amount by the profits and preserve a certain amount of the equity for the creditors. The obligation that the general meeting has to decide on the allocation of the balance sheet profit, which stems from German national legislation, leads to shareholder protection. The principle of equal treatment in distributions also protects shareholders. In this respect, German law contains further protective provisions, as it prescribes that the shareholders’ resolution and the management board’s proposal on the allocation of the balance sheet profit must be published in the Joint Electronic Register Portal of the Federal States and that the shareholders have the possibility to challenge resolutions that may lead to


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incorrect distributions. The national provisions prescribing the liability of members of the management board and the supervisory board for losses caused by unlawful distributions are also shareholder protective even though this rule is of minor practical importance. Regarding creditor protection, the obligation of the shareholders to return to the company any payment received contrary to the Stock Corporation Act is of importance. 4.1.2.4 Capital maintenance German law provides for different instruments dealing with capital maintenance. Among these, are the provisions on the limitation of the acquisition by the company of its own shares and the prohibition of financial assistance as well as the provisions on capital reductions, the withdrawal of shares, the serious loss of the subscribed capital and hidden distributions. Furthermore, the question arises in how far contractual self protection is of importance. 4.2.1.4.1 Acquisition by the company of its of own shares 4.1.2.4.1.1 Legal framework In Germany, public companies are allowed – based on the provisions of the 2nd CLD - to acquire their own shares provided that certain conditions are observed. The first case allows the acquisition by the company of its own shares on the basis of an authorisation of the general meeting. In Germany, the acquisition by the company of its of own shares is subject to several conditions. The German Stock Corporation Act requires a resolution by shareholders which shall determine the duration of the period for which authorisation is given to the management board to the acquisition by the company of its own shares and which may not exceed 18 months, the maximum and minimum consideration for the shares as well as the nominal value of shares to be acquired which may not exceed 10% of the subscribed capital. Furthermore, the German Stock Corporation Act prescribes that the nominal value or the accountable par of acquired shares held by the company, including shares previously acquired by the company and held by it, and shares acquired by a third person acting in his own name but on behalf of the company, may not exceed 10% of the subscribed capital. Also under German law, only fully paid up shares may be acquired and the acquisition may not affect the subscribed capital and the reserves not available for distributions. Furthermore, German law provides for additional informational and procedural requirements. For instance, the management board is required to give notice of the shareholders’ authorisation to the company to acquire its own shares to the Federal Financial Supervisory Authority. The management board is also required to inform the next general meeting after the acquisition has been carried out, of the reasons for and the purpose of the acquisition. The German legislator used the possibilities of the 2nd CLD to provide for exemptions to the strict requirements on share repurchase where the acquisition serves specific purposes, e.g. in cases in which the acquisition is necessary to prevent serious and imminent harm to the company and in cases in which the acquired shares are to be distributed to the company’s current or former employees or the current or former employees of an associated company. In accordance with the 2nd CLD, the German Stock Corporation Act prescribes that shares repurchased in contravention of the legal provisions must be disposed of and, where this is not carried out during a period of one year, cancelled. Beyond the provisions of the 2nd CLD, under German law, not only the voting rights attaching to the shares but all rights are suspended if the company acquires its own shares.


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When shares are included on the asset side of the balance sheet, a reserve of the same amount not available for distribution must be set up and specific information about the acquisition and the reselling of shares must be laid down in the notes to the accounts. In respect to the reselling of own shares, the principle that shareholders who are in the same position must be treated equally, applies. Furthermore, the German legislator did not make use of the option under the 2nd CLD to provide for certain exceptions where a subsidiary of the company acquires its shares. In such case, under German law, the acquisition or holding of shares in a company by its subsidiary is regarded as having been effected by the company itself. The amendments of the 2nd CLD have not yet been implemented into national law. 4.1.2.4.1.2 Economic analysis In Germany, the amendments to the 2nd CLD in the year 2006 have not yet been enacted into German legislation (dropping of the 10 percent limit, prolongation of the authorisation by another five years). Thus, the interview results still refer to the current German arrangements for the acquisition of a company’s own shares. From a company law perspective, most efforts go into the proposal for the authorisation to purchase the company’s own shares. However, the actual buyback of shares may entail much higher costs. Unfortunately, we have not received detailed data on this from the German companies interviewed, but have similar experiences in other EU countries. Nevertheless, only incremental costs invoked by company law are relevant to this analysis. Thus, these costs resulting from securities legislation are remarkable - but not from an incremental cost perspective. Practical steps To acquire its own shares a company has to follow this process: Figure 4.1.2-13: Process for the acquisition of own shares (Germany)

Acquisition of own shares – authorisation by the general meeting

Step 1 Proposal of the management board to acquire the company’s own shares.

Step 2 Calling a general meeting, publishing the agenda of the general meeting in the company gazette.

Step 3 Calling a general meeting, resolution by shareholders on acquisitions of the company’s own shares, notarial recording of the resolution, filing with the registrar (§ 130 AktG).

Step 4

Monitoring inter alia that shareholders’ authorisation is not given for a period which exceeds 18 months, that the maximum and minimum consideration for the shares is stated and that the nominal value or accountable par of shares to be acquired does not exceed 10% of the subscribed capital.

Step 5 Giving notice of the shareholders’ authorisation to acquire the company’s own shares to the Federal Financial Supervisory Authority.

Step 6 Acquisition of the company’s own shares.

Step 7

Monitoring that only fully paid up shares are acquired, that a reserve on the liabilities’ side of the balance sheet is set up without reducing the subscribed capital and undistributable reserves, that, for example, the nominal value or accountable par of the shares acquired do not exceed 10% of the subscribed capital or the lower


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amount stated in the shareholders’ resolution and that the consideration paid for shares is within the scope of the minimum and maximum consideration stated in the shareholders’ resolution.

Step 8 Setting down in the notes to the accounts specific information about the acquisition of own shares.

Step 9

Informing the next general meeting of the reason for and the purpose of the acquisition, the number and nominal value or accountable par of shares acquired, the proportion of the subscribed capital they represent and the consideration for these shares.

Analysis Two-thirds of the companies interviewed (5 companies), have authorisation by the shareholders’ assembly to the company’s management to acquire the company’s own shares. One third of these authorisations (2 companies) are making use of their authorisation and actually acquire the company’s own shares. Authorisations are normally renewed at least every two years within the legally permitted timeframe of 18 months. The relaxation of the revised 2nd CLD will prolong these periods to five years and, thus, will help to lift the burden for companies by less frequent renewals of authorisations. Within the legal process, there are several steps that require preparations mainly by the company’s departments responsible for legal matters and for treasury. The first step is the proposal by the management board which takes between 2 to 3 hours of preparation of highly qualified personnel. This proposal is regularly an update of pre-existing documents which have been elaborated at the time of the initial introduction. This proposal is in some cases checked by an external lawyer as part of a routine check of legal documents. The initial elaboration of the documentation and other documents is a costly exercise which may incur fees for external legal advice of tens of thousands Euro. The written notice of the share buyback authorisation to the German securities regulator BAFIN is not very demanding, as it is simply a repetition of the shareholder resolution. The time effort does not exceed 0.1 to 0.5 hours for highly qualified personnel. The actual buyback is handled differently from company to company. It is normally commissioned to one or several banks and depends on the company how closely it is involved in the buyback process. We have not received detailed data on the costs of the banks in this regard. However, in general, we were reassured that the companies would pay “normal” or “low” fees for their engagement which nevertheless can be very high in comparison to other burdens associated with the process of buying back shares. This is shown by the experience in other EU countries. Another step is the preparation of the notes to the accounts to inform about the acquisition of the company’s own shares. Depending on the complexity of the buyback activity, the average time effort will be between 1 and 2 hours of highly qualified personnel. The required information to shareholders requires on average between 2 to 3 hours of highly qualified personnel.


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In general, we have not noticed significant deviations in the workload between different sizes of companies. It rather depends on the level of activity of the company regarding stock buyback programmes and the way the company reacquires its own shares. Incremental Costs HighQ LowQ Other Costs Hours spent 3 to 5 - - Hourly rate €100 €70 - €300 to €500 - €50,000 Total costs €50,300 to €50,500 4.1.2.4.1.3 Protection of shareholders and creditors Under the aspect of shareholder and creditor protection, one can draw the following key conclusions from the above mentioned provisions on the acquisition by a company of its own shares. Firstly, it should be noted that, with respect to the most important case of acquisitions of a company’s own shares - the acquisition of shares on the basis of an authorisation of the general meeting – the shareholders have to authorise the acquisition of the shares by a resolution which can be valid for a maximum period of 18 months, which is shareholder protective. Furthermore, the provisions which limit the amount of the shares which can be acquired (the 10% threshold) and the provision which prescribes that the shares may not be acquired with the subscribed capital and not distributable reserves, aim at protecting shareholders and creditors. Furthermore, the obligation of the management board to give notice of the shareholders’ authorisation to acquire the company’s own shares to the Federal Financial Supervisory Authority is creditor and shareholder protective. If shares have been purchased, different shareholder and creditor protection rules are applicable. Of importance are, for example, the provisions which prescribe that all rights attached to the acquired shares are suspended. Also of importance is the provision that, when acquired shares are included on the asset side of the balance sheet, a reserve of the same amount not available for distribution must be set up and specific information about the acquisition and the reselling of shares must be laid down in the notes to the accounts. With respect to the reselling of the company’s own shares, under German law, the principle that shareholders who are in the same position must be treated equally, applies and this must be characterised as shareholder protective. 4.1.2.4.2 Capital reduction 4.1.2.4.2.1 Legal framework The German Stock Corporation Act provides for two kinds of capital reductions: the ordinary capital reduction and the simplified capital reduction. The ordinary capital reduction is subject to a shareholders’ resolution which must be passed by a majority of the votes and at least ¾ths of the subscribed capital represented in the general meeting. In line with the 2nd CLD, German law requires that the shareholders’ resolution specifies the purpose of the capital reduction and the way in which the reduction is carried out. The reduction may only be carried out by way of consolidating the shares if otherwise the nominal value of shares falls below the minimum amount of €1. With regard to safeguards to creditors, the German provisions correspond to the provisions of the 2nd CLD. Accordingly, every creditor whose claims antedate the publication of the shareholders’ resolution, which have not fallen due and which have been notified within a certain period of time, have a right to obtain security. Unless


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creditors have obtained security or have been satisfied, no payment may be made to shareholders. The right to obtain security may not be set aside. In Germany, the simplified capital reduction may serve either to offset losses or to include sums of money in the capital reserve. In effect, the simplified capital reduction is only permissible where it is necessary to establish sound conditions. The amounts deriving from the capital reduction and from dissolving the capital and profit reserves may not be used for making payments or distributions to shareholders or to discharge shareholders from their obligation to make their capital contributions. Beyond this, further restrictions on profit distributions apply. The amendments of the 2nd CLD with respect to the burden of proof have not yet been implemented into national law. 4.1.2.4.2.2 Economic analysis Within our sample of German companies, we have not encountered any capital decreases. 4.1.2.4.2.3 Protection of shareholders and creditors Regarding the shareholder and creditor protection existing with respect to capital reductions, firstly the requirement that the shareholders have to agree to the capital reduction with a qualified majority, is of importance. Furthermore, the safeguards to creditors, which have, under certain circumstances, the right to obtain security, are creditor protective. 4.1.2.4.3 Withdrawal of shares 4.1.2.4.3.1 Legal framework German law allows the compulsory withdrawal of shares. Furthermore, German law provides for the withdrawal of the company’s own shares. Not possible are redemption of the subscribed capital without reduction of the latter and the issuance of redeemable shares. In accordance with the 2nd CLD, the compulsory withdrawal of shares is only permissible if it is prescribed or authorised by the statutes before the shares to be withdrawn are subscribed. Where the compulsory withdrawal of shares is merely authorised by the statutes, German law requires – in line with the 2nd CLD – a resolution by shareholders. In this respect, a majority of at least ¾ths of the votes attaching to the subscribed capital represented in the general meeting, is required. Only where the compulsory withdrawal follows the simplified procedure, for instance in cases in which fully-paid up shares which are made available to the company free of charge are withdrawn and in cases in which the shares are to be withdrawn using funds available for distributions, a simple majority is sufficient. Also under German law, in the context of a compulsory withdrawal of shares, the rules on creditor protection apply which are also applicable in the context of an ordinary decrease in capital. Only in cases in which fully-paid up shares which are made available to the company free of charge are withdrawn and in cases in which the shares are to be withdrawn using funds available for distributions, do the rules on creditor protection not - in line with the 2nd CLD – apply. In respect to the reduction of the subscribed capital by redemption of shares acquired by the company, the same rules apply. In this connection, it should be noted that - different from the provisions of the 2nd CLD - shares acquired by a subsidiary or third person in his own name but on behalf of the company, may not be redeemed.


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4.1.2.4.3.2 Economic analysis Within our sample of German companies, we have only encountered one case in which capital decrease provisions have been used to lower the number of shares. It concerned the redemption of the company’s own shares. The company concerned described the time effort for the capital reduction to amount to 5 to 10 hours of highly qualified personnel. A very complicated procedure was the split of the global certification of the company’s shares with the clearing house which administers the shares. Incremental Costs HighQ LowQ Other Costs Hours spent 5 to 10 - - Hourly rate €100 €70 - €500 to €1,000 - - Total costs €500 to €1,000 4.1.2.4.3.3 Shareholder and creditor protection Regarding the withdrawal of shares, it is, with respect to shareholder and creditor protection, firstly of importance that it is only permissible if the statutes allow it before the shares to be withdrawn are subscribed or if the shareholders concerned approve the withdrawal if it is made possible by the statutes after the shares have been subscribed. Furthermore, the safeguards to creditors which correspond to those which apply in the case of capital decreases are of importance. The same principles apply with respect to the reduction of the subscribed capital by redemption of shares acquired by the company. 4.1.2.4.4 Financial assistance 4.1.2.4.4.1 Legal framework Under the German Stock Corporation Act, public companies are still prohibited to provide financial assistance with a view to the acquisition of its shares by a third party. The amendments of the 2nd CLD by Directive 2006/68/EC have not yet been implemented into national law. 4.1.2.4.4.1 Economic analysis As the changes to 2nd CLD have not been implemented, there could not have been any practical cases in the course of the interviews with German companies. 4.1.2.4.5. Serious loss of half of the subscribed capital 4.1.2.4.5.1 Legal framework In Germany, the management board is - in line with the provisions of the 2nd CLD - required to call a general meeting in the case of a loss of half of the subscribed capital. The management board must notify the general meeting of the loss and the notification must be already announced in the agenda of the general meeting which is to be published in the company’s gazette when the general meeting is called. In the general meeting, the shareholders may then vote on resolutions on measures to be taken. Suitable measures are particularly resolutions on corporate action or the resolution to wind-up the company.


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4.1.2.4.5.2 Economic analysis The German companies interviewed spent very little time on the monitoring of this provision on the serious loss of subscribed capital. In general, they would see a significant increase in monitoring activity, if the financial position of the company showed indications that such a situation could actually occur. The management of the companies interviewed normally use their normal internal reporting and risk management systems to monitor the financial position of the company/group. This would give them sufficient lead time to recognise critical situations. 4.1.2.4.5.3 Shareholder and creditor protection The provisions dealing with the serious loss of the subscribed capital have a shareholder and also creditor protective character, as the general meeting gets the possibility to decide on safeguarding measures. 4.1.2.4.6 Contractual self protection 4.1.2.4.6.1 Legal framework In Germany, there are no specific legal provisions concerned with contractual self protection of creditors. Surveys showed that, in Germany, it is not possible that creditors negotiate contracts with a public company to limit the distributable amount. Such contracts are rather a side issue. However, credit institutions will usually demand security for lending, such as a guarantee from third persons. 4.1.2.4.6.2 Economic analysis More than half of the German companies interviewed have covenants in the form of financial ratios in loan agreements which are mainly contracted with continental European banks. These covenants do not usually provide direct restrictions on profit distributions as there are restrictions resulting from the competencies of the general meeting. Instead, they refer to certain debt/income, debt/equity ratios that reflect the business of the company. These may, under certain conditions, indirectly result into restrictions on profit distributions. The existence of such covenants is a matter of negotiation with the banks. Some companies interviewed did not have such covenants in loan contracts. Others had several different covenants. Specifically the question whether such ratios can be met is decisive for the effectiveness for the company on the one hand; on the other hand badly negotiated covenants can also result in considerable payments to banks for breaches of such covenants. In one case, a company regularly has to pay several tens of thousands of Euro for a waiver of each breach of a covenant. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data


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4.1.2.4.6.3 Shareholder and creditor protection Regarding the aspect of creditor protection it should be noted, that covenants are based on private law contracts which do not, in Germany, seem to be extensively used. Furthermore, only individual creditors are, under German law, protected by them. 4.1.2.5. Insolvency 4.1.2.5.1 Legal framework In Germany, three factors trigger insolvency: the inability to pay one’s debts, the impending inability to pay one’s debts and over-indebtedness. A company is unable to pay its debts if it is not able to pay its payment obligations due which shall be assessed on the basis of a balance sheet showing liquidity. A company is on the verge of insolvency if it is expected to be unable to pay its payment obligations that fall due at a specific point in time which shall be assessed on the basis of a cash budget. A company is over-indebted if its assets do not cover its liabilities. Whether this is the case shall be judged on the basis of a statement of assets and liabilities for which the annual accounts are not suitable. Under German law, there is no formal duty of the management board to apply the above mentioned tests; the point in time when the tests are to be applied is, hence, not stipulated, either. A duty of the management board to apply these tests may, at the best, be inferred from the general duty of the board to take due care and will arguably be triggered when the company is in financial distress. Pursuant to the German Stock Corporation Act, the management board is required to file for insolvency when the company is unable to pay its debts or is over-indebted. 4.1.2.5.1 Economic analysis As with the provision on the serious loss of subscribed capital, the German companies interviewed spent very little time on the monitoring of insolvency triggers. Again, they would generally see a significant increase in monitoring activity if the financial position of the company showed indications that such a situation could actually occur. The management of the companies interviewed normally use their normal internal reporting and risk management systems to monitor the financial position of the company/group. This would give them sufficient lead time to recognise critical situations.


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4.1.3 Poland 4.1.3.1 Structure of capital and shares

4.1.3.1.1 Legal framework Polish law on equity financing by shareholders is based on the subscribed capital and share premiums. Polish law differentiates between shares with a nominal value and notional “no par value shares”. Structure of capital Subscribed capital Under Polish law, public companies are required to have a minimum subscribed capital of PLN500,000 (approx. €131,000 according to the exchange rate on 6 December 2006). Above this minimum amount there are no statutory limits as to the maximum amount of the share capital. Under the Polish Commercial Companies Code, the statutes may provide for a minimum or/and maximum share capital to be subscribed by the initial shareholders. The incorporation of the company is effected with the subscription of the shares up to the minimum share capital. The subsequent subscription of shares of a company which was already incorporated in this way has the effect of an increase in the company’s share capital. Furthermore, the Commercial Companies Code also provides the possibility of creating authorised capital in the statutes. The legal institution of authorised capital is provided more as a means of increasing the share capital in a company that has already been registered. It is the right and the power of the management board to decide on the increase of the share capital within the thresholds provided for in the statutes, and, upon specific authorisation provided for therein, granted for a period not exceeding three years. Premiums Under the Polish Commercial Companies Code, premiums may be fixed at the stage of formation and if so, must be paid in full before the company is registered. Premiums are regarded as being associated with the contribution to the share capital, in particular with respect to the rule that they may not be returned to shareholders. Premiums must be allocated to the compulsory reserve. Compulsory and voluntary reserves may be used under a resolution of the general meeting. Reserves up to an amount of 1/3 of the registered share capital may be used only to cover the losses shown in the annual financial statements. Protection of the company’s assets The share capital and the premiums may not be returned to shareholders. Structure of shares The Polish Commercial Companies Code only offers shares with a nominal value.


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4.1.3.1.2 Economic analysis Practical relevance of subscribed capital and structure of shares for an assessment of the viability of a company The Polish companies interviewed saw no particular advantage of the subscribed capital for the viability of their company. It is rather considered as a statistical figure. In general, the interviewees are interested in their net equity figures and the market capitalisation of their company. In this sense, one interviewee made the remark that the share premium is an “expression of the market situation and Polish GDP”. To verify this statement, we have additionally performed an analysis of certain ratios concerning subscribed capital for the main Polish stock exchange index WIG 20: Figure 4.1.3-1: Ratio of subscribed capital to market capitalisation (Poland)

Poland: Subscribed Capital to Market Capitalisation

84%

16%

< 5%5% - 10%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of September 2006 For 84 percent of the WIG 20 companies, the subscribed capital represents less than 5 percent of their market capitalisation. Thus, the overall importance of the subscribed capital figure seems to be marginal. Restriction for distribution The results from the CFO questionnaire sent to 133 Polish public companies show a diversified picture of attitudes concerning distribution restrictions. However, it has to be noted that there was only a very low number of Polish responses.


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Figure 4.1.3-2: CFO survey results: necessity of subscribed capital (Poland)



33%

33%

33% True

False

NA

Source: CFO questionnaire, September 2007 The responses received pointed to a support for the existence of subscribed capital. However, there does not seem to be an appetite for excessive restrictions to distributions: Figure 4.1.3-3: CFO survey results: level of subscribed capital (Poland)

"The company's management considers it adantageous to increase the level of


for distributions."

0%

100%

True

False

Source: CFO questionnaire, September 2007 The responses received unanimously rejected the idea of increasing the level of subscribed capital to the highest extent possible to avoid distributions. Role of the subscribed capital The subscribed capital as such is not by far, in their opinion, sufficient to finance the operation of the company. Because it is so low, neither does the subscribed capital constitute a restriction on the ability to distribute excess capital.


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For WIG 20 companies, the ratio of subscribed capital to total shareholders’ equity shows that for 68 percent of the WIG 20 companies, the subscribed equity portion remains under 20 percent of total shareholders’ equity. Figure 4.1.3-4: Ratio of subscribed capital to total shareholder`s equity (Poland)

Poland: Subscribed Capital to Total Shareholder's Equity

31%

16%21%

16%

16%

< 5%5% - 10%10% - 20%20% - 30 %> 30%

Source: One source: Subscribed capital for the FY 2005, shareholders’ equity (consolidated) for the FY 2005 This illustrates that equity financing is not largely dependant on subscribed capital and that there is a sufficient equity base in the WIG 20 companies and their subsidiaries to allow for adequate distributions. The existence of subscribed capital does seem to be a stumbling block for the WIG 20 companies in their approach to equity financing and distribution policy from a group perspective. The following answers to the CFO questionnaire concerned the attitude of companies to capital increases: Figure 4.1.3-5: CFO survey results: Attitudes towards increases of subscribed capital (Poland)

"Our company intends to keep its maximum flexibility and will try to minimise the

portion allocated to stated/subscribed capital to the amount strictly necessary for

legal or other reasons."

100%

0%

True

False

Source: CFO Questionnaire, September 2007


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All of the responses received stated that they usually try to keep the level of subscribed capital to the minimum amount necessary. These responses show that companies are generally not interested in a dominant role of subscribed capital in equity financing. Subsequent formations We have not received any information on subsequent formations as these provisions are not relevant to the Polish companies interviewed. 4.1.3.2 Capital increase

4.1.3.2.1 Legal framework In accordance with the 2nd CLD, Polish law differentiates between different forms of capital increase and mechanisms which ensure that the subscribed capital is contributed to the company. Increase of capital Under Polish law, one can distinguish between ordinary capital increases, increases by authorised capital and special forms of capital increases such as increases by capitalisation of the reserves and the “conditional increase of capital”. Ordinary capital increase For an ordinary capital increase, an amendment to the statutes and, in consequence, a resolution by the shareholders is required. The increase in capital may be performed by either issuing new shares or raising the nominal value of the existing shares. In the case of issuing new shares, a “subscription contract” is required. Because of the abovementioned requirement of amending the statutes, a qualified majority of at least ¾ths of the votes is needed. Since the ordinary capital increase requires an amendment to the statutes, it also requires registration in the court and subsequent publication in the Official Journal. Authorised capital Under Polish law, the statutes can contain an authorisation to the management board to increase the capital up to a set amount for a maximum period of three years. Within the set amount, this may be performed in several increases. The shareholders` resolution amending the statutes in order to authorise the management board requires a ¾ths majority of the votes with at least half of the capital present. If the company is listed, this resolution requires only 1/3rd of the capital present. The management board may not issue privileged shares. The maximum amount of the capital increase may not exceed ¾ths of the company’s subscribed capital on the day of the authorisation. The management board is empowered to decide on the authorised capital increase. The resolution amending the statutes as well as the increase in capital performed by the management board is required to be published in the Official Journal. The shareholders’


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resolution on the amendment of the statutes is subject to notarial recording and must be registered at the register court and then be published. Other forms of capital increase Furthermore, the Polish Commercial Companies Code provides for an increase in capital by capitalisation of the reserves from the company’s reserve fund or other funds created from profits if these may be utilised in this way. The shareholders` resolution on capitalisation of the reserves is an amendment to the statutes and requires a qualified majority of ¾ths of the votes, registration at the register court before publication in the Official Journal. Another special kind of increase in capital is the “conditional increase of capital”. The shareholders meeting may adopt a resolution on the increase of capital on the condition that the person granted the right to subscribe the new shares will exercise that right in the manner indicated in the resolution. The nominal value of the conditional increase in capital may not exceed twice the value of the company’s capital at the moment of adopting the resolution. The shareholders` resolution requires a qualified majority of ¾ths of the votes, registration at the register court and publication in the Official Journal. Contributions of premiums The capital obtained from shares paid in at a premium price must be transferred to the reserve capital account and is not available for distribution. Mechanisms to ensure the contribution of capital Subscription of shares Under Polish law, the subscription of the shares must be finalised within two weeks from the deadline set. Public companies are prohibited to subscribe their own shares. The prohibition also applies to subsidiaries and dependant cooperatives. The Polish Commercial Companies Code provides that, in case of an increase in capital, the newly issued shares may not be issued below their nominal value which has to be a minimum of 1 grosz (1/100 of PLN). The resolution amending the statutes must include the amount of the increase in the capital. Contributable assets / paying-in Under Polish law, in the context of capital increases, capital may be contributed in cash or in kind. Besides the requirement that the asset must be capable of economic assessment as set out in the 2nd CLD, the Polish Commercial Companies Code provides that the contribution to the capital of the company may only be an asset that is transferable. Services and work may not be considered as contributions. The Commercial Companies Code provides that ¼th of the nominal value of shares subscribed for cash must be paid-up before registration. Shares subscribed for in kind contributions should be paid-up in full (the contributions should be transferred to the company) not later than 1 year after the company was registered.


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If shares are subscribed for in kind contributions or mixed in kind and cash contributions, at least in ¼th of the value of the prescribed registered share capital of PLN500,000 must be paid-up before registration of the company. Protection against over-valuations Contributions in kind are subject to a valuation by the company's founders, who must deliver a report in this respect. The report should include in particular: a description of the assets, the number and types of the shares and other title to participate in the profits or in the company’s assets after its liquidation, the individuals that make the in-kind contributions and the adopted method of valuation. In the case of a contribution of an enterprise (business), its financial statements for the last 2 years must be attached to the report. Sanctions If a contribution in kind was properly subjected to the above mentioned evaluation procedure but the value the shareholder contributed is nevertheless less than the value intended, the statutes may not release the shareholder from his responsibility for the remainder of that contribution. He is obliged to indemnify the company for the damage caused. If the shareholder pays less than the value required, the company may redeem the uncovered shares. Pre-emption rights The Polish Commercial Companies Code grants current shareholders pre-emption rights in proportion to the number of shares held. Pre-emption rights apply to shares to be subscribed for cash as well as for contributions in kind. The general meeting may, in the interests of the company, exclude the shareholders` pre-emption rights, in part or in whole, by a resolution adopted by a majority of 4/5ths of the votes. A written opinion stating the grounds for the exclusion of the pre-emption rights and a proposed issuing price of the shares or the manner of fixing the price must be presented by the board. Under Polish law, the general meeting may not delegate the power to restrict or exclude pre-emption rights to the management board empowered to decide on the capital increase. 4.1.3.2.2 Economic analysis The Polish companies interviewed showed a preference for ordinary capital increases. Authorised capital was not used by the Polish companies interviewed. However, one company stated that the notarial costs may be cheaper in the case of a capital increase via authorised capital. Only one of the Polish companies interviewed used authorised capital in the past but let this authorised capital lapse last year due to lack of justification (i.e. no capital increase was implemented). Ordinary capital increase The first traditional way of increasing capital is the ordinary capital increase, where the company’s management proposes a shareholders’ resolution with an immediate capital increase.


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Practical steps Under Polish company law, the practical steps necessary for such an ordinary capital increase in chronological order are: Figure 4.1.3-6: Process for ordinary capital increase (Poland)



Step 2 Invitation to shareholders’ meeting Step 3 Resolution by shareholders on capital increase and alteration of statutes

Step 4 Resolution by shareholders on pre-emption rights in case of cash consideration or possible resolution that bank should offer shares

Step 5 Amending statutes to raise the amount of subscribed capital Step 6 Publication of the decision Step 7 Subscription of the shares Step 8 Registration of the increase in capital and amendment of the statutes Step 9 Issue of the shares Analysis Two of the Polish companies interviewed conducted an ordinary capital increase in the past. In this process, the requirements stemming from company law play a minor role in comparison to those from securities legislation. The most burdensome aspect is the preparation of prospectuses which requires a high documentation effort. Due to the complexity of the undertaking, companies were only able to provide overall figures, not clearly differentiating between company law and securities law provisions. The process requires about 500 hours of highly qualified personnel and 5,000 hours of lower qualified personnel over a time period of several months. The legal costs amount to at least PLN500,000 and administrative costs amount to PLN100,000. In addition, the registration of the increase in capital and amendment to the statutes cause administrative costs as high as PLN20,000. Thus, the average total costs of an ordinary capital increase amount to a minimum of PLN620,000 (= €165,000). Incremental Costs HighQ LowQ Other Costs Hours spent 50 500 - Hourly rate €100 €70 - €5,000 €35,000 €15,634 Total costs €55,634


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Authorised capital Practical steps To issue authorised capital, the following legal steps in chronological order are required: Figure 4.1.3-7: Process for authorised capital increase (Poland)


Step 1 Proposal of the founders/board on how the company should be financed (amount of subscribed capital, amount of premiums)

Step 2 Laying down in the statutes/ decision by shareholders’ meeting Step 3 Decision of the board

Step 4 Resolution by shareholders (or by board being so entitled by statute) on pre-emption rights in case of cash consideration or possible resolution that bank should offer shares

Step 5 Amendment to statutes to raise the amount of subscribed capital Step 6 Publication of the decision Step 7 Subscription of the shares Step 8 Registration of the increase in capital Step 9 Issue of the shares Analysis In practice, most Polish companies interviewed have not used the opportunity to create authorised capital. Only one Polish company interviewed had done this in the past but has not actually used it. It expired due to lack of reason for keeping the authorised capital.

Mechanisms to ensure the contribution of capital - contributions in kind Practical steps To inject capital into the company, the following steps for cash contributions and contributions in kind have to be taken in chronological order: Figure 4.1.3-8: Process for the injection of contributions (Poland)


Step 1 Monitoring whether assets to be contributed are capable of economic assessment

Step 2 Monitoring whether the designated amount is paid-up in the intended timeframe Step 3 Performance of valuation process with respect to contributions in kind Step 4 Publication of report Step 5 Amendment of the statutes Analysis Unfortunately, we have not encountered any practical cases of contributions in kind during our interviews with Polish companies. However, a general opinion was that the most


85

burdensome aspect is the valuation process of the contribution. This requires, on the one hand, enormous effort to collect relevant data for the valuation and the cost for the outside expert may also be considerable. The actual burden for such valuations largely depends on the complexity of the subject to be valued. This may be a single asset or a highly complex company, thus the costs were estimated to range from a few PLN1,000 to PLN100.000. 4.1.3.2.3 Protection of shareholders and creditors One can draw the following conclusions under the aspect of shareholder and creditor protection in case of capital increases. Firstly, it should be noted that the requirement that the shareholders have to agree to the ordinary capital increase as well as to the conditional capital increase with a qualified majority has clearly a shareholder protective character. Furthermore, the provisions on authorised capital contain elements which are shareholder protective as the authorisation must be stated in the statutes or, if this is not the case, an amendment of the statutes with a qualified majority is necessary. The fact that the authorisation period is limited to three years and the amount which can be covered by the authorisation - half of the capital present – are also shareholder protective. In this respect, Polish law contains further protective provisions, as it prescribes the registration of the shareholders’ resolution to increase the capital, the registration and publication of the increase in capital and the registration and publication of the amendment of the statutes. To ensure that equal treatment in contributions takes place, Polish law prescribes the drawing-up of a report by an independent expert in case of contributions in kind to protect shareholders from overvaluations and their consequences. Under the aspect of shareholder protection, the mandatory pre-emption rights are furthermore of importance as they prevent dilution. It should be noted that, under Polish law, these provisions protect the shareholders not only in the case of contributions in cash but also in the case of contributions in kind. 4.1.3.3. Distribution

4.1.3.3.1 Legal framework Polish provisions on distributions differentiate between provisions dealing with the calculation of the distributable amount, the determination of the amount to be distributed and the consequences of incorrect distributions. Calculation of the distributable amount In accordance with the provisions of the 2nd CLD, under Polish law shareholders are entitled to participate in the profit shown in the audited financial statements and appropriated by the general meeting to be paid to shareholders. Distributions may not be paid out before the compulsory reserve and other reserves – to be accumulated out of the net profit – reach the level provided in the company’s statutes. In any event, contributions paid in return for shares can never be refunded to shareholders. Connection to accounting rules The balance sheet profit is determined with reference to the annual accounts which must be drawn up in accordance with the Act on Accounting and in conformity with IFRS. The annual accounts must be audited.


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Determination of the distributable amount – responsibilities In Poland, distributions have to be proposed by the management board. The proposals are subject to the opinion of the supervisory board. The general meeting is, in any event, competent to decide on the distribution of profit and is not obliged to accept the management board’s proposals and may resolve solely at its own discretion. The resolution must state the amounts required to cover losses, the amounts allocated to particular reserves and the amounts to be distributed. The resolution on the dividend requires a simple majority of the votes cast. No specific quorum is required. Annual resolutions on distribution of profit have to be submitted to the court within 15 days from the approval of the financial statements. Sanctions Shareholders who have received any benefits (including any form of distributions) from the company, in violation of provisions of the law or the company’s statutes, are obliged to return the same. The exception to this general rule is a case where the shareholder receives a share of profit in good faith. Good faith of the shareholder does not change the liability of board members. The liability of board members responsible for the unlawful benefit is not based on fault. 4.1.3.3.2 Economic analysis Overall, the Polish companies interviewed considered the Polish company law provisions on profit distribution as easy to comply with. The reference to the accounting profit derived from the annual accounts prepared under IFRS, provides a high degree of legal certainty. The reference to IFRS does not cause difficulties for the Polish companies interviewed which may also be caused by the fact that the use of fair value measurements was very limited. There have been issues in the application of IAS 29 (“inflation accounting”) due to hyperinflation in Poland in the mid-1990s. From an incremental cost perspective, all Polish companies interviewed considered step 1, i.e. the proposal of the management board using the annual accounts / monitoring of provisions determining the distributable amount, to be the most time-consuming effort concerning the compliance with company law provisions. Further, major expenses are associated with the actual payment of dividends. However, the actual requirements are closely linked to securities legislation and depend significantly on the number of shareholders in the company. Practical steps In chronological order, the series of practical steps comprises: Figure 4.1.3-9: Due process for distributing profits (Poland)


Step 1 Proposal of the management board using the annual accounts / monitoring of provisions determining the distributable amount

Step 2 Opinion of supervisory board in respect of the proposal

Step 3 Resolution of the annual general meeting of shareholders on allocation of net profit/resolution of management board on payment of advance towards the dividend.

Step 4 Publication / payment of dividend


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Analysis Calculation of the distributable amount The preparation of the dividend proposal typically involves the CFO and CEO and other selected high ranking company representatives preceded by preparations in the company’s administration (treasury, tax and/or accounting departments). As the level of dividends is also a political decision concerning the attractiveness of the shares to investors, investor relation experts may also play a significant role in the elaboration of the dividend proposal. The dividend proposal is subsequently subject to a discussion in the company’s management board before it is handed over to the supervisory board. The intensiveness of the discussion in the management and supervisory boards depends on the specific importance of dividend levels for the performance of the shares of the company. An important point of reference for the determination of the distributable amount is the IFRS consolidated accounts. The results of a CFO questionnaire sent to Polish companies listed on main indices reconfirm this: Figure 4.1.3-10: Determinants for the distribution of dividends in the holding company (Poland)


3,67

2,002,331,67

5,00

4,00

2,96

4,223,64

2,15 2,12

3,06

1

2

3

4

5


accounts)



Dividendcont inuity


Tax rules

Determinants

Impo

rtan

ce

Poland

EU Average

Source: CFO Questionnaire, September 2007 IFRS are also regularly applied to the individual accounts which are the basis for calculating profit distribution restrictions. Nonwithstanding the application of IFRS, the results of the CFO questionnaire show that the responding CFOs rank legal restrictions higher than market led solutions like rating agencies’ requirements or bank covenants, even under an IFRS accounting framework.


88

Figure 4.1.3-11: Important deterrents when considering the level of profit distribution (Poland)


4,33

2,50

2,00

3,50

2,653,44 2,25

2,16

1

2

3

4

5





Deterrents

Impo

rtan

ce

Poland

EU Average

Source: CFO Questionnaire, September 2007 One common feature with other EU Member States under consideration concerns the fact that the Polish companies interviewed have to ensure that there is sufficient profit and cash at parent level to allow for distributions, based on considerations from the group’s perspective. Again, the results of a CFO questionnaire sent to Polish companies listed on main indices show the relevance of tax considerations in this regard: Figure 4.1.3-12: Determinants for the distribution of dividends by the subsidiaries (Poland)


3,503,33

4,33

2,743,14

4,07

1

2

3

4

5


Determinants

Impo

rtan

ce

Poland

EU Average

Source: CFO Questionnaire, September 2007 Connection to accounting rules Due to the direct link to the audited financial statements under IFRS, the Polish companies interviewed considered it relatively easy to determine the distributable amount. There is no specific effort needed in this regard. Concerning the use of IFRS, there were no relevant implementation and application issues except for the accounting for hyperinflation under IAS 29 and, in one case, concerning the accounting for stock options under IFRS 2. Accounting for hyperinflation has been a general theme with Polish companies in the changeover to IFRS, due to Polish hyperinflation in the mid-1990s. There was only a very limited use of fair value measurements with the companies interviewed.


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Determination of the distributable amount The total time spent on the distribution proposal is rather minimal and varies between 0.1 and 4 hours of highly qualified personnel of the company. However, the time requirement for the distribution proposal by management varies depending on the culture and organisation of the individual company and is typically not linked to certain size criteria. Another 2 hours of highly qualified personnel time concerns the specific time needed for the supervisory board’s opinion on the distribution proposal and the preparation for the general meeting. The monetary amount to be spent on the publication is also considered minimal and remains under PLN20,000. The companies interviewed do not generally engage external legal advisors in this process and rather use in-house solutions. The remaining steps were considered to be non-incremental as, from the companies’ perspective, they did not result from compliance with distribution provisions such as the preparation of the accounts, the annual audit and the holding of the annual general meeting. Sanctions The companies interviewed considered the risk of liability for the company’s management due to non-compliance with the provisions concerning incorrect dividend distributions, to be low. The reason for this is mainly the very clear-cut legal provisions on profit distributions which, due to their simplicity, provide a high level of legal certainty. Related parties There were no significant issues concerning the question of the monitoring of the relationships with related parties and other potential return of funds to shareholders. This monitoring is mainly performed for transparency (accounting) or tax purposes, not primarily for compliance reasons stemming from company law. Incremental Costs HighQ LowQ Other Costs Hours spent 2.1 – 4 - - Hourly rate €100 €70 - €210 – €400 - < €5,043 Total costs €210 to €5,443 4.1.3.3.3 Protection of shareholders / creditors Under the aspect of shareholder and creditor protection, one can draw the following key conclusions from the abovementioned provisions on distributions. Firstly, under Polish law, clearly formulated legal distribution provisions exist. The reference to IFRS does not cause problems to the Polish companies interviewed. However, the use of fair value measurements under IFRS could lead to more distribution decisions which are not based on the principle of prudence and this could potentially undermine the protection of creditors. The obligation that the general meeting has to decide on the allocation of the balance sheet profit, which stems from the national legislation, provides shareholder protection. The principle of equal treatment in distributions also protects shareholders. In this respect, Polish law contains


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further protective provisions, as it allows shareholders to challenge resolutions that may lead to incorrect distributions. The national provisions prescribing the liability of members of the management board and the supervisory board for losses caused by unlawful distributions are also shareholder protective. Regarding creditor protection, the obligation of the shareholders to return to the company any payment received contrary to the Company Commercial Code, is of importance. 4.1.3.4 Capital maintenance Polish law provides for different instruments dealing with capital maintenance. Among these are the provisions on the limitation of the acquisition by the company of its own shares and the prohibition of financial assistance as well as the provisions on capital reductions, the withdrawal of shares, the serious loss of the subscribed capital and hidden distributions. 4.1.3.4.1 Acquisition by the company of its own shares 4.1.3.4.1.1 Legal framework In Poland, a public company may not, in principle, acquire its own shares. The prohibition on the company acquiring its own shares also applies to the acquisition of a dominant company's shares by its dependent companies or cooperatives. The prohibition also applies to persons acting for the account of a dependent company or cooperative. The Polish CCC provides several exceptions for cases in which public companies acquire shares in order to comply with obligations resulting from warrants convertible into shares; acquisitions of shares by universal succession; cases in which a financial institution which, for a consideration, acquires fully paid-up shares for another's account for re-sale; acquisitions of shares to be redeemed; acquisitions of fully paid-up shares by execution, to satisfy such claims of the company which cannot be otherwise satisfied from the shareholder's estate; gratuitous acquisitions of fully paid-up shares; acquisitions of shares in other circumstances provided for in the Act; acquisitions of shares with the object of preventing major damage with which the company is directly threatened; acquisitions of shares to be offered to employees or persons who were employed in the company or its related companies for no less than three years; cases in which a financial institution acquires shares for its own account with the object of reselling them within the limits of an authorisation granted by the general meeting for a period no longer than one year; however, the financial institution may not hold shares so acquired the total nominal value of which exceeds 5 % of the initial capital. Regarding the last three cases, there are further limitations, namely, shares may be acquired only if the shares to be acquired are fully paid-up, the total nominal value does not exceed 10% of the registered capital, the total purchase price and purchase costs are not higher than capital distributable as dividends. Shares acquired against the law should be resold within 1 year. Shares acquired lawfully but in excess of the 10% of the registered capital should be resold within 2 years. If not, the management board should redeem the shares. If the company holds its own shares, it is not allowed to exercise the participation and voting rights attached to those shares, except for the power to transfer the same or to perform acts conducive to preserving such rights. Furthermore, it is necessary in this case that the shares are shown in the balance sheet as a separate liability. At the same time, the reserve capital must be reduced and the supplementary capital increased correspondingly.


91

The provisions covering the acquisition of the company’s own shares are also applicable to pledges of shares. However, this does not apply with respect to financial institutions, if the creation of the pledge over the shares is in connection with the financial institution’s normal business. The recent amendments to the second directive have not been implemented into national law. At the present time, no legislative proposals to implement the said amendments are known. 4.1.3.4.1.2 Economic analysis Practical steps To acquire its own shares, a company has to follow this process: Figure 4.1.3-13: Process for the aquisition of own shares (Poland)

Acquisition by the company of its own shares

Step 1 Proposal of board to acquire the company’s own shares

Step 2 Notify the next general meeting of the reasons for or purpose of acquisition of the shares

Step 3 Facultative resolution by shareholders on acquisitions of the company’s own shares Step 4 Monitoring of provisions (amount of nominal value, net assets, fully paid in etc) Step 5 Board’s report on acquisition Step 6 Appropriate entries into the balance sheet Analysis Two of the three companies have set up programs to buy back their own shares. The process of setting up a proposal for the buy-back of a company’s own shares depends on the complexity of the buy-back program. We have encountered in the one case a work commitment of 4 hours of highly qualified personnel and 8 hours of lower qualified personnel and in the other case around 80 hours (around 5-6 working days for 2-3 persons such as CEO, CFO, legal or administrative staff) of highly qualified personnel. In both cases, a second opinion is usually obtained from a law firm to secure the right approach. Moreover, there are extensive transparency and information duties with regard to the Warsaw stock exchange supervisory institution for the buying of shares. Thus, the main activity is compliance and monitoring for stock exchange purposes (which takes 60 hours of lower qualified personnel and costs around PLN10,000). The actual buying of the shares usually takes place via a brokerage house. Negotiation of terms of buy-back with brokerage house (no set share price; long buy-back period not to disturb share price) needs intensive work by the legal department (3 working days). The stock exchange requires continuous reporting on share buy-backs (which is done weekly by a brokerage house). In general, we have not noticed significant deviations in the work load between different sizes of companies. It rather depends on the level of activity of the company regarding stock buy-back programmes and the way the company re-acquires its own shares.


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Incremental Costs HighQ LowQ Other Costs Hours spent 28 -104 0 - 8 - Hourly rate €100 €70 - €2,800 to €10,400 up to €560 - Total costs €2,800 to €10,960 4.1.3.4.1.3 Protection of shareholders and creditors Under the aspect of shareholder and creditor protection, one can draw the following key conclusions from the before mentioned provisions on the acquisition by a company of its own shares. The provisions which limit the amount of shares which can be acquired (the 10% threshold) and the provision which prescribes that the shares may not be acquired with the subscribed capital and not distributable reserves, aim at protecting shareholders and creditors. If shares have been purchased different shareholder and creditor protection rules are applicable. Of importance are, for example, the provisions that all rights attached to the acquired shares are suspended. Also of importance is the provision that the acquired shares are shown in the balance sheet as a separate liability. 4.1.3.4.2. Capital reduction 4.1.3.4.2.1 Legal framework The Polish Commercial Companies Code provides for the possibility of an ordinary reduction in capital. The minimum required for the resolution is a ¾ths majority of the votes. If different classes of shares exist within the company, any resolution on a reduction in capital that may infringe rights of holders of certain classes of shares must be adopted by resolutions of the different classes of shareholders. The management board has to announce the intended capital reduction, requesting the creditors of the company to raise their objections within three months from the date of the announcement in the event that they should be against the reduction. Creditors of the company that raise their objections within the prescribed time must be satisfied (if the claims are due), or secured. The creditors who fail to raise their objections are deemed to have agreed to the intended capital reduction. Shareholder’s claims raised during the procedure of the reduction in capital shall be satisfied after 6 months from the announcement of registering the capital reduction in the national register. A reduction to an amount less than that prescribed in the Polish Commercial Companies Code is not possible. The Polish Commercial Companies Code provides that the maximum reduction of capital is limited by the minimum capital of the company as prescribed (PLN500,000).


93

The Polish Commercial Companies Code provides for some exceptions to the above mentioned procedure, such as: a) although the capital is reduced, shareholders’ contributions for shares are not returned to

shareholders, and shareholders are not released from the duty to make contributions to the initial capital and at the same time the capital is increased at least to its initial value, or

b) the capital reduction is effected with the object of covering losses suffered or transferring certain amounts of capital to the reserve capital, or

c) the capital reduction is effected in the case of a redemption of shares which were acquired by the company and not sold within the timeframe provided by the Polish CCC (2 years).

The amendments of the 2nd CLD with respect to the burden of proof have not yet been implemented into national law. 4.1.3.4.2.2 Economic analysis Within our sample of Polish companies, we have not encountered any capital decreases. 4.1.3.4.2.3 Protection of shareholders and creditors Regarding the shareholder and creditor protection existing with respect to capital reductions, firstly the requirement that the shareholders have to agree to the capital reduction with a qualified majority (3/4ths majority of the votes) is of importance. Furthermore, the safeguards to creditors which have, under certain circumstances, the right to obtain security are creditor protective. 4.1.3.4.3 Withdrawal of shares 4.1.3.4.3.1 Legal framework Polish law allows the compulsory withdrawal of shares. Furthermore, Polish law provides for the withdrawal of a company’s own shares. Not possible are redemption of the subscribed capital without reduction of the latter and the issuance of redeemable shares. A compulsory withdrawal in this way is only permissible if the company's statutes so provide, as well as for the grounds and the procedure thereof. The redemption of the shares requires a resolution of the general meeting. The resolution has to state, in particular, the legal grounds for the redemption, the compensation and the manner of reducing the initial capital. A compulsory redemption is subject to compensation. The resolution on the redemption of the shares must be adopted by a majority of 3/4ths of the votes. Where at least half of the capital is represented at the general meeting, a simple majority of votes is sufficient. The company's statutes may set more rigorous requirements. The resolution shall follow the terms and manner previously fixed in the statutes. The resolution on the redemption must be published. The Commercial Companies Code stipulates that the company's shares acquired by the company itself and not sold within the timeframe provided in the Commercial Companies Code are subject to redemption by the authority of the management board without the need of


94

a resolution of the general meeting. This method of redemption does not need to be provided for in the statutes. 4.1.3.4.3.2 Economic analysis Two of three companies have made use of the redemption of their own shares acquired in a buy-back programme, but this has seldom happened. One of the companies mentioned that it has twice annulled its own shares in the last ten years. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.1.3.4.3.3 Shareholder and creditor protection Regarding the withdrawal of shares, it is, with respect to shareholder and creditor protection, of importance that it is only permissible if the statutes allow it before the shares to be withdrawn are subscribed for. 4.1.3.4.4 Financial assistance

4.1.3.4.4.1 Legal framework The Polish Commercial Companies Code provides that companies may not make loans, provide security, advance payments or in any other manner, directly or indirectly finance the acquisition or taking-up of their own shares. This does not, however, apply to transactions in the ordinary course of business of financial institutions or share issues to employees of the company or of an associated company provided that a reserve capital was previously created for this purpose. The amendments of the 2nd CLD by Directive 2006/68/EC have not yet been implemented into national law. 4.1.3.4.4.2 Economic analysis As the changes to the 2nd CLD have not yet been enacted into Polish law, there could not have been any practical cases in the course of the interviews conducted with Polish companies. 4.1.3.4.5 Serious loss of half of the subscribed capital 4.1.3.4.5.1 Legal framework In Poland, if the balance sheet prepared by the management board shows a loss in excess of the total of the compulsory and voluntary reserves, and one third of the registered capital, the management board is required to call a general meeting with the object of adopting a resolution on the continuation of the existence of the company. A separate notification of the loss does not have to be published. The calling of the general meeting should include its agenda i.e. that a resolution on the continuation of the existence of the company is required by the law due to the amount of losses incurred by the company.


95

The general meeting must adopt a resolution in respect of the continuation of the company or a resolution winding-up the company. Failure to call the general meeting can lead to civil liability and/or penal liability of the management board and may give grounds for dismissal of the board. 4.1.3.4.5.2 Economic analysis The Polish companies interviewed spent very little time on the explicit monitoring of this provision on the serious loss of subscribed capital. The management of the companies interviewed normally use their normal internal reporting and risk management systems to monitor the financial position of the company/group. This is typically a monthly report with key figures concerning the company/group. This would give management sufficient lead time to recognise critical situations. In general, they would see a significant increase in monitoring activity once the financial position of the company showed indications that such a situation could actually occur. 4.1.3.4.5.3 Shareholder and creditor protection The provisions dealing with the serious loss of the subscribed capital have a shareholder and also creditor protective character as the general meeting gets the possibility to decide on safeguarding measures such as winding-up the company. 4.1.3.4.6 Contractual self-protection 4.1.3.4.6.1 Legal framework In Poland there are no specific legal provisions concerned with contractual self protection of creditors. As the board represents the company vis-à-vis the creditors, and the general meeting decides upon the dividend, any of such contractual obligations (limitations) would have to be made by the board as the competent body. There are no obstacles to a shareholders’ agreement suspending payment of the dividend. In case of such contracts, especially in the case of public companies, it must be considered whether the legitimate rights of minority shareholders are not violated, so that their consent would be required. 4.1.3.4.6.2 Economic analysis Only one of the three Polish companies interviewed had covenants in a loan contract with Polish banks. These concerned restrictions on the disposal of main assets as well as the maintenance of certain liquidity ratios. There are no direct restrictions on the distribution of profits. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data


96

4.1.3.4.6.3 Shareholder and creditor protection Regarding the aspect of creditor protection it should be noted that covenants are based on private law contracts which do not, in Poland, seem to be extensively used. Furthermore, only individual creditors are, under Polish law, protected by them. 4.1.3.5 Insolvency

4.1.3.5.1 Legal framework According to the Polish Insolvency and Rehabilitation Act (IRL), bankruptcy proceedings are initiated in respect of a debtor (including a legal entity) that has become insolvent, i.e. that is not able to fulfill its current and due liabilities. This is particularly the case when liabilities of the company exceed its assets, or while the debtor has reasonable assets, due to inadequate cash flow cannot pay its current debts. A presumption exists that if the liabilities of a company exceed the value of its property, the company is deemed to be insolvent. In the case of minor or temporary difficulties in meeting liabilities or non-material indebtedness (i.e. when the period for which the company is late in payment of debts does not exceed 3 months and the amount of due liabilities does not exceed 10% of net assets), the court may refuse to declare bankruptcy. There are two kinds of proceedings in the case of insolvency: liquidation (when the company is liquidated) or arrangement (when its operation is supervised by the court and creditors and special arrangement with creditors must to be made). The latter may be taken into consideration when the probability of satisfying the creditors is higher than in the case of liquidation. The reasons for insolvency are of an objective nature and must be evaluated by the person obliged to file a proper petition to the court (the company management) or a person entitled to do so (creditor). The circumstances are examined by the court. The petition may be filed by the debtor or its creditors. When the company becomes insolvent, the duty of each and every member of the management board is to file the petition. The petition for a declaration of bankruptcy must be filed within two weeks from the moment the company became insolvent. 4.1.3.5.2 Economic analysis As for the provision on the serious loss of subscribed capital, the Polish companies interviewed spent very little time on the monitoring of insolvency triggers. The management of the companies interviewed normally use their internal reporting and risk management systems to monitor the financial position of the company/group. This would give them sufficient lead time to recognise critical situations. Again, they would generally see a significant increase in monitoring activity if the financial position of the company showed indications that such a situation could actually occur.


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4.1.4 Sweden 4.1.4.1. Structure of capital and shares 4.1.4.1.1 Legal framework Structure of capital Subscribed capital Also under the new Swedish Companies Act (“Aktiebolagslagen”= ABL) which came into force on 1 January 2006, public companies must have a minimum subscribed capital of SEK 500,000 what goes beyond the minimum set by the 2nd CLD (SEK 500,000 equal about €50,000). Above this minimum amount the founders are entitled, as it is provided for in the 2nd CLD, to freely fix a higher capital amount. Private Companies are required to have a minimum subscribed capital of SEK 100,000 (which equals about €10,000). The founders are also entitled to freely fix a higher capital amount. Swedish law prescribes that share capital must be determined in the statutes. Premiums and other forms of equity contribution Under Swedish Law it is permissible to fix premiums in the stage of formation. The New Swedish Companies Act provides that the payment for a share may not be less than the share's quotient value. For example, if the founders have decided that the company's share capital shall be SEK 100,000 and there are 1,000 shares in the company, payment for each share must thus be not less than SEK 100. On the other hand, there is nothing to prevent the shares being issued at a premium, i.e. in exchange for payment which exceeds the shares' quotient value. In such case, the part of the payment for the shares which corresponds to the quotient value will constitute the company's share capital while the premium will be reported as unrestricted equity under the heading Share Premium Reserve. Under Swedish Law the payment for the subscribed shares must take place in cash or through non-cash consideration. Set-off is not permitted in conjunction with formation of a company. Protection of the public company’s assets In the new Swedish Companies Act, rules concerning the way and extent to which assets can be transferred from the company to shareholders or other parties have been assembled under the term "value transfers". Value transfers are prohibited for sums so large as to leave the restricted equity without full coverage after the transfer (“monetary barrier”). When the scope for a value transfer is decided, an examination must also be made of whether the planned value transfer is justifiable bearing in mind the amount of equity required by the type and size of the business and the risks involved (“the prudence rule”).


98

The concept of value transfer refers to: - dividends - acquisition of own shares - reduction of the share capital or statutory reserve fund for repayment to shareholders,

and - other business transactions of a non-commercial nature that entail a reduction in the

company’s assets. Structure of shares Every share represents the same fraction of the subscribed capital (“quotient value”). The concept of nominal value was abolished in the new Swedish Companies Act. Accordingly, the subscribed capital may be broken down according to the number of shares which requires shares of the same amount. All Swedish companies had to amend their statutes in this respect. 4.1.4.1.2 Economic analysis Practical relevance of subscribed capital and structure of shares for an assessment of the viability of a company In general, the Swedish companies interviewed did not see a high degree of practical relevance of the legally imposed subscribed capital concerning the assessment of their viability by outsiders. There was no significant difference seen between par value and no-par value shares. No-par value shares are considered to be a bit less burdensome to administrate. The companies interviewed are rather looking at the figures “net equity” and “market capitalisation” as relevant to determine their equity position and their assessment of their chances to preserve their business or to attract additional capital. One company gave a specific example by referring to a self-created trademark which cannot be capitalised in the balance sheet, but generates significant cash flows for the company. This trademark is not reflected in the balance sheet but in the market capitalisation of the company. To verify the statement, we have additionally performed an analysis of certain ratios concerning subscribed capital fort the main Swedish stock exchange index Attract 40. For nearly all (98 percent) of the Attract 40 companies the subscribed capital represents less than 5 percent of their market capitalisation. Thus, the overall importance of the subscribed capital figure seems to be marginal.


99

Figure 4.1.4-1: Common Stock – Market Capitalisation (Sweden)

Sweden: Common Stock / Market Capitalisation

98%

2%

< 5%5% - 10%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of September 2006 Restriction for distribution The results from the CFO questionnaire sent to 245 Swedish public companies showed support for the concept of subscribed capital. 62 percent of the respondents considered the existence of subscribed capital to be necessary. This view was opposed for more than a third of the respondents (38 percent). Figure 4.1.4-2: CFO survey results: necessity of subscribed capital (Sweden)



38%

62%

True

False

Source: CFO questionnaire, September 2007 However, according to the respondents to the CFO questionnaire there is no interest in excessive restrictions to distribution. A clear majority of 95 percent of the respondents rejected the idea to increase the level of subscribed capital to the highest extent possible to avoid distributions.


100

Figure 4.1.4-3: CFO survey results: level of subscribed capital (Sweden)



for distributions."

0%

95%

5% True

False

NA

Source: CFO questionnaire, September 2007 Role of the subscribed capital in equity financing For Attract 40 companies, the ratio of subscribed capital to total shareholder’s equity shows that for 81 percent of the Attract 40 companies the subscribed equity portion stays under 20 percent of total shareholder’s equity. This underpins that the equity financing is not largely dependant on the subscribed capital and that there is a sufficient equity base in the Attract 40 companies and their subsidiaries to allow for adequate distributions. The existence of a subscribed capital does not seem to be a stumble block for the Attract 40 companies in their approach to equity financing and distribution policy from a group perspective. Figure 4.1.4-4: Ratio of common stock to total shareholders`s equity (Sweden)

Sweden: Common Stock / Total Shareholder's Equity

41%

25%

15%

8%

11%

< 5%5% - 10%10% - 20%20% - 30 %> 30%

Source: One source: Subscribed capital for the FY 2005, shareholder’s equity (consolidated) for the FY 2005


101

The following answers to the CFO questionnaire concerned the attitude of companies regarding capital increases: 86 percent of the respondents stated that they usually try to keep the level of subscribed capital to the minimum amount necessary. Only 10 percent of the respondents opposed this view. These responses show that companies are generally not interested in a dominant role of subscribed capital in equity financing. Figure 4.1.4-5: CFO survey results: Attitudes towards increases of subscribed capital (Sweden)


reasons."

86%

10%

5%

True

False

NA

Source: CFO questionnaire, September 2007 Subsequent formations We have not received any information on subsequent formations as these provisions are not relevant to the Swedish companies interviewed. 4.1.4.2. Capital increase 4.1.4.2.1 Legal framework In the new Swedish Companies Act, rules concerning increase in share capital have been restructured and given a different legal design. Still, in substance the rules are similar to what applied before. A Swedish limited company can increase its share capital through bonus issues and new issues. With respect to both types of increase in share capital, the share capital may not be increased in a way which violates the statutes. Thus, the Companies Act prescribes that the statutes must be altered before a resolution is adopted regarding an issue, if the resolution is not compatible with the statutes. If the share capital in the statutes is stated as a fixed amount, a resolution to increase the share capital cannot be adopted unless the statutes are altered at the same time. This is also the case if the statutes state a minimum and a maximum share capital


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and the increase results in the maximum capital being exceeded. If there is more than one class of shares in the company, an issue resolution may not result in the maximum number, or the maximum portion, of shares of a particular class as prescribed in the statutes being exceeded. Ordinary capital increase As a main rule, under Swedish Law a resolution regarding a new issue is adopted by the general meeting. Where the shareholders have pre-emption rights to subscribe for new shares, a simple majority is normally sufficient to adopt a resolution regarding a new issue. Thus, the resolution must be supported by shareholders with more than half of the votes cast. If the issue resolution requires an alteration of the statutes, the qualified majority requirements applicable to a resolution regarding such alterations must be observed (two thirds of the votes cast and shares represented at the meeting). This is also the case if the general meeting decides to derogate from the shareholders' pre-emption rights and carry out a private placement; in that case too the resolution must be supported by shareholders representing two thirds of the votes cast and shares represented at the meeting. In the event of a new issue against payment in cash or by set-off, the shareholders have pre-emption rights to new shares pro rata to the number of shares held previously. Thus, the shareholders are entitled to subscribe for, and be allotted, shares in the issue pro rata to their previous shareholdings. The Swedish legislator has not made use of the option laid down in Art. 41 (1) of the 2nd CLD which allows member states to depart from the requirement of a shareholders’ resolution to increase the capital to the extent that it is necessary for the adoption or application of provisions designed to encourage the participation of employees in the capital of undertakings. In accordance with the 2nd CLD, the Swedish Companies Act requires the publication of the shareholders’ resolution to increase the capital. All documents shall be available for the shareholders and presented to the general meeting. The resolution shall be published within six month after the resolution for registration in the Companies Register. Authorised capital The Swedish Companies Act uses the possibility of fixing authorised capital. If the statutes state a minimum and maximum share capital, the board of directors can decide on a new issue based on advance authorisation provided by the general meeting. Such authorisation, which is often granted at the annual general meeting, may not extend for a period of time beyond the next annual general meeting. Other forms of capital increase Another form of capital increases concern the capitalisation bonuses. A bonus issue means that the share capital is increased through the contribution of an amount which is taken from the statutory reserve, the revaluation reserve or unrestricted equity in accordance with the most recently adopted balance sheet or through the value of a fixed asset being written-up. The share capital increases without an external contribution of capital.


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A bonus issue may take place with or without new shares being issued. In the former case, the new shares are allotted between the existing shareholders. In the latter case, the increase gives rise only to an increase in the shares' quotient value. In the event of a bonus issue in which new shares are to be issued, the shareholders have an unconditional right to such shares pro rata to the number of shares previously held. A resolution regarding a bonus issue must always be adopted by the general meeting. The resolution is adopted by simple majority of the votes cast. Contributions of premiums Under Swedish Law it is permissible to fix premiums in capital increases. The only provision of the new Swedish Companies Act is that the payment for shares may not be less than the share’s quotient value. Quotient value means that each share represents an equally large portion of the of the share capital. Shares may not be issued for a sum below the quotient value. If shares are issued for a sum exceeding the quotient value, the premium must be set aside in a special fund, the share premium reserve. This share premium reserve constitutes non-restricted equity of the company, i.e. funds allocated to the premium reserve can be distributed to shareholders in the same way as profits. Mechanisms to ensure the contribution of capital Subscription of shares The Swedish Law is based on the principle that all shares need to be subscribed before the capital increase may be registered. The subscription for new shares takes place on a subscription list which contains the issue resolution. The documents presented to the general meeting and a copy of the statutes must be attached to the subscription list. If all shares are subscribed for by the persons entitled to subscribe at the time when the general meeting decides on the new issue, subscription can take place through a simplified procedure, referred to as simultaneous subscription. This means that share subscription takes place directly in the minutes of the meeting. A Swedish company may not subscribe to its own shares. Where the shares have been subscribed for by a person on behalf of the company, the subscriber shall be deemed to have subscribed for the shares on his or her own behalf. Contributable assets/ paying in Under Swedish law capital increases can be performed by contributions in cash and contributions in kind. In the event of non-cash consideration, payment shall take place through the property being separated and included in the company's property. An auditor must issue a written, signed statement with respect to the payment verifying that non-cash consideration has been provided to the company, that it is or may be assumed to be of benefit for the company's operations and that it has not been reported at a higher value than the actual value for the company. The statement should be registered with the Companies Register. Within six months of the new issue resolution, the board must notify the resolution for registration in the Companies Register, unless the resolution is ineffective due to insufficient subscription. As a general rule, registration is conditional, among other things, on full


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payment having been made for all subscribed and allotted shares. In this respect, the Act does not differentiate between payment in cash or contributions in kind. Protection against over-valuation Where shares are issued for a consideration other than in cash, Swedish law requires that a report on the consideration other than in cash needs to be drawn up by an independent expert before the company is incorporated. Swedish Law determines that an auditor shall provide a written, signed statement in respect of the payment. An auditor shall be any authorised public accountant or approved public accountant or a registered accounting firm. The Swedish Companies Act does not prescribe which methods of valuation are allowed. However, the auditor shall describe the non-cash consideration and state the method of valuation and also any special difficulties associated with the estimation of the value of the property. Non-cash consideration may not be set higher than the actual value to the company. Sanctions As a consequence of incorrect financing, the company will not be registered and the formation of the company lapses. The amounts paid for subscribed shares as well as accrued income thereon, less costs incurred as a consequence of measures take, shall be repaid immediately. This shall also apply to non-cash consideration. The founders and the members of the board of directors shall be jointly and severally liable for such repayment. Pre-emption rights The Swedish Companies Act provides for pre-emption rights against payment in cash or by set-off in the context of capital increase. A pre-emption right confers the right to have new shares pro rata to the number of shares held previously. Thus, the shareholders are entitled to subscribe for, and be allotted, shares in the issue pro rata to their previous shareholdings. Furthermore, the rule regarding pre-emption rights does not apply if the statutes contain different provisions regarding pre-emption rights. If the company has shares which carry different rights to the company's assets or profits or which carry different voting rights, the issue of pre-emption rights in the event of a cash issue of new shares must be specifically regulated in the statutes. It is also possible to prescribe derogation from the main rule in the actual issue resolution – to decide on a "private placement", for example to an external investor with full coffers. The Swedish legislator provides for the possibility that the board of directors can decide on the exclusion or reduction of pre-emption rights, if this decision is authorised or subsequently ratified by the general meeting. The general meeting’s resolution regarding the authorisation shall be notified immediately for registration in the Company’s Register. Furthermore, an auditor’s review takes place and shall apply with respect to the content of the board’s resolution.


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4.1.4.2.2 Economic analysis None of the companies interviewed had recently performed a capital increase or disposes of an authorised share capital. One company serviced its employee stock option programmes via share buy backs. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.1.4.2.3 Protection of shareholders and creditors The basic element of shareholder protection is the fact that the shareholders have to agree to the ordinary capital increase or an authorisation to the board of directors to increase capital. To ensure that equal treatment in contributions takes place, Swedish law prescribes the drawing up of a report by an independent expert in case of contributions in kind to protect shareholders against over-valuations and their consequences. 4.1.4.3 Distribution 4.1.4.3.1 Legal framework Swedish distribution requirements can be categorised in provisions concerning the calculation of the distribution, the procedural determination of the distributable amount and the consequences of incorrect distributions. Calculation of the distributable amount The distributable amount is determined based on the concept of a value transfer. A value transfer may not take place where, after the transfer, there is insufficient coverage for the company’s restricted equity (“monetary barrier”). The calculation shall be based on the most recent balance sheet taking into consideration changes in the restricted shareholders equity which have occurred subsequent to the balance sheet date. Notwithstanding this, under the “prudence rule” the company may effect a value transfer to shareholders or another party only provided such appears to be justified taking into consideration - The demands with respect to size of shareholders equity which are imposed by the nature, scope and risks associated with the operations and - The companies need to strengthen its balance sheet, liquidity and financial position in general. Both circumstances are subject to a written statement from the board confirming compliance to be presented to the general meeting when deciding upon distribution.


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Connection to accounting rules The amount that can be distributed consists of two parts. Firstly, the reported net profit for the financial year less obligatory reserves. Secondly, the non-restricted reserves or retained profits which can serve for distributions. For a group of companies, the distributable amount for dividend payment is determined as the lesser of distributable amounts available at the parent company’s level or the distributable amount according to the group accounts. In this context, the above mentioned “prudence rule” also plays a decisive factor in determining the actual distribution. This requires specific considerations concerning the company’s/group’s financial position, especially in view of cash flows. Determination of the distributable amount – responsibilities The board proposes a resolution to the general meeting. If the distribution is to be decided on by the annual meeting the proposal is included in the annual report. The general meeting may resolve upon the distribution of a larger amount than proposed or approved by the board only where such an obligation exists in accordance with the statutes or where the distribution was resolved upon at the request of a minority of shareholders. If the decision of the shareholders is to be taken at a meeting other then the annual general meeting (extraordinary general meeting), additional information is to be prepared/distributed. The decision is nevertheless to be based on available capital according to the most recent adopted balance sheet. The auditor of the company provides a statement to be presented to the general meeting The resolution by the general meeting must be taken with a simple majority at the annual general meeting. The basis for this resolution is the profit and loss account, the balance sheet and allocation of profits or losses as adopted by the general meeting. If taken at an general meeting, the resolution on proposal comes from the board. If the resolution has been adopted at the general meeting, the annual report shall be sent to the Companies Register including an attestation on the resolution regarding profit or loss. If the resolution has been adopted at an extraordinary general meeting, the resolution shall be notified to the Companies Register. Sanctions Swedish law provides for different ways of challenging the distribution resolution. If the challenge to the distribution resolution refers to an error that can be adopted with unanimous consent of all shareholders, the challenge must be commenced within three months from the date of resolution. If the challenge refers to an error that can not be adopted this way, there is no time limitation. 4.1.4.3.2 Economic analysis Due to the application of the “prudence rule”, Swedish law offers a universal approach for value transfers to shareholders and other stakeholders. It obliges the management to assess whether a dividend appears to be justified taking into consideration the demands with respect to size of shareholders equity which are imposed by the nature, scope and risks associated with the operations and the company’s need to strengthen its balance sheet, liquidity and


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financial position in general. Nevertheless, the overall administrative effort still seems not overly burdensome and was at least partly seen as rather positive for the Swedish companies concerned. The actual payment of dividends may also present a major effort. However, the costs are linked to capital market requirements and are depending on the number of shareholders. Practical steps Based on the legal analysis, the distribution of profits requires the following practical steps which are the basis for the economic analysis. Figure 4.1.4-6: Due process for distributing profits (Sweden)


Step 1 Monitoring either preparation of annual accounts (annual meeting) and/or capital available for distribution (extraordinary shareholders meeting)

Step 2

Monitoring proposal to be presented by the board (chapter 18, section 1). The shareholders meeting may resolve upon the distribution of a larger amount than proposed or approved by the board only where a) such an obligation exists in accordance with the statutes b) the distribution was resolved upon at the request of a minority

Step 3

The board establish a proposal for decision to be presented to the shareholders meeting (chapter 18, sections 2-4), if the distribution is to be decided on by the annual meeting the proposal is included in the annual report. If the decision of the shareholders is to be taken at a meeting other then the annual meeting (extraordinary shareholders meeting), additional information is to be prepared/distributed (chapter 18, section 5). The decision is nevertheless to be based on available capital according to the most recent adopted balance sheet (chapter 17, sec. 3)

Step 4 The auditor of the company provides a statement to be presented to the shareholders meeting (chapter 9, section 32 (annual meeting) or chapter 18, section 6 (extraordinary shareholders meeting))

Step 5 Invitation to attend shareholders meeting (chapter 7, section 18 and chapter 18, section 8)

Step 6 Proposal to be made available for the shareholders (chapter 18, section 7)

Step 7

Resolution by the shareholders meeting (chapter 18, section 9) - Annual meeting; the profit and loss account, balance sheet and allocation of

profit or loss is to be adopted by the shareholders meeting (chapter 7, section 11) - Extraordinary meeting; resolution on proposal from the board

Step 8

If the resolution is has been adopted at the annual meeting, the annual report shall be sent to the Companies Register including an attestation on the resolution regarding profit or loss (Annual Reports Act, chapter 8, section 3) If the resolution has been adopted at an extraordinary shareholders meeting, the resolution shall be notified to the Companies Register (chapter 18, section 10)


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Analysis Calculation of the distributable amount From an economic point of view, the establishment of the dividend proposal typically involves the CFO and CEO and other selected high ranking company representatives preceded by preparations in the company’s administration (treasury, tax and/or accounting departments). The companies interviewed have defined dividend policies by distributing certain percentages of their consolidated profits. Also the aspect of dividend continuity plays a certain role. The clear point of reference for the determination of the distributable amount is the consolidated financial statements of the company, not the individual financial statements. Depending on the structure of the company, it may be necessary to bring the consolidated view in line with the disposable profits / cash at parent company level. For the companies interviewed, this was of lesser importance as the main business lied with the parent company. However, it was indicated to us that tax advantages in other jurisdictions may give incentives not to transfer profit immediately to the parent company. The results of a CFO questionnaire sent to Swedish companies listed on main indices reconfirm this: Figure 4.1.4-7: Determinants for the distribution of dividends in the holding company (Sweden)


3,26

2,212,163,57

2,42

4,10

2,122,15

3,06

3,642,96

4,22

1

2

3

4

5


accounts)



Dividendcont inuity


Tax rules

Determinants

Impo

rtan

ce

Sw eden

EU Average

Source: CFO Questionnaire, September 2007 However, concerning the importance of the current legal restrictions on profit distribution, the CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market led solutions like rating agencies’ requirements or bank covenants.


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Figure 4.1.4-8: Important deterrents when considering the level of profit distribution (Sweden)


2,19

3,00

2,293,292,65

2,25

2,16

3,44

1

2

3

4

5





Deterrents

Impo

rtan

ce

Sw eden

EU Average

Source: CFO Questionnaire, September 2007 Concerning the determinants of distributions by subsidiaries, the results of a CFO questionnaire show the importance of tax considerations: Figure 4.1.4-9: Determinants for the distribution of dividends by the subsidiaries (Sweden)


2,74

3,253,68 2,743,14

4,07

1

2

3

4

5


Determinants

Impo

rtan

ce

Sw eden

EU Average

Source: CFO Questionnaire, September 2007 Connection to accounting rules Due to the immediate link to the audited financial statements, the Swedish companies interviewed considered it simple to determine the distributable amount. However, for compliance reasons, both, the individual and consolidated accounts situation, needs to be taken into account. The “prudence rule” also asks for the assessment of cash flows at company and group level. Furthermore, the compliance with the “prudence rule” requires a more detailed assessment of the financial position of the company / group, especially from a cash flow perspective. Determination of the distributable amount The proposal for dividend distribution is part of a wider assessment by the board of directors of the companies interviewed as already described in the previous section. The overall


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compliance effort amounts between 30 to 40 hours of highly qualified personnel. This figure also includes time needed for the actual dividend proposal. However, these number are individually determined for the companies interviewed and could easily change depending the financial position and the complexity of the business of an individual company / group. Other steps were considered to be non-incremental as they did not, from the companies’ perspective, originate from the compliance with distribution provisions such as the preparation of the accounts, the annual audit and the holding of the annual general meeting. Regarding cash-flow projections, the companies interviewed have a very detailed cash flow planning for at least one year. However, this planning is based on internal rules on how to prepare such projections and is clearly linked to the business needs of these companies. The maximum projection period which allowed for serious estimations was considered between three to five years, depending on the nature of the business of the company. Sanctions Concerning the efforts to comply with provisions concerning incorrect dividend distributions, the companies interviewed considered the risk of liability for the company’s management as rather low. Related parties Transactions with related parties may also be caught by the prudence rule as they may constitute value transfers. This would require including such transactions in the assessments to be made in this regard by the board of directors. Incremental Costs HighQ LowQ Other Costs Hours spent 30 – 40 - - Hourly rate €100 €70 - €3,000 – €4,000 - - Total costs €3,000 – €4,000 4.1.4.3.3 Protection of shareholders / creditors Both shareholders and creditors benefit from the introduction of the concept of value transfer. The board of directors needs to give assertion via a statement that such transactions do harm the financial position of the company. The obligation that the general meeting has to decide on the allocation of the profit also leads to a high degree of shareholder protection. 4.1.4.4 Capital maintenance Swedish law provides for different instruments dealing with capital maintenance. Among these, are the provisions on the limitation of the acquisition by the company of its own shares and the prohibition of financial assistance as well as the provisions on capital reductions, the withdrawal of shares and the serious loss of the subscribed capital. The analysis also contains the contractual self protection of creditors via covenants. It has to be noted that since the enactment of the new Swedish Companies Act in 2006 transfers to shareholders and other stakeholders generally fall under the prudence rule assessment by the board of directors. This specifically includes the acquisition of own shares, reductions of the share capital or statutory


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reserve fund for repayment to shareholders and other business transactions of a non-commercial nature that entail a reduction in the company’s assets. 4.1.4.4.1 Acquisition by the company of its of own shares 4.1.4.4.1.1 Legal framework Even though as a general rule the acquisition of own shares is not allowed under Swedish law, there are exceptions and permissions, mainly for Swedish public companies. In general, the Swedish law provides that a company may not subscribe its own shares. This shall also apply with respect to a subsidiaries’ subscription. Where a company has subscribed for its own shares the management board shall be jointly and severally liable for payment. Shares which have not been withdrawn through a reduction shall be disposed of as soon as they may occur without loss, however not later than three years from the date of the acquisition. Shares which have not been disposed of within this time frame shall be declared void by the company. General exceptions to acquire own shares are:

- shares for which is it not obliged to pay; - included in business operations which are acquired by the company, where the shares

represent a small portion of the company’s share capital; - redeem own shares in accordance with Ch. 25 Sec. 22 ABL; - purchase at auction its own shares if the auction is held in the course of the execution in

respect of the company’s claims. For Swedish public companies, a separate regime applies. A public company listed on a Swedish or foreign exchange, authorised market or any other regulated market may acquire its own shares in addition to the provisions above if the acquisition takes place on an exchange and the company does not acquire more than one tenth of all shares in the company which is in line with the provisions of the 2nd CLD. In such case, a resolution regarding the acquisition shall be adopted by 2/3rds of both the votes cast and the shares represented at the general meeting. In this respect a proposal is necessary which states the period of time within which the resolution must be executed, the number of shares, the consideration to be given for the shares and other conditions and terms. As the acquisition of own shares constitutes a “value transfer”, the board of directors needs to observe the “prudence rule”, i.e. an examination whether the planned value transfer is justifiable bearing in mind the amount of equity required by the type and size of the business and the risks it involves. The Swedish Companies Act requires a resolution by 2/3 of the shareholders either to perform an acquisition or to delegate to the board of directors to perform the acquisition. As provided for by the 2nd CLD – Swedish Law determines the maximum and minimum consideration for the shares as well as the value of shares to be acquired which may not exceed 10% of the subscribed capital. After the acquisition there must be full coverage for the company’s restricted equity. Shares acquired in breach of these provisions shall be disposed of within six months from the date of the acquisition.


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4.1.4.4.1.2 Economic analysis From a company law perspective, most efforts go into the proposal for the authorisation to purchase the company’s own shares. However, the actual buyback of shares may entail much higher costs. Unfortunately, we have not received detailed data on this from the Swedish companies interviewed, but have similar experiences in other EU countries. Nevertheless, only incremental costs invoked by company law are relevant to this analysis. Thus, these costs resulting from securities legislation are remarkable - but not from an incremental cost perspective. Practical steps To acquire its own shares a company has to follow this process: Figure 4.1.4-10: Process for the acquisition of own shares (Sweden)


Step 1 Monitoring amount available for value transfers (chapter 19, section 22)

Step 2

The board establish a proposal for decision to be presented to the shareholders meeting (chapter 19, section 19). The proposal includes, but is not limited to, the manner in which the shares shall be acquired, the numbers of shares/classes of shares to which the offer shall relate, consideration to be given and other terms and conditions for the acquisition (chapter 19, sections 20-21). If the decision of the shareholders is to be taken at a meeting other then the annual meeting, additional information is to be prepared/distributed (chapter 19, section 23). - It is possible for the shareholders meeting to authorise the board to adopt a resolution regarding acquisition/selling of own shares (chapter 19, sections 17 and 33)

Step 3 Notice to attend shareholders meeting (chapter 19, section 26) Step 4 Make proposal available to the shareholders (chapter 19, section 25)

Step 5 Resolution by the shareholders meeting (chapter 19, sections 27 and 28 (authorisation))

Step 6 Monitoring acquire/selling of own shares (chapter 19, sections 13- 15 (acquire) and sections 31-32 (selling)

Analysis In order to propose a share buy back, the management of the company needs to assess the “value transfer” linked to the share buy back. In doing this, the board of directors needs to observe the “prudence rule”, i.e. an examination whether the planned value transfer is justifiable bearing in mind the amount of equity required by the type and size of the business and the risks it involves. In the course of the interviews, it was stated that the compliance with the prudence principle a detailed assessment of the company’s financial position both from a net assets as well as a cash perspective within the individual legal entity and the group. However, as the authorisation is usually given in the same shareholder assembly which also decides on the dividend distribution, both value transfers, i.e. the buyback and the dividend, are assessed at the same time. One company assessed this effort as very positive for the company as it helps the management of the company to take conscious decisions in this


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regard. The combined effort amounts to about 32 hours of high qualified work. This also includes the proposal to the shareholder which is regularly an update of pre-existing documents and, thus, requires an insignificant effort The holding of the shareholders’ annual meeting is considered a non-incremental effort as this also serves other purposes. The actual buyback may be handled differently from company to company. It is normally commissioned to banks and it depends on the company how closely it is involved in the buyback process. We have not received detailed data on the costs of the banks in this regard. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.1.4.4.1.3 Protection of shareholders and creditors Concerning shareholder protection, it must be noted that the shareholders have to authorise the acquisition of the shares by a resolution. If shares have been purchased, different shareholder and creditor protection rules are applicable. Of importance are, for example, the provisions which prescribe that all rights attached to the acquired shares are suspended. 4.1.4.4.2 Capital reduction 4.1.4.4.2.1 Legal framework The Swedish Companies Act provides for the possibility of a decrease in capital. In accordance with the 2nd CLD, a decrease in capital is subject to a shareholders’ resolution. A general meeting must therefore be called. A proposal to reduce the capital must be set down in the agenda for the general meeting. The resolution must be passed with a majority of at least 2/3 of the votes cast and shares represented at the general meeting – the same majority requirement applies within classes of shares. In accordance with the 2nd CLD the resolution must specify the purpose of the reduction in capital, particularly whether it serves to return capital to shareholders or to cover losses where unrestricted shareholders’ equity equal to the loss is not available or for transfer to a fund to be used pursuant to a resolution adopted by the general meeting and, furthermore, the way in which the capital reduction is to be effected – with or without withdrawal of shares. The capital reduction is also subject to the “prudence rule”, whereby the board of directors has to examine whether the planned value transfer is justifiable bearing in mind the amount of equity required by the type and size of the company. In line with the 2nd CLD the Swedish Companies Act requires the board to register the resolution with the Companies House within 4 months. 4.1.4.4.2.2 Economic analysis Within our sample of Swedish companies, we have not encountered any capital decreases.


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4.1.4.4.2.3 Protection of shareholders and creditors Regarding the shareholder and creditor protection existing with respect to capital reductions, it is of utmost importance that the shareholders have to agree to the capital reduction with a qualified majority. 4.1.4.4.3 Withdrawal of shares 4.1.4.4.3.1 Legal framework In Sweden, there is no general regulation on compulsory withdrawal, but the statutes may provide a redemption clause. However, a court may order the company to buy-out the shares of a shareholder. This is a remedy available to the court following fraud on minority shareholders. 4.4.4.3.2 Economic analysis In the course of the interviews conducted, we have not been made aware of cases of compulsory withdrawals. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.1.4.4.3.3 Shareholder and creditor protection Minority shareholder may be protected via the statutes or a court decision. 4.1.4.4.4 Financial assistance 4.1.4.4.4.1 Legal framework In Sweden, the amendments of the 2nd CLD Directive 2006/68/EC have not been implemented into national law. However, a parent company may provide financial assistance to a third party buying shares in a subsidiary (Ch. 21 Sec. 5 ABL). 4.1.4.4.4.2 Economic analysis As the changes to 2nd CLD have not taken effect, we have not been able to identify such cases with the Swedish companies interviewed. 4.1.4.4.5 Serious loss of half of the subscribed capital 4.1.4.4.5.1 Legal framework If there is reason to believe that more than 50% of the capital has been lost, the board must prepare a special balance sheet for liquidation purposes. If the balance sheet shows that there


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is less than 50% of the share capital remaining, the board has 8 months to restore the shareholders capital. 4.1.4.4.5.2 Economic analysis The Swedish companies interviewed spent very little time on the monitoring of this provision on the serious loss of subscribed capital. In general, they would see a significant increase in monitoring activity, if the financial position of the company showed indications that such a situation could actually occur. The management of the companies interviewed normally use their normal internal reporting and risk management systems to monitor the financial position of the company/group. This would give them sufficient lead time to recognise critical situations. 4.1.4.4.5.2 Shareholder and creditor protection The provisions dealing with the serious loss of the subscribed capital have a shareholder and also creditor protective character, as it sets conscious time limits to the companies’ directors to take action on the worsening financial position of the company. 4.1.4.4.6 Contractual self protection 4.1.4.4.6.1 Legal framework There is no regulation in Sweden concerning self protection of creditors respectively covenants. 4.1.4.4.6.2 Economic analysis The Swedish companies interviewed are exposed to covenants in connection with bank loans. These covenants do not directly limit distributions. They rather aim at limitations concerning the disposal of assets as well as cash-flow related ratios and change of control clauses. The strictness of the covenants depends on the credit rating of the company. The companies interviewed considered them easy to comply with as they could be determined in a simple manner by referring to annual account figures. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.1.4.4.6.3 Shareholder and creditor protection Covenants result from negotiations of major creditors with the companies willing to take loans. These protections are not primarily designed for smaller creditors and shareholders. However, they may benefit from them.


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4.1.4.5. Insolvency 4.1.4.5.1 Legal framework The issue of insolvency is not regulated in the Swedish Companies Act, but in the Insolvency Act. In general terms, a Swedish company is insolvent when it is not in a position to pay it debts when due and when this incapacity is not temporary. 4.1.4.5.2 Economic analysis The Swedish companies interviewed spent very little time on the monitoring of this provision on the serious loss of subscribed capital. In general, they would see a significant increase in monitoring activity, if the financial position of the company showed indications that such a situation could actually occur. The management of the companies interviewed normally use their normal internal reporting and risk management systems to monitor the financial position of the company/group. This would give them sufficient lead time to recognise critical situations.


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4.1.5 United Kingdom 4.1.5.1. Structure of capital and shares 4.1.5.1.1 Legal framework As regards equity financing by shareholders, the UK Companies Act 2006 (CA 2006) is based on the subscribed capital and on share premiums. According to s 542(1) CA 2006, shares must each have a fixed nominal value. An allotment of a share that does not have a fixed nominal value (no-par value share) is void. Structure of capital Subscribed capital Under the UK Companies Acts, a public company is required to have an authorised minimum share capital of £50,000. The authorised share capital, to which this minimum applies, is an upper limit, set out in the statutes, as to the aggregate nominal value of shares which the company may have. It need not allot all of this capital at incorporation (formation). The founders are entitled to freely fix a higher capital amount. The called-up share capital is not available for distributions to shareholders. Under the Companies Act 1985, founders of a public limited company are required to state in the memorandum of association the amount of the share capital with which the company proposes to be registered and the nominal amount of each of its shares. This is known in the UK as the "authorised share capital" and acts as a ceiling on the amount of capital which can be issued - although the limit may be subsequently raised by members’ ordinary resolution. Under the Companies Act 2006 the requirement for a company to have an authorised share capital is abolished. However, the founders of the company are free to limit the maximum share capital in the statutes. Premiums The British UK Companies Acts do not require the possibility of fixing premiums, yet such possibility is implicit in national law. Hence, the terms of a company’s statutes could require that its shares be allotted only at a specified premium. The amount of the premium is the real value (i.e., not accounting values) of the assets’ contributed in excess of the nominal value of the shares (Shearer v Bercain Ltd [1980] 3 All ER 295). If the company decides to issue shares at a premium, the premium must be added to the “share premium account”. Exceptions are for share-for-share transactions and subscription of non-cash assets intra-group (provided the subscriber and the issuer are within a wholly owned (portion of the) group). The share premium account is treated in virtually all respects as if it were subscribed capital. Thus, the share premium account is not available for distributions); if however it is dissolved in accordance with the rules on a formal reduction in capital, then the amount may be used to offset a deficit of distributable reserves or, unless the court specifies otherwise in the course of the reduction process, to create a surplus available for distribution; this latter is currently a matter of legal analysis but is expected to be codified in secondary legislation under powers set out in the 2006 Act. Moreover, UK law requires that premiums on formation must be in cash.


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Protection of the public company’s assets There is no statutory facility to return funds to shareholders other than by way of one of the 2nd CLD exceptions or by way of distribution. Structure of shares Under UK law shares must have a nominal value. The possibility of the 2nd CLD to allow the issuance of shares with an accountable par has not, therefore, been included in national law. 4.1.5.1.2 Economic analysis Practical relevance of subscribed capital and structure of shares for an assessment of the viability of a company The UK companies interviewed did not see any specific benefit of the legally imposed minimum subscribed capital of £50,000 for different reasons. Creditors would rather rely on other instruments such as covenants to secure their outstanding balances. Some companies remarked that this low number should rather be increased for listed companies. One respondent believed that the minimum capital requirement would rather drive his group to transform its UK subsidiaries into Ltds to be able to abandon the legal capital regime for PLCs. Another respondent remarked that it may be a theoretical sign of solidity and substance but in practice had no merit. Concerning the par value of shares, most of the UK companies interviewed generally did not see a specific merit. The companies are able to live with the concept but missed the practical relevance. One argument was that there is no fundamental difference between subscribed capital and share premiums as neither can generally be distributed. To verify the relevance of the subscribed capital figure for equity financing, we have additionally performed an analysis of certain ratios concerning subscribed capital for the main UK index FTSE 100: Figure 4.1.5-1: Ratio of subscribed capital to market capitalisation (United Kingdom)

UK: Subscribed Capital to Market Capitalisation

59%24%

10%

3%

4%

< 5%5% - 10%10% - 20%20% - 30 %> 30%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of September 2006


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Compared to the market capitalisation, the subscribed capital shows even a lower portion. For 59 percent of the FTSE 100 companies the subscribed capital represents less than 5 percent of their market capitalisation. Thus, the overall importance of subscribed capital figure seems to be marginal. Restriction for distribution However, the UK companies interviewed did not particularly question the distribution restrictions implied by the concept of legal capital. The latter was also reconfirmed by results from the CFO questionnaire sent to UK public companies. Figure 4.1.5-2: CFO survey results: necessity of subscribed capital (United Kingdom)



41%

48%

10%True

False

NA

Source: CFO questionnaire, September 2007 48 percent of the respondents considered the existence of subscribed capital to be necessary. This view was opposed by 41 percent of the respondents However, according to the respondents to the CFO questionnaire there is no interest in excessive restrictions on distributions:


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Figure 4.1.5-3: CFO survey results: level of subscribed capital (United Kingdom)



for distributions."

3%

86%

10% True

False

NA

Source: CFO questionnaire, September 2007 A clear majority of 86 percent of the respondents rejected the idea of increasing the level of subscribed capital to the highest extent possible to avoid distributions. Role of the subscribed capital in equity financing The subscribed capital figure as part of the wider equity of the company is necessary for the financing of the company. According to the companies interviewed, the subscribed capital is not sufficient for the equity financing of the operations of the company. For FTSE 100 companies, the ratio of subscribed capital to total shareholders’ equity shows that for 84 percent of the FTSE 100 companies the subscribed equity portion stays under 20 percent of total shareholders’ equity. Figure 4.1.5-4: Ratio of subscribed capital to total shareholders’ equity (United Kingdom)

UK: Subscribed Capital to Total Shareholder's Equity

36%

28%

20%

6%

10%

< 5%5% - 10%10% - 20%20% - 30 %> 30%

Source: One source: Subscribed capital for the FY 2005, shareholders’ equity (consolidated) for the FY 2005


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This underpins that the equity financing is not largely dependant on the subscribed capital and that there is a sufficient equity base in the FTSE companies and their subsidiaries to allow for adequate distributions. The existence of a subscribed capital does seem to be a stumbling block for the FTSE companies in their approach to equity financing and distribution policy from a group perspective. The following answers to the CFO questionnaire concerned the attitude of companies to capital increases: Figure 4.1.5-5: CFO survey results: Attitudes towards increases of subscribed capital (United Kingdom)


reasons."

69%

21%

10%True

False

NA

Source: CFO Questionnaire, September 2007 69 percent of the respondents stated that they usually try to keep the level of subscribed capital to the minimum amount necessary. Only 21 percent of the respondents opposed this view. These responses show that companies are generally not interested in a dominant role of subscribed capital in equity financing. Subsequent formations The UK companies interviewed are already in existence for a longer period. Therefore, it was neither feasible nor useful to extract data on the initial foundation of these companies. This is also true for the application of rules concerning subsequent formations. 4.1.5.2 Capital increase 4.1.5.2.1 Legal framework According to the 2nd CLD, UK law differentiates between different forms of capital increase and mechanisms which ensure that the subscribed capital is contributed to the company.


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Increase in capital 1985 Act Under the 1985 Act the initial authorised share capital is established in the memorandum of association required on the formation of the company. The memorandum must state the amount of share capital with which the company purposes to be registered and the different classes of the share capital into shares of fixed amounts (i.e. the nominal amount of each class of each share). This authorised share capital is a limit upon the capacity of the company itself. This is different from the question as to the authorisation of the directors to allot of such of its authorised share capital that is not yet allotted; this authorisation corresponds with that set out in Article 25 of 2nd CLD. Under the 2006 Act, there is no authorised share capital. Under the 1985 Act following the initial establishment of the authorised share capital, a company can increase its authorised share capital by passing an ordinary resolution (unless its statutes require a special resolution) in a general meeting of its members. A copy of the resolution and a notice of the increase must be filed on the public registry. There is no maximum amount of share capital established by UK law nor is there any period for which the increase occurs – the increase is (except in the case of reduction) permanent. There are however time limits on the actual allotment of share capital as discussed below. Under the 1985 Act, even though a company will have authorised share capital, the directors of the company do not have complete power to issue additional shares up the amount of the authorised share capital. The Act requires that in order for the directors to have such powers they need either consent of the shareholders (by the passing of an ordinary resolution by its general meeting – at which the different classes of shares have such voting rights as are set out in the statutes) or be so authorised within the statutes of the company. These powers granted are limited as the resolution is required to contain the maximum of shares that can be issued under that resolution and that the period of authority cannot exceed five years from the date of the resolution. 2006 Act Under the 2006 Act, the directors of the company do not have complete power to issue additional shares. The Act requires that in order for the directors to have such powers they need either consent of the shareholders (by the passing of an ordinary resolution by its general meeting – at which the different classes of shares have such voting rights as are set out in the statutes) or being so authorised by the statutes of the company. The powers granted under the 2006 Act are limited as the resolution is required to contain the maximum of shares that can be issued under that resolution and that the period of authority cannot exceed five years from the date of the resolution. When shares are actually allotted notification must be filed on the public registry within a month of the allotment. Other forms of capital increase Under the 2006 Act the company may allot bonus shares to its existing shareholders applying amounts previously credited to the share premium account, the capital redemption reserve, a revaluation reserve or, subject to the statutes, out of its unrealised or realised profits. The allotment is in essence a form of distribution.


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Contribution of premiums UK law allows the use of share premiums in the context of an increase in capital. The share premium account is treated in virtually all respects as if it were subscribed share capital. Mechanisms to ensure the contribution of capital Subscription of shares The 2006 Act prohibits shares being allotted by a public company pursuant to an offer for subscription unless all shares issued are subscribed for or the terms of the offer state otherwise. If the shares are not fully subscribed, the company has to return the monies received to the applicants. Furthermore, the 2006 Act prohibits a company from acquiring its own shares via subscription and extends this prohibition to its subsidiaries. In accordance with the 2nd CLD, UK law prescribes that they are issued at a discount off their nominal amount. A subscription of new shares does not require any change to the statutes unless, under the 1985 Act, it is necessary to increase the authorised share capital (statement of the total maximum capital and the classes and numbers of shares into which it is divided) to facilitate the subscription. Under the 2006 Act there is no concept of authorised share capital. Under both Acts it is, however, necessary to furnish a return of allotment to the registrar of companies, detailing the number and nominal value of shares allotted, the allotees and the consideration paid or payable. Contributable assets / paying in UK law requires that shares which are allotted by a company may be paid up in money or money’s worth (including goodwill and know-how). Only a quarter of the nominal value, along with the full amount of any premium, must be paid-up on allottment. Protection against over-valuations If shares are to be paid for other than in cash (as required by the 2nd CLD), a valuation report is generally required before the shares are allotted. The report must state the nominal value of the shares to be wholly or partly paid for by the consideration in question, the amount of any premium payable on the shares, the description of the consideration, the method used to value it, the date of valuation and whether the value covers the nominal value of the shares and any premium proposed to be treated as paid up by the consideration. Sanctions If a share is allotted at a discount to nominal value, the allottee is liable to pay up the discount in cash with interest at the appropriate rate. In the same way the allottee of a share allotted for less then one quarter paid-up or less then the full amount of any premium, must pay the shortfall in cash with interest. If the valuation report requirements (for non-cash consideration) are not complied with, the allottee is liable to pay the subscription price in cash. The company and any officer in default in incorrect financing are liable to a fine.


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Pre-emption rights UK law on pre-emption rights in the context of capital increases. The rights relate only to the allotment for cash of equity shares (shares carrying unrestricted rights both as to income and capital) or of securities that are convertible into such shares or that carry the right to subscribe for such shares. In addition the Act provides that the pre-emption rights may be excluded. The law governing such exclusion provides that when the directors are being authorised to issue the shares they may seek authority from the shareholders to exclude the pre-emption rights. In order to be granted such powers, the shareholders of the company are required to pass a special resolution (75% majority) at a general meeting. Alternatively the statutes may provide that pre-emption rights are automatically excluded where an allotment authority is granted. Furthermore, UK law contains the requirement that any permission can be given with a limited life (it cannot be longer than the outstanding period of the Section 80/ 551 authority – itself limited to five years) and hence the permission will cease if revoked or if it expires (without being renewed). 4.1.5.2.2 Economic analysis Capital increases can be very complex and require – especially in view of securities regulations – a high level of internal efforts and external costs. Lighter procedures come into play in connection with employee stock option programmes which are, from a compliance perspective, very easy to handle and involve few burdens. There are regularly shareholder pre-approvals for such increases. The increase in capital was used by the interviewed companies for major capital increases or acquisitions. Practical steps The following chronological order of practical steps would be necessary for such an ordinary capital increase: Figure 4.1.5-6: Process for ordinary capital increase (United Kingdom)


Step 1 Proposal of the board on how the company should be financed (amount of capital to be issued and allotted, amount of premiums)

Step 2 Invitation to general meeting to approve increase in authorised share capital (only required in cases in which the authorised capital does not suffice), to give directors authority to allot shares and on pre-emption rights

Step 3 Ordinary resolution[s] by shareholders on increase in authorised share capital, if needed, and authority to allot shares

Step 4 Special resolution by shareholders on pre-emption rights in case of cash consideration

Step 5 Filing of resolution approved by shareholders’ meeting and appropriate form with the Registrar of Companies

Step 6 Issuing of shares and filing requirements


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Analysis UK companies interviewed have not volunteered detailed information on such capital increases. We have received some total cost numbers which range between £6,000,000 to £9,000,000. Internal preparation can consume around 5,400 hours of highly qualified personnel. However, it should be kept in mind that these figures relate to very specific circumstances. The high costs are, to a large extent, also necessary to comply with securities market regulation. In practice, four UK companies interviewed regularly consult the general meeting for an approval of capital increases, mainly for employee stock option programmes. Of these companies, one has not made use of the authorisation. From a procedural point of view, it is mainly a repetitive shareholder resolution which the company reuses when it comes to the renewal. According to the estimates received the use of internal resources amounts to from 1 to 10 hours, partly highly and less qualified personnel, depending on the individual circumstances as well as the culture and organisation of the company. In one case, we received information concerning the engagement of external legal advisors charging around £5,000 to £10,000. The effort required is not linked to the size (market capitalisation) of the company. Due to the specific nature of the capital increases for stock options, the actual increase of shares is not overly burdensome. It requires between 1 and 80 hours of usually highly qualified personnel. Again, the workload and costs can vary from company to company depending on the individual circumstances. Incremental Costs HighQ LowQ Other Costs Hours spent 2 to 90 - - Hourly rate €100 €70 - €200 to €9,000 - €7,403 to €14,806 Total costs €7,603 to €23,806 Mechanisms to ensure the contribution of capital - contributions-in-kind None of the interviewed companies provided us with information on practical experiences with contributions in kind because it was irrelevant for them in recent years. Practical steps With respect to contributions in kind effected during a capital increase the following steps have to be taken under UK law:


126

Figure 4.1.5-7 Process for the injection of contributions (United Kingdom)


Step 1 Decision by the company as to number of shares to be issued and allotted Step 2 Determination of issue price (nominal price is fixed, the premium is variable)

Step 3 Monitoring if assets to be contributed are those the company may accept as consideration for the shares allotted

Step 4 Performance of valuation process with respect to contributions in kind Step 5 Filing of report

Step 6 Monitoring of subscription and allotment (no subscription by the company, in cases in which the offer for subscription does not state otherwise, no allotment of shares unless all shares offered have been subscribed for)

Step 7 Monitoring that shares are not issued under the nominal value Step 8 Filing of documents with registrar Analysis Unfortunately, we were not able to retrieve any specific recent cost information on practical cases of contributions in kind during our interviews with UK companies. 4.1.5.2.3 Protection of shareholders and creditors Regarding the provisions on capital increase, one can draw the following conclusions under the aspect of shareholder and creditor protection. Firstly, it should be noted that the requirement that the shareholders according to the 2006 Act have to agree to the capital increase has a shareholder protective character. Furthermore, the provisions on the authorisation of the board contain elements which are shareholder protective as the authorisation must be stated in the statutes. The fact that the authorisation period is limited to five years and that the general meeting has to fix the maximum amount of shares that can be issued are shareholder protective. In this respect, UK law contains further protective provisions, as it is necessary to furnish a return of allotment to the registrar of companies, detailing the number and nominal value of shares allotted, the allottees and the consideration paid or payable. The 2006 Act also requires a statement of capital to be furnished to the registrar, detailing the post-allotment share capital of the company (number, nominal value, amounts paid-up including premium and share rights). To ensure that equal treatment in contributions takes place, UK law prescribes the drawing up of a report by an independent expert in case of contributions in kind to protect shareholders against over-valuations and their consequences. Under the aspect of shareholder protection, the mandatory pre-emption rights for contributions in cash are furthermore of importance as they prevent dilution. 4.1.5.3 Distributions 4.1.5.3.1 Legal framework UK provisions on distributions differentiate between provisions dealing with the calculation of the distributable amount, the determination of the amount to be distributed and the consequences of incorrect distributions.


127

Calculation of the distributable amount Under UK law, a public company may not make a distribution if, at the time of the distribution or to the extent that immediately after the distribution, its net assets are less than the aggregate of its called-up share capital and (defined) undistributable reserves. A company’s undistributable reserves are i) the share premium account (i.e. that pursuant to Article 26, ii) the capital redemption reserve (i.e. that pursuant to Article 39(e)), iii) the excess amount of unrealised profits over unrealised losses, iv) any other reserve which is prohibited from being distributed by another enactment or by its statutes. The redenomination reserve (which exists only under the 2006 Act) is also undistributable. Net assets mean a company’s total assets (not including uncalled share capital) less its total liabilities (including provisions) as shown in usually the last annual accounts under the 4th CLD. Furthermore, it should be noted that, under UK law, a public company can only make distributions out of its accumulated, realised profits, so far as not previously distributed or capitalised, less accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital. The maximum amount that can be distributed under this principle (and under (aa)) is determined by reference to the profits, losses, assets, liabilities and share capital and reserves as stated in (usually) the company’s annual accounts, under the 4th CLD, laid before members in general meeting. A profit is a realised profit if it is generally accepted as so for accounting purposes. Pursuant to that section there are various pieces of authoritative accounting guidance in relation to determining what profits are realised, issued by the Institute of Chartered Accountants in England and Wales (ICAEW) jointly with Institute of Chartered Accountants of Scotland (ICAS). These are listed in the general information section of this document.5 Put simply, whilst the starting point for determining realised profits is the accounts profits, this is far from the end of the matter. First of all not all accounts profits may be realised. Second, some accounting losses may not be losses for the purposes of company law (e.g., accrual of capital repayment, on liability classified preference shares, presented as an interest charge on a liability). Third, some items are profits as a matter of law but not for accounting purposes (e.g., contribution of capital otherwise than for share capital). Thus the accounting profits must first be adjusted to add in some items and take out others; and then what is left must be further narrowed down to leave only the realised items. Put briefly, and subject to the question of fair value accounting, something is realised if is in the form of cash, an asset readily convertible to cash, a debtor meeting certain conditions or elimination of a liability (collectively, called Qualifying Consideration). In relation to fair value accounting, the key is whether the asset or liability that is so accounted is itself readily convertible into cash. This requires that an asset can be immediately cashed-in, e.g. by being able to close out the position; that observable market data for this are available; and that the company can actually dispose of/ close out the position, e.g. without needing to curtail its business or accept adverse terms. Taking the net assets and earned surplus tests together, the effects of accounting under IAS 32 (and its UK equivalent – FRS 25 – applied in annual accounts of companies that do not adopt IFRS) are complex and a source of difficulty in application. The ICAEW guidance in this area (TECH 2/07) devotes considerable material to this topic. The effect of IAS 32 is in some cases to recognise a liability in relation to a share (typically a preference share) or in relation to a written option to acquire the company’s own shares in the future. The first complicates 5 Cf. s275 (1985), s841 (2006) for guidance on realised profits and losses for revalued fixed assets. Cf. s268 (1985); s843 (2006) for guidance on realised profits for insurance companies with long term business.


128

the operation of the net assets test but does not necessarily change its result: since share capital and net assets are to be determined according to the accounts, both are reduced equally. On the other hand, the latter case restricts distributions. This is because when the liability to purchase the share is recognised, net assets are reduced and a debit is taken directly to reserves. The debit does not fall to be included (as a deduction from) share capital and undistributable reserves and thus distributions are restricted (net assets are reduced but share capital etc. is not). This is so notwithstanding that the debit is not, as a matter of law, a loss and thus cannot be a realised loss. (It is not a loss because, as a matter of law, the amount is the advance recognition of a future capital repayment or distribution.) Thus not only are the rules difficult to comprehend and apply in the context of modern accounting practice, but they have an adverse effect on companies’ distributable reserves. Modern accounting practice is also having the effect of including ever more fair values in the accounts. This has the effect of straining or creating a disconnect between accounting profits and distributable profits on the realised earned surpluses test. As a result, there is a strong climate of opinion in the UK (e.g., it is the position of the ICAEW that the usefulness and operability of a distribution test based upon accounting measures (including pursuant to IAS 32) calls for a fundamental re-appraisal of the distribution regime with the aim of breaking that link. Connection to accounting rules The balance sheet profit is determined with reference to the annual accounts which must be drawn up in accordance with national UK GAAP or IFRS. The annual accounts must be audited except where the company is considered to be small. As under UK law, a public company can only make distributions out of its accumulated, realised profits, the question whether a profit is considered as “realised” is of the utmost importance. An accounting profit under UK GAAP is not immediately considered as “realised”. There are various pieces of authoritative accounting guidance in relation to determining what profits are realised, issued by the Institute of Chartered Accountants in England and Wales (ICAEW) jointly with Institute of Chartered Accountants of Scotland (ICAS). Determination of the distributable amount – responsibilities Under the standard Table A statutes (the default statutes of a company under the CA 1985 unless it adopts something different), a distribution can be decided on by the directors or be declared by the members in general meeting by a simple majority. In the latter case the amount must not exceed that recommended by the directors. As regards the content of the resolution, there is no specific national provision. The resolution will be documented in the minutes of the board or general meeting (as appropriate). In the case of a dividend to be approved by shareholders, typically the amount of the proposed dividend per share, the date on which the dividend will be paid and the date on which the shareholder must be included on the company’s register of shareholders to be entitled to the dividend, will be given. The distribution would be considered unlawful unless it is supported by the accounts. There is no specific procedural requirement to check the accounts, but sanctions apply if the distribution is unlawful. But note that if the accounts relied upon are the annual accounts (4th


129

CLD), they must first be laid before the general meeting; if they are interim accounts, they must be filed on the public registry. Sanctions UK law provides for different instruments for the case that the distribution was not in line with the aforementioned provisions. Firstly, if an illegal distribution has been made this would give rise to a claim by the company against the recipients of the dividend who knew or have reasonable grounds for believing that the distributions are unlawful. There is also the possibility under case law for recovery to be sought from the directors, cf. recovery for an illegal distribution to be sought from the directors - Bairstow vs Queens Moat Houses Plc [2001] 2 BCLC 531. Where a member receives an unlawful distribution and at the time of the distribution, he knew or had reasonable grounds to know that the distribution had been unlawfully made, he is liable to repay it. See s277(1985); s847 (2006). 4.1.5.3.2 Economic analysis The actual UK practice of profit distributions pointed to some particularities which we did not encounter in other EU jurisdictions. One particularity of the UK system is the fact that the differentiation between accounting profits and realised profits causes the companies to make adjustments to their accounting figures under UK GAAP. With one exception, IFRS are not used by the UK companies interviewed for specific reasons. This reconciliation requirement may be difficult to comply with depending on the extent that the companies use fair value measurements in their accounts. Severe practical problems and burdens for the companies seem to be linked to the necessity to channel sufficient profits and cash up to the parent company. Every few years, some of the interviewed companies spend enormous amounts of time and external costs to secure sufficient profit and cash levels at the parent company in order to distribute dividends. However, it is debatable if these efforts are actually linked to company law requirements or whether they are rather driven by tax optimisation efforts. We have encountered similar practical needs in other EU Member States but were not pointed to severe burdens in this respect. The most efforts of the company concern the preparation of the dividend proposal for the board. The actual payment also may present a major effort. However, the costs are linked to capital market requirements and depend on the number of shareholders.


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Practical steps The series of practical steps comprises: Figure 4.1.5-8: Due process for distributing profits (United Kingdom)


Step 1 Directors establish the value of the distribution they wish to make

Step 2 Directors consult the relevant accounts of the company and authoritative accounting guidance to see if sufficient distributable reserves exist.

Step 3 Directors consider whether circumstances have arisen subsequent to the date of the relevant accounts which have reduced the distributable reserves calculated in step 2.

Step 4 If required following Step 3, the directors revise the value of the distribution they wish to make.

Step 5 Where insufficient distributable reserves exist to cover the amount to be distributed, but profits have subsequently been earned and assets have built up accordingly, directors draw up properly prepared interim accounts.

Step 6 The interim accounts are filed with the registrar

Step 7 Dividend is either approved by the Board (ALTERNATIVE A) or declared by shareholders in general meeting (ALTERNATIVE B)

ALTERNATIVE A: Dividend authorised by the directors Figure 4.1.5-9: Process of dividend distribution authorised by the directors (United Kingdom) Step 8 Board meeting of the Directors held Step 9 Board resolves to pay the dividend Step 10 Resolution is documented in board minutes

Step 11 Update of Step 3 (Consideration of whether profits have been lost since last annual accounts) before payment of dividend

Step 12 Dividend is paid. ALTERNATIVE B: Dividend declared by the shareholders Figure 4.1.5-10: Process of dividend distribution declared by the shareholders (United Kingdom)

Step 8 Update of Step 3 (Consideration of whether profits have been lost since last annual accounts)

Step 9 General meeting of the shareholders is held Step 10 Shareholders vote on the proposed distribution

Step 11 Shareholders pass an ordinary resolution declaring the dividend and dividend becomes a liability of the company

Step 12 Declaration is documented in minutes of general meeting Step 13 Dividend is paid. TOTAL


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Analysis Calculation of the distributable amount From an economic point of view, the establishment of the dividend proposal typically involves the CFO and CEO and other selected high ranking company representatives preceded by preparations in the company’s administration (treasury, tax and/or accounting departments). As the level of dividends is also a political decision concerning the attractiveness of the shares to investors, investor relation experts may also play a significant role in the elaboration of the dividend proposal. The dividend proposal is subsequently subject to a discussion in the company’s board. The intensiveness of the discussion in the board depends on the specific importance of dividend levels for the performance of the shares of the company. In determining the distributable amount, all companies referred to the consolidated financial statements of the company, not the individual financial statements which are the legally decisive set of accounts. Partly, the companies have published explicit dividend policies which base their distribution on certain percentages of their net earnings based on the consolidated financial statements. Furthermore, companies interviewed considered other relevant aspects like dividend continuity and return on investment. Finally, companies interviewed assessed the effects of certain dividend levels on the future cash flow situation of the company / group. The results of a CFO questionnaire sent to UK companies listed on main indices reconfirm this: Figure 4.1.5-11:Determinants for the distribution of dividends in the holding company (United Kingdom)


1,961,97

3,39

3,97

2,82

4,14

2,122,153,063,642,96

4,22

1

2

3

4

5


accounts)



Dividendcont inuity


Tax rules

Determinants

Impo

rtan

ce

UKEU Average

Source: CFO Questionnaire, September 2007 However, the CFO questionnaire shows that the responding CFOs rank legal restrictions on profit distribution higher than market led solutions like rating agencies’ requirements or bank covenants.


132

Figure 4.1.5-12: Important deterrents when considering the level of profit distribution (United Kingdom)


2,392,141,97

3,48

2,65

2,252,163,44

1

2

3

4

5





Deterrents

Impo

rtan

ce

UK

EU Average

Source: CFO Questionnaire, September 2007 A particular point that seemed to cause substantial burdens for the UK companies interviewed is the issue of bringing sufficient profits and cash into the parent company. Several companies interviewed conduct a “restructuring programme” every few years to channel the profits/cash to the parent level. These efforts can take internal efforts of 80 to 860 hours of highly qualified personnel and external advisor fees ranging from £30,000 to £500,000. However, as this planning effort may be largely based on tax optimisation any effort in this respect could also be considered non-incremental. Again, the results of a CFO questionnaire sent to UK companies listed on main indices show the importance of tax considerations: Figure 4.1.5-13: Determinants for the distribution of dividends by the subsidiaries (United Kingdom)

"What ar the determinants for the distribution of dividends by your subsidaries?"

2,563,07

4,07

2,743,144,07

1

2

3

4

5


Determinants

Impo

rtan

ce

UK

EU Average

Source: CFO Questionnaire, September 2007 Connection to accounting rules All UK companies interviewed use IFRS for their consolidated accounts. The majority of companies interviewed use UK GAAP for their individual accounts, only one uses IFRS. The very distinctive UK practice of differentiating between accounting profits and realised profits imposes an additional burden on some of the UK companies interviewed. One company spends ½ of a man-year (1,040 h) of highly qualified personnel in the adjustments for its


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individual accounts. Another company estimates its burden at 100 hours of highly qualified personnel. Other, mainly smaller companies do not show differences between accounting and realised profits due to the nature of their business. In general, we have gained the impression that UK companies do not seem to put much effort into distinguishing between accounting and realised profits if they do not use fair value accounting and at the same time have large “headroom” in profits. Partly, the companies interviewed indicated reasons why IFRS are not chosen for the individual statements. The reasons include certain accounting treatments which seem unfavourable under IFRS, e.g. the off-setting of pre-acquisition retained earnings from the book value of the investment or the creation of unrealised profits under IAS 39. Another reason may be the lack of appropriate transitional measures for the introduction of IFRS. Determination of the distributable amount From an incremental cost perspective, all UK companies interviewed considered the preparation of board meetings to establish the value of the distribution to take the most efforts. The total time spent on this process amounts to between 30 and 160 hours of highly qualified personnel of the company. The time effort needed varies depending on the culture and organisation of the individual company and cannot be clearly linked to certain size criteria. Most companies reported a time effort of about 40 hours of highly qualified personnel. Usually, the tax, legal and finance department participate in the preparation. The second considerable effort concerns the actual payment of dividends. Depending on the individual arrangements of the companies and the number of shareholders, paying the dividends will cost several hundred thousand British pounds. The UK companies interviewed estimated the incremental cost of Alternative A and B (with or without involvement of the general meeting) to be the same as the general meeting would be held anyway. The companies interviewed do not generally seem to engage external legal advisors in this process and rather use in-house solutions. The remaining steps were considered to be non-incremental as, from the companies’ perspective, they did not originate from the compliance with distribution provisions such as the original preparation of the accounts, the annual audit or, in case of Alternative B, the holding of the annual general meeting. Regarding the establishment of alternative cash-flow projections to be used in the distribution process, all companies interviewed had a very detailed cash flow planning for at least one year. However, this planning is based on internal rules on how to prepare such projections and is clearly linked to the business needs of these companies. Companies interviewed mainly project their cash flows over a time period of three to five years. One company makes forecasts over a period of ten years. One particular practice of UK companies interviewed concerned the delivery of an annual “going concern report” by the company’s management, specifically mentioned by two companies interviewed. It is a by-product of the company’s internal operational efforts to have a good understanding of the company’s cash flow position. The specific effort to prepare such a report can be estimated at up to 32 hours of highly qualified personnel. “Going concern


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reports” are regarded as common UK practice. This report is regularly reviewed by the external auditors. Sanctions Concerning the efforts to comply with provisions concerning incorrect dividend distributions, the companies interviewed generally considered the risk of liability for the company’s management to be low. The reason for this is mainly the high compliance effort invested in the distribution process. Related parties There were also no significant risks seen concerning the monitoring of the relationships with related parties and potential other refluxes of funds to shareholders. However, this could depend on the individual shareholder composition of a company. Incremental Costs HighQ LowQ Other Costs Hours spent 30 to 1,200 - - Hourly rate €100 €70 - €3,000 to €120,000 - - Total costs €3,000 to €120,000 4.1.5.3.3 Protection of shareholders / creditors Under the aspect of shareholder and creditor protection, one can draw the following key conclusions from the above mentioned provisions on distributions. Firstly, it should be noted that the clearly formulated legal distribution limitations, including, in particular, the subscribed capital and the premiums as well as the structured link to the audited financial statements, provide legal certainty. The authoritative accounting guidance by the ICAEW and ICAS helps to transform accounting profits into realised profits and, thus, takes a more realistic view whether profits under UK GAAP are realised. This may also help shareholder and creditor protection as the guidance seems to be aimed at securing the viability of the company. Furthermore it should be noted that, under UK law, a distribution can be decided on by the directors or be declared by the members in general meeting by a simple majority (in this case the amount must not exceed that recommended by the directors). This leads to less shareholder protection in comparison to the countries in which only the general meeting can decide on the allocation of the profits. The national provisions prescribing the liability of members of the board for losses caused by unlawful distributions are also shareholder protective. Regarding creditor protection, the obligation of the shareholders to return to the company any payment received contrary to the Companies Act is of importance. 4.1.5.4 Capital maintenance The principle of capital maintenance in UK Company Law is usually discussed in connexion with four main categories: distributions (see above), share buy-backs, capital reductions, and financial assistance. Furthermore, measures in case of a serious loss of capital and creditors’ contractual self-help are important.


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4.1.5.4.1 Acquisition by the company of its own shares 4.1.5.4.1.1 Legal framework The general rule is that a company may not acquire its own shares. There are, however, a number of exceptions to this. There may be an acquisition and holding of shares (treasury shares), an acquisition and cancellation without reduction or various other cases. Own shares can be acquired according to a shareholders’ resolution (majority, time frame, content) stating a certain amount of fully-paid shares and having regard to a guarantee that net assets are not affected. A maximum of 10% of each class of qualifying shares may be held by the company at any one time. Purchases via a recognised investment exchange (“market purchases”) must be authorised by a shareholder resolution (simple majority). Such a resolution may relate to a specific purchase or be general but must specify the maximum number of shares that can be acquired, a maximum and minimum price that may be paid, and contain an expiry date (not more than 18 months after the date of the resolution). Different rules apply for purchases of shares otherwise than via a recognised investment exchange (“off-market purchases”). In overview, the terms must be authorised by a special resolution (75% majority) and the resolution must state a date by which the authority will expire, such date not to exceed 18 months from the date of the resolution. The ability of a company to purchase treasury shares (or make any other type of distribution of profits) is also controlled by the “net assets test”. This allows a distribution (or purchase of treasury shares) to be made only if the amount of the company’s net assets is not less than the aggregate of its called-up share capital and undistributable reserves and provided that the distribution (or purchase of treasury shares) would not reduce the company’s net assets below this amount. The company must deliver to the registrar of companies a prescribed form stating each class of share purchased as well as the number and nominal value of those shares and the date on which they were delivered to the company. In addition, public companies shall also state the aggregate amount paid by the company for the shares; and the maximum and minimum prices paid in respect of shares of each class purchased. This requirement goes beyond the requirements of the 2nd CLD. Other, general exemptions from the prohibition of a company acquiring its own shares are as follows: acquisition otherwise than for valuable consideration (no restrictions); acquisition as part of a reduction in capital (no restrictions); acquisition as a result of a court order as a result of alteration of the company’s objects (1985 Act only), or relief to members unfairly prejudiced (as the court may order); and the acquisition as a result of forfeiture by a shareholder for failure to pay an amount due on the shares. The national legislation does not contain provisions relating to acquisition of own shares explicitly on the grounds of avoiding harm to the company. If a company acquires its own shares when this does not fall within one of the permitted exceptions above, the company is liable to a fine and the directors responsible are liable to a fine, imprisonment or both and (other than for purchases of treasury shares) the transaction is void. In the event that the rules governing the maximum holdings of treasury shares are


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contravened, the company must dispose of or cancel the excess shares within 12 months of the date on which the contravention occurs. Where shares are held, the company may not exercise voting rights in respect of such shares. Provided such shares are not cancelled, the existing balances in share capital and share premiums in respect of these shares remain unchanged. The costs of acquiring the shares must be met from distributable profits. Where a company acquires shares in itself and those shares are shown in the balance sheet (albeit that this is no longer permitted under UK GAAP or EU adopted IFRS), an amount equal to the value of those shares is transferred out of profits to a non-distributable reserve. Companies accounting under UK GAAP that hold treasury shares must disclose the number and aggregate nominal value of such shares held. With respect to the resale of treasury shares, UK law prescribes the same rules as for the issue for new shares. These require that the existing shareholders are first offered the chance to purchase the shares on terms at least as favourable as any external offer. 4.1.5.4.1.2 Economic analysis In the United Kingdom, the amendments to the 2nd CLD in the year 2006 have not yet been enacted in UK legislation (dropping of the 10 percent limit, prolongation of the authorisation by another five years). Thus, the interview results still refer to the current UK arrangements for the acquisition of the company’s own shares. From a company law perspective, most efforts go into the proposal for the authorisation to purchase such shares. However, the actual buyback of shares will regularly result into much higher costs which are, from a compliance perspective, mainly related to securities regulation. We have only received some rough data on the total cost of the buybacks which underpin this assumption. Nevertheless, only incremental costs invoked by company law are relevant to this analysis. Thus, these costs resulting from securities legislation are remarkable - but not from an incremental cost perspective. Practical steps To acquire its own shares a company has to follow this process: Figure 4.1.5-14: Process for the acquisition of own shares (United Kingdom)


Step 1 Ascertain whether the company’s articles permit the purchase of treasury shares. Step 2 Proposal of board to acquire (and hold) own shares.

Step 3 Shareholders’ meeting called, with requisite notice (at least 14 days, given in writing).

Step 4

If purchase is from the market, ordinary resolution (simple majority) by shareholders specifying maximum number of shares that may be acquired, maximum and minimum prices that may be paid and date on which authority expires (no more than 18 months hence). If purchase is off-market, the contract must be approved in advance by special shareholder resolution (75% majority); again such a resolution must specify when the authority for the purchase expires (a maximum of 18 months hence).

Step 5 Directors ensure that adequate distributable profits are available by reference to relevant accounts and authoritative accounting guidance, and consider whether there has been any loss of distributable profits since those accounts.


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Step 6 Purchase is made, subject to shares being fully paid-up, total holding not exceeding limit of 10% of nominal value of shares.

Step 7 Return with details of purchase submitted to registrar of companies within 28 days (a return also has to be made for any subsequent cancellation or disposal of treasury shares).

Step 8 Information given in the annual accounts and directors’ report. Analysis Nearly all UK companies interviewed (two exceptions) have an authorisation by the general meeting to the company’s management to acquire shares of the company. Three companies of our sample are making use of their authorisation and actually acquire shares of the company. These companies have permanently been buying back shares and regularly renew their authorisations in this regard. Within the legal process, there are several steps that require preparations mainly by the company’s departments responsible for legal matters and for treasury. The first step is the proposal by the management board which takes between 2 to 40 hours of preparation of highly qualified personnel. This proposal is regularly an update of pre-existing documents which have been elaborated at the time of the initial introduction. The actual buyback is handled differently from company to company. The amounts charged by external advisors and facilitators are quite substantial and the data we have received on this from the companies ranges altogether between £150,000 and £2,000,000. Internal preparations may amount to up to 200 hours of highly qualified personnel. It has to be kept in mind that these costs seem to a large extent to be related to requirements from the securities market and, thus, may not be considered incremental cost from a company law perspective. The buyback has to be submitted to the registrar. This activity is partly outsourced. We have not been able to obtain details on the associated costs. If handled internally, preparations may take around 100 hours of highly qualified personnel. Another step is the preparation of the notes to the accounts to inform about the repurchase of shares. Depending on the complexity of the buyback activity, the average time effort will be between 10 and 80 hours of highly qualified personnel. In general, we have not noticed significant deviations in the work load between different sizes of companies. It rather depends on the level of activity of the company in this regard. Incremental Costs HighQ LowQ Other Costs Hours spent 12 – 120 - - Hourly rate €100 €70 - €1,200 to €12,000 - - Total costs €1,200 to €12,000


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4.1.5.4.1.3 Protection of shareholders and creditors Under the aspect of shareholder and creditor protection, one can draw the following key conclusions from the above mentioned provisions on the acquisition by a company of its own shares. Firstly, it should be noted that, with respect to the most important case of acquisitions of a company’s own shares – purchases via a recognised investment purchase (“market purchases”) – the shareholders have to authorise the acquisition of the shares by a resolution which can be valid for a maximum period of 18 months, which is shareholder protective. Furthermore, the provisions which limit the amount of the shares which can be acquired (the 10% threshold) and the provision which requires the “net assets test”, aim at protecting shareholders and creditors. Furthermore, the obligation to deliver to the registrar of companies a prescribed form stating each class of share purchased as well as the number and the nominal value of those shares and the date on which they were delivered to the company, is creditor and shareholder protective. The same applies to the obligation of public companies to state the aggregate amount paid by the company for the shares; and the maximum and minimum prices paid. If shares have been purchased, different shareholder and creditor protection rules are applicable. Of importance are, for example, the provisions which prescribe that voting rights attached to the acquired shares are suspended. Also of importance is the provision, which applies when the shares are not cancelled, that the existing balances in share capital and share premiums in respect of these shares remain unchanged and the costs of acquiring the shares has to be met from distributable profits. With respect to the reselling of the company’s own shares, under UK law, the same rules as for the issue for new shares apply. These require that the existing shareholders are first offered the chance to purchase the shares of terms at least as favourable as any external offer and this must be characterised as shareholder protective. 4.1.5.4.2 Capital reduction 4.1.5.4.2.1 Legal framework Under UK Law all public company capital reductions must be permitted by the statutes (1985 Act only) and resolved upon by the members (75% majority) and be confirmed by the court prior to the reduction being undertaken. The court has power in all cases to ensure that creditors have been consulted, been paid off or been secured. As part of the court process, legislation provides that, where the proposed reduction of share capital involves either diminution of liability in respect of unpaid share capital, the payment to a shareholder of any paid-up share capital, or in any other case if the court thinks it fit, every creditor of the company who at the date fixed by the court is entitled to any debt or claim which, if that date were the commencement of the winding-up of the company, would be admissible in proof against the company is entitled to object to the reduction of capital. The so-called convert/discharge procedures may, however, be dispensed with if, having regard to the circumstances, the court thinks it proper to do so. In practice companies always seek to have the court dispense with the procedures by demonstrating to the court that the creditors’ positions are adequately safeguarded. If the court has been satisfied as to the consent/safeguarding of the creditors it may make an order confirming the reduction in capital on such terms and conditions as it thinks fit. The “simplified” procedure under Article 33 (1)) has not been included into UK law.


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The recently amended text of the 2nd Company Law Directive which must be implemented by 15 April 2008, to changes Article 32 with respect to the burden of proof has not already been implemented into national law nor is there currently any proposal in this context. 4.1.5.4.2.2 Economic analysis Within our sample of UK companies, we have not encountered any capital reductions. Especially the larger companies of our sample had conducted capital reductions at subsidiary level in order to gain distributable reserves at the level of the parent company. However, these took place under the laws of several jurisdictions. 4.1.5.4.2.3 Protection of shareholders and creditors Regarding the shareholder and creditor protection existing with respect to capital reductions, firstly the requirement that the shareholders have to agree to the capital reduction with a qualified majority, is of importance. Furthermore, the safeguards to creditors, which have, under certain circumstances, the right to obtain security, are creditor protective. 4.1.5.4.3 Redeemable shares 4.1.5.4.3.1 Legal framework UK law provides for redeemable shares. Furthermore, UK law provides for the redemption of the company’s own shares. Not possible is redemption of the subscribed capital without reduction of the latter. In accordance with the 2nd CLD, a company may, if authorised to do so by its statutes, issue shares which, according to their terms (in the statutes), are liable to be acquired and cancelled, either mandatorily or at the option of the company or the shareholder. These are referred to as redeemable shares. The company may also have a general power in its statutes to acquire and cancel shares even though the shares in question are not so liable according to their terms. This is referred to as a purchase of shares. The procedures for a purchase are the same as for redemption of redeemable shares (except that the paragraphs referring to market purchases and off-market purchases are not relevant to the redemption of redeemable shares). Redeemable shares may not be redeemed unless they are fully paid-up. Redemption may only be out of distributable profits or the proceeds of a fresh issue of shares made for the purposes of the redemption. The shares redeemed are treated as cancelled and share capital must be reduced by the nominal value of the shares. Other than where the share capital has been replaced by new share capital from a fresh issue of shares, the reduction in capital must be replaced by a corresponding increase in the capital redemption reserve, which may not be reduced (other than in the same manner as share capital). When a company redeems its shares, the company must make a return of specified particulars to the public register.


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4.1.5.4.3.2 Economic analysis We have not encountered any cases of capital redemption. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.1.5.4.3.3 Shareholder and creditor protection Regarding the issuance of redeemable shares, it is, with respect to shareholder and creditor protection, firstly of importance that it is only permissible if the company is authorised by its statutes to issue redeemable shares. Furthermore, the provisions that redeemable shares may only be redeemed if they are fully paid-up and that a redemption may only be made out of distributable profits or the proceeds of a fresh issue of shares made for the purposes of the redemption, are shareholder and creditor protective. 4.1.5.4.4 Financial assistance 4.1.5.4.4.1 Legal framework Financial assistance by a company for the acquisition of its own shares is generally prohibited. There are, however, some exceptions, principally in respect of lending of money in the ordinary course of business and assisting employees to acquire shares in the company. The recent amendments to the 2nd CLD have not been implemented in the UK, nor is there any current, published proposal to do so. 4.1.5.4.4.2 Economic analysis As the changes to 2nd CLD have not been implemented, there could not have been any practical cases in the course of the interviews with UK companies. 4.1.5.4.5 Serious loss of half of the subscribed capital 4.1.5.4.5.1 Legal framework Under UK law, the directors of the company shall call an ordinary general meeting where the net assets of a public company are half or less of its called-up share capital. The purpose of the general meeting is to consider whether any, and if so what, steps should be taken to deal with the situation. 4.1.5.4.5.2 Economic analysis The UK companies interviewed spend very little time on the direct monitoring of this provision on the serious loss of subscribed capital. In general, they would see a significant increase in monitoring activity if the financial position of the company showed indications that such a situation could actually occur. The management of the companies interviewed normally use their normal internal reporting and risk management systems as well as cash


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flow projections to monitor the financial position of the company/group. The reporting on debt covenants can also help in this regard. This would give them sufficient lead time to recognise critical situations. 4.1.5.4.5.3 Shareholder and creditor protection The provisions dealing with the serious loss of the subscribed capital have a shareholder and also creditor protective character, as the general meeting gets the possibility to decide on safeguarding measures. 4.1.5.4.6 Contractual self protection 4.1.5.4.6.1 Legal framework Under UK law it is entirely usual for certain creditors to negotiate the terms of contractual protections with companies. As long as these are not illegal under any statutory provision any such terms are permitted. There are no standard contracts prescribed, though banks and similar financial institutions will normally try to impose their institution’s standard terms. However, each case is negotiated on its own facts. The most common contractual protections are security for lending (fixed or floating charges); financial covenants in relation to lending (e.g. ratio based); retention of title over stock; invoice discounting (factoring) of debts; and guarantees from other parties. 4.1.5.4.6.2 Economic analysis All UK companies have to adhere to certain covenants. The existence of such covenants is a matter of negotiation with the banks. Most of the UK companies interviewed have covenant in the format of financial ratios in loan agreements which are mainly contracted with UK banks. These covenants do not usually provide direct restrictions on profit distributions. Instead they refer to certain debt/income and cash flow related ratios that try to capture the business of the company. These may under certain conditions indirectly result in restrictions on profit distributions. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.1.5.4.6.3 Shareholder and creditor protection Regarding the aspect of creditor protection it should be noted, that covenants are based on private law contracts which are, however, often used in the UK. By these covenants only individual creditors are directly protected. However, shareholders might be protected by these agreements indirectly insofar, as they aim at the long-term viability of the company.


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4.1.5.5 Insolvency 4.1.5.5.1 Legal framework In the UK there are several different types of insolvency process ranging from those to promote rescue of the company to winding up and dissolution. These are described in the Insolvency Act 1986. There is also one process contained in the Companies Acts, the Scheme of Arrangement, which may be used to compromise the claims of creditors outside an insolvency process. According to the Insolvency Act 1986, a company is unable to pay its debts if: • a statutory demand (a formal demand that a debt be paid) is served on the company for a

sum exceeding £750 and remains unpaid for 21 days thereafter, • the execution of a court order to enforce a debt could not satisfy the whole of the debt

due, • it is proved to the satisfaction of the court that the company cannot pay its debts as they

fall due (cash flow test), • it is proved to the satisfaction of the court that the value of the company’s assets is less

than the amount of its liabilities, taking into account prospective and contingent liabilities (balance sheet test). The inclusion of prospective and contingent liabilities makes this a difficult test to apply. However, the test is not a strict one but one for the court’s discretion.

However, there is no formal timeframe for applying these tests, as they are occurrences instigated by creditors which the directors cannot predict. In practice, responsible directors will take advice if these events occur on anything more than a one-off basis. The exact point at which insolvency is inevitable (by which time the directors must act in the creditors’ interests and enter insolvency proceedings) is dependent on the specific facts of each case and is not set down by statute. There is a general common law test of “a director having reasonable knowledge, skill and care”. The courts will thus look at what a director ought to have done in that light. Again, there is substantial case law, but see Re Produce Marketing Consortium [1989] 5 B.C.C. 569. There is no statutory obligation on the directors to commence insolvency proceedings. However the directors are open to statutory liability once they know that there is no prospect of avoiding insolvent liquidation. 4.1.5.5.2 Economic analysis Similarly to the provision on the serious loss of subscribed capital, the UK companies interviewed spent very little time on the monitoring of insolvency triggers. Again, they would generally see a significant increase in monitoring activity if the financial position of the company showed indications that such a situation could actually occur. The management of the companies interviewed normally use their normal internal reporting and risk management systems to monitor the financial position of the company/group. This would give them sufficient lead time to recognise critical situations.


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4.1.6 Conclusions for the five EU Member States The 2nd CLD sets the most significant provisions concerning capital regimes in the European Union. All five EU Member States under consideration stick closely to the 2nd CLD; there are few significant additional protective measures in national legislation. This can be explained by the fact that the main legal instruments used by these EU Member States start from the basis of the 2nd CLD and that there is only limited room for deviations in favour of differing approaches. In most cases, we found less important deviations – also with respect to the incremental costs - arising from the transformation of the 2nd CLD into national legislation where EU Member States use explicit options or discretions contained in the 2nd CLD, interpret not clearly defined areas or provide for additional provisions where the 2nd CLD does not contain any rules (e.g. in the field of sanctions). Deviations of importance also with respect to the costs were rather seldom and were found in particular with respect to the use of IFRS and the question of what can be understood by realised profits. The compliance cost concerning the 2nd CLD company law requirements are generally low for companies interviewed throughout the five EU Member States; significant costs rather arise outside the area of the core company law requirements, specifically with regard to securities legislation (e.g. capital increases; acquisition of own shares). Main pillars of the capital regime in the European Union Structure of capital A main pillar of the current capital regime of the European Union is the structure of capital that is based on the concept of a subscribed capital. Each company must have a minimum subscribed capital that consists of the nominal values or accountable pars of the shares. In the process of formation or capital increase, the subscribed capital has to be contributed and this amount is accounted for in a specific balance sheet position which is protected from distributions. In addition, the EU capital regime foresees that shares can be issued with a premium. The premium amount has to be accounted for in a specific reserve. The capital regime as embedded in the 2nd CLD offers shares with a nominal value (par value shares) or, alternatively, shares with an accountable par, so called „notional“ no-par value shares. Nominal value describes the amount of the contribution which must be paid to subscribed capital. For shares with an accountable par it is characteristic that every no-par value share represents the same fraction of the subscribed capital as that in which all no-par value shares participate in the subscribed capital. Capital increase For the injection of additional equity capital after the formation of the company, the 2nd CLD offers the legal instrument of the capital increase. The contributions received from the issuance of new shares will be assigned to the subscribed capital or, if applicable, to the premium reserve. Furthermore, the 2nd CLD prescribes that a capital increase can only be effectuated if the general meeting so decides via a resolution. The general meeting can also authorise the management of the company to increase the subscribed capital within certain limits for a period of up to 5 years (“authorised capital”). Another important element is pre-emption rights that have to be granted to shareholders in the case of cash contributions. These could only be waived via a resolution of the general meeting.


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Moreover, the 2nd CLD determines for all EU Member States how capital will be raised, in the first place for formations and subsequently for capital increases. This includes the obligation to sign-up for a certain amount and to take over shares that equal at least that portion of subscribed capital (prohibition of below par emissions). It also concerns the question of whether a potential contribution is actually contributable and the issue of expert valuations for contributions in kind. Distributions The 2nd CLD prescribes the legal framework for dividend distributions. The EU model refers to the distribution of the profits of the audited individual financial statements that must be determined under the national GAAP derived from the 4th CLD or, alternatively, under IFRS applied to the individual accounts. Distributable are the profits from the current accounting period and other retained profits from previous periods. Capital maintenance The 2nd CLD provides different instruments to maintain the capital of the company. This includes provisions on the acquisition of the company’s own shares which start from a general prohibition on the acquisition by a company of its own shares but allow several exemptions. This is specifically possible if there is a resolution by the general meeting authorising the acquisition and if the amount of acquired shares is limited to ten percent of the subscribed capital and the net assets of the company are not impinged by this transaction. Beyond this, the 2nd CLD provides for a range of different exceptions which include, for example, the case that the acquisition is necessary to prevent the company from suffering a major harm. Furthermore, the 2nd CLD provides for additional provisions in this respect dealing, for example, with treasury shares (the rights linked to them and the necessity to account for a reserve) as well as the consequences arising from acquisitions or shares held in contravention of the provisions of the 2nd CLD. In view of the required authorisation of the general meeting, there are further differences concerning the required quorum in the general meeting. Furthermore, there are provisions for the reduction of subscribed capital, which in a normal course envisage a shareholder resolution and particular creditor protection rights. Moreover, there are provisions on the compulsory withdrawal of shares, redeemable shares, share redemptions and the amortisation of shares. Also in this respect, the 2nd CLD provides for different shareholder and creditor protective provisions, in particular provisions which link the reduction of the shares to an authorisation by the statutes or the general meeting and the necessity that the net assets are not affected by the transaction. Finally, the 2nd CLD contains a prohibition of financial assistance which was, however, liberalised by Directive 2006/68 EC of 6th December 2006. Structure of capital and shares Subscribed capital The five EU Member States under consideration have all set a minimum subscribed capital in national laws that exceed the minimum subscribed capital required under the 2nd CLD of €25,000 by at least 100 percent. France is the only one of the five EU Member States that differentiates between the minimum subscribed capital of listed companies and those of other companies.


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Figure 4.1.6 – 1: Minimum subscribed capital in the five EU Member States Minimum subscribed capital

Listed companies [€]

Other companies [€]

France 225,000 37,000 Germany 50,000 50,000 Poland 131,000 131,000 Sweden 50,000 50,000 United Kingdom 72,000 72,000 2nd CLD 25,000 25,000 The practical relevance of the subscribed capital for an assessment of the viability of a company has generally been seen as low by the companies interviewed in the five EU Member States. These companies and their “peers” like banks, rating agencies and analysts, rather look at other equity figures like “net equity” and “market capitalisation”. A survey of CFOs of listed companies in the major stock indices of the five EU Member States showed that responding companies did not particularly question the distribution restriction implied by the concept of legal capital. In each country, with the exception of Poland, which had a poor return rate, the majority of CFOs was not in favour of lifting the necessity of legal capital because it constitutes a barrier for distributing excess capital. Figure 4.1.6 – 2: Importance of subscribed capital (EU comparison)

0%

10%20%

30%

40%50%

60%70%

80%

90%100%

Perc

enta

ge

F rance Germany Po land Sweden U K EU A verag e

"In general, we do not consider stated/subscribed capital to be necessary; it unnecessarily reduces our company's flexibility to distribute excess capital."

TrueFalse NA

Source: CFO Questionnaire Concerning the role of the subscribed capital in the equity financing of companies, an analysis of the relation of subscribed capital to the shareholders’ equity for the main stock indices in the five EU Member States has shown that the subscribed capital as part of the wider equity of the companies is necessary for the equity financing of the operations of these companies. This was confirmed in the interviews conducted with selected companies of different sizes throughout the five EU Member States.


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Figure 4.1.6 – 3: Ratio of subscribed capital to shareholders equity (average for 5 EU Member States)

Average for 5 EU States: Subscribed Capital to

Total Shareholder's Equity

33%

26%

20%

9%

12%< 5%5% - 10%10% - 20%20% - 30%> 30 %

Source: Onesource: Subscribed capital for the FY 2005, shareholders equity (consolidated) for the FY 2005. These figures illustrate that the equity financing is not largely dependant on the subscribed capital and there is sufficient equity base to allow for adequate distributions. The existence of subscribed capital does not seem to be a stumbling block for the companies in the main stock indices of the five EU Member States in their approach to equity financing and distribution policy from a group perspective. Premiums For the five EU Member States under consideration, there is a mixed picture with regard to a potential distribution of these premiums to shareholders. In the UK, premiums are treated in the same way as subscribed capital; in Germany and Poland, premiums can, under certain circumstances, be used to offset losses, so that the premiums are protected from distributions in these Member States. In France and Sweden, the premiums belong to the distributable amount to shareholders. Figure 4.1.6 – 4: Permissibility to distribute premiums in the five EU Member States Premiums Distributable France Yes Germany No Poland No Sweden Yes United Kingdom No Furthermore, some of the EU Member States under consideration extend the protection of the company’s capital beyond the subscribed capital and the premiums. In Germany, for example, the total assets of the company are protected and cannot be subject to distributions to shareholders except for those resulting from a formal distribution resolution. This also includes transactions with shareholders that are not conducted at “arm’s length”. In Sweden, the concept of value transfer plays a decisive role. This concept prohibits value transfers of sums so large as to leave the restricted equity without full coverage after the transfer


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(monetary barrier). In France, further limits to distributions can follow in particular from the prohibition on the misuse of the company’s funds (“abus de biens sociaux”). Structure of shares For the five EU Member States under consideration, there is again a mixed picture. France and Germany allow both shares with a nominal value and an accountable par. The United Kingdom and Poland have only shares with nominal values. Sweden has introduced shares with accountable par since it enacted its new Companies Act in 2006; all Swedish companies had to change over to shares with accountable par and amend their statutes accordingly. Interviews with companies have shown that there is no significant difference seen in shares with a nominal value and shares with an accountable par. However, the administration of shares with an accountable par is considered to be slightly less burdensome. This was also specifically reconfirmed by the Swedish companies interviewed. Capital increase For ordinary capital increases, there are deviations concerning the required quorum for resolutions. The 2nd CLD provides for a minimum of two thirds of the votes or the subscribed capital represented by the shares. The required majority varies in the five EU Member States under consideration from two thirds of the votes up to three quarters of the subscribed capital represented. Furthermore, it has to be noted that capital increases in France have to take place in the context of an extraordinary general meeting that, however, can be linked to an ordinary general meeting. Concerning authorised capital increases, the 2nd CLD requires, besides a shareholder resolution or a clause in the statutes, a maximum duration of the authorisation of five years. It is also required that the authorisation can only be exercised up to a maximum amount. The authorisation period in Germany and the UK amounts to five years, in France to 26 months (execution within five years); the maximum amount is limited in Germany to half of the subscribed capital, in Poland to three quarters of the subscribed capital; in France and the UK, the maximum amount is set by the general meeting. For pre-emption rights, there are deviations concerning the question whether the provisions are only applicable to cash contributions or, alternatively, also applicable to contributions in kind. In Germany and Poland, there are provisions that are also applicable to contributions in kind. Moreover, there are differences concerning the required quorum of the general meeting for the exclusion of pre-emption rights. Concerning the burdens associated with capital increases, it has to be noted that the companies interviewed considered the actual burdens stemming from company law to be marginal in comparison to those resulting from securities regulation. The most burdensome aspect is the preparation of prospectuses which requires a high effort of internal and external resources to prepare. Such costs form the major part of total figures indicated to us, e.g. for the companies interviewed: £6,000,000 to £9,000,000 for UK companies, €1,000,000 for a German company or PLN620,000 for a Polish company. There are also differences in how capital increases are actually conducted by the companies interviewed. For the French and German companies interviewed, it is popular to mainly increase capital via authorisations to the management board; they have not used any ordinary


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capital increase processes in the recent past. Reasons for this are the inflexibility of the latter processes. One German company also expressed concerns that the ordinary capital increase process is too vulnerable in view of possible legal challenges from “professional shareholder activists” who seek to receive extra compensation for not further pursuing their legal proceedings in courts. The Polish companies interviewed, on the other hand, mainly use ordinary increases; one company that had an authorised capital let it expire without using it. Companies interviewed in the UK showed a mixed picture where authorisations had been used in connection with stock option programmes. The incremental burdens to comply with company law requirements are relatively low. The preparation of the proposal to the general meeting is mainly handled in-house and takes from 1 to 40 hours of highly qualified personnel. External legal costs which are used in some cases are also moderate and are normally in the range of several thousand Euro or even covered by general service agreements with law firms. The holding of the general meeting is considered as non-incremental as it is used for other purposes anyway. The cost portion to be allocated to the resolution on the capital increase is insignificant. In France, a specific extraordinary meeting must be held for such kinds of resolutions. However, in general French practice, such meetings seem to be linked to the ordinary general meetings. Therefore, the French companies interviewed saw the extra cost for such extraordinary meetings as insignificant. For the issuance of shares, the incremental burdens ranged from 1 to 80 hours of highly qualified personnel. This process is typically supported by banks which charge fees for this service; again, these fees are normally moderate in the range of several thousand Euro. In France, a specific form of service has emerged to support the administrative side of the capital increase procedure. There, so called “formalistes” professionally handle the registration aspects of French companies; again, costs seem to be moderate. For the specific form of contributions-in-kind, we have only found a few cases with the companies interviewed. Moreover, we have not received any relevant cost data on the necessary steps to be taken. However, we were reassured by the companies interviewed that the most significant burden is the formal valuation of the contribution in kind. This includes not only the costs for an external expert but also internal preparations for such a valuation. However, the actual burdens of such an endeavour depend on the complexity of the valuation object. In general, burdens are typically not linked to the size of a company and rather depend on specific circumstances at the individual company. Distribution All five EU Member States have implemented the 2nd CLD restrictions on profit distributions in the form of dividends. In general, the balance sheet profit is the profit for the financial year after setting off losses and profits brought forward as well as sums in mandatory and optional reserves. Nevertheless, there may be significant deviations due to the fact that individual EU Member States only permit their national GAAP (France, Germany, Sweden). Poland also uses IFRS for profit distribution purposes; interviews showed no particular problems at the Polish companies concerning the use of IFRS. The UK offers national GAAP as well as IFRS to its companies; however, the UK companies interviewed nearly all used UK GAAP as it was considered more favourable concerning certain accounting treatments. A second reason relates to the fact that the UK GAAP accounting profits are regularly adjusted to “realised profits” for distribution purposes under guidelines prepared by two major accountancy institutes ICAEW and ICAS. For IFRS, there is no final guidance in this respect. Furthermore,


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the determination of distributable profits may be influenced by the existence of differing mandatory reserves which the companies must build-up. Table 4.1.6 – 5: Characteristics of balance sheet tests and solvency tests (EU comparison) France Germany Poland Sweden United

Kingdom Balance sheet test(s) Statutory testing requirement

Balance sheet net assets test / earned surplus test





Mandatory accounting basis in accordance with 4th CLD or IAS Regulation

French GAAP German GAAP Polish GAAP / IFRS

Swedish GAAP

UK GAAP / IFRS

Modification of the accounting basis

No No No No ICAEW / ICAS guidance

Distribution allowed, if (initial) balance sheet test is not met

No No No No No

Additional requirements in company legislation

No No No “Prudence rule”

No

Concerning the importance of the current legal restriction on profit distribution, a CFO questionnaire sent to the companies listed in the main indices of the five EU Member States showed the following results: Figure 4.1.6 – 6: Deterrents to distributions (EU comparison)

1

2

3

4

5

Impo

rtan

ce

F rance Germany Po land Sweden U K EUA verage


Distribut ion/Legal capital requirements

Rating agencies' requirements

Contractual agreements with creditors(covenants)Possible violat ions of insolvency law

Source: CFO questionnaire, September 2007 This shows that the legal restrictions concerning profit distribution are considered by the responding CFOs as more important than market led solutions like rating agencies’ requirements or bank covenants.


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From an economic point of view, the determination of the distributable profits shows a certain lack of any connection between economic reality and the European Union’s legal restrictions on profit distribution. The regular practice of the companies interviewed – and not only in the EU – showed that dividend levels are subject to a “political decision” by the company’s management with a view to its share price. This includes aspects like dividend continuity or giving certain signals to the capital market. The consolidated accounts and consolidated cash flow situation form the starting point for such a decision, i.e. decisions are taken from a group perspective. The results of a CFO questionnaire sent to the companies listed in the main indices of the five EU Member States reconfirm these experiences: Figure 4.1.6 – 7: Determinants of distribution for holding companies (EU comparison)

1

2

3

4

5

Impo

rtan

ce

F rance Germany Poland Swed en U K EUA verage


Fin. performance (group accounts)

Financial performance (individual accounts ofthe parent company)Dividend cont inuity

Signalling device

Credit rat ing considerat ions

Tax rules

Source: CFO Questionnaire, September 2007 To bring the parent company’s financial situation in line with the group perspective, the companies interviewed in nearly all cases steer the profits and cash flow situation of the parent company. This is mostly done in a structured planning process over several years, mainly to achieve tax optimisation for intra-group distributions. Especially some UK companies have pointed to high expenditures in this regard. Again, the results of a CFO questionnaire sent to the companies listed in the main indices of the five EU Member States show the increased importance of tax rules:


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Figure 4.1.6 – 8: Determinants of distributions by subsidiaries (EU comparison)

1

2

3

4

5

Impo

rtan

ce

F rance Germany Po land Sweden U K EUA verag e

"Whate are the determinants for the distribution of dividends by your subsidiaries?"

Demands f rom the ult imate parentTax rulesOwn investment decisions

Source: CFO Questionnaire, September 2007 Concerning the profit distribution process, the incremental burden ranged between 2 and 50

hours of highly qualified personnel. In the UK, the transition from accounting profits to realised profits took in specific cases up to 1200 hours of highly qualified personnel where certain accounting treatments were heavily used. The holding of a general meeting, the preparation of accounts as well as the statutory audit of the accounts is considered as not incremental or insignificant. Capital maintenance Acquisition by the company of its own shares All five EU Member States have used the options of the 2nd CLD to exempt companies from the prohibition of repurchasing their own shares. In France, Germany and the UK, companies can acquire their own shares based on an authorisation by the general meeting up to a limit of 10 percent of the subscribed capital; in Sweden this is also the case though under additional conditions. The necessary quorum for the authorisation of the general meeting varies in the different Member States. Furthermore, most of the Member States made an extensive use of the other options allowing the acquisition of the company’s own shares. Several Member States impose additional provisions as to he publication of the acquisition. With respect to the holding of treasury shares, differences exist, for example, in so far as some Member States (Germany and France) provide that not only the voting rights but all rights attached to the shares are cancelled. The redemption of shares is permitted in all five EU Member States. With respect to the reselling of the company’s own shares, there are provisions only in some of the five EU Member States, e.g. Germany and the UK.


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Figure 4.1.6 – 9: Conditions for the repurchasing of own shares (5 EU Member States) France Germany Poland Sweden United

Kingdom Revised

2nd CLD 2006

1. General authorisation for any purpose

Yes Yes No Yes, for listed

companies

Yes Yes

Selected criteria: Resolution by the general meeting

Yes Yes N/A Yes Yes Yes

Maximum percentage of subscribed capital

10 % 10 % N/A 10 % 10 % No limitation (Member

State option) Maximum authorisation period

18 months 18 months N/A 18 months 18 months 5 years

Performance of a balance sheet test

Yes Yes N/A Yes Yes Yes

2. Specific conditions for certain situations

Selected situations: Serious and imminent harm to company

- Yes Yes - - Yes

Distribution to employees

Yes Yes Yes - - Yes

Capital reduction/ Withdrawal of shares

Yes Yes Yes Yes Yes Yes

Repurchasing commission by financial institution

- Yes Yes - - Yes

Gratuitous acquisition of fully paid-up shares

- Yes Yes Yes Yes Yes

Protection of minority shareholders

- Yes - - Yes Yes

Universal succession

- Yes Yes Yes Yes Yes

Securities trading - Yes Yes - - Yes None of the five EU Member States has so far implemented the most recent changes of the 2nd CLD. Authorisations of share buybacks have been a very common feature for the EU companies interviewed. We have encountered them in all five EU Member States. The time effort required for the proposal amounts from 2 to 80 hours of highly qualified personnel. Mostly, the proposal is a routine mechanism which requires a regular update of existing material. As the matter may be legally complex, there is a second opinion on the proposal by an external law firm. The acquisition is mainly conducted via banks or brokerage houses which handle the actual buyback of shares to differing degrees. In some of the five EU Member States there is also an extensive reporting requirement to the local securities regulator on share


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repurchases. This may require enormous effort but as it stems from securities regulation it is not relevant as an incremental burden. Capital reduction / share redemption The procedure of capital reduction is very similar between the five EU Member States. In most of the Member States, the simplified reduction procedure (following the objective to cover losses) is possible; in the UK this provision has not been implemented. Regarding the other means to reduce the number of shares, the following picture exists: France, Germany, Poland and the UK permit a compulsory withdrawal of shares (Sweden allows for redemption clauses in the statutes). The amortisation of shares only exists in France and the possibility to issue redeemable shares in the UK. We have not encountered a single case of an ordinary capital reduction in the interviews conducted with EU companies. Concerning share redemption, we have seen some cases but have mostly not been able to retrieve detailed cost data. Thus, a general characterisation of the associated burdens is not possible. Serious loss of subscribed capital The provision concerning serious losses of subscribed capital is enacted in the five EU Member States without significant differences. In France, Germany, Sweden and the UK, the duty exists to call a general meeting if the half of the subscribed capital is lost. In Poland, this duty already takes effect when there is a loss of a third of the subscribed capital. In the practice of the companies interviewed, this provision does not play an immediate role in the daily operations of the company. The board of directors will usually monitor the general financial situation via at least monthly internal reporting instruments which allow an assessment of the financial position of the company. Companies would have to significantly step up their monitoring once they enter into difficult financial circumstances. Incremental cost table for the five EU countries The following table summarises the incremental cost implied by the national regulations of the five EU Member States based on the 2nd CLD. A detailed definition of incremental cost can be found in the methodology section of this report.


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4.1.6 – 10: Incremental costs for the five EU Member States France

€ Germany

€ Poland

€ Sweden

€ UK €

EU Average

€ Capital Increase

€12,260 to

€16,750

€8,500 to €42,000

€55,634 No data €7,603 to €23,806

€27,774

Distribution €1,600 to €2,700

€1,000 to €15,000

€210 to €5,443

€3,000 to €4,000

€3,000 to €120,000

€15,596


€53,300 to

€55,400

€50,300 to €50,500

€2,800 to €10,960

No data €1,200 to €12,000

€29,558

Capital reduction

No data No data No data No data No data No data

Redemption/ Withdrawal of shares

No data €500 to €1,000

No data No data No data €750

Contractual Self Protection


Concerning the shareholder and creditor protection arguments please refer to the sections on the individual EU Member States.


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4.2 Comparative analysis - situation in non-EU countries 4.2.1 USA – MBCA 4.2.1.1 Introduction The modern corporation law emerged in the United States (US) at the end of the 19th century6. The corporate structure was used to pool financial resources needed to realise the big construction projects at that time. Corporate attributes such as those protecting shareholders were designed to make the investment an attractive one. Because most of those projects were of local scale only, their oversight was initially left to the individual states. Furthermore, the founders of the US had considered and defeated provisions for federal incorporation7. Thus, US corporations still remain organised under state laws with the consequence that there are, in general, 50 different corporation statutes. A US corporation can be formed in any state, no matter where it does business. Management can choose the state of incorporation and therefore the law that will govern the corporation’s internal affairs, including procedures for corporate actions and the rights and duties of shareholders, directors, and officers. As an unintentional result of state regulation, the states began to compete with each other to attract corporate registrations and the revenue that followed them. States simplified the registration process and gave protections and other benefits to those corporations that were established under their laws. Today, the undisputed champion of this competition is Delaware8. More than half of the publicly traded corporations are incorporated in Delaware9. Efforts to harmonise the US corporation law have been made since the 1920s10. The National Conference of Commissioners on Uniform State Laws published a Uniform Business Corporation Act in 1928. However, this Act was not widely adopted and was finally withdrawn. Another attempt to harmonise the corporation law was undertaken by the American Bar Association in the 1940s. They created the Model Business Corporation Act (MBCA) which was published for the first time in 1950. The MBCA was designed as a model corporation statute to be enacted in its entirety by the state legislatures. Since then, the Model Act has been revised regularly. Far-reaching revisions to the financial provisions of the MBCA were adopted in the early 1980s. They were made part of the overall revision of the 6 For further details on the historical sources of the US corporate law cf. Choper/Coffee/Gilson, Cases and Materials on Corporations, 6th edition, 2004, pp. 15-27; Palmiter, Corporations, 5th edition, 2006, pp. 7-8. 7 Cf. Henn/Alexander, Laws of Corporations and other Business Enterprises, 3rd edition, 1983, p. 25. There is, however, an extensive federal presence through federal securities laws that affects the internal affairs of corporations. 8 Some commentators describe this process as a “race to the bottom”. Others argue that competition among the states produced efficiency and benefits for investors and call it a “race to the top”. For further details on this debate cf. e.g. Gevurtz, Corporation Law, 2000, pp. 41-43; Choper/Coffee/Gilson, Cases and Materials on Corporations, 6th edition, 2004, pp. 24-25. 9 Cf. Bainbridge, Corporation Law and Economics, 2002, p. 16. There is empirical evidence that the majority of corporations either incorporate in their home state, i.e. the state where the corporate headquarters is located at, or in the state of Delaware. Cf. Bebchuk/Cohen, Firms’ Decisions Where to Incorporate, Harvard Law Review, Vol. 105 (2003), pp. 394-396. There are a number of explanations for Delaware’s dominance: The Delaware General Corporation Law is designed to give management flexibility in structuring and running the business. There is a large body of case law interpreting the Delaware statute which provides certainty to corporate decision makers. Further, Delaware courts and corporate bar have great experience in corporate law matters. 10 Cf. Eisenberg, The Model Business Corporation Act and the Model Business Corporation Act Annotated, The Business Lawyer, Vol. 29 (1974), pp. 1407-1428; Booth, A Chronology of the Evolution of the MBCA, The Business Lawyer, Vol. 56 (2000), pp. 63-67; Model Business Corporation Act Annotated, 3rd edition, 2002 (2005 Supplement), Introduction, pp. 27-30.


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MBCA in 198411. The MBCA in its current version has been characterised as a modern, comprehensible, and rationally structured text of law12. Contrary to the Uniform Business Corporation Act, the MBCA emerged as a set of laws of national significance and remarkable influence. Today, approximately 30 states have adopted the MBCA in its entirety or for the most part and many other states have adopted selected provisions13. Moreover, the Model Act is frequently cited as the source of or the authority for current state statutes and in state and federal court decisions14. The commentary on the MBCA, the Model Business Corporation Act Annotated, is often used to interpret adopted provisions. As a consequence, by now, there is a considerably high degree of uniformity between the states compared to former times. However, it has to be pointed out that the states, although having adopted the MBCA in general, do not enact the constantly added revisions and amendments immediately and simultaneously. Furthermore, court decisions play an important role in interpreting and in filling in the gaps of the statutory rules. State court decisions are usually based on the particular state law and, as a consequence, case law may differ from state to state. Finally, the most prominent corporate law states of Delaware, New York and California have their own unique corporation statutes. The MBCA regulates all aspects of corporate existence, including the formation of a corporation (Chapters 1 to 5), financial rights of shareholders (Chapter 6), the rights and duties of shareholders, directors, and officers (Chapters 7, 8), and structural changes such as the amendment of articles of incorporation and bylaws, mergers and dissolutions (Chapters 10 to 14). The most important provisions on capital formation, capital maintenance and distributions are described in the following15. 4.2.1.2 Capital formation Pursuant to § 6.01(a) MBCA, the articles of incorporation must prescribe the classes of shares and the number of each class that the corporation is authorised to issue. § 6.01(b) MBCA leaves the design of the shares to the parties in the business transaction, but subject to the requirements that among all the classes of shares authorised, there must be shares that have unlimited voting rights and shares that are entitled to receive the residual net assets of the corporation upon dissolution. § 6.03(c) MBCA requires that at all times shares having these two characteristics must be outstanding. The 1980 amendments to the Model Act eliminated the concepts of stated capital and par value. In the US, practitioners and legal scholars long ago recognised that these concepts are not only complex and confusing but also fail to meet the original purpose of protecting creditors and senior security holders from payments to junior security holders and are

11 Because of the substantial amendments, rewriting and consolidation of the MBCA, the Act was renamed Revised Model Business Corporation Act (RMBCA). In 1994, “Revised” dropped from the name of the Act. Cf. Booth, A Chronology of the Evolution of the MBCA, The Business Lawyer, Vol. 56 (2000), p. 63; Palmiter, Corporations, 5th edition, 2006, p. 9. For a description of how the new statute was developed cf. Hamilton, Reflections of a Reporter, Texas Law Review, Vol. 63 (1985), pp. 1455-1470. 12 Cf. Manning, Assets in and Assets out: Chapter VI of the Revised Model Business Corporation Act, Texas Law Review, Vol. 63 (1985), p. 1530. 13 Cf. Model Business Corporation Act Annotated, 3rd edition, 2002 (2005 Supplement), Introduction, p. 27. 14 Cf. Booth, A Chronology of the Evolution of the MBCA, The Business Lawyer, Vol. 56 (2000), p. 63. 15 For a very readable description of these provisions at a glance cf. Manning/Hanks, Legal Capital, 3rd edition, 1990, pp. 180-192. For an in-depth description including official comments, case summaries, and statutory cross references cf. Model Business Corporation Act Annotated, 3rd edition, 2002.


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therefore misleading to the extent security holders and creditors believe in their protection16. Nonetheless, § 2.02(b)(2)(iv) MBCA permits a corporation to state a par value in its articles of incorporation if it wishes to do so. The consideration of the shares issued is determined by the board of directors (§ 6.21(b) MBCA), or by the shareholders if the articles of incorporation so provide (§ 6.21(a) MBCA). There are virtually no restrictions on the kind of the consideration received for the issued shares. The consideration may consist of any tangible or intangible property or benefit to the corporation, including cash, promissory notes, services performed, contracts for services to be performed, or other securities of the corporation. “For purposes of buying shares, John Rockefeller’s promissory note and Barbara Streisand’s contract for a future concert performance are now recognised as the valuable economic assets that everyone but lawyers always knew they were.”17 Before the corporation issues shares, the directors must, however, determine that the consideration received or to be received for them is adequate (§ 6.21(c) MBCA). While exercising their business judgment as to the adequacy of consideration received, the directors have to meet the standards of conduct set forth in § 8.30 MBCA. The only obligation of a purchaser of shares from the corporation is to pay the consideration. § 6.22(a) MBCA specifies that upon the transfer of the consideration as determined by the board, the shareholder has no further responsibility to the corporation or its creditors. § 6.30 MBCA adopts an “opt in” approach for pre-emptive rights. No pre-emptive rights exist unless they are explicitly included in the articles of incorporation. If the corporation opts in, § 6.30(b) MBCA provides a standard model for pre-emptive rights. 4.2.1.3 Capital maintenance Definition of distribution The revision of the MBCA in the 1980ies led to a radical simplification and modernisation of the provisions relating to distributions. The distribution requirements of § 6.40 MBCA apply the same tests to all types of distributions. § 1.40(6) MBCA defines “distributions” to include “direct or indirect transfer of money or other property (except its own shares) or incurrence of indebtedness by a corporation to or for the benefit of its shareholders in respect of any of its shares. A distribution may be in the form of a declaration or payment of a dividend; a purchase, redemption, or other acquisition of shares; a distribution of indebtedness; or otherwise.” The MBCA abolished the legal capital concepts of stated capital, capital surplus (paid-in surplus, revaluation surplus, reduction surplus), and earned surplus as well as the tests that varied with the type of distribution. Instead, distributions may be made if two tests are passed: the equity insolvency test and the balance sheet test. In addition, limitations upon distributions under the articles of incorporation have to be obeyed (§ 6.40(a) MBCA). 39 states have adopted dividend provisions substantially similar to the ones of the MBCA18. Distributable amount Under the MBCA, the declaration of dividends is generally left to the discretion of the board of directors and protected by the business judgment rule. However, directors have to obey any

16 Cf. Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.21, pp. 64-65. 17 Manning/Hanks, Legal Capital, 3rd edition, 1990, p. 180. 18 Cf. Black, Corporate Dividends and Stock Repurchases, 2006, § 3:1.


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restrictions in the articles of incorporation and the applicable provisions of the Act, which are described in the following. Equity insolvency test Distributions to shareholders are prohibited if the corporation is, or as a result of the payment would be, insolvent in the equity sense19. § 6.40(c)(1) MBCA provides that “no distribution may be made, if, after giving it effect (…) the corporation would not be able to pay its debts as they become due in the usual course of business.” The equity insolvency test focuses on the main interests of creditors. The creditors’ primary concern is to know if the corporation generates enough cash to repay its debts. It is questionable, however, under what circumstances a corporation is solvent in terms of § 6.40(c)(1) MBCA20. There are strong indications that the equity insolvency test is met if the corporation operates under normal conditions, has significant shareholders’ equity, regularly audited financial statements and no qualification in its most recent auditor’s opinion concerning the corporation’s status as a “going concern”. If the corporation faces difficulties concerning its operation and liquidity the directors have to address the issue and evaluate the future financial position in detail. The directors have to determine if the predicted demand for the corporation’s products and services will generate cash flows over a period of time sufficient to meet its existing and anticipated obligations when due. Furthermore, they have to determine the future ability to borrow additional money or to refinance indebtedness which matures in the near future. Contingent liabilities have to be taken into consideration, too. Finally, there “may be occasions when it would be useful to consider a cash flow analysis, based on a business forecast and budget, covering a sufficient period of time to permit a conclusion that known obligations of the corporation can reasonably be expected to be satisfied over the period of time that they will mature.”21 Balance sheet test In addition to the equity insolvency test a proposed distribution must meet the balance sheet test22 of § 6.40(c)(2)MBCA. It requires that, after the distribution, assets must equal or exceed the sum of liabilities and the dollar amount that would be needed to satisfy the shareholders’ superior preferential rights upon liquidation if the corporation were to be dissolved at the time of the distribution. Therefore, a solvent corporation that does not have outstanding shares with liquidation preferences can declare a distribution which will leave no shareholders’ equity23. Accounting methods The balance sheet test of § 6.40(c)(2) MBCA is inherently dependent upon the accounting methods used in determining assets, liabilities and equity. The MBCA leaves a lot of

19 The test is called equity insolvency test, because it was used in equity courts to determine the debtor’s solvency. Cf. Manning/Hanks, Legal Capital, 3rd edition, 1990, pp. 63-65; Palmiter, Corporations, 5th edition, 2006, p. 535. 20 For the following cf. Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.40, p. 198-199. 21 Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.40, p. 199. The commentary, however, does not define the term “sufficient period of time”. 22 The test is also referred to as the bankruptcy insolvency test, because it was applied by law courts to determine the debtor’s solvency. Cf. Manning/Hanks, Legal Capital, 3rd edition, 1990, pp. 64-65; Palmiter, Corporations, 5th edition, 2006, p. 540. 23 Cf. Gevurtz, Corporation Law, 2000, p. 162.


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leeway24. Pursuant to § 6.40(d) MBCA the board of directors may base the test either on financial statements prepared on the basis of accounting practices and practices that are reasonable in the circumstances, or on a fair valuation method, or on another method that is reasonable in the circumstances. Therefore, the directors may depart from historical cost accounting and revalue their assets above historical cost. The drafters of the MBCA did not mandate a specific accounting system like the US generally accepted accounting principles (US GAAP), because they wanted to achieve a high degree of flexibility and considered the needs of the different types of corporations which are subject to these provisions (e.g. smaller or closely held corporations which might not prepare their financial statements in conformity with US GAAP)25. However, the US GAAP are always regarded as “reasonable in the circumstances”26. Determination of time of distribution and application of restrictions A distribution is payable to shareholders of record on a specific record date27. The record date is usually fixed in the bylaws or by the board of directors (§ 7.07(a) MBCA). If the directors do not fix it, § 6.40(b) MBCA fixes the record date for distributions as the date when the board authorises the distribution (this is not applicable to a reacquisition of shares). § 6.40(e)(3) MBCA provides that the legality of a distribution (excluding the reacquisition of shares and distribution of indebtedness) is tested on the date of its authorisation if the distribution is paid within 120 days after the authorisation date. If, however, the payment occurs more than 120 days after the authorisation its legality must be tested on the date of payment. In case of a share buyback, § 6.40(e)(1) MBCA provides that the time for measuring the effect of a distribution is the earlier of the two dates: (1) the payment date, (2) the date the shareholder ceases to be a shareholder with respect to the acquired shares. Finally, in case of indebtedness issued as a distribution, the effect of each payment has to be measured on the date the payment is made (§ 6.40(g) MBCA). Directors’ liability for illegal distributions The potential liability of directors making distributions in violation of the statute or of restrictions in the articles of incorporation is determined under §§ 8.30 (“Standards of Conduct for Directors”) and 8.33 MBCA (“Directors’ Liability for Unlawful Distributions”). A director who votes for or assents to an improper distribution is personally liable to the corporation for the amount that exceeds the permissible limit (§ 8.33(a) MBCA). However, a plaintiff must show within two years that the director did not comply with the standards of conduct set forth in § 8.30 MBCA. § 8.30(a), (b) MBCA requires that the director acts in good faith, in a manner he reasonably believes to be in the best interests of the corporation and with the care that a person in a like position would exercise under similar circumstances. § 8.30(c)-(e) MBCA further provides that a director is entitled to rely on reports from corporate officers, legal counsel, accountants, and other external experts. A director, for example, will be protected by his reliance on an investment bank stating that both the equity insolvency test and the balance sheet test are met and a legal opinion that the dividend is proper, as long as he has no knowledge that would cause his reliance to be unwarranted. 24 Bainbridge, Corporation Law and Economics, 2002, p. 778, puts it this way: “A sad truth is that 90 percent of what we do as corporate lawyers is not very creative. (…) Figuring out ways for a company to pay a dividend despite the literal terms of the statute and the present state of the firm’s balance sheet, however, is one item that falls within the 10 percent or so where creativity is desirable. And lawyers have gotten quite good at what accountants would cf. as juggling the books.” 25 Cf. Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.40, pp. 200-201. 26 Cf. Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.40, p. 201. 27 Cf. Hamilton, The Law of Corporations, 5th edition, 2000, p. 583.


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Under § 8.33(b) MBCA, a director who is held liable for an unlawful distribution is entitled to contribution from all other directors who voted for or assented to the illegal distribution and from all shareholders who accepted the distribution with knowledge of its illegality28. The MBCA imposes liability solely in favour of the corporation and generally does not allow actions by creditors against the directors. Creditors may be able to recover the amount of the unlawful distribution in the corporation’s bankruptcy proceedings29.

28 Apart from this contribution obligation the MBCA does not otherwise impose any liability on shareholders. Cf. Bainbridge, Corporation Law and Economics, 2002, p. 777. 29 Cf. Gevurtz, Corporation Law, 2000, p. 166; Eisenberg, Corporations and other Business Organizations, 9th edition, 2006, pp. 858-860. For a discussion of the relevant case law on the federal Bankruptcy Act and state fraudulent transfer statutes cf. Black, Corporate Dividends and Stock Repurchases, 2006, § 4:10, pp. 29-30, §§ 4:36-4:48.


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4.2.2 USA – Delaware 4.2.2.1 Structure of capital and shares 4.2.2.1.1 Legal framework Delaware follows traditional legal capital rules and divides shareholders’ equity into two basic categories: capital and surplus. However, capital does not necessarily equal what the shareholders paid for their stock. Instead, a Delaware corporation may, by resolution of its board of directors, determine that only a part of the consideration received by the corporation for the shares issued shall be capital. The amount of capital depends on the design of the stock. A Delaware corporation may issue stock with par value or stock without par value (no-par shares). In the case of par value shares, the minimum amount of capital is determined by multiplying the number of shares issued by their par value. In addition, the board of directors may designate an additional portion of the consideration received by the corporation for its shares as capital. In the case of no-par shares, capital is that part of the consideration received designated by the directors as capital. Therefore, directors can designate zero to be capital. The excess, if any, of the “net assets” (total assets less total liabilities) of the corporation over the amount so determined to be capital is surplus. Structure of capital Subscribed capital The Delaware General Corporation Law does not prescribe a minimum capital. Instead the certificate of incorporation shall set forth the total number of shares of stock which the corporation shall have authority to issue and the par value of each of such shares, or a statement that all such shares are to be without par value. Premiums Under Delaware law, the term “share premiums” does not exist. The determination of the amount that is to be “capital” and the amount that is to be “surplus” is one that essentially is within the control and discretion of the board of directors with one exception: an amount equal to the par value of all shares with par value must be allocated to capital. Protection of the stock corporations assets As already mentioned, under Delaware’s statute, capital initially represents the portion of the consideration the corporation received in exchange for its shares which the directors, at the time the corporation sold the shares, decided to designate as capital. This can be the entire purchase price or any fraction of it, as long as the amount is no less than the sum of the par value of those shares sold which have a par value. The rest of the consideration is deemed surplus. In the case of no-par shares directors can designate zero to be capital. As a consequence, theoretically, a legal distribution can leave no shareholders’ equity (surplus test). Furthermore, a corporation can even pay so called “nimble dividends” when the equity is negative (net profits test). It has to be pointed out, however, that these kinds of distributions might violate the federal Bankruptcy Act, statutory fraudulent transfer law, and case law and as a consequence increase the liability risk of the directors.


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Structure of shares In Delaware, every corporation may issue stock with par value or stock without par value as shall be stated in the certificate of incorporation, or in the resolution providing for the issue of such stock adopted by the board of directors pursuant to authority expressly vested in it by the provisions of its certificate of incorporation. If stock is issued without par-value, the corporation has to specify this in the certificate of incorporation. 4.2.2.1.2 Economic analysis Practical relevance of capital and structure of shares for an assessment of the viability of a company The corporations interviewed had shares with a par value in a range from US$0.0001 to US$0.1. The interviewees were unanimously of the opinion that par value and capital are irrelevant nowadays for the assessment of a company’s viability. The reason for having a par value at all instead of issuing no-par shares is that the Delaware franchise tax is based on the capital in the case a corporation has par value shares. The franchise tax would be higher in case of no-par shares because then it would be based on a higher fictitious par value fixed by the tax statute. This constellation of very low capital does not raise concerns by banks, rating agencies or shareholders because it is not considered unusual. Instead, the Delaware corporations interviewed rather looked at the figures “net equity” and “market capitalisation” as relevant to determine their equity position and the assessment of their chances to preserve their business or to attract additional capital. In respect to the corporations’ viability, banks typically rely on cash flow predictions. To verify the importance of capital, we have additionally performed an analysis of certain ratios concerning the stated capital of S&P 500 companies:


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Figure 4.2.2-1: Ratio of share capital to market capitalisation (USA)

USA: Share Capital to Market Capitalisation

83%

5%

5%

3%4%

< 5%5% - 10%10 % bis 20 %20 % bis 30 %> 30 %

Source: One source: Share capital for the FY 2005, market capitalisation as of September 2006 Compared to the market capitalisation, the capital is mostly below 5 percent of the market capitalisation. This is true in 83 percent of these companies. The overall importance of the capital figure seems to be marginal. Restriction on distribution The capital as a profit distribution restriction does not play a significant role. Role of the capital in equity financing Based on their latest audited consolidated financial statements prepared under generally accepted accounting principles (US GAAP), the corporations interviewed had an equity ratio of 43 to 86 percent. Except for a negligible small capital, these high amounts of equity mainly comprise surplus and retained earnings. This increases the leeway for corporations to make distributions. However, the interviewees pointed out that other restrictions on the corporation and fraudulent transfer statutes as well as market forces limit the practical relevance of this possibility. For the S&P 500 companies, the ratio of capital to total shareholder’s equity shows that for 64 percent of the companies the capital portion stays under 5 percent of total shareholders' equity.


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Figure 4.2.2-2: Ratio of share capital to total shareholder`s equity (USA)

USA: Share Capital to Total Shareholder's Equity

64%11%

9%

3%

13%

< 5%5% - 10%10 % bis 20 %20 % bis 30 %> 30 %

Source: One source: Share capital for the FY 2005, shareholders' equity (consolidated) for the FY 2005 This indicates that the equity financing is not largely dependent on the capital and that there is a sufficient equity base in these companies and their subsidiaries to allow for adequate distributions. The existence of capital does not seem to be a stumbling block for the S&P 500 companies in their approach to equity financing and distribution policy from a group perspective. Formations The Delaware corporations interviewed are already in existence for a longer period. Therefore, it was neither feasible nor useful to extract data on the initial foundation of these corporations. 4.2.2.2 Capital increase 4.2.2.2.1 Legal framework Under Delaware law, there are provisions concerning capital increases by the use of authorised capital including mechanisms to ensure the contribution of capital. In addition, public corporations have to obey specific rules of US stock exchanges. Increase of capital Under Delaware law, the authority of the corporation to issue new shares is set forth in the certificate of incorporation. The issuance of new shares must be by the use of authorised capital. Delaware law requires that if the corporation has only a single class of stock, the certificate must recite the number of shares authorised for the issue and whether they are par or no-par. If the corporation has authority to issue more than one class of shares, then the certificate must set forth the number of shares of all classes and of each class and whether the shares are par or no-par. The board of directors must authorise any issuance of stock by the corporation. There is no maximum amount the authorised shares may cover set by law.


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If all shares that are covered by the certificate of incorporation have already been issued, the corporation may amend its certificate of incorporation to increase its authorised capital. The amendment must first be proposed by the board of directors in a resolution setting forth the proposed amendment, declaring its advisability and submitting it to the stockholders entitled to vote on the approval of the amendment. After the proposed amendment has been duly approved by the board of directors, it must then be submitted to the stockholders at the next annual meeting, or at a special meeting called for the purpose of considering the amendment, or it may be submitted to the stockholders entitled to vote thereon for adoption by written consent, if the certificate so allows. If a majority of the outstanding stock entitled to vote thereon, and a majority of the outstanding stock of each class entitled to vote thereon as a class has voted in favour of the amendment, a certificate setting forth the amendment and certifying that such amendment has been duly adopted in accordance with statutory requirements shall be executed, acknowledged and filed and shall become effective. In addition to the rules of the Delaware General Corporation Law there are rules of US stock exchanges (e.g. Listed Company Manual of the New York Stock Exchange) that require stockholder approval for issuing shares under certain circumstances. Mechanisms to ensure the contribution of capital With respect to the subscription of new shares which were issued during a capital increase, the same rules apply which Delaware law provides for the subscription of shares during the formation of the corporation. Regarding capital contributions and their payment at the stage of a capital increase, the same regulations apply as those at the stage of formation. As in the stage of formation, the Delaware General Corporation Law allows both contributions in cash and contributions in kind. The board of directors has the responsibility of valuing contributions in kind. Delaware law allows stockholders to determine the contribution if the certificate of incorporation so provides. If the certificate of incorporation reserves to the stockholders the right to determine the consideration for the issue of any shares, the stockholders shall, unless the certificate requires a greater vote, do so by a vote of a majority of the outstanding stock entitled to vote thereon. Pre-emption rights Delaware adopts an “opt-in” approach for pre-emption rights. The Delaware General Corporation Law states that no stockholder shall have any pre-emption right to subscribe to an additional issue of stock or to any security convertible into such stock unless, and except to the extent that, such right is expressly granted to such stockholder in the certificate of incorporation. 4.2.2.2.2 Economic analysis The corporations interviewed have not increased their capital for a long time. In order to avoid capital increases and the necessary amendments of the articles of incorporation as a consequence, the corporations have set a very high authorised share capital (e.g. several hundred million).


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Practical steps The following practical steps would be necessary for a capital increase in chronological order: Figure 4.2.2-3: Process of capital increase (USA-Delaware)

Capital increase

Step 1 Directors propose to issue new shares.

Step 2 Directors check if the shares to be issued are covered by the certificate of incorporation (authorised capital).

Step 3 If all shares covered by the certificate of incorporation have already been issued: Resolution of the board of directors setting forth the proposed amendment.

Step 4 Approval of the amendment by the board of directors.

Step 5 Amendment is submitted to the stockholders at the next annual meeting, or at a special meeting, or submitted to the stockholders entitled to vote thereon for adoption by written consent (if the certificate so allows).

Step 6 Amendment is executed, acknowledged and filed. The injection of contributions and the valuation process would comprise the following steps: Figure 4.2.2-4: Process of injection of contributions (USA-Delaware)


Step 1 The board authorises capital stock to be issued for consideration consisting of tangible or intangible property or any benefit to the corporation, or any combination thereof

Step 2 If consideration is outstanding, the amount of consideration outstanding shall be documented on the face or back of each stock certificate issued to represent partly paid shares, or upon the books and records of the corporation

Step 3 Board of directors’ judgment of value of consideration received for stock is conclusive in the absence of “actual fraud” (if sold to the corporation itself there is heightened scrutiny to show independent evidence of the market value of stock)

Analysis Because theses processes have not been relevant to the corporations interviewed in recent years, we have not received any information on practical cases of capital increases, or contributions in kind. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.2.2.2.3 Protection of shareholders and creditors Based on the legal analysis, one can draw the following key conclusions concerning the shareholders’ and creditors’ protection under the Delaware provisions on capital increases.


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Shareholders are protected insofar as the board of directors can only increase the capital if the additional shares are covered by the authorised capital set forth in the certificate of incorporation. If all shares covered by the certificate of incorporation have already been issued, the shareholders’ approval is needed to amend the certificate of incorporation. However, it has to be pointed out that a very high authorised share capital can be fixed in the certificate with the consequence that the shareholders will not have to be asked for approval. In specific circumstances, public corporations are required to get stockholders’ approval for issuing shares pursuant to rules of US stock exchanges. Under Delaware law, it is not necessary to draw up a report by an independent expert in the case of contributions in kind. Instead, it is the directors’ duty to determine the consideration for stock. Case law suggests that directors should seek independent evidence of the market value of the consideration when selling stock to themselves. If the certificate of incorporation reserves to the stockholders the right to determine the consideration for the issue of any shares, the stockholders shall, unless the certificate requires a greater vote, do so by a vote of a majority of the outstanding stock entitled to vote thereon. Stockholders, receivers in the case of an insolvent corporation, or creditors may make claims concerning unpaid or partially paid stock. The party bringing the claim generally has the burden of proof. Furthermore, the Delaware statute states that when the whole of the consideration payable for shares of a corporation has not been paid-up, and the assets are insufficient to satisfy the claims of its creditors, each holder of or subscriber for such shares shall be bound to pay on each share held or subscribed for by such holder or subscriber the sum necessary to complete the amount of the unpaid balance of the consideration for which such shares were issued or are to be issued by the corporation. Under Delaware law, pre-emption rights that safeguard a stockholder’s right to maintain ownership of his proportionate share of the assets and protect a proportion of the voting control, are possible. However, such a right has to be expressly granted in the certificate of incorporation (“opt-in approach”). 4.2.2.3 Distribution 4.2.2.3.1 Legal framework The Delaware General Corporation Law contains several requirements for legal distributions as well as provisions concerning the consequences of unlawful distributions. In addition, there is case law on the question of what accounting rules have to be applied in determining the distributable amount. Calculation of the distributable amount Under the Delaware General Corporation Law, there are two alternative tests for determining the legality of a distribution: the surplus test (also referred to as capital impairment test) and the net profits test (so-called nimble dividends). The Delaware statute contains no explicit prohibition against dividends when the corporation is, or would be rendered, insolvent. However, directors violate their fiduciary duties to creditors if they make a distribution when the corporation is insolvent. The surplus test provides that the directors of every corporation, subject to any restrictions contained in its certificate of incorporation, may declare and pay dividends upon the shares of


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its capital stock out of its surplus. As mentioned above, the term “surplus” is defined as the excess, if any, at any given time, of the net assets (total assets less total liabilities) of the corporation over the amount so determined to be capital. “Capital” is generally the sum of the aggregate par value of all issued shares with par value. In addition, the directors may designate an additional portion of the consideration received when shares are issued as capital. In the case of no-par shares, capital is that part of the consideration received designated by the board as capital. Thus, under Delaware law, a dividend cannot be paid if, before or after payment of the dividend, the capital is or would be impaired. Under the net profits test, a Delaware corporation may pay dividends even if there is no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. However, these “nimble dividends” may not be paid if capital representing preferred shares is impaired. There is a special rule for corporations in the business of exploiting a non-replenishable asset, such as a mine, an oil well, or a rock quarry. Such “wasting assets corporations” may add accumulated depreciation, amortisation, or depletion to net profits for purposes of calculating dividend paying capacity. In Delaware, wasting assets include not only natural resources but also other wasting assets, including patents. Connection to accounting rules Delaware law does not specify particular accounting methods. Thus, Delaware corporations do not have to adhere to US GAAP or any other specific accounting method in determining whether a dividend may lawfully be paid. The Delaware Supreme Court has made it clear that directors may revalue assets at current value or fair market value for purposes of calculating net assets even though US GAAP requires historical costs. To be sure, any such revaluation must be undertaken in good faith and should thus include a consistent and comprehensive review of both assets and liabilities and not merely a selective write-up of particular assets. The board of directors may rely on outside experts such as accountants. The Delaware courts have taken a broad view of board discretion concerning revaluation. The Delaware Supreme Court approved the calculation of net assets based on a valuation of discounted cash flow less long-term liabilities. This test ignores the balance sheet altogether. It rather permits the use of projected cash flows. Determination of the distributable amount – responsibilities In Delaware, the declaration of dividends generally is within the discretion of the board of directors and protected by the business judgement rule. However, directors have to obey any restrictions in the certificate of incorporation and the applicable statutory provisions. Sanctions Under Delaware law, directors are jointly and severally liable for any illegal dividends resulting from wilful misconduct or negligence, at any time within six years after paying such unlawful dividend. Liability for unlawful dividends cannot be limited by the corporation in its certificate of incorporation. Liability runs to the corporation and to its creditors in the event of its dissolution or insolvency, to the full amount of the dividend unlawfully paid.


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Even if a director voted for an illegal dividend, he is not liable if he relied in good faith on the corporation’s records, or other kinds of information presented to the corporation by an officer, employee, a committee of the board of directors or by any other expert who has been selected with reasonable care by or on behalf of the corporation. They may provide the board with information as to the value and amount of the assets, liabilities and/or net profits of the corporation, or any other facts pertinent to the amount of surplus or other funds from which dividends might properly be paid. Any director against whom a claim is successfully asserted is entitled to contribution from the other directors who voted for or concurred in the unlawful dividend. Furthermore, a director is entitled by subrogation to the right of the corporation against shareholders who received the dividend with knowledge of facts indicating that the dividend was illegal. 4.2.2.3.2 Economic analysis Overall, the Delaware corporations participating in the interviews considered the Delaware law on this issue to be very straightforward and easy to comply with. They derive the distributable amount from the audited consolidated US GAAP financial statements. To avoid different sets of accounts, they have never performed a revaluation of assets and liabilities for the purpose of the surplus test. The net profits test (nimble dividends) and the exception for wasting asset corporations have never been applied, either. Due to the very good economic situation, high retained earnings and high amounts of cash, the compliance with the solvency test is not seen as a major issue. The decision of the board of directors on the distribution policy and its preparation takes a lot of time, but the associated costs are not incremental. However, it was pointed out that distribution law is one of the few areas in US corporate law where there is an increased necessity for directors to underpin their business judgment in order to avoid personal liability. As a general rule of thumb, the more difficult the business condition of the company becomes the higher and the more burdensome are the precautions in this respect. Practical steps Based on the legal analysis, the distribution process generally requires the following practical steps which are the basis for the economic analysis. Figure 4.2.2-5: Due process for distributing profits (USA-Delaware)


Step 1 Directors establish the value of the distribution they wish to make.

Step 2 Directors determine whether the dividend would render the corporation unable to pay its debts as they become due in the usual course of business (performance of the solvency test).

Step 3

Directors consult the relevant accounts of the corporation and determine whether, after the distribution, assets will exceed liabilities plus stated capital (performance of the surplus test/capital impairment test). If necessary, directors perform a revaluation of assets and liabilities before applying the surplus test/capital impairment test.

Step 4 If necessary, directors declare nimble dividends (performance of the net profits test).


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Step 5 If applicable, directors add accumulated depreciation to net profits (applying the exception for wasting asset corporations).

Step 6 Directors check if there are any additional restrictions contained in the certificate of incorporation.

Step 7 The board of directors authorises the distribution by the corporation (amount, date of payment, etc.)

Step 8 Directors who do not vote in favour of the dividend make sure that their dissent is recorded in the minutes at the time of the resolution.

Step 9 Payment to shareholders. Analysis Calculation of the distributable amount All Delaware corporations interviewed use their audited consolidated financial statements in conformity with US GAAP as the basis for determining the distributable amount. There is no specific effort needed in this regard as the preparation and the audit of the annual accounts is not considered as an incremental cost. The statutory calculations are seen as simple, technical and cheap. The results of a CFO questionnaire sent to US companies listed on main indices reconfirm this: Figure 4.2.2-6: Determinants for the distribution of dividends in the holding company (USA)

"What are the determinants for the distribution by your holding company?"

1,90

3,39

2,19

3,30

2,35

3,66 2,543,19

2,26

3,49

2,78

4,10

1

2

3

4

5

Fin.performance

(groupaccounts)

Fin.performance(individual

accounts of theparent

company)

Dividendcont inuity

Signallingdevice

Credit rat ingconsiderat ions

Tax rules

Determinants

Impo

rtan

ce

USA

Non-EU Average

Source: CFO Questionnaire, September 2007 However, concerning the importance of the current legal restrictions on profit distribution, the CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market led solutions like rating agencies’ requirements or bank covenants. However, the compliance with bank covenants is ranked higher than compliance with insolvency legislation.


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Figure 4.2.2-7: Important deterrents when considering the level of profit distribution (USA)


3,38

3,58

2,19

3,94 3,47

3,382,22

3,93

1

2

3

4

5

Distribut ion/Legalcapital requirements


Contractual agreementswith creditors(covenants)


Deterrents

Impo

rtan

ce

USA

Non-EU Average

Source: CFO Questionnaire, September 2007 The results of a CFO questionnaire sent to US companies listed on main indices show the importance of tax considerations as determinant of dividends distributions from subsidiaries. Tax rules are ranked higher than distribution demands from the ultimate parent and own investment decisions. Figure 4.2.2-8: Determinants for the distribution of dividends by the subsidiaries (USA)


3,73

4,10

2,88

3,95

3,87

2,73

1

2

3

4

5

Demands from the ult imateparent

Tax rules Own investment decisions

Determinants

Impo

rtan

ce

USA

Non-EU Average

Source: CFO Questionnaire, September 2007 Determination of the distributable amount From a cost perspective, all Delaware corporations interviewed considered step 1, the preparation of the decision of the board of directors, to be the most time-consuming effort in this process. Before the initial distribution, the companies started wider consultation processes in various ways. Amongst other things, the business situation, forecasts and debt covenants were taken into consideration. Tax considerations are taken into account when bringing cash to the top of the group pyramid. One corporation based the initial decision on internal cash flow forecasts covering a period of time of at least five years in order to make sure that it was able to increase the amount of dividends every year and to avoid negative publicity in the US when dividends are decreased.


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In general, there are several main drivers of the distribution policy of the corporations interviewed. With the involvement of public relations experts, the corporations predict how the market would react to certain levels of dividend. The needs of the company’s investor base are taken into consideration as well. This leads one corporation to demonstrate continuity as far as cash dividends are concerned and to perform share repurchases at the same time. Another corporation discontinued paying (small) dividends because there was no positive market reaction to dividends with the consequence that the money was wasted. In addition, this corporation rather wants to be recognised as a growth company and is of the opinion that paying dividends is a signal to the market that there are no longer enough internal investment opportunities. As a consequence, this company uses the cash previously used to pay the dividend for its stock repurchase program which is seen as a better device to meet the shareholders’ expectations. One corporation mentioned that, under specific circumstances, governmental rules encourage corporations to distribute cash. In the US, a company with too much cash will be regarded as an investment company, which has to apply special investment company accounting rules. All corporations interviewed spend a lot of time to determine the distribution policy and to prepare the distribution decision of the board of directors. In this process, highly qualified personnel of the company are involved. We have not been able to obtain details on the associated cost. They are not, however, considered to be incremental. The pure legal compliance effort of the corporations interviewed, i.e. applying the technical requirements of the Delaware distribution law, is only a matter of minutes to approximately 20 hours of highly qualified personnel of the company. Thus, the incremental costs can be considered as negligible. One major reason for this result might be that all the corporations interviewed are very profitable companies which generate a lot of cash and therefore do not even get close to the statutory limits on distributions. Overall, the performance of the solvency test (step 2), which is not mandatory by law, is not seen as a big issue. The actual design of this test varies. The treasury department of one corporation performs the test as a matter of prudence and to demonstrate continuous practice in this regard, even though the corporation knows what the result of the test will be in advance due to high amounts of cash and very good economic conditions. The solvency test is balance sheet driven and therefore is based on historic figures. Specific ratios are calculated in the format of an excel spreadsheet. Another corporation only initially performed a solvency test, but mainly for tax reasons. When performing the solvency test, this company mainly looks at the payables as shown in the consolidated US GAAP financial statements. The company’s liquidity of the following 12 months at a minimum as well as long-term debts and leases are taken into consideration. The interviewee pointed out that, in the case of a dividend in a “crisis situation”, a good explanation and a cash flow analysis might be appropriate. Furthermore, the company would make sure that all debts are in the books. In addition, already at the stage of distributions, the company already takes into account the insolvency provisions of the federal Bankruptcy Law. One corporation neither performs an explicit solvency nor an explicit surplus test. Instead, on the basis of the audited US GAAP accounts, it is assumed that the tests are met. Applying the surplus test (step 3) is described as an easy task. However, one company is of the opinion that this would change drastically in “crisis situations” or in case e.g. goodwill and other intangibles were impaired. The corporations interviewed have never performed a


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revaluation of assets and liabilities and do not depart from US GAAP to keep the calculations simple and avoid separate calculations. Also, a revaluation is not considered necessary due to much headroom. It would, in general, only be considered under rather exceptional circumstances, e.g. for certain real estate with low book values. Additional tests (net profits test, wasting asset exemption) have never been applied, either. As mentioned before, the clear point of reference for the determination of the distributable amount is the audited consolidated financial statements prepared under US GAAP. The fact that the calculations are based on audited figures adds additional confidence. At present, the corporations perform the statutory tests on their own and the calculations are not explicitly reviewed by the accountants. The preparation of the distribution decision typically involves selected high ranking company representatives (e.g. CFO, Chief Administrative Officer, General Counsel, Head of Treasury, and Head of Accounting) as well as highly qualified personnel in the controlling, treasury and accounting departments. The results of the preparation work are usually presented to the board of directors. Depending on the risk awareness, the directors simply rely on the work done by the officers or ask their staff and outside experts explicit questions with regard to compliance. Sanctions Concerning the efforts to monitor compliance with distribution regulations, the companies interviewed considered the risk of liability for the company’s directors to be low. The reason for this is mainly the very good economic condition of the corporations interviewed. However, one interviewee pointed out that distribution is one of the few areas in US corporate law where there is an increased necessity for directors to underpin their judgment with sufficient evidence. Because directors are individually liable in case of illegal distributions, the company makes sure that the distribution requirements are applied correctly in the first place. The effort needed to comply with the statutory distribution rules would be a lot higher and would involve outside experts if the economic situation was negative. In performing the surplus test, a revaluation would, in general, only be considered under rather exceptional circumstances. This would also need some underpinning as to the fair value to be used in the surplus test (some reliable value). From a conservative legal point of view, this would limit deviations from the US GAAP accounts in order to avoid potential liability for directors. Related parties There has not been a significant issue concerning the monitoring of the relationships with related parties and potential other refluxes of funds to shareholders. Incremental Costs HighQ LowQ Other Costs Hours spent 1 to 20h - - Hourly rate €100 €70 - €100 to €2,000 - - Total costs €100 to €2,000


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4.2.2.3.3 Protection of shareholders / creditors Based on the legal and economic analysis, one can draw the following key conclusions concerning the shareholders’ and creditors’ protection of the Delaware distribution rules. The decision whether or not to make a distribution generally rests in the discretion of the board of directors of the corporation. Therefore, the shareholders have no statutory right to share in the corporation’s profits unless the board of directors declares a distribution. The board’s declaration of a dividend creates a legal obligation to the shareholders which generally cannot be repealed. Notwithstanding the foregoing, (minority) shareholders might bring a lawsuit against directors, arguing that the board abused its discretion either in declaring, or in refusing to declare, dividends. There are cases in which courts ordered closely-held corporations to pay, or not to pay, a dividend. Because the decision to pay a dividend, and its size, are normally matters protected by the business judgment rule, the courts generally are hesitant to reverse the board’s decision. As long as directors can identify some arguable corporate need to retain funds, courts generally will not second guess the board’s decision. There seems to be no case where the court ordered a dividend of a public corporation. However, due to the market forces, public corporations, such as those taking part in the interviews, take the shareholders’ expectations into consideration in order to increase the value of the shares. Because the shareholders elect the directors, and the directors are often substantial shareholders themselves, one might suppose that the directors have a strong incentive to make distributions when consistent with maximising shareholder value. Creditors do not seem to be protected by the Delaware legal capital system and statutory distribution requirements. By allowing directors to designate as capital sums which are less than what the company received for its shares, creditors cannot rely on the original investment by the shareholders as a cushion. In Delaware, distributions that leave the corporation without equity or even with a deficit in equity, are allowed. However, due to other federal and statutory restrictions as well as liability risks, it does not seem realistic that corporations make use of these possibilities. Furthermore, there are various contractual protections. From the directors’ perspective, the distribution rules leave a lot of leeway and flexibility. They can retain money when needed for internal investments and future growth of the business and they can easily distribute excess cash. Pursuant to the interviews conducted, directors seem to live well with the statutory directors’ liability for illegal distributions. When determining the distributable amount they refer to the audited consolidated financial statements and to internal cash flow predictions. Complying with the Delaware distribution requirements does not cause much of a burden, as long as the economic condition of the corporation is good, i.e. there is headroom in retained earnings and cash. In the case of operating difficulties of the corporation, a liquidity problem etc., the risk of liability increases if the directors nevertheless declare a distribution. Therefore, considerable work is needed to underpin distributions in such circumstances. 4.2.2.4 Capital maintenance As described above, Delaware follows the concept of legal capital, thus providing various measures which supposedly preserve the corporation’s capital. However, there is no statutory minimum capital and capital does not necessarily equal what the shareholders paid for their stock. Instead, capital generally is whatever sum directors choose to call capital. In the case of no-par shares, capital can equal zero. Furthermore, there are statutory provisions on share repurchases, capital reductions, related party transactions and fraudulent transfers. In addition, in practice, contractual self-protection of creditors is of importance.


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4.2.2.4.1 Acquisition by the company of its own shares 4.2.2.4.1.1 Legal framework The Delaware law generally allows share repurchases provided the corporation adheres to certain statutory restrictions. With specified exceptions, the financial limitations on repurchases are the same as those for dividends. The Delaware General Corporation Law contains one main test for determining the legality of a share repurchase: a corporation must satisfy the surplus test/capital impairment test. There is no explicit solvency test under the Delaware statute; it is part of case law. Directors violate their fiduciary duties to creditors if they repurchase shares when the corporation is or would be insolvent. A Delaware corporation may purchase its own stock, provided that it may not do so if its capital is impaired or if the repurchase would cause its capital to be impaired. A corporation may also purchase preferred or, if there are no preferred shares outstanding, common shares out of capital, so long as the shares are retired, and the corporations’ capital is reduced. If the shares are acquired out of surplus, the corporation may retire them or retain them as treasury shares. Directors are not restricted in the way they calculate surplus. The Delaware Supreme Court allows directors to revalue assets in order to show a surplus, as 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 surplus that is not so far off the mark as to constitute actual or constructive fraud. Under Delaware law, as long as the mentioned restrictions are met, there is no specific maximum amount of its own shares which the company may acquire. A Delaware corporation, registered with the Securities and Exchange Commission (SEC) as a publicly traded corporation, has to follow certain disclosure obligations. In accordance with the Exchange Act, in each quarterly report on Form 10-Q and in the annual report on Form 10-K, the corporation must provide a table showing, on a month-to-month basis the following: the total number of shares purchased, the average price paid per share, the total number of shares purchased under publicly announced repurchase programs, and the maximum number of shares that may be repurchased under these programs (or maximum dollar amount if the limit is stated in those terms). In the case of an illegal share repurchase, the same statutory liability applies as for illegal dividends. Directors are jointly and severally liable for any wilful or negligent violation of the statute. Liability runs to the corporation and, in the event of its dissolution or insolvency, to its creditors. A director is specifically protected against liability if he relies in good faith on the accounts of the corporation or on reports of officers or outside experts selected with reasonable care in determining whether there are sufficient funds legally available for the purchase of stock. A director who has been found liable and who has paid back moneys to the corporation is entitled by subrogation to the rights of the corporation against shareholders who received assets with knowledge of facts indicating that the transaction was unlawful.


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In case the Delaware corporation is publicly traded and therefore has to obey the rules of the SEC, there are a number of sanctions if shares were acquired in contradiction of the law and SEC rules respectively. 4.2.2.4.1.2 Economic analysis All the Delaware corporations interviewed have stock repurchase programs approved by their board of directors authorising their company to buy back a specific number of shares or a specific dollar amount of shares over an agreed upon period of time. One of the corporations has not executed the program yet. Due to the fact that the statutory requirements for dividends and stock repurchases are nearly identical and the necessary calculations are done only once for both kinds of distributions, the evaluation of the law by the corporations is the same: only a minimal amount of work is needed to comply with the rules. Thus, the associated incremental costs are negligibly low. Practical steps To acquire its own shares, a company generally has to follow this process: Figure 4.2.2-9: Process of acquisition of own shares (USA-Delaware)


Step 1 Directors establish the amount of shares they wish to buy back.

Step 2 Directors determine whether the share repurchase would render the corporation unable to pay its debts as they become due in the usual course of business (performance of the solvency test).

Step 3

Directors consult the relevant accounts of the corporation and determine whether, after the share repurchase, assets will exceed liabilities plus stated capital (performance of the surplus test/capital impairment test). If necessary, directors perform a revaluation of assets and liabilities before applying the surplus test/capital impairment test.

Step 4 The board of directors authorises the share repurchase by the corporation.

Step 5 Directors who do not vote in favour of the share repurchase make sure that their dissent is recorded in the minutes at the time of the resolution.

Step 6

If publicly traded, the corporation must disclose in the Form 10-Q quarterly report and in the Form 10-K annual report in a table showing, on a month-to-month basis: the total number of shares purchased, the average price paid per share, the total number of shares purchased under publicly announced repurchase programs and the maximum number of shares that may be repurchased under these programs

Analysis All Delaware corporations interviewed dispose of an authorisation by the board of directors that allows the corporation to repurchase shares. Three companies of our sample are making use of their authorisation and constantly acquire their own shares. These companies purchase shares from time to time in the open market or through privately negotiated transactions at management’s discretion, depending upon market conditions and other factors. They regularly renew their authorisation by the board of directors in this regard.


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The decision to buy back shares is part of the overall distribution policy of the board described above. Except for one company of our sample that has not executed its share repurchase program yet, the amount of the distribution to shareholders via share repurchases plays a much more important role than dividends, if dividends are paid at all. The companies interviewed by us explained different reasons for buying back shares. Most of the companies are of the opinion that their shareholders, or at least a group of them, prefer share repurchases to dividends. One corporation designed a stock repurchase program to return value to its shareholders and minimise dilution from stock issues in the past. Another corporation uses share buy-backs to distribute excess cash to its shareholders and to improve ratios such as “earnings per share”. The application of the statutory requirements (steps 2 and 3) – as described in detail above – is described as not burdensome. Therefore, practically no incremental costs are involved in this legal process. Again, due to the comfortable financial situation of the corporations interviewed, the compliance with the tests is not a big issue. Another step in this process is the preparation of the notes to the accounts to provide information about the acquisition of the company's own shares. Two corporations describe the compliance with the SEC quarterly disclosure requirements as a time-consuming process, especially concerning the open market transactions. Furthermore, whenever new stock repurchase programs are approved by the board, a lot of disclosure requirements have to be met (e.g. press release). The other two corporations, however, described the disclosure requirements as very simple, being a by-product of the accounting process. Anyway, the associated costs occur because of the requirements of the US securities legislation, not because of statutory requirements and are not, therefore, incremental. Depending on the design and the size of the stock repurchase program, setting up the program and managing the stock repurchase process leads to high amounts of time spent by highly qualified personnel. In addition, there are substantial amounts of money charged by external advisors and investment banks. We did not obtain exact data in this regard. The associated costs, however, are not incremental and therefore not important for the purposes of this study. Incremental Costs HighQ LowQ Other Costs Hours spent 15 - - Hourly rate €100 €70 - €1,500 - €3,935 Total costs €5,435 4.2.2.4.1.3 Protection of shareholders and creditors Due to the fact that, under Delaware law, the statutory restrictions on dividends and share repurchases are nearly identical, one can draw the same key conclusions concerning the associated shareholders’ and creditors’ protection of these rules based on the legal and economic analysis.


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4.2.2.4.2 Capital reduction 4.2.2.4.2.1 Legal framework Delaware law provides that a corporation, by resolution of its board of directors, may reduce its capital in any of the following ways: (1) by reducing or eliminating the capital represented by shares of capital stock which have been retired; (2) by applying to an otherwise authorised purchase or redemption of outstanding shares of its capital stock some or all of the capital represented by the shares being purchased or redeemed, or any capital that has not been allocated to any particular class of its capital stock; (3) by applying to an otherwise authorised conversion or exchange of outstanding shares of its capital stock some or all of the capital represented by the shares being converted or exchanged, or some or all of any capital that has not been allocated to any particular class of its capital stock, or both, to the extent that such capital in the aggregate exceeds the total aggregate par value or the stated capital of any previously unissued shares issuable upon such conversion or exchange; or (4) by transferring to surplus (i) some or all of the capital not represented by any particular class of its capital stock, or (ii) some or all of the capital represented by issued shares of its par value capital stock, which capital is in excess of the aggregate par value of such shares, (iii) some of the capital represented by issued shares of its capital stock without par value. Under Delaware law, board resolutions are sufficient in order to reduce the capital of a corporation. Board resolutions are considered corporate documents and are available to the corporation’s stockholders. The Delaware statute provides that no reduction of capital shall be made or effected unless the assets of the corporation remaining after such reduction shall be sufficient to pay any debts of the corporation remaining after such reduction for which payment has not been otherwise provided. No reduction of capital shall release any liability of any stockholder whose shares have not been fully paid. 4.2.2.4.2.2 Economic analysis Capital reductions have never been relevant to the corporations in our sample. Therefore, we have not obtained any information concerning this process. 4.2.2.4.2.3 Protection of shareholders and creditors The provisions on capital decreases generally do not protect shareholders or creditors. However, there may be a minimum protection due to the fact that the par value of the shares cannot be reduced without the shareholders’ approval. In this context, we would like to note that we have encountered companies with a marginal stated capital in relation to total shareholders’ equity. 4.2.2.4.3 Share redemption 4.2.2.4.3.1 Legal framework A Delaware corporation can distribute assets to stockholders by acquiring outstanding shares through redemption or repurchase. While a repurchase is a voluntary buy-sell transaction between the corporation and a stockholder, redemption refers to a forced sale initiated by the corporation, in accordance with a contract or the certificate of incorporation.


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Delaware law provides that any stock of any class or series may be made subject to redemption by the corporation at its option or at the option of the holders of such stock or upon the happening of a specified event; provided however, that, immediately following any such redemption, the corporation shall have outstanding one or more shares of one or more classes or series of stock, which share, or shares together, shall have full voting powers. Shares may be made redeemable at such price or prices or at such “rate or rates, and with such adjustments” as are stated in the certificate of incorporation or appropriate board resolution. The redemption of stock cannot, however, be used as a technique to maintain management in control of the corporation. If the shares are redeemed, the corporation may reduce its capital by applying to an otherwise authorised purchase or redemption of outstanding shares of its capital stock some or all of the capital represented by the shares being purchased or redeemed, or any capital that has not been allocated to any particular class of its capital stock. Any redeemable stock may be redeemed for cash, property or rights, including securities of the same or another corporation, at such time, price, or rate, and with such adjustments, as shall be stated in the certificate of incorporation or in the resolution providing for the issue of such stock adopted by the board of directors. 4.2.2.4.3.2 Economic analysis Within our sample of Delaware corporations, we have not received any information on share redemptions. Incremental Costs HighQ LowQ Other Costs Hours spent - - Hourly rate €100 €70 Total costs No data 4.2.2.4.3.3 Shareholder and creditor protection Shareholders and creditors are protected in so far as the terms of the redemptions have to be stated in the certificate of incorporation. Furthermore, if the stockholders do not believe that the price they receive for their redeemed shares is appropriate, they generally have the possibility to challenge this. Principles of good faith and fair dealing may be involved in the setting of a redemption price. 4.2.2.4.4 Financial assistance 4.2.2.4.4.1 Legal framework Delaware law does not deal directly with transactions such as leveraged buy-outs (LBOs). However, Delaware law does restrict certain business combinations between a Delaware corporation and an “interested stockholder” (in general, a stockholder owning 15 % or more of the outstanding voting stock of such corporation).


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4.2.2.4.4.2 Economic analysis Within our sample of Delaware corporations, we have not received any information on financial assistance. 4.2.2.4.5 Serious loss of half of the subscribed capital 4.2.2.4.5.1 Legal framework Under Delaware law, there is no provision which requires the board of directors to call a general meeting in case of a loss of half of the subscribed capital. 4.2.2.4.5.2 Economic analysis Not applicable. 4.2.2.4.5.3 Shareholder and creditor protection Not applicable. 4.2.2.4.6 Contractual self protection 4.2.2.3.6.1 Legal framework Delaware law does not bar corporations from entering into contractual credit agreements which might have, amongst other things, an impact on the distribution capacity, as long as statutory requirements are not violated. For over a century, it has been common practice in the US that banks and other institutional lenders who extend a large amount of credit for a substantial period of time to corporations protect themselves by negotiating a bond or debenture indenture, or a loan agreement. These contracts usually contain elaborate provisions concerning what the borrowing company has obliged itself to do and not to do, and the consequences in an event of breach. 4.2.2.3.6.2 Economic analysis All Delaware corporations interviewed have credit agreements with banks and other financial institutions. All these contracts contain various affirmative and negative covenants including financial covenants (specific financial ratios). The interviewees unanimously pointed out that the monitoring of the covenants involves more time than applying the statutory distribution rules. Unfortunately, we have not received detailed information concerning the associated costs. One corporation estimated that, for the whole process, 20 hours of work of highly qualified personnel is needed four times a year. While the covenants of the corporations interviewed differed in design and range, there is a substantial similarity in the process of entering into a credit agreement and of monitoring the compliance with the covenants. The financial ratios are defined by the banks and normally try to capture the business model of the borrower. The most recent audited consolidated financial statements are the starting point for the computation of the ratios. However, there are certain (minor) departures from the US GAAP accounts, so that the additional information has to be gathered and processed into the calculation. These departures are explicitly described in the loan contract. Most of the corporations created a “little model”, plug in the numbers in an excel spreadsheet, and report


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the calculations and further necessary documents to the banks and other financial institutions on a quarterly basis. The financial ratios of the companies in our sample comprise: leverage ratios (e.g. a specific leverage ratio like EBITDA to total debt must be maintained), and other financial ratios concerning liquidity (e.g. certain specified levels of cash and cash equivalents have to be maintained) and profitability. In addition, there are usually many affirmative and negative covenants which do not require calculations. In order to make sure that these covenants are not in breach, one corporation sends a checklist to key people of the corporation (tax and controlling department, etc.) who have to tick them off. None of the corporations have covenants directly restricting the payment of dividends or share repurchases. One company had such a dividend covenant many years ago. To change the dividend covenant with the lending institution, costs of approximately US$20,000 were incurred. For every quarterly filing with the SEC, a letter by the audit firm is needed stating that compliance with the debt covenants has been reviewed. In addition, analysts frequently ask questions in this regard which have to be answered. Overall, all the companies interviewed are comfortable with the limitations and believe they will not impact their credit or cash in the future or restrict the ability to execute their business plan. Due to the very good economic situation and the flexible covenants initially negotiated, the risk of breaching the covenants is presently seen as very low. In addition, one company is of the opinion that it could easily renegotiate the covenants when necessary. All the Delaware corporations pointed out, however, that the described process is very burdensome for companies operating on the edges of the restrictions on credit agreements. A breach of debt covenants can be very costly. The consequences are that the whole loan may be due immediately (in the worst case, this might also lead to a breach of the statutory dividend restrictions) or a waiver has to be negotiated. Incremental Costs HighQ LowQ Other Costs Hours spent 80 - - Hourly rate €100 €70 - €8,000 - - Total costs €8,000 4.2.2.4.6.3 Shareholder and creditor protection The terms of the credit agreements are negotiated between the corporation and an individual creditor or a group of creditors, and thus reflect a realistic view of what creditors desire for their protection. The creditors of the companies interviewed rely on the future prospects of a company, mainly its profitability and its ability to generate cash necessary to pay the debts when due. These creditors will not enter into the transaction without having a close look at the general economic condition and future cash flow and earning potential. The maintenance of specific liquidity and leverage ratios as well as limitations on further issuance of debt, as frequently negotiated in loan contracts, reduce the leveraged risk of the corporation. It is thus apparent that creditors do not focus on the sufficiency of assets remaining upon liquidation of the corporation for the settlement of their claims, but rather on the corporation’s prospects for remaining a viable, on-going concern. Corporation statutes, in contrast, do not deal with the borrowers’ incurring additional debt.


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In addition to the creditors who negotiated the contract, other (weak) creditors lacking adequate bargaining power (e.g. certain trade creditors) also benefit from these provisions, as long as the covenants are not breached. Obviously, credit agreements and financial covenants are not specifically designed for the shareholders’ needs. However, shareholders might be protected by these contractual agreements indirectly to the extent that their aim is the long-term viability of the corporation. 4.2.2.5 Insolvency 4.2.2.5.1 Legal framework Delaware law does not discuss filing for insolvency. Federal bankruptcy law neither requires an insolvent company to file for bankruptcy, nor is insolvency a requirement to commence a bankruptcy proceeding. Corporations may seek to accomplish an out of court restructuring. Under the Delaware Uniform Commercial Code, “insolvent” means: (a) having generally ceased to pay debts in the ordinary course of business other than as a result of a bona fide dispute; (b) being unable to pay debts as they become due; or (c) being insolvent within the meaning of federal bankruptcy law. There are no specific duties of the board of directors concerning insolvency. A board of directors of a solvent company always owes duties of care and loyalty to the shareholders. Some court cases suggest, however, that, when a company moves toward the “zone of insolvency”, those duties may broaden to include a duty to creditors. 4.2.2.5.2 Economic analysis The corporations interviewed only spend very little on the monitoring of insolvency triggers, because they not only generate high amounts of cash, but also have very good levels of equity. However, the companies are of the opinion that significant efforts would be needed if they were “close to the edge”. In case of bankruptcies, the trustees focus on illegal distributions prior to the bankruptcy. Under the federal bankruptcy law, creditors can already attack a dividend as fraudulent in the case of unreasonably small remaining assets after the distribution. Therefore, already at the stage of distributions, the corporations, in general, have to take into account the insolvency law provisions of the federal bankruptcy and statutory laws.


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4.2.3 USA – California 4.2.3.1 Structure of capital and shares 4.2.2.1.1 Legal framework In 1977, California was the first US state to eliminate the traditional concept of legal capital. There is no statutory requirement for a California corporation to have a par value or subscribed capital. The California Corporations Code, however, permits a corporation to state a par value in its articles of incorporation if it wishes to do so. Structure of capital Subscribed capital The California law neither prescribes subscribed capital nor a minimum capital. Instead, the members of the board of directors, or the shareholders if the articles of incorporation so provide, determine the consideration for the shares being issued. Notwithstanding the foregoing, the Supreme Court of California has held that a corporation needs to be adequately capitalised and has found that a corporation is inadequately capitalised if the corporation is likely to have insufficient assets to meet its debts or if the capital is “illusory” or “trifling” compared with the business to be done and the risk of loss. Premiums Under California law, the term “share premiums” does not exist. Accounting principles and terminology generally divide the shareholders’ equity section of the balance sheet into two parts: contributed capital and retained earnings. The California law eliminates “stated capital” and thereby eliminates the necessity for dividing contributed capital under US generally accepted accounting principles (US GAAP). Protection of the stock corporations assets Under California’s statute, contributed capital initially represents the whole consideration the corporation received in exchange for its shares. In California, the board of directors cannot designate parts of the consideration to be “surplus” which can be distributed to the shareholders. In general, in California a distribution can only be made out of the retained earnings with the consequence that the entire purchase price of the shares cannot be distributed. However, the board of directors may declare a distribution in excess of retained earnings if the equity insolvency test is satisfied and the equity ratio is still at least 20 percent after the distribution has been made (for details see below). Structure of shares As mentioned above, the California law does not require par value shares. A corporation is, however, permitted to state a par value in its articles of incorporation. Besides that, each corporation must have at least one class of shares. The articles of incorporation are required to state the authorised number of each class of shares that (or series within a class) the corporation is permitted to issue. The number of issued shares of each class cannot exceed the number authorised under the articles of incorporation.


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4.2.3.1.2 Economic analysis Practical relevance of capital and structure of shares for an assessment of the viability of a company In our interviews, we have only encountered no-par value shares. The complete contribution is accounted for under common stock. The interviewees pointed out that common stock is for economic reasons not distributed to shareholders. This is a major difference compared with Delaware law, where directors can determine large parts or even all of the consideration to be “surplus” which can be distributed. Nevertheless, we were told that banks do not rely on the California Corporations Code provisions concerning capital formation and distributions when entering into loan agreements with California corporations. Concerning the verification of the importance of capital in the United States, please refer to a general analysis of certain ratios concerning the stated capital of S&P 500 companies in the Delaware section of this report. Restriction for distribution As already mentioned before, contributed capital generally cannot be distributed. Role of the capital in equity financing Concerning the role of equity financing in the United States, please refer to the Delaware section of this report where for the S&P 500 companies the ratio of capital to total shareholder’s equity shows has been analysed. Formations Our sample consisted of companies being already in existence for a longer period. Therefore, it was neither feasible nor useful to extract data on the initial foundation of this corporation. 4.2.3.2 Capital increase 4.2.3.2.1 Legal framework Under California law, there are provisions concerning capital increases by use of authorised capital including mechanisms to ensure that the contribution is paid. In addition, public corporations have to obey specific rules of US stock exchanges. Increase of capital A California corporation, through the board of directors (or the shareholders if the articles of incorporation so provide), has the statutory power to create, value and issue authorised shares. The number of shares authorised for issuance must be stated in the articles of incorporation. There is no maximum amount the authorised shares may cover set by law. If there are not enough authorised shares, the articles need to be amended for new issuances to occur. If a new class or series of shares are being issued, an amendment to the articles or other certificate of determination must be filed with the California Secretary of State that describes the characteristics of such new class or series of shares.


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In California, shares may also be created by the exercise of an option or warrant to purchase or subscribe to shares of any class or series, the exercise of a conversion right, stock split or share divided, reverse stock split, reclassification of outstanding shares into shares of another class, conversion of outstanding shares into shares of another class, exchange of outstanding shares for shares of another class or other change affecting outstanding shares. In addition to the rules of the California Corporations Code there are rules of US stock exchanges (e.g. Listed Company Manual of the New York Stock Exchange) that require stockholder approval for issuing shares under certain circumstances. Mechanisms to ensure the contribution of capital With respect to the subscription of new shares which were issued during a capital increase the same rules apply which California law provides for the subscription of shares during the formation of the corporation. The California Corporations Code provides that the board of directors, or the shareholders if the articles so provide, may authorise capital stock to be issued for consideration consisting of cash. In addition, in-kind consideration such as labour done; services actually rendered to the corporation or for its benefit or in its formation or reorganisation; debts or securities cancelled; and tangible or intangible property actually received either by the issuing corporation or by a wholly owned subsidiary are allowed. However, consideration may not consist of promissory notes of the purchaser (unless adequately secured by collateral other than the shares acquired or unless permitted as part of an employee stock purchase plan) nor future services. The board of directors (or the shareholders if the articles of incorporation so provide) has the responsibility of valuing contributions in kind. If the articles of incorporation grant the stockholders this right, such determination shall be made by approval of the majority of the outstanding stock entitled to vote thereon. If the articles do not grant the shareholders this right, then only the board is empowered to decide whether and what in-kind contributions the corporation will accept. Pre-emption rights Under the California Corporations Code, shareholders of a corporation are entitled to pre-emption rights only if the articles of incorporation explicitly provide for them (“opt in” approach). 4.2.3.2.2 Economic analysis In order to avoid capital increases and necessary amendments of the articles of incorporation as a consequence, one corporation interviewed has authorised almost one billion shares. It continually has slight increases in share numbers due to a stock option program for employees. To this end, the board had to approve the program including number and price of shares. The program ends after ten years. The board delegates to senior officers the power to negotiate the underwriting. The interviewees pointed out that under California law, companies would rarely have to amend the article as the number of share capital authorised can be set very high.


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Practical steps The following chronological order of practical steps would be necessary for a capital increase: Figure 4.2.3-1: Process for capital increase (USA-California)

Capital increase

Step 1 Directors consider to issue new shares.

Step 2 Directors check if the shares to be issued are covered by the articles (authorised capital).

Step 3 If all shares covered by the articles have already been issued: Resolution of the board of directors setting forth the proposed amendment.

Step 4 Approval of the amendment by the board of directors.

Step 5 Approval of the amendment by the affirmative vote of the majority of the outstanding shares entitled to vote.

Step 6 Amendment is filed with the California Secretary of State. The injection of contributions and the valuation process would comprise the following steps: Figure 4.2.3-2: Process for the injection of contribution (USA-California)


Step 1

The board authorises capital stock to be issued for consideration consisting of any or all of the following: money paid; labor done; services actually rendered to the corporation or for its benefit or in its formation or reorganisation; debts or securities cancelled; and tangible or intangible property actually received either by the issuing corporation or by a wholly owned subsidiary. However, consideration may not consist of promissory notes of the purchaser (unless adequately secured by collateral other than the shares acquired or unless permitted as part of an employee stock purchase plan) nor future services.

Step 2 If consideration is outstanding, the amount of consideration outstanding shall be documented on the certificate issued to represent partly paid shares.

Step 3 Board of directors’ determination on value of consideration is conclusive absent fraud.

Analysis Because theses processes have not been relevant to the corporation interviewed in recent years, we have not received any information on practical cases of capital increases, or contributions in kind. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data


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4.2.3.2.3 Protection of shareholders and creditors Based on the legal analysis one can draw the following key conclusions concerning the shareholders’ and creditors’ protection of the California provisions on capital increases. Shareholders are protected insofar, as the board of directors can only increase the capital if the additional shares are covered by the authorised capital set forth in the articles of incorporation. In the case all shares covered by the certificate of incorporation have already been issued, the shareholders’ approval is needed to amend the articles of incorporation. However, it has to be pointed out that a very high number of authorised share capital can be fixed in the articles with the consequence that the shareholders will not have to be asked for approval later. In specific circumstances, public corporations are required to get stockholders’ approval for issuing shares pursuant to rules of US stock exchanges. Under California law, it is not necessary to draw up a report by an independent expert in the case of contributions in kind. Instead, it is the directors’ (or shareholders’) duty to determine the consideration for stock. Although the California Corporations Code provides directors with broad discretion in the issuance and valuation of shares, the directors are constrained by their fiduciary duty as directors of the corporation to act in the best interests of all the shareholders of the corporation, and not for the purpose of personal profit or gain. If the board attempts to manipulate the issuance of shares where the shares are issued at an unreasonably low price or in favour of certain persons without a legitimate corporate purpose, then the transaction may be enjoined by the courts or the persons responsible may be held liable in damages. Under California law, pre-emptive rights that safeguard a stockholder’s right to maintain ownership of his proportionate share of the assets and protect a proportion of the voting control are possible. However, such a right has to be expressly granted in the certificate of incorporation (“opt in approach”). 4.2.3.3 Distribution 4.2.3.3.1 Legal framework The revision of the California Corporations Code in the mid-1970ies led to major changes in the treatment of distributions to shareholders by a corporation. The California law prescribes the circumstances under which a “distribution to its shareholders” may be made. Whether a corporation can do so generally depends on the ability to pay its debts as they become due and upon its retained earnings or its financial position, determined almost entirely in accordance with generally accepted accounting principles. In addition, there are statutory provisions concerning directors’ and shareholders’ liability for illegal distributions. Calculation of the distributable amount The California Corporations Code contains three tests for determining the legality of distribu-tions. A corporation cannot make a distribution if the corporation is, or as a result of the distribution would be likely to be unable to meet its liabilities (equity insolvency test). In addition, the corporation must satisfy two tests. Dividends are permitted out of a corporation’s retained earnings (retained earnings test). Alternatively, a corporation may pay a dividend if two balance sheet tests are satisfied (also referred to as remaining assets test). The first compares total assets to total liabilities (quantitative solvency test), and the second compares current assets to current liabilities (liquidity test). Furthermore, there are additional


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restrictions imposed on dividends on junior shares if a corporation has preferred stock outstanding. In California, distributions are prohibited which would cause the corporation to be rendered insolvent in the equity sense. The California Corporations Code provides: “Neither a corporation nor any of its subsidiaries shall make any distribution to the corporation’s shareholders (Section 166) if the corporation or the subsidiary making the distribution is, or as a result thereof would be, likely to be unable to meet its liabilities (except those whose payment is otherwise adequately provided for) as they mature.” If a California corporation meets the equity insolvency test a “distribution may be made if the amount of the retained earnings of the corporation immediately prior thereto equals or exceeds the amount of the proposed distribution”. In the event that sufficient retained earnings are not available for the proposed distribution, only one alternative is provided (remaining asset test). Under California law, the corporation must meet two balance sheet tests. First, the quantitative solvency test requires that, immediately after the distribution, total assets are no less than one and one-quarter times total liabilities, i.e. the equity ratio must be at least 20 percent. For the purpose of the quantitative solvency test only, goodwill, capitalised research and development expenses and deferred charges have to be subtracted from the assets. Deferred taxes, deferred income, and other deferred credits have to be subtracted from the liabilities. Secondly, the liquidity test requires that after the distribution, current assets equal current liabilities. However, if the average earnings of the corporation before income taxes and inter-est expense were less than the average interest expense for the preceding two fiscal years, the current assets are required to be at least one and one-quarter times current liabilities after distribution (contrary to US GAAP, the statutory provisions – under certain conditions – permit the inclusion of projected receipts as current assets if they are to be received pursuant to contracts obligating customers to make future payments). Where there are two or more classes of stock, additional restrictions are imposed on distributions to the junior shares. A corporation with outstanding shares entitled to liquidation preferences, cannot make a distribution to shareholders on junior shares if, after the distribution, the excess of its assets (exclusive of goodwill, capitalised research and development expenses, and deferred charges) over its liabilities (exclusive of deferred taxes, deferred income, and other deferred credits) would be less than the liquidation preference of the senior shares. A corporation with outstanding shares with dividend preferences may not make a distribution on junior shares unless, after the distribution, there would be sufficient retained earnings to cover all dividends in arrears on such preferred shares. The statute expressly authorises the creation of additional restrictions on distributions by provision in the articles of incorporation, bylaws, indenture or other agreement. The California law specifies the time at which the tests are to be applied. § 166 CCC provides that the time of any distribution by way of dividend shall be the date of declaration thereof. Therefore, the directors must act upon the latest financial statements available and on the basis of their general knowledge of the affairs of the corporation to the effect that its financial condition has not substantially deteriorated in the interim between the date of that balance sheet and the time when they take the action.


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Shareholders must be notified if a dividend is not chargeable to retained earnings. The notice must state the accounting treatment of the dividend. It must accompany the dividend or be given within three months after the end of the fiscal year in which it was paid. Connection to accounting rules California is the only state in the US which explicitly states what accounting rules have to be the basis of the distribution requirements. Wherever the California Corporations Code refers to “financial statements, balance sheets, income statements, and statements of cash flows, and all references to assets, liabilities, earnings, retained earnings, and similar accounting items of a corporation” it means that those items are prepared “in conformity with generally accepted accounting principles then applicable”. California also is the only state that requires the use of consolidated financial statements in determining the amount available for distributions. The purpose of consolidated financial statements is to present the financial position of the parent and its subsidiaries as if the group were a single company. The term “subsidiary” is defined under the California statute as “a corporation shares of which possessing more than 50 percent of the voting power are owned directly or indirectly through one or more subsidiaries by the specified corporation.” “Voting power” means the power to vote for the election of directors. The mere fact that a parent-subsidiary relationship exists does not always mean that a consolidated statement is required under US GAAP, and in case of doubt, attention will have to be given to US GAAP to determine where it is required or permitted. The California Corporations Code requires that the restrictions on distributions be applied to each corporation in the group. A separate determination has to be made for each corporation and its subsidiaries. Therefore, in a three-tier corporate group, for example, the ultimate parent must satisfy the tests based on the consolidated group financial statements (consolidation of the parent and both subsidiaries). The middle corporation must meet these tests based on the consolidated financial statements of the sub-group (consolidation of the middle corporation and its one subsidiary). The bottom level subsidiary must satisfy the tests on the basis of its single financial statements. The California Corporations Code contains a limited number of special modifications of the US GAAP accounts. Contrary to US GAAP, the profits derived from an exchange of assets shall not be included unless the assets received are currently realizable in cash. In conjunction with the application of the quantitative solvency and liquidity tests, the California law specifies several accounting practices. Even though such practices may contravene US GAAP, adherence to them is mandatory (for details see above “Calculation of the distributable amount”). Notwithstanding the foregoing, the financial statements of any corporation with fewer than 100 holders of record of its shares are not required to be prepared in conformity with US GAAP, if they reasonably set forth the assets and liabilities and the income and expense of the corporation and disclose the accounting basis used in their preparation. Determination of the distributable amount – responsibilities The California law provides that the declaration of distributions is left to the corporation subject to any restrictions in the articles of incorporation and by the applicable statutory provisions. In practice, the declaration of distributions generally is within the discretion of the


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board of directors and protected by the business judgement rule. However, directors have to obey any restrictions in the articles or bylaws or any other agreement and the applicable statutory provisions. Sanctions Directors who approve a distribution which violates the statutory restrictions are jointly and severally liable to the corporation for the benefit of non-consenting creditors or shareholders. In order to avoid liability an individual director has to vote against the illegal distribution. If a director voted for an illegal distribution, he is not liable if he performed his duties as a director with the care specified in the California Corporations Code. Directors may rely in good faith on the corporation’s financial statements, or other kinds of information presented to the corporation by an officer, employee, a committee of the board of directors or by any other expert who has been selected with reasonable care. For example, the directors are entitled to rely on the reports of independent accountants. Any director who is sued for recovery of improper distributions may implead all other directors liable and may compel contribution. If a director is liable for such improper distri-bution, he is subrogated to the rights of the corporation against shareholders. Shareholders who received the distribution with knowledge of facts indicating its impropriety are liable to the corporation for the benefit of all creditors or shareholders entitled to institute an action. The measure of liability is the amount of the unlawful distribution received plus interest thereon at the legal rate on judgments until paid. A shareholder who is sued for recovery of an illegal distribution may implead other shareholders who may be liable in order to compel their contribution. In addition, the California law explicitly provides that shareholder’s liability is not exclusive and shareholders may be liable under the fraudulent transfer law of the California Civil Code. 4.2.3.3.2 Economic analysis Overall, California law on distributions is considered to be very straightforward and easy to comply with. The distributable amount is derived from the most recent audited consolidated US GAAP financial statements. The tests are described as very mechanical. Due to the very good economic situation, high retained earnings and high amounts of cash, the compliance with the solvency test is not seen as a major issue. The decision of the board of directors on the distribution policy and its preparation takes a lot of time, but the associated costs are not incremental. Practical steps Based on the legal analysis, the distribution process generally requires the following practical steps which are the basis for the economic analysis.


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Figure 4.2.3-3: Due process for distributing profits (USA-California)


Step 1 Directors establish the value of the distribution they wish to make.

Step 2 Directors determine whether the distribution would likely render the corporation unable to meet its liabilities (except those whose payment is otherwise adequately provided for) as they mature (performance of the equity solvency test).

Step 3

Directors consult the US GAAP (consolidated) financial statements of the corporation and determine whether, immediately prior to the distribution, the retained earnings equal or exceed the amount of the proposed distribution (performance of the retained earning test).

Step 4

In case there are no or not sufficient retained earnings, directors determine whether, immediately after the distribution, (a) total assets (exclusive of goodwill, capitalised research and development expenses, and deferred charges) are no less than 125 % of total liabilities (exclusive of deferred taxes, deferred income, and other deferred credits) (quantitative solvency test) and (b) current assets equal current liabilities (in case the corporation has not earned its interest expense before taxes in the preceding two years the current ratio is increased to 1 ¼ to 1) (liquidity test) (performance of the remaining assets test).

Step 5 If there are shares outstanding entitled to liquidation preferences, directors determine whether the additional restrictions imposed on distributions to junior shares are satisfied (§ 502 CCC).

Step 6 If there are shares outstanding with dividend preferences, directors determine whether the additional restrictions imposed on distributions to junior shares are satisfied (§ 503 CCC).

Step 7 Directors check if there are any additional restrictions contained in the articles, bylaws, indenture or other agreement.

Step 8 The board of directors authorises the distribution by the corporation (amount, date of payment, etc.)

Step 9 Payment to shareholders.

Step 10 If applicable, notice must be given to shareholders identifying such distribution as being made from a source other than retained earnings.

Analysis Calculation of the distributable amount The basis for both the equity insolvency and the retained earnings test are the most recent audited US GAAP consolidated financial statements. Therefore, the performance of the tests is not very time-consuming; the numbers are already available. Due to the high retained earnings, the performance of the quantitative solvency test (total assets are no less than 125 percent of total liabilities) and the liquidity tests (current assets equal current liabilities) are not regarded as an issue. It is not intended to distribute more than the retained earnings. As a consequence, the statutory calculations are seen as simple and mechanical. Concerning the results of the CFO questionnaire with regard to determinants for distributions of US holding companies and their subsidiaries, please refer to the Delaware section of this report.


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Determination of the distributable amount Dividend policies and the intended target payout ratio are regularly communicated to the market. The decision of the board of directors is normally prepared by different departments of a company. The financial planning and accounting group performs a mid-term projection to determine how much cash will be available for paying dividends and buying back shares. They take into consideration how much cash will be required for operating purposes, the financial commitments, and the budget. These calculations result in the figure “cash available for distribution” which is not disclosed in the SEC report of the company (being a non-US GAAP number) but is made public via the company’s web-site. The treasury group normally reviews these calculations on behalf of the CFO. The whole process is primarily done for economic reasons. In addition, the calculations are used for meeting the statutory distribution requirements, especially the equity insolvency test. A quarter to a half person’s work (approximately 500 to 1,000 hours) per year is needed by average for the distribution process. The cash projections take 95 percent of the time; the actual calculation to see if the proposed dividend can be declared (i.e., can the corporate law tests be met) take only 5 percent of the time. Therefore, there are only about 25 to 50 hours of work incurred by application of the California distribution rules. Sanctions Much effort is put into applying the distribution requirements correctly in the first place and it is made sure that there is enough headroom concerning retained earnings and cash and cash equivalents. Therefore, the risk of a possible liability of the board of directors is seen as low. The application of the tests and the monitoring are purely internal processes. No external experts are involved, except for the fact that the tests are based on financial statements which have been audited before by the corporation’s audit firm. Related parties There were also no significant issues concerning the monitoring of the relationships with related parties and potential other refluxes of funds to shareholders. Incremental Costs HighQ LowQ Other Costs Hours spent 25 – 50 - - Hourly rate €100 €70 - €2,500 to €5,000 - - Total costs €2,500 to €5,000 4.2.3.3.3 Protection of shareholders / creditors Based on the legal and economic analysis one can draw the following key conclusions concerning the shareholders’ and creditors’ protection of the California distribution rules. The decision whether or not to make a distribution generally rests in the discretion of the board of directors of the corporation. Therefore, the shareholders have no statutory right to share in the corporation’s profits unless the board of directors declares a distribution. The board’s declaration of a dividend creates a legal obligation owed to the shareholders which generally cannot be repealed. Not withstanding the foregoing, (minority) shareholders might bring a lawsuit against directors, arguing that the board abused its discretion either in declaring, or in


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refusing to declare, dividends. In the United States, there are cases in which courts ordered closely-held corporations to pay, or not to pay, a dividend. Because the decision to pay a dividend, and its size, are normally matters protected by the business judgment rule, the courts generally are hesitant to reverse the board’s decision. As long as directors can identify some arguable corporate need to retain funds, courts generally will not second guess the board’s decision. There seems to be no case where the court ordered a dividend of a public corporation. However, due to the market forces public corporations take the shareholders’ expectations into consideration in order to increase the value of the shares. Because the shareholders elect the directors, and the directors are often substantial shareholders themselves, one might suppose that the directors have a strong incentive to make distributions when consistent with maximizing shareholder value. Shareholders and creditors are protected by the California statutory capital formation and distribution requirements. As explained above, the entire purchase price for the shares issued generally cannot be distributed. In case a corporation wants to distribute an amount in excess of retained earnings, there has to be an equity ratio after the distribution of at least 20 percent. It has to be pointed out that for the purpose of the quantitative solvency test (applicable where the proposed distribution is higher than the retained earnings) the US GAAP consolidated financial statements have to be adjusted. For example, goodwill has to be subtracted from the asset side of the balance sheet. Goodwill usually is a significant asset and its subtraction reduces the distribution capacity a lot. In addition, it has to be mentioned that – based on the interviews conducted in the US – distributions in excess of retained earnings do not seem to be common practice. In fact, all the corporations interviewed indicated that they have never done it and do not plan doing it. Because of other federal and statutory restrictions as well as liability risks it does not seem realistic that corporations make use of these possibilities. Another strong mean of creditor protection can be seen in the mandatory equity insolvency test. Furthermore, there are various contractual protections. From the directors’ perspective, the distribution rules leave less leeway and flexibility compared with other US state statutes. Nevertheless, directors can retain money when needed for internal investments and future growth of the business without asking for shareholders’ approval and they can easily distribute excess cash. Pursuant to the interview conducted, directors seem to live well with the statutory directors’ liability for illegal distributions. When determining the distributable amount they refer to the audited consolidated financial statements and to internal cash flow predictions. Complying with the California distribution requirements is not considered very burdensome, as long as the economic condition of the corporation is good, i.e. there is headroom in retained earnings and cash. In the case of operating difficulties of the corporation, a liquidity problem etc., the risk of liability increases if the directors nevertheless declare a distribution. Therefore, there are high efforts needed to underpin distributions in such circumstances. 4.2.3.4 Capital maintenance As described above, California law provides various provisions which preserve the corporation’s contributed capital. The capital of a California corporation generally equals what the shareholders paid for their stock and cannot be distributed (for details on the exemptions to this rule see above). Furthermore, there are statutory provisions on share repurchases, capital decreases, related party transactions and fraudulent transfers. In addition, in practice, contractual self protection of creditors is of importance.


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4.2.3.4.1 Acquisition of own shares 4.2.3.4.1.1 Legal framework California law generally allows share repurchases. It authorises the corporation to have the power to issue, purchase, redeem, receive, take or otherwise dispose of, pledge, use and otherwise deal in and with its own shares, bonds, debentures and other securities, subject to the statutory provisions and any limitations contained in the articles and any other applicable laws, including, importantly, the California Corporations Code restrictions on distributions. The California law applies identical restrictions to cash and property dividends, redemptions and share repurchases (for details see above). The California Corporations Code contains the following tests for determining the legality of a share repurchase. A corporation cannot acquire own shares if the corporation is, or as a result of the repurchase would likely be unable to meet its liabilities (equity insolvency test). If the proposed distribution meets the equity insolvency test, additional tests must be satisfied as well. The corporation may make purchases out of its retained earnings (retained earnings test). Alternatively, a corporation may purchase own shares if two balance sheet tests are satisfied (also referred to as remaining assets test). The first compares total assets to total liabilities (quantitative solvency test), and the second compares current assets to current liabilities (liquidity test). Furthermore, there are additional restrictions imposed on repurchases of the junior securities if a corporation has preferred stock outstanding. Finally, the California law expressly authorises additional restrictions upon repurchases under the articles of incorporation or the bylaws, or under an indenture or other agreement. A California corporation registered with the Securities and Exchange Commission (SEC) as a publicly traded corporation has to follow certain disclosure obligations. In accordance with the Exchange Act, in each quarterly report on Form 10-Q and in the annual report on Form 10-K the corporation must provide a table showing, on a month-to-month basis the following: the total number of shares purchased, the average price paid per share, the total number of shares purchased under publicly announced repurchase programs, and the maximum number of shares that may be repurchased under these programs (or maximum dollar amount if the limit is stated in those terms). In the case of an illegal share repurchase, the same statutory liability applies as for illegal dividends. Directors are jointly and severally liable to the corporation for the benefit of non-consenting creditors or shareholders. Shareholders who received the distribution with knowledge of facts indicating its impropriety are liable to the corporation for the benefit of all creditors or shareholders entitled to institute an action. In case the Delaware corporation is publicly traded and therefore has to obey the rules of the SEC, there are a number of sanctions if shares were acquired in contradiction of the law and SEC rules respectively. Economic analysis One California corporation interviewed entered into an accelerated share repurchase agreement with an investment bank approved by the board of directors authorising the company to buy back a specific number of shares or a specific dollar amount of shares over a agreed upon period of time. Because of the fact that the statutory requirements for dividends and stock repurchases are nearly identical and the necessary calculations are done only once for both kinds of distributions, the evaluation of the law by the corporation is more or less the same: only a minimal amount of work is needed to comply with the rules. Thus, the


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associated incremental costs are low. If a company decided to buy back shares despite difficult business conditions, we would expect that the incremental costs of the application of the statutory requirements would increase in order to achieve legal certainty. Practical steps The series of practical steps comprises: Figure 4.2.3-4: Process for the acquisition of own shares (USA-California)


Step 1 Directors establish the amount of shares they wish to buy back. Step 2 Directors perform the equity solvency test.

Step 3 Directors consult the US GAAP (consolidated) financial statements of the corporation and perform the retained earning test.

Step 4 In case there are no or not sufficient retained earnings, directors perform (a) the quantitative solvency test and (b) the liquidity test.

Step 5 If there are shares outstanding entitled to liquidation and/or dividend preferences, directors determine whether the additional restrictions imposed on distributions to junior shares are satisfied (§§ 502-503 CCC).

Step 6 Directors check if there are any additional restrictions contained in the articles, bylaws, indenture or other agreement.

Step 7 The board of directors authorises the share repurchase by the corporation. Step 8 If applicable, notice of distribution that is not chargeable to retained earnings.

Step 9

If publicly traded, the corporation must disclose in the Form 10-Q quarterly report and in the Form 10-K annual report in a table showing, on a month-to-month basis: the total number of shares purchased, the average price paid per share, the total number of shares purchased under publicly announced repurchase programs and the maximum number of shares that may be repurchased under these programs

Analysis One California corporation interviewed disposes of an authorisation by the board of directors that allows the corporation to repurchase shares. The decision to buy back shares is part of the overall distribution policy of the board described above. The corporation pointed out that the internal process to comply with the statutory requirements applicable to stock repurchases is similar to the dividend distribution process described in detail above. A procedural difference is seen in the fact that for California corporate law purposes the board must approve the aggregate amount of repurchases, a cap per share, and a definite time period within which the repurchases must be made. The board delegates to the CFO the power to enter into the relevant agreements within the parameters approved by the board. In addition, provisions of the federal Securities Exchange Act of 1934 (Section 10(b) and SEC Rule 10b-18) have to be applied which are more time-consuming and burdensome than the requirements of the California Corporations Code. SEC Rule 10b-18 provides a “safe harbour” for repurchases that comply with the conditions of the rule. If the conditions are met, the repurchase will not be deemed manipulative of the share price. The associated costs occur


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because of the requirements of the US securities legislation, not because of statutory requirements and, therefore, are not incremental. Therefore, practically no incremental costs are involved in this legal process. Again, due to the comfortable financial situation, the compliance with the tests is not a big issue. Incremental Costs HighQ LowQ Other Costs Hours spent 500 - - Hourly rate €100 €70 - €50,000 - - Total costs €50,000 4.2.3.4.1.3 Protection of shareholders and creditors Due to the fact that, under California law, the statutory restrictions on dividends and share repurchases are nearly identical, one can draw the same key conclusions concerning the associated shareholders’ and creditors’ protection of these rules based on the legal and economic analysis. 4.2.3.4.2 Capital decrease 4.2.3.4.2.1 Legal framework The California Corporations Code does not specifically address capital decreases. As previously stated, the California Corporations Code does not prescribe a (minimum) stated capital. 4.2.3.4.2.2 Economic analysis Capital “decreases” have never been relevant to corporations in our sample. Therefore we have not obtained any information concerning this process. 4.2.3.4.2.3 Protection of shareholders and creditors The California provisions on capital “decreases” protect shareholders and creditors if a shareholders’ approval is needed (in case so required by the articles of incorporation). In general, the capital “decrease” has to be disclosed to the public. 4.2.3.4.3 Share redemption 4.2.3.4.3.1 Legal framework A California corporation can distribute assets to stockholders by acquiring outstanding shares through redemption or repurchase. While a repurchase is a voluntary buy-sell transaction between the corporation and a stockholder, redemption refers to a forced sale initiated by the corporation, in accordance with a contract or the articles of incorporation. California law provides that a corporation may redeem any or all shares which are redeemable at its option by (a) giving notice of redemption, and (b) payment or deposit of the redemption price of the shares as provided in its articles or deposit of the redemption price pursuant to a trust fund.


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The trust fund shall be set up by the corporation with any bank or trust company in the state of California if, on or prior to any date fixed for redemption of redeemable shares, the corporation deposits (a) a sum sufficient to redeem, on the date fixed for redemption thereof, the shares called for redemption, (b) in the case of redemption of any uncertificated securities, an officer’s certificate setting forth the holders thereof registered on the books of the corporation and the number of shares held by each, and (c) irrevocable instructions and authority to the bank or trust company to publish the notice of redemption thereof (or to complete publication if theretofore commenced) and to pay, on and after the date fixed for redemption or prior thereto, the redemption price of the shares to their respective holders upon the surrender of their share certificates, in the case of certificated securities, or the delivery of the officer’s certificate in the case of uncertificated securities, then from and after the date of the deposit (although prior to the date fixed for redemption) the shares called shall be redeemed and the dividends on those shares shall cease to accrue after the date fixed for redemption. The deposit shall continue full payment of the shares to their holders and from and after the date of the deposit the shares shall no longer be outstanding and the holders thereof shall cease to be shareholders with respect to the shares and shall have no rights with respect thereto except the right to receive from the bank or trust company payment of the redemption price of the shares without interest, upon surrender of their certificates therefore, in the case of certificated securities, and any right to convert the shares which may exist and then continue for any period fixed by its terms. The California Corporations Code permits a corporation to establish one or more classes or series of shares which are redeemable, in whole or in part, (a) at the option of the corporation or (b) to the extent and upon the happening of one or more specified events. Subject to special exceptions for investment companies and professional or other corporations whose ability to conduct business is contingent upon certain shareholders continuing to hold shares, no redeemable common shares shall be issued or redeemed unless the corporation at the time has outstanding a class of common shares that is not subject to redemption provided with a few limited exceptions. The circumstances under which the corporation may reacquire its own shares also may be established by contract. The corporation may give notice of the redemption of any or all shares subject to redemption by causing a notice or redemption to be published in a newspaper of general circulation in the county in which the principal executive office of the corporation is located at least once a week for two successive weeks, in each instance on any day of the week, commencing not earlier than 60 nor later than 20 days before the date fixed for redemption. The notice of redemption shall set forth: (1) the class or series of shares or portion thereof to be redeemed; (2) the date fixed for redemption; (3) the redemption price; and (4) if the shares are certificated securities, the place at which the shareholders may obtain payment of the redemption price upon surrender of their share certificates. Notice also should be provided to the holder of books and records for the corporation. A corporation’s redemption is one of the transactions within the meaning of “distribution to its shareholders” by a corporation. Such redemption, therefore, is subject to the same restrictions imposed on all such distributions, like for example the equity solvency test and the retained earnings test.


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4.2.3.4.3.2 Economic analysis We have not received any information on share redemptions and the associated costs. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs - 4.2.3.4.3.3 Shareholder and creditor protection Shareholders and creditors are protected insofar, as the terms of the redemptions have to be stated in the articles of incorporation. Furthermore, if the stockholders do not believe that the price they receive for their shares redeemed is appropriate, they generally have the possibility to challenge this. Principles of good faith and fair dealing may be implicated in the setting of a redemption price. 4.2.3.4.4 Financial assistance 4.2.3.4.4.1 Legal framework California law does not deal directly with transactions such as leveraged buy-outs (LBOs). 4.2.3.4.4.2 Economic analysis We have not received any information on financial assistance. 4.2.3.4.5 Serious loss of half of the subscribed capital 4.2.3.4.5.1 Legal framework Under California law, there is no provision which requires the board of directors to call a shareholders’ meeting in case of a loss of half of the subscribed capital. 4.2.3.4.5.2 Economic analysis Not applicable. 4.1.1.4.5.3 Shareholder and creditor protection Not applicable. 4.2.3.4.6 Contractual self protection 4.2.3.4.6.1 Legal framework California law does not bar corporations to enter into contractual credit agreements which might have, amongst other things, an impact on the distribution capacity, as long as statutory requirements are not violated. For over a century it has been common practice in the US that banks and other institutional lenders who extend a large amount of credit for a substantial


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period of time to corporations protect themselves by negotiating a bond or debenture indenture, or a loan agreement. These contracts usually contain elaborate provisions concerning the things, the borrowing company has obliged itself to do and not to, and the consequences in an event of breach. 4.2.3.4.6.2 Economic analysis The interviewees pointed out that the monitoring of the covenants involves much more time than applying the statutory distribution rules. Approximately one person’s work per year is needed (2,080 hours). Incremental Costs HighQ LowQ Other Costs Hours spent 2.080 - - Hourly rate €100 €70 - €208,000 - - Total costs €208,000 4.2.3.4.6.3 Shareholder and creditor protection The terms of the credit agreements are negotiated between the corporation and an individual creditor or a group of creditors, and thus reflect a realistic view of what creditors desire for their protection. The creditors of the company interviewed rely on the future prospects of a company, mainly its profitability and its ability to generate cash necessary to pay the debts when due. These creditors will not enter into the transaction without having a close look at the general economic condition and future cash flow and earning potential. The maintenance of specific liquidity and leverage ratios as well as limitations on further issuance of debt, as frequently negotiated in loan contracts, reduce the leveraged risk of the corporation. It is thus apparent that creditors do not focus on the sufficiency of assets remaining upon liquidation of the corporation for the settlement of their claims, but rather on the corporation’s prospects for remaining a viable, on-going concern. Corporation statutes, in contrast, do not deal with the borrowers’ incurring additional debt. The interviewees pointed out that banks do not rely on the California Corporations Code restrictions. In addition to the creditors who negotiated the contract, other (weak) creditors lacking adequate bargaining power (e.g. certain trade creditors) benefit from these provisions as well, as long as the covenants are not breached. Obviously, credit agreements and financial covenants are not specifically designed for the shareholders’ needs. However, shareholders might be protected by these contractual agreements indirectly insofar, as they aim at the long-term viability of the corporation. 4.2.3.5 Insolvency 4.2.3.5.1 Legal framework California law does not discuss filing for insolvency. Federal bankruptcy law neither requires an insolvent company to file for bankruptcy, nor is insolvency a requirement to commence a bankruptcy proceeding. Corporations may seek to accomplish an out of court restructuring. In the United States, under the Bankruptcy Code, an entity is insolvent if its debts are greater than its assets, at a fair valuation, exclusive of property exempted or fraudulently transferred.


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The subject of fraudulent transactions by a debtor has been codified in California by the enactment of the Uniform Fraudulent Transfer Act (UFTA), which is contained in the California Civil Code. This statute applies in connection with any debtor and, in general, its application is not affected by the fact that the debtor is a corporation. However, the UFTA does have a particular application in connection with any distributions by a corporation to its shareholders. The California Civil Code provides that a transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation: (1) with actual intent to hinder, delay or defraud any creditor of the debtor; or (2) without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor: (a) was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (b) intended to incur, or believed or reasonably should have believed that the debtor would incur, debts beyond the debtor’s ability to pay as they became due. 4.2.3.5.2 Economic analysis Generally, little time is spent on the monitoring of insolvency triggers, because companies generate high amounts of cash, but also have very good levels of equity. Economic aspects still prevail over legal form. However, it was pointed out that significant efforts are needed in periods of economic crisis. In case of bankruptcies the trustees focus on illegal distributions prior to the bankruptcy. Under the federal bankruptcy law, creditors can already attack a dividend as fraudulent in the case of unreasonably small remaining assets after the distribution. Therefore, already at the stage of distributions, the corporation, in general, takes into account the insolvency law provisions of the federal bankruptcy and statutory laws.


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4.2.4 Canada 4.2.4.1 Structure of capital and shares 4.2.4.1.1 Legal framework Canada does not follow the traditional system of legal capital rules. The general framework for Canadian companies is the federal Canada Business Corporations Act (CBCA) which includes provisions on Corporate Finance in Part V. It explicitly states that shares shall be without nominal or par value. As is the United States, Canada is a federal jurisdiction subdivided into ten provinces and three territories. However, both the federal government and the provincial governments regulate in the area of corporate law. Accordingly, there are fourteen corporate law statutes. For purposes of the study, only the federal CBCA will be examined. Structure of capital Subscribed capital Under the CBCA, there is no minimum capital requirement in Canada. Generally, a Canadian company will choose to have unlimited authorised capital. It may, however, in its articles, provide for a limit on capital. The more usual practice is to have no limit on authorised capital. In either case, this capital is referred to as authorised capital – not stated capital. The board of directors establishes the price for which shares are issued, including the value of any non-cash consideration. This consideration must represent the fair value of the goods or services provided – a matter to be determined by the board, which is entitled to rely on the assistance of experts. The articles deal only with authorised capital – not with issued capital. According to the CBCA the articles of incorporation shall set out the classes and any maximum number of shares that the corporation is authorised to issue, if there will be two or more classes of shares, the rights, privileges, restrictions and conditions attaching to each class of shares and if a class of shares may be issued in series, the authority given to the directors to fix the number of shares in, and to determine the designation of, and the rights, privileges, restrictions and conditions attaching to, the shares of each series. Except that there must be one class of shares which is characterised as common shares, these being shares which carry the right to elect directors, the right to dividends and the right to distribution of any remaining assets after obligations to all creditors and all other classes of shares have been satisfied, there are no limitations on the classes of shares which may be issued and the rights attaching to them. Since authorised capital may be unlimited, there is no requirement to subscribe for all authorised shares in either the articles or the CBCA nor is there any time limit by which shares must be subscribed. Premiums Because there is no concept of par value securities, there is no premium or contributed surplus. A company shall maintain a separate stated capital account for each class and series of shares it issues and shall add the appropriate stated capital account the full amount of any consideration it receives for the shares it issues. In the financial statements, stated capital (the consideration received for the issuance of shares) is usually described under the heading


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“shareholders equity” as “share capital“. Unless the company is a reporting issuer, its statements are generally not available to the public – that is, there is no public disclosure of stated capital. Protection of the stock corporations assets In Canada a distribution can generally only be made out of the retained earnings with the consequence that the entire purchase price of the shares cannot be distributed. Structure of shares In Canada, the CBCA requires that share capital must not have a nominal or par value and therefore shares do not have a stated value. Only non-par value shares may be issued. Most companies have only one class of shares (common) but a company may issue shares of as many classes with as many preferences and/or restrictions as the articles provide. Further, Canadian corporate and securities law permit multiple-voting and subordinate-voting shares. Shares of a class may be issuable in series with each series having certain common rights (for example, voting rights) but varying other rights (for example, the right to, or the amount of, a preferential dividend). If the company has more than one class of shares, one class is usually designated as common shares with the attributes described above and the other class or classes are generally entitled to a preference on dividends and distributions and either entitled to special voting rights or restricted from voting except in limited circumstances. However, the common shore rights may be in one or more classes of shares and need not be in a single class. The share conditions must be fully set out in the articles, which are a public document. 4.2.4.1.2 Economic analysis Practical relevance of capital and structure of shares for an assessment of the viability of a company There is no par value of shares in Canada. Based on interviews conducted, we have not been able to identify a particular view of Canadian companies regarding no-par value shares. Regarding the importance of capital, we have additionally performed an analysis of certain ratios concerning the capital of the main Canadian stock exchange index TSX 50.


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Figure 4.2.4-1: Ratio of share capital to market capitalisation (Canada)

Canada: Share Capital to Market Capitalisation

11%

22%

33%

19%

15%

< 5%5% - 10%10 % bis 20 %20 % bis 30 %> 30 %

Source: One source: Share capital for the FY 2005, market capitalisation as of September 2006 Compared to market capitalisation, the capital is below of 10 % of the market capitalisation in 33 percent of the companies. For 15 percent of the companies, the capital figure amounts to more than 30 percent. These ratios may also be influenced by the fact that the companies shall add to the appropriate stated capital account the full amount of any consideration it receives for the shares it issues, including premiums. In the financial statements, stated capital is usually described under the heading “shareholders equity” as “share capital“. In any case, the overall importance of the capital figure does not seem to be significant. Restriction for distribution As the share capital does not serve as a restriction for distributions there is no role for share capital in this regard. Role of the capital in equity financing Even though the capital amounts do not serve as distribution restrictions, the amounts allocated to share capital are quite substantial. Again, these ratios may also be influenced by the fact that the companies shall add to the appropriate stated capital account the full amount of any consideration it receives for the shares it issues, including premiums. In the financial statements, stated capital is usually described under the heading “shareholders equity” as “share capital“. The following figures have been accumulated for TSX50 companies:


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Figure 4.2.4-2: Ratio of share capital to total shareholder`s equity (Canada)

Canada: Share Capital to Total Shareholder's Equity

9%

17%

72%

0%2%

< 5%5% - 10%10 % bis 20 %20 % bis 30 %> 30 %

Source: One source: Share capital for the FY 2005, shareholder’s equity (consolidated) for the FY 2005 Formations Companies interviewed are regularly in existence for a longer period. Therefore, it was neither feasible nor useful to extract data on the initial foundation. 4.2.4.2 Capital increase 4.2.4.2.1 Legal framework In Canada, the number of shares which a company can issue is unlimited unless a company chooses to limit the number of shares authorised by its articles. Increase of capital Under Canadian law it is possible for a company to choose to have unlimited authorized capital. Generally, shares will be issued by resolution of the directors and no shareholders’ resolution is necessary. An exceptional situation would arise if a company limited the number of shares via an authorisation in its articles. However, such situations are rather unusual. The company would need to amend its articles to issue shares beyond its authorised capital. This would entail shareholder approval by an extraordinary resolution – that is, by two-thirds of those voting - and filing of the articles of amendment with the governmental authority. A proposal by a company to capitalise retained earnings (reserves) would be extremely rare as there are tax disincentives to a step of this nature but, to effect this step, a company must obtain the approval of two-thirds of the shareholders voting on the resolution. If a listed company sets aside shares for stock option plans, it must comply with applicable stock exchange rules (under the rules of the Toronto Stock Exchange (TSX), a shareholder vote is required). Under TSX rules, the strike price for stock options must not be less than the formula market price at the time of grant.


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In addition to the above TSX rules, the most important securities regulatory rule relates to related party transactions. In this situation, if, as a result of the transaction, the number of new shares (together with, in some cases, shares already held by the related party) cannot exceed 25% of the issued capital at the time of the transaction, on a undiluted basis, without the approval by the requisite majority of all shareholders (for many transactions, two-thirds of those voting) together with the favourable vote of a “majority of the minority” – that is, a majority of the shareholders who do not have an interest in the transaction. If a class of shares is issuable in series, the directors may authorise a new series complying with the class conditions and, in doing so, must file articles of amendment to authorise the series. The shareholders have no right to set any aspect of share consideration except where this right has been removed from the directors under an unanimous shareholders agreement. In connection with certain related party transactions in a public company context, shareholders may have the right to review and approve the decision of the directors to issue shares to a related party. Mechanisms to ensure the contribution of capital The directors determine the consideration for shares. A share shall not be issued until the consideration is fully paid. Principles applicable to the purchase price on share issuance are as follows: (i) shares may be issued at such times and to such persons and for such consideration as the directors determine; (ii) shares may only be issued as fully-paid and non-assessable (iii) if the consideration is property or past services, the directors must determine that payment in kind is not less in value than the equivalent of the money that the company would have received if the shares had been issued for money (iv) none of a promise to pay, a promissory note or an obligation to provide future services is acceptable property for the payment of shares. Pre-emption rights The issue of pre-emptive rights is governed by the CBCA. In Canada, there is no general pre-emptive right. The legislation specifically allows a company to include pre-emptive rights in its articles but provides that no pre-emptive right exists if shares are to be issued for a non-cash consideration, as a share dividend or on the exercise of a conversion, option or similar right. 4.2.4.2.2 Economic analysis We have not been able to retrieve reliable data for capital increases for Canada. We have been reassured that the bulk of the compliance cost regarding capital increases of public companies are mainly related to securities regulation, i.e. for the preparation of a prospectus. The efforts regarding the valuation of contributions in kind mainly depend on the size and complexity of the transaction. Smaller private deals are internally handled by M&A groups; for large public deals, a formal valuation by investment firms are performed; such a valuation could cost several million Can$.


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Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.2.4.2.3 Protection of shareholders and creditors Based on the legal analysis one can draw the following key conclusions concerning the shareholders’ and creditors’ protection of the Canadian provisions on capital increases. Shareholders are protected insofar, as the board of directors can only increase the capital if the additional shares are covered by the authorised capital set forth in the articles of incorporation. Usual practice is to have no limit on authorized capital. The board of directors establishes the price for which shares are issued; No shareholders resolution is necessary. In some exceptional cases, e.g. (1) a listed company sets aside shares for stock option plans, it must comply with applicable stock exchange rules, where a shareholder vote is required; (2) In connection with certain related party transactions in a public company context, shareholders may have the right to review and approve the decision of the directors to issue shares to a related party. Under Canadian law, it is not necessary to draw up a report by an independent expert in the case of contributions in kind. Instead, it is the board of directors’ duty to determine the consideration for stock expect where this right has been removed from the directors under an unanimous shareholders agreement. Generally, in Canada, there is no pre-emptive right. Pre-emptive rights can be included under certain circumstances in the company’s articles (“Opt in approach”). 4.2.4.3 Distribution 4.2.4.3.1 Legal framework The board of directors has the sole right to declare dividends. A dividend becomes a debt owing by the company only after it has been declared and not paid when due. Directors have the right to pay dividends in cash or in specie and to permit shareholders to elect to receive stock dividends in lieu of cash. If they do, the company, in effect, buys the stock and distributes it to the shareholders. If a company is a reporting issuer, there are requirements relating to the setting of record dates for the payment of dividends so that the stock can trade ex-dividend after the appropriate date and publication requirements of these dates established by the stock exchanges. A dividend (even a fixed dividend on preferred shares) may be declared and paid only if the company can meet the applicable solvency test after the payment of the dividend. Calculation of the distributable amount The only Canadian condition applicable to payment of a dividend is a solvency test. The Canadian test for the declaration of dividends is quite simple. A company is not entitled to declare or pay dividends if there are reasonable grounds for believing that:


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(a) the company is, or would be after the payment is made, unable to pay its liabilities as they fall due; or (b) after payment of the dividend, the realisable value of its assets will be less than the total of its liabilities and its stated capital. This is not a GAAP test nor is there any requirement as to the accounting method to be used. There is no direction as to the method of valuation but it must be appropriate in the circumstances; accordingly, the going concern assumption is usually most appropriate. In the ordinary course, a company which has earnings in excess of its dividend requirements generally is not concerned with the solvency test. The test only becomes an issue when there is a concern as to whether the company can meet the test. As directors will be personally, jointly and severally liable for repayment of an improper dividend, they generally take care in this area. The decision is ultimately that of the board but, for its own protection (it is entitled to rely on the advice of experts if it has a reasonable belief in their credibility), it will engage financial advisors for this purpose. Connection to accounting rules The solvency test is not a GAAP test nor is there any requirement as to the accounting method to be used. There is no direction as to the method of valuation but it must be appropriate in the circumstances; accordingly, the going concern assumption is usually most appropriate. Determination of the distributable amount – responsibilities The directors generally have the sole responsibility for determining whether a dividend is to be declared and paid. Each shareholder will know about the dividend when he or she receives his or her pro rata payment. Further, the financial statements of the company will show what dividends have been paid in the preceding year. Finally, if the company is a reporting issuer, the company will have an obligation to publish a dividend notice in advance setting out the amount and timing of dividends to allow trading pre- and ex-dividend. Sanctions Shareholders are entitled to challenge a dividend which has been made in violation of the solvency test. Otherwise, the board is free to declare a dividend in whatever amount it thinks fit. The only other remedy available to the shareholders is the oppression remedy. Because dividends are paid pro rata, it is difficult to see how this would be effective unless the company is closely held and there is an argument that the money is being siphoned out through wages or consulting contracts to the benefit of certain shareholders and the detriment of others. 4.2.4.3.2 Economic analysis Compliance requirements concerning dividend distributions mainly derive from solvency certificates whose format is determined by the provincial rules of Canada.


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Practical steps Based on the legal analysis, the distribution process generally requires the following practical steps which are the basis for the economic analysis. Figure 4.2.4-3: Due process for distributing profits (Canada)


Step 1 Directors determine if the applicable solvency test is met Step 2 Directors fix a record date Step 3 If required, directors publish the record date (dividend notice) Step 4 Directors declare the dividend Step 5 The company pays the dividend. Analysis Calculation of the distributable amount From an economic point of view, Canadian companies seem to follow an array of policies concerning the level of dividend distributions. Some companies seem to determine a certain percentage to their consolidated profits; others put more emphasis on investor relation aspects to individually determine what could be an appealing level of dividends to the capital markets. Companies conduct financial planning for several years ahead to make sure that the dividend can be paid not only in the current year but is also sustainable in the future. An interruption in constant dividend payments could have an adverse effect on the share price. As companies are not formally bound to an accounting framework, the starting point to check the legal compliance of a foreseen dividend payment is the solvency certificate which based on provincial law prescribes in more or less precise legal terms which conditions the company has to meet. The results of a CFO questionnaire sent to Canadian companies listed on main indices name the following factors as important and reconfirm the importance of the consolidated accounts: Figure 4.2.4-4: Determinants for the distribution of dividends in the holding company (Canada)

"What are the determinants for distribution of dividends by your holding company?"

2,88

1,502,50

3,25

3,383,75

3,192,262,54

3,49

2,78

4,10

1

2

3

4

5

Fin.performance

(groupaccounts)



company)

Dividendcont inuity

Signallingdevice


Tax rules

Determinants

Impo

rtan

ce

Canada

Non-EU Average



209

However, concerning the importance of the current legal restrictions on profit distribution, the CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market led solutions like rating agencies’ requirements or bank covenants. Bank covenants are ranked higher than insolvency legislation. Figure 4.2.4-5: Important deterrents when considering the level of profit distribution (Canada)


3,50

1,25

2,632,38

3,473,38

2,22

3,93

1

2

3

4

5





Deterrents

Impo

rtan

ce

Canada

Non-EU Average

Source: CFO Questionnaire, September 2007 Concerning the determinants of distributions from subsidiaries, CFOs ranked tax rules higher than demands from the ultimate parent and own investment decisions. Figure 4.2.4-6: Determinants for the distribution of dividends by the subsidiaries (Canada)


4,14

3,14

4,00

2,73

3,873,95

1

2

3

4

5


Determinants

Impo

rtan

ce

Canada

Non-EU Average

Source: CFO Questionnaire, September 2007 Determination of the distributable amount The legal compliance process is organised in the following way: the company consults with a legal counsel concerning the required form of the solvency certificate of the relevant provincial law under which the company is incorporated. The formats may vary from province to province and may contain vague legal terms which need judgment calls from the company’s side.


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The exact wording of the solvency certificate is the starting point for all legal compliance efforts. Typically, a solvency assessment is conducted by certain key executives of the company, e.g. CFO or vice president of treasury, and would include a check of the current (consolidated) balance sheet position, current cash at hand to pay dividends and a projection into the mid-term future. The relevant documentation may already be in existence for other purposes, e.g. bank covenants. This is possible because the requirements are not exactly defined by the solvency certificates. The certificate is presented with additional documentation to the finance/audit committee of the board of directors. The overall internal effort can require up to 520 hours of highly qualified personnel (¼ man year) depending on the financing of the company. In this context it is important to note that this effort may already include documentation for other purposes, i.e. bank covenants. The board of director finally decides on the dividend after the finance/audit committee has concluded on the solvency certificate. The solvency certificate is part of the board minutes; it is normally not available to the general public. Sanctions As directors will be personally, jointly and severally liable for repayment of an improper dividend, they generally take care Related parties We have not received any specific information concerning the monitoring activity in this regard. Incremental Costs HighQ LowQ Other Costs Hours spent 52 - - Hourly rate €100 €70 - €5,200 - - Total costs €5,200 4.2.4.3.3 Protection of shareholders / creditors The decision whether or not to make a distribution generally rests in the discretion of the board of directors of the company. Therefore, the shareholders have no statutory right to decide on a dividend unless the board of directors declares a distribution. However, due to market forces public companies normally will take the shareholders’ expectations into account when deciding on strategies concerning the levels of dividends or an increase of the share value. Creditors are not explicitly protected by the Canadian capital system and statutory distribution requirements. In Canada, distributions are allowed that leave the company almost without any equity. However, due to the required testing as well as associated liability risks, it does not seem realistic that companies make use of these possibilities. Concerning incentives to comply with distribution restrictions, every director who votes in favour of a distribution must sign a certificate stating that, in his opinion, the company satisfies the solvency test. The solvency certificate could support shareholders and creditors in


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their assessment of the viability of the company. However, the certificate is part of the minutes of the board and normally not publicly accessible. 4.2.4.4 Capital maintenance Canadian law provides for different instruments dealing with capital maintenance. Among these are the provisions on the limitation of the acquisition by the company of its own shares and the prohibition of financial assistance as well as the provisions on capital reductions and the withdrawal of shares. Furthermore, contractual self protection may play a certain role in the company’s practices concerning capital maintenance. 4.2.4.4.1 Acquisition of own shares 4.2.4.4.1.1 Legal framework Under Canadian law, the general principle is a prohibition on the acquisition of own shares, except as permitted in the legislation, a company may neither: (a) hold its own shares or the shares of its controlling shareholder; nor (b) permit any subsidiary to acquire its shares. If, however, a subsidiary does hold shares of the parent (for example, it was a shareholder before it became a subsidiary), it must dispose of the shares within five years. There are some specific exceptions – for example, a corporation can hold its own shares in a representative capacity (a trustee for a third party beneficial owner) or by way a security for a loan made in the ordinary course of business. There is also an exception if the shareholding is necessary to enable the company to meet a minimum Canadian content share ownership requirement of regulatory legislation - for example, telecom legislation. Most importantly, shares may be purchased or redeemed under a provision in the articles and according to the CBCA if, after paying for the acquired shares, the company meets the applicable solvency test. Unusually, the shares must be cancelled except in the case of a company with limited authorised capital where the shares can be restored to treasury. Further, in all cases, the stated capital account of the applicable class of shares will be reduced by the pro rata stated capital of the cancelled shares and the balance of the payment will be made from retained earnings. A reporting issuer may make either an “issuer bid” or a “normal course issuer bid” in accordance with applicable securities legislation. An issuer bid must comply, to the extent applicable, with the same regime as is applicable to related party transactions and takeover bid rules. These include timely disclosure, a formal valuation unless an exemption exists and pro rata treatment of all shareholders except for those who agree before the bid not to tender. A “normal course issuer bid” is a process by which a company can acquire up to 5% of its shares in any twelve-month period provided that no more than 2% of the shares is acquired in any thirty-day period. It is preceded by a timely disclosure report in a form required by securities legislation. Generally, the issuer is not active in the market in periods when insiders are free to trade and an issuer under a normal course issuer bid cannot make the market – that is, it can only respond at the market price from time to time by buying at market.


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If shares have been improperly purchased or redeemed, the company may apply for a court order requiring the shareholder to return the improperly paid money and the directors are also jointly and severally liable for any improper payment, subject to their ability to recover from the shareholder. In both cases, the action must be brought within two years. 4.2.4.4.1.2 Economic analysis We have not received any specific data on share buybacks. We were reassured that the procedure as such was very burdensome if it entailed the preparation of a prospectus. Furthermore, we have encountered “normal course issuer bids”. However, this instrument has in fact not been used. The internal preparations covered a financial analysis based on the normal documentation as used for distribution purposes or covenants. Incremental Costs HighQ LowQ Other Costs Hours spent - Hourly rate €100 €70 Total costs No data 4.2.4.4.1.3 Protection of shareholders and creditors Based on the legal and economic analysis one can draw the following key conclusions concerning the shareholders’ and creditors’ protection of the Canadian rules for acquisition of own shares. A Canadian company may generally neither hold its own shares or the shares of its controlling shareholder; nor permit any subsidiary to acquire its shares. However, some specific exceptions are possible. Most importantly in those cases, after paying for the acquired shares, the company meets the applicable solvency test. Further, in all cases, the stated capital account of the applicable class of shares will be reduced by the pro rata stated capital of the cancelled shares and the balance of the payment will be made from retained earnings. Moreover, a reporting issuer has to consider special safety measures: e.g. limited number of shares and disclosure duties. 4.2.4.4.2 Capital decrease 4.2.4.4.2.1 Legal framework A company may/must reduce its stated capital by the pro rata stated capital of the class of any shares acquired by the company on: (a) a purchase or redemption made by agreement or tender; (b) a purchase to compromise a debt, eliminate fractional shares or cash out a director, officer or employee; (c) a purchase under a shareholders’ right of dissent and appraisal where a shareholder is opposed to a fundamental corporate action (for example, an amalgamation) and the holders of a majority of the shares have approved the transaction; and (d) a purchase to satisfy an oppression remedy court order. In addition, a company may reduce its capital for any purpose by a special resolution under a favourable vote of two-thirds of the shares voting on the resolution. Unless the purpose is,


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however, to reduce its capital to an amount represented by realisable assets, it may not do so unless it meets the applicable solvency test. 4.2.4.4.2.2 Economic analysis We have not encountered any cases of capital decreases. 4.2.4.4.2.3 Protection of shareholders and creditors The Canadian rules are in so far shareholder and creditor protective, as they allow a reduction of the company’s stated capital only in specified cases by law or when special resolution of the shareholders meeting with a qualified majority of two-thirds has been past. Furthermore under certain circumstances a solvency test is necessary. 4.2.4.4.3 Share redemption 4.2.4.4.3.1 Legal framework Redeemable shares are expressly permitted under the Canadian legislation. Generally, the articles of a company will set out the terms of redemption of a class of shares and, if shares are issuable in series, the articles will set out what terms are common to the class and what terms may be set for each series issued within the class. If the shares are issuable in a series, the directors must approve an appropriate amendment to the articles to designate the terms of the series. The articles will, therefore, set out a complete code for the redemption of shares including matters such as notice and, on a partial redemption, the manner in which the shares to be redeemed are to be selected (pro rata, by lot, etc.). The one provision stipulated by the legislation is that shares may be redeemed only if the company can meet the applicable solvency test. If a company is a reporting issuer, the main features of its redeemable shares must be set out in its financial statements and accompanying notes as must any financial condition (for example, breach of a covenant in a loan document) which might impair redemption in accordance with the share conditions. 4.2.4.4.3.2 Economic analysis We have not received any information on share redemptions. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.2.4.4.3.3 Shareholder and creditor protection Shareholders and creditors are protected insofar, as the terms of the redemptions have to be stated in the terms of the issuance of shares or/and the constitution of the company.


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Furthermore, shares may be redeemed only if the company can meet the applicable solvency test. 4.2.4.4.4 Financial assistance 4.2.4.4.4.1 Legal framework Restrictions on financial assistance to shareholders are gradually being eliminated in Canada and have been eliminated in the federal legislation. Accordingly, the only rules that apply are where the target is a reporting issuer and the transaction is a takeover bid, an insider bid, an issuer bid, a business combination or a related party transaction. There are no specific rules applicable to LBOs. 4.2.4.4.5.2 Economic analysis We have not received any information on financial assistance. 4.2.4.4.5 Serious loss of half of the subscribed capital Under Canadian law, there is no provision which requires the board of directors to call a shareholders’ meeting in case of a loss of half of the subscribed capital. 4.2.4.4.6 Contractual self protection 4.2.4.4.6.1 Legal framework Both traditional lenders (banks) and corporate bondholders negotiate both negative and positive covenants in their loan and bond purchase agreements, as applicable. In recent years, these covenants have grown increasingly lax. The effect of this trend has been particularly noticed in private equity transactions (where investment grade corporate bonds are often reduced to junk bonds) as a result of the additional leverage employed by the private equity firms and in the recent period of economic uncertainty. The most common of these provisions do not deal with distributions; rather they impose a limit on leverage and an interest coverage test. Accordingly, dividends and other distributions to shareholders are often only impacted if their payment would lead to the company failing to meet these tests. On default, further distributions to shareholders are normally prohibited. In addition, if there is subordinated shareholder debt, repayment of this will be restricted as will payment of interest if the senior loan is in jeopardy. In times of economic uncertainty, covenants tend to be more tightly negotiated. There are no standard forms. If a company fails, small creditors will generally be unprotected – primarily because they are unsecured and, in these situations, there is usually only money available for secured creditors. In a CCAA-style workout, unsecured creditors may not be treated as well as bondholders but there are some protections available to them. To the extent that they extend credit to the company while it is under the CCAA protection (“rescue money”), this credit is generally a priority. Further, there are priority protections available in bankruptcy to employees and, to a much lesser extent, landlords. Finally, they may enjoy a class vote on the restructuring proposal, which may give them some negotiating leverage.


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The main reasons why lenders typically negotiate these contractual arrangements are: (a) on default, their debt crystallizes and they can demand repayment, subject to the ability of the company to repay and to whatever CCAA protection it negotiates; (b) these protections give them a leverage in negotiating favourable terms on bankruptcy or a workout, as applicable; (c) these provisions give them some control over the operations of the company during the period of negotiation; and (d) in the case of operating lenders (for example, banks), they can withhold further advances if it is in their best interests to do so. 4.2.4.4.6.2 Economic analysis Debt covenants play an important depending on the finance leverage of the company. Covenants relate to key performance figures of the companies, e.g. cash flow or EBITDA. Covenants may require enormous documentation and reporting efforts. However, this documentation may also be used for distribution and other purposes where a solvency assessment is required. Incremental Costs HighQ LowQ Other Costs Hours spent 468 - - Hourly rate €100 €70 - €46,800 - - Total costs €46,800 4.2.4.4.6.3 Shareholder and creditor protection The terms of the credit agreements are negotiated between the corporation and the creditor, and thus reflect a realistic view of what creditors desire for their protection. In addition to the creditors who negotiated the contract, other (weak) creditors lacking adequate bargaining power (e.g. certain trade creditors) benefit from these provisions as well, as long as the covenants are not breached. Even though, debt contracts and financial covenants are not specifically designed for the shareholders’ needs. However, shareholders might be protected by these contractual agreements indirectly insofar, as they aim at the long-term viability of the corporation. 4.2.4.5 Insolvency 4.2.4.5.1 Legal framework In Canada, a company is insolvent for insolvency legislation purposes if it is unable to meet its liabilities as they fall due (the going concern test) or if the realisable value of its assets is less than the amount of its liabilities. In theory, both of these tests are maintenances test which must be met at all times. In practice, however, the board is concerned with the tests only if the company is financially troubled. The duty of the directors is to the company and not to the creditors or even the shareholders, although some aspects of the U.S. concept of the “zone of insolvency” are beginning to be discussed in Canada.


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The directors must apply their business judgment as to whether and when a company files for protection under the Bankruptcy and Insolvency Act (BIA) or the Companies Creditors Arrangement Act (CCAA). The latter statute is a somewhat novel alternative to a standard bankruptcy proceeding. In general terms, it affords the company and its board greater time to effect a workout. Some companies have been under CCAA protection for up to two years. In other words, CCCA affords a U.S.-style debtor-friendly opportunity to negotiate a workout from insolvency. Under the bankruptcy and insolvency legislation, however, unless a workout proposal receives speedy creditor approval, a trustee-in-bankruptcy is appointed and control of the company is then effectively removed from the board. Because Canada does not have par value shares, there are no share premiums. Stated capital ranks as the last priority on an insolvency. Subject to any claim made under the oppression remedy, shareholder loans are treated in the same manner as any other debt and are afforded whatever contractual rights they enjoy. If there is a going concern issue, the board monitors both the financial pressures on the company and its ability to meet the solvency test. If the company is not forced into insolvency, the board determines whether to assign the company into bankruptcy under the BIA or to seek protection under the CCAA. Generally, if the board believes the company is viable, it will pre-emptively move under the CCAA to avoid being forced into bankruptcy and to retain control of the situation. 4.2.4.5.2 Economic analysis It was indicated that the specific effort of monitoring triggers of insolvency is low. The monitoring takes place via the regular internal reporting of key financial figures. The mindset of directors is directed towards the current assessment of the company’s financial position, especially from a cash perspective.


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4.2.5 Australia 4.2.5.1 Structure of capital and shares 4.2.5.1.1 Legal framework Australia does not follow the traditional system of stated legal capital. The Australian Corporations Act 2001 specifically requires that share capital must not have a stated value and therefore shares must also not have a par value. Structure of capital Subscribed capital Under the Corporations Act 2001, shares in all companies have no par value (effective from 1 July 1998). The concept of having a par value was abolished as, amongst other things, it was considered that par values could mislead unsophisticated investors as to the value of a particular share. The Explanatory Memorandum to the Company Law Review Bill 1997 notes the par value was simply an arbitrary monetary denomination which was attributed to shares and gave no indication of the value of a share at any particular time. There is no stated capital amount provided in the statutes although limits on capital can be specified in the constitution of the company and companies may have a numerical limit on shares in their constitution. For various (tax and practical) reasons, the minimum number of shares issued is generally at least two shares although these can be of any dollar value. Different share types can be issued which may be issued at various prices as determined by the board of the company. Premiums Under Australian law, the term “share premiums” does not exist. Shares are accounted for in accordance with the amount received since the concept of par value does not exist under current corporation legislation. All money received is credited to the company’s share capital account with no distinction between “par value” and “share premiums”. Australian Accounting Standard AASB 101: Presentation of Financial Statements prescribes the basis for preparation of general purpose financial reports for reporting entities - Clause 76 requires disclosures in the financial statements details in respect of share capital. Protection of the stock corporations assets In Australia a distribution can generally only be made out of the retained earnings with the consequence that the entire purchase price of the shares cannot be distributed. Structure of shares In Australia, the Corporations Act specifically requires that share capital must not have a nominal or par value and therefore shares do not have a stated value.


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4.2.5.1.2 Economic analysis Practical relevance of capital and structure of shares for an assessment of the viability of a company In Australia shares do not have a par value. Upon the introduction of no-par value shares the companies interviewed which were effected by that change faced no specific problems in transitioning to no-par value shares. There was just a reclassification in equity with no immediate impact on the distribution capability. The companies interviewed saw no merit in the concept of a par value of shares and one company called the par value an “outdated concept”. Regarding the importance of capital, we have additionally performed an analysis of certain ratios concerning the capital of the main Australian stock exchange index ASX 50. Figure 4.2.5-1: Ratio of share capital to market capitalisation (Australia)

Australia: Share Capital to Market Capitalisation

13%

30%

19%

21%

17%

< 5%5% - 10%10 % bis 20 %20 % bis 30 %> 30 %

Source: One source: Share capital for the FY 2005, market capitalisation as of September 2006 Compared to market capitalisation, the contributions allocated to capital are below of 10 % of the market capitalisation for 43 percent of the companies. The overall importance of this capital figure does not seem to be too significant. Restriction for distribution The capital as a profit distribution restriction does not play a significant role.


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Role of the capital in equity financing Figure 4.2.5-2: Ratio of share capital to total shareholder`s equity (Australia)

Australia: Shared Capital to Total Shareholder's Equity

2%

2%

13%

83%

0%

< 5%5% - 10%10 % bis 20 %20 % bis 30 %> 30 %

Source: One source: Share capital for the FY 2005, shareholder’s equity (consolidated) for the FY 2005 As contributions are allocated to the company’s capital, the ratio of this capital in relation to the total shareholder’s equity is relatively high in comparison to other countries. For more than 83 percent of the companies the ratio stays above 30 percent. Formations Most of the Australian companies interviewed were already in existence for a longer period and one recently formed company faced a specific situation which can not be considered as representative for the “regular” formation of a company. Therefore, it was neither feasible nor useful to extract data on the initial foundation of these companies. 4.2.5.2 Capital increase 4.2.5.2.1 Legal framework Australia law disposes of different rules regarding the issuance of new shares. Increase of capital When issuing securities including the issue of new shares, the process to be followed is prescribed by the Corporations Act 2001. The issuance of shares can be to existing shareholders or the general public (which will include existing shareholders) and generally needs a shareholder approval. However, the Australian regulatory environment allows shares to be issued from time to time subject to the internal company constitution at whatever price is sought. Where the share capital of a corporation is restricted in some way by the constitution of the company, then it will be necessary to alter the constitution in order to provide for additional capital. This process will be defined to some extent by the specific provisions of the constitution.


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There are certain rules relating to the listing requirements of the Australian Stock Exchange. The key features of these rules are as follows: • Shares can be issued without the approval of the holders of the ordinary shares (commonly referred to as a share placement) where the issue and any other issues in the last 12 months, is less than 15 percent of the shares outstanding at the beginning of the 12 month period; otherwise • Approval of the issue is required by the shareholders at a general meeting. Mechanisms to ensure the contribution of capital In Australia contributions in cash and in kind are possible. Non cash consideration is permissible under the Corporations Law subject to certain notices and requirements being satisfied. Australian case law shows that not only the general adequacy but also the particular value of non-cash consideration for the issue of shares has traditionally been regarded as a question for the directors' judgment. Pre-emption rights The Corporations Act 2001 provides pre-emption rights for existing shareholders. When a company decides to issue shares in a particular class it is required to offer those shares on a pro-rata basis to existing holders of shares of that class. That offer is to be made in a statement to shareholders setting out the terms of the offer, including the number of shares offered and the period of time that the offer will remain open. Where the pre-emption right is not exercised by the existing shareholders, any shares not taken up may be issued by the directors in any manner they see fit. As an alternative to complying with the foregoing, the company may, in general meeting, pass a resolution authorising the directors to make a particular issue of shares. 4.2.5.2.2 Economic analysis The cost for capital increases of public companies seem to be mainly dominated by compliance cost with securities regulation, e.g. for the preparation of a prospectus. Practical steps The following chronological order of practical steps would be necessary for a capital increase: Figure 4.2.5-3: Process for capital increase (Australia)

Capital increase

Step 1 Proposal of the board to issue new shares Step 2 Invitation to shareholders’ meeting

Step 3 Resolution by shareholders on capital increase and amendment to the Constitution (Memorandum and Articles of Association)

Step 4 Amending the Constitution to raise the amount of capital / funds Step 5 Publication


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The injection of contributions and the valuation process would comprise the following steps: Figure 4.2.5-4: Process for the injection of contributions (Australia)


Step 1 Monitoring if assets can be contributed Step 2 Monitoring of the requirements linked to the payment

Step 3 Performance of the valuation process by the board / possibility of shareholders setting the amount that must be paid in themselves

Analysis Because theses processes have not been relevant to nearly all of the corporations interviewed in recent years, we have only received very limited information on practical cases of regular capital increases including contributions-in-kind. Only one company interviewed had a capital increase in form of a major “rights issue”. In this case, there had not been any shareholder approval needed for this “rights issue”. A board approval was sufficient. The issue represented a major effort for the company in which the legal, tax and treasury departments were involved. Eight to twelve man-months were spent on the preparation of the respective decision. The board discussions could have taken approximately 20 hours. Furthermore external advice is needed including legal advice and accounting. Overall several million A$ were spent on this advice. Furthermore the publications necessary amounted to a minor expense (compared to the overall expense) as well. This process included the documentation of the issue and the preparation of a prospectus. Overall, the burdens for this issue were mainly driven by securities legislation and, thus, do not represent incremental costs stemming from company law. The specific circumstances of this “rights issue” would also not necessarily be indicative for the Australian situation concerning capital increases. Incremental Costs HighQ LowQ Other Costs Hours spent 20 - - Hourly rate €100 €70 - €2,000 - - Total costs €2,000 4.2.5.2.3 Protection of shareholders and creditors Under Australian law preventive rights exist. Based on the legal analysis one can draw the following key conclusions concerning the shareholders’ and creditors’ protection of the Australian provisions on capital increases. The issuance of shares generally needs a shareholder approval. However, the Australian regulatory environment allows shares to be issued from time to time subject to the internal company constitution at whatever price is sought. With respect to listed companies the following exception exists: Shares can be issued without the approval of the holders of the ordinary shares (commonly referred to as a share placement) where the issue and any other issues in the last 12 months, is less than 15 percent of the shares outstanding at the beginning of the 12 month period. Under Australian law, it is not necessary to draw up a report by an independent expert in the case of contributions-in-kind. Instead, it is the directors’ duty to determine the consideration for stock.


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4.2.5.3 Distribution 4.2.5.3.1 Legal framework The Australia Corporations Act does not define “distributions”. However, pursuant to the prevailing opinion, distributions include distributions of profits, being dividends and distributions of capital. In addition, the directors may fix the method of payment of a dividend. The methods of payment include the payment of cash, the issue o shares, the grant of options and the transfer of assets. Calculation of the distributable amount In Australia, the profit distribution rules are straight forward: any amount can be distributed as long as they are paid out of profits and do not render the corporation insolvent. In addition to the statutory requirements there are court decisions on distributions. Therefore, the principles established by case law have to be taken into consideration, too, when an Australian corporation determines the amount of a legal distribution. This series of rules governing the payment of dividends comprises that (1) dividends must not be paid if the result is that the company is unable to pay its debts; (2) current revenue profits may be distributed without making good revenue losses of previous periods; and (3) undistributed profits remain profits which can be distributed in later years. According to the profits test, in Australia dividends may only be paid out of the corporation’s profits. Moreover, Australian law provides that a dividend may be payable by way of cash, the issue of shares, the grant of options and the transfer of assets. Being a replaceable rule, technically, the company could amend that definition by adopting an alternate rule as part of its constitution. In Australia, there is case law on the treatment of losses of fixed assets when determining the distributable amount. Losses in circulating assets in the current accounting period must be taken into account in calculating divisible profit. With respect to solvency tests, in Australia, there is a need for an overriding condition of solvency. Australian law makes it clear that the payment of a dividend may be an act of insolvent trading. While it is well established that a company may borrow in order to obtain the cash necessary to pay the dividend it appears that the money borrowed together with funds in hand must be sufficient to cover not only the dividend but also liabilities presently due and payable. The relevant guiding principles are defined by Australian case law: “(1) Dividends including capital dividends may be paid only out of profits, or putting the matter conversely, may not be paid out of paid up capital without the Court’s approval of a reduction of capital. (2) The payment of a dividend out of paid up capital will occur if the payment has the effect of reducing the company’s net assets (often referred to as shareholders’ funds) below the amount of its paid up capital. The expression ‘net assets for present purposes’ means the amount which remains after deducting all the company’s liabilities both actual and contingent prudently assessed from the sum of all its assets prudently valued. Accounts should be taken


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to demonstrate the company’s position overall. A capital or income transaction should ordinarily not be viewed in isolation. (3) Whether there are profits and if so how much thereof should be paid out as dividend is essentially a matter of commercial assessment and judgment but that assessment and judgment must be made and exercised with these and the following propositions in mind. (4) No dividend may be paid, whether out of capital or income profits, if the company is in a state of trading insolvency. (5) No dividend may be paid, whether out of capital or income profits, if the company is in a state of balance sheet insolvency, or will enter that state as a result of the payment. (6) No dividend may be paid, whether out of capital or income profits, if the company is in a state of doubtful trading or balance sheet solvency [sic] unless the directors can demonstrate, if later challenged, that they believed in good faith and on reasonable grounds that the payment of the dividend would not jeopardise the company’s ability promptly to satisfy its creditors present and future and whether secured or unsecured. (7) Even if the company is fully solvent in both the trading and balance sheet senses no dividend may be paid whether out of capital or income profits if the directors ought to have appreciated that such payment was likely to jeopardise the company’s balance sheet or trading solvency.” All companies, registered schemes and disclosing entities required to prepare annual financial statements must also prepare a directors' declaration about the financial statements. The directors' declaration must state firstly: whether, in the directors' opinion, there are reasonable grounds to believe that the company, scheme or entity will be able to pay its debts as and when they become due and payable (known as the "solvency declaration); secondly: whether, in the directors' opinion, the financial statements and notes have been prepared in accordance with the Act including accounting standards present a true and fair view. While not specifically stated in the Act, because the directors' declaration on the financial statements forms part of the financial report. Both, ASIC and the AuASB, hold the view that the directors' declaration forms part of the financial statements and should be audited. The auditor's duty is to form an opinion as to whether the directors' declaration is in accordance with the Act. With respect to nimble dividends, there are Australian court decisions concerning the question whether or not current revenue profits may be distributed without making good revenue losses of previous periods. It was held that losses in prior years need not be made good before ascertaining available profit for the current year. Connection to accounting rules All companies in Australia are subject to IFRS as adopted in Australia. The profits/retained earnings determined under these standards form the basis for dividend distributions. Shares are accounted for in accordance with the amount received since the concept of par value does not exist under current corporation legislation. All money received will be credited to the company’s share capital account with no distinction between “par value” and “share premiums”.


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Australian Accounting Standard AASB 101: Presentation of Financial Statements prescribes the basis for preparation of general purpose financial reports for reporting entities - Clause 76 requires disclosures in the financial statements details in respect of share capital. The Australian equivalents of International Financial Reporting Standards (AIFRS) apply for reporting periods on or after 1 January 2005. ASIC has clarified that its interpretation of the impact of the AIFRS is that retained profits reported on a pre-AIFRS basis will not be relevant for the payment of dividends. Thus, for the purposes of determining whether or not companies are able to pay dividends, only retained profits and current year profits recorded under AIFRS will be relevant from that time going forward: This will include unrealised gains under AIFRS. Determination of the distributable amount – responsibilities In Australia, the declaration of dividends generally is within the discretion of the board of directors. Pursuant to Australian law, the directors may determine that a dividend is payable and fix the amount, the time for payment and the method of payment. However, directors have to obey any restrictions in the statutes and the applicable statutory provisions as well as the principles derived from case law. Unless a public company has a constitution which provides for shares in a class to have different dividend rights or different dividend rights are provided for by special resolution, each share comprised in that class has the same dividend rights. In relation to listed companies, the holders of partly-paid securities are entitled to a dividend no greater than the proportion paid up (ignoring amounts being paid in advance of calls). Sanctions A dividend that is paid other than out of profits would result in a reduction of capital. The directors may be liable to the creditors or liquidator of a company for the amount of a dividend paid which exceeds available profits Auditors may be liable in negligence for acts or omissions which result in a payment of dividends out of capital. It would also appear that a right of action may exist against shareholders who receive wrongly paid dividends. This right of action may depend on the shareholders’ state of mind when the payment was received. At least in the case of a knowing recipient who was aware of the wrongfulness of the payment, liability is fairly settled. The position of innocent recipients is less clear. Their liability may turn on the nature of the action. 4.2.5.3.2 Economic analysis The Australian requirements concerning profit distributions are mainly governed by comprehensive jurisprudence. However, this large amount of jurisprudence is rather focussed on extreme situations that companies may face and is not likely to affect companies with a good earnings position. Practical steps Based on the legal analysis, the distribution process generally requires the following practical steps which are the basis for the economic analysis.


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Figure 4.2.5 -5: Due process for distributing profits (Australia)


Step 1 Directors determine the amount of dividend to be paid (Performance of impairment of capital test/ retained earnings test etc; Performance of solvency test)

Step 2 Final dividend formally approved by shareholders at a general meeting

Step 3 Amount, ex-dividend date, taxable amount (franked versus unfranked amounts) and payment date

Step 4 Payment to shareholders Analysis Calculation of the distributable amount From an economic point of view, the management of the companies interviewed follow diverse policies concerning the level of dividend distributions. For example, some companies generally determine a certain percentage to their consolidated profits; others put more emphasis on investor relation aspects to individually determine what could be an appealing level of dividends to the capital markets. Another aspect that is taken into account is the fact that Australian taxation regarding dividends paid is based on a “franking system”. All companies in Australia have to apply the Australian adoption of International Financial Reporting Standards. One company applied the international version of IFRS additionally. The profits/retained earnings determined under these standards form the basis for dividend distributions. The results of a CFO questionnaire sent to Australian companies listed on main indices show the following determinants for distributions from subsidiaries: Figure 4.2.5-6: Determinants for the distribution of dividends in the holding company (Australia)

"What are the determinants for the distribution of dividends by your holding company

4,74

2,89 3,212,74

3,443,89

2,78

4,103,49

2,542,26

3,19

1

2

3

4

5

Fin.performance

(groupaccounts)



company)

Dividendcontinuity

Signallingdevice


Tax rules

Determinants

Impo

rtan

ce

Australia

Non-EU Average

Source: CFO Questionnaire, September 2007 However, concerning the importance of the current legal restrictions on profit distribution, the CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market led solutions like rating agencies’ requirements or bank covenants.


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Figure 4.2.5-7: Important deterrents when considering the level of profit distribution (Australia)

"Which of the following deterrents are important for you when you consider the level of profit distributions?"^

3,95

3,26

3,63

2,58

2,22

3,47

3,38

3,93

1

2

3

4

5





Deterrents

Impo

rtan

ce

Australia

Non-EU Average

Source: CFO Questionnaire, September 2007 Concerning the determinants of the distributions from subsidiaries, the results of a CFO questionnaire sent to Australian companies listed on main indices shows the following picture. Figure 4.2.5-8: Determinants for the distribution of dividends by the subsidiaries (Australia)


3,72

2,50

4,61

2,733,95

3,87

1

2

3

4

5


Determinants

Impo

rtan

ce

Australia

Non-EU Average

Source: CFO Questionnaire, September 2007 Determination of the distributable amount The responsibility for the decision on dividend distributions lies with the board of directors. The CFO, the tax and treasury departments are regularly involved in the process of preparing that decision and proposing a dividend to the board. In one company a specifically dedicated employee of the CFO team prepares a document which after the review by the CFO is used as a basis for the decision of the board. Also the audit committee of the company may get involved in the discussion on the distribution proposal. Generally, the companies undergo this process twice a year due to an interim dividend paid. The preparation time was estimated in a range between 5 to 20 hours of highly qualified personnel and the board decisions including discussions of the board and the audit committee take between 1.5 to 84 man hours of the same category. The actual time spent also depends on the size and complexity of the company.


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The companies interviewed generally perform cash flow projections, budget forecasts or business plans for the management of the company. This information is also used for the decisions concerning distributions. But no company indicated that a special cash flow projection system was set up exclusively for distribution purposes. Furthermore, some companies stated that the board has to issue a “solvency declaration” in another context. Even though not dedicated for distribution purposes, distributions are an issue when there are discussions in the board on this “solvency declaration”. It depends on the specific situation of the company whether a significant effort is necessary to channel up profit and cash to the parent company level in order to be able to make distributions. Some of the companies interviewed stated that this was not an issue due to their group structure; others indicated significant efforts in this regard. We have neither been given specific reasons nor have we been in a position to receive detailed cost data on these efforts. All companies engage specific agencies for the final payment of dividends. These costs are covered by service agreements and depend on the number of shareholders as well. Since these costs are mainly driven by capital market requirements, they may not be seen as incremental. One company indicated that 4 hours of highly qualified personnel were spent for the internal preparations for the payment of the dividends. Sanctions One company regarded the effort spent on monitoring the compliance with distribution regulations as high; the other companies saw the specific monitoring effort as low. All companies regarded the liability risk due to non-compliance as low. This may be based on the reliance on distribution process implemented and/or simply due to a positive economic situation of the company. Related parties The level of monitoring concerning related party transactions depends on the individual shareholder structure of the companies interviewed. Half of the companies interviewed considered the efforts to be high and the other half of the companies to be low. One company has a major shareholder and reviews related party transactions regularly every three month. Some of the companies interviewed do not have significant related parties outside the group. The focus of tracking related party transactions generally lies on related party disclosures required in the financial statements of the companies. The reflux of funds does not appear to be an immediate focus of the monitoring processes. Incremental Costs HighQ LowQ Other Costs Hours spent 6.5 to 104 - - Hourly rate €100 €70 - €650 to €10,400 - - Total costs €650 to €10,400


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4.2.5.3.3 Protection of shareholders / creditors Based on the legal and economic analysis one can draw the following key conclusions concerning the shareholders’ and creditors’ protection of the Australia distribution rules. The decision whether or not to make a distribution generally rests in the discretion of the board of directors of the corporation. Therefore, the shareholders have no statutory right to share in the corporation’s profits unless the board of directors declares a distribution. Shareholders and creditors are protected by the Australian statutory capital formation and distribution requirements. As explained above, a dividend may only be paid out of profits of the company, accordingly the entire purchase price for the shares issued generally cannot be distributed. All companies in Australia are subject to IFRS as adopted in Australia. The profits/retained earnings determined under these standards form the basis for dividend distributions. Furthermore, in Australia, there is a need for an overriding condition of solvency. The Corporations Act makes it clear that the payment of a dividend may be an act of insolvent trading. 4.2.5.4 Capital maintenance Australian law provides for different instruments dealing with capital maintenance. Among these are the provisions on the limitation of the acquisition by the company of its own shares and the prohibition of financial assistance as well as the provisions on capital reductions and the withdrawal of shares. Furthermore, contractual self protection may play a certain role in the company’s practices concerning capital maintenance. 4.2.5.4.1 Acquisition of own shares 4.2.5.4.1.1 Legal framework A prohibition of the self-acquisition of shares (or units in shares) reflects the concerns expressed in the case law. It was held that persons who deal with a company “are entitled to assume that no part of the capital which has been paid into the coffers of the company has been subsequently paid out, except in the legitimate course of its business.” According to the Corporations Act 2001, a company must not acquire shares in itself except: (a) in buying back shares under § 257A CA; or (b) in acquiring an interest (other than a legal interest) in fully-paid shares in the company if no consideration is given for the acquisition by the company or an entity it controls; or (c) under a court order; or (d) in circumstances covered by § 259B(2) or (3) CA, i.e. taking security over own shares under an employee share scheme or by a financial institution. Concerning the conditions for share repurchases, it is firstly required that buy-backs do not materially prejudice the company’s ability to pay its creditors and secondly, the company must follow procedures laid down by the Corporations Act 2001. The solvency test only refers to the ability to pay the creditors and is confined to a material impact. Under the Corporations Act, the directors may have to compensate the company if the company is, or becomes, insolvent when the company enters into the buy-back agreement. A table in the Corporations Act specifies the steps required for, and the sections that apply to, the different types of buy-back. An ordinary resolution is required if the buy-back exceeds


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10% of the voting rights during a period of 12 month (10/12 limit), a selective buy-back requires a special or unanimous resolution. Immediately after the registration of the transfer to the company of the shares bought back, the shares are cancelled. Regarding disclosure, in cases of a selective buy-back or a share buy-back under an equal access scheme the offer documents must be lodged with the Australian securities regulator ASIC and the company must include with the offer to buy back shares a statement setting out all information known to the company that is material to the decision whether to accept the offer. 4.2.5.4.1.2 Economic analysis Some of the companies interviewed have acquired own shares in the recent past. One of the reasons given for the repurchase of own shares was excess funds of the companies. The share buyback processes implemented in the companies are comparable to those for dividend distributions. Generally, the treasury function is involved in the buybacks. Depending on the specific circumstances the time spent on the preparation of the board decision amounts from 30 to a few hundred hours of highly qualified personnel. The board decision itself takes between 5.5 and 24 man hours. Additionally, one company has spent a significant amount of fees (approx. A$ 380,000) for legal advice deemed necessary for a major buyback of shares. In addition to the buyback itself there are reporting requirements. One company indicated that it takes 5 minutes per month of reporting time. Some interviewees had stock option programmes in which share-buybacks are an essential element. One company outsourced this task to a trustee. One other company estimated the effort for these buybacks between two and three hours of highly qualified personnel. Overall, the efforts for these acquisitions are not as burdensome as the “regular” re-acquisitions of own shares. Incremental Costs HighQ LowQ Other Costs Hours spent 35.5 to 325 - - Hourly rate €100 €70 - €3,550 to €32,500 - - Total costs €3,550 to €32,500 4.2.5.4.1.3 Protection of shareholders and creditors Under Australian law a company generally must not acquire shares in itself. An acquisition of own shares is only possible, if the buy-back does not materially prejudice the company’s ability to pay its creditors. Furthermore, shareholders are protected insofar as a shareholders’ resolution is required if the buy-back exceeds 10% of the voting rights during a period of 12 month (10/12 limit); a selective buy-back requires a special or unanimous resolution.


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4.2.5.4.2 Capital decrease 4.2.5.4.2.1 Legal framework Australian Law applies the alternative model for capital in that no par value applies. Nonetheless there are various means by which capital can be returned to the company. The Corporations Act defines the means and requirements for reductions in capital and share buy-backs. The rules are designed to protect the interests of shareholders and creditors by: (a) addressing the risk of these transactions leading to the company’s insolvency (b) seeking to ensure fairness between the company’s shareholders (c) requiring the company to disclose all material information. Subject to a company’s constitution, a company may reduce its share capital in a way that is not otherwise authorised by law if the reduction is fair and reasonable to the company’s shareholders as a whole and does not materially prejudice the company’s ability to pay its debts. A cancellation of a share for no consideration is generally a reduction of share capital. One of the ways in which a company might reduce its share capital is cancelling uncalled capital. The company must not make the reduction unless it complies with these requirements. If the company contravenes the requirements, the contravention does not affect the validity of the reduction or of any contract or transaction connected with it and the company is not guilty of an offence. Any person who is involved in such a company’s contravention and the involvement is dishonest, commits an offence. Reductions in capital are either an equal reduction or a selective reduction. The reduction is an equal reduction if it relates only to ordinary shares, it applies to each holder of ordinary shares in proportion to the number of ordinary shares they hold and the terms of the reduction are the same for each holder or ordinary shares. Otherwise, the reduction is a selective reduction. The Corporations Act requires that if the reduction is an equal reduction, it must be approved by a resolution passed at a general meeting of the company. If the reduction is a selective reduction, it must be approved by either (a) a special resolution passed at a general meeting of the company, with no votes being cast in favour of the resolution by any person who is to receive consideration as part of the reduction or whose liability to pay amounts unpaid on shares is to be reduced, or by their associates; or (b) a resolution agreed to, at a general meeting, by all ordinary shareholders. If the reduction involves the cancellation of shares, the reduction must also be approved by a special resolution passed at a meeting of the shareholders whose shares are to be cancelled. The company must lodge with ASIC a copy of any resolution concerning a selective reduction within 14 days after it is passed. The company must not make the reduction until 14 days after the lodgement. Furthermore, the company has to pass the solvency test, otherwise the directors may have to compensate the company if the company is, or becomes, insolvent when the company reduces its share capital.


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4.2.5.4.2.2 Economic analysis Within our sample of Australian companies, we have not encountered any “regular” capital decreases. One similar situation encountered was company specific and is not covered by the rules of Australian corporation law. 4.2.5.4.2.3 Protection of shareholders and creditors Both kinds of reductions in capital, i.e. an equal reduction or a selective reduction, require a resolution of the shareholders. Therefore, in both cases shareholders are involved in the decision making process. Furthermore, the company has to pass the solvency test, otherwise the directors may have to compensate the company if the company is, or becomes, insolvent when the company reduces its share capital. 4.2.5.4.3 Share redemption 4.2.5.4.3.1 Legal framework An Australian company may issue redeemable preference shares. Under the Corporations Act, a company’s power to issue shares includes the power to issue preference shares including redeemable preference shares. The power to issue redeemable shares is also determined by the constitution of the company, and follows the approval process as set out in the constitution (including the statutes) or by approval of the shareholders by special resolution. The conditions under which the redeemable shares can be redeemed are prescribed by the terms of issue (included in any offering document such as a Prospectus or Information Statement). On redemption, the shares are cancelled. A company may only redeem redeemable preference shares if the shares are fully paid-up and out of profits or the proceeds of a new issue of shares made for the purpose of the redemption. Furthermore, the company has to pass the solvency test, otherwise the directors may have to compensate the company if the company is, or becomes, insolvent when the company reduces its share capital. If a company redeems shares in contravention of the Corporations Act, the contravention does not affect the validity of the redemption or of any contract or transaction connected with it; and the company is not guilty of an offence. Any person who is involved in a company’s contravention of the Corporations Act and the involvement is dishonest, commits an offence. 4.2.5.4.3.2 Economic analysis Within our sample of Australian corporations, we have not received any information on share redemptions. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data


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4.2.5.4.3.3 Shareholder and creditor protection Shareholders and creditors are protected insofar, as the terms of the redemptions have to be stated in the terms of the issuance of shares or/and the constitution of the company. Furthermore, the company has to pass the solvency test, otherwise the directors may have to compensate the company if the company is, or becomes, insolvent when the company reduces its share capital. 4.2.5.4.4 Financial assistance 4.2.5.4.4.1 Legal framework The Australian Corporations Act 2001 deals directly with assistance by a company in the purchase of its own shares. Pursuant to the Corporations Act, a company may financially assist a person to acquire shares (or units of shares) in the company or a holding company of the company only if (a) giving the assistance does not materially prejudice the interests of the company (or its shareholders), or the company’s ability to pay its creditors; or (b) shareholders’ approval is given by special resolution or a resolution agreed to by all ordinary shareholders; or (c) the assistance is exempted under § 260C CA. The provision includes in particular an exemption for financial institutions, for subsidiaries of debenture issuers, and for cases in which other provisions must be complied with, such as capital reduction or share buy-backs. There is no definition in the Corporations Act of what is meant by “financially assist”. The issue of what constitutes financial assistance only becomes relevant for a transaction which involves a material prejudice to the company, its shareholders or its ability to pay its creditors. If there is no material prejudice it is unnecessary to decide whether the transaction involves the giving of financial assistance. As with “material prejudice”, it would seem that what constitutes financial assistance is a question of fact to be answered in light of the prevailing circumstances. In the absence of legislative guidance to the contrary, the expression would appear to be intended to be given a wide meaning. To that end, the illustrative examples given in the former § 205(2) CA of the Law can be taken as illustrative for the purposes of the present Act, these examples include the making of a loan, the giving of a guarantee, the provision of security, the release of an obligation and the forgiving of a debt. It is further submitted that in assessing whether a transaction constitutes financial assistance, the economic and commercial substance and effect of the transaction should prevail over its legal form. Accordingly, a transaction may have the effect of providing financial assistance for the acquisition of shares (or units of shares) in a company, notwithstanding the existence of an alternate intent. The use of the expression “on ordinary commercial terms” in § 260C(5)(d) CA may indicate that the whole of a transaction could be viewed as providing financial assistance where it is made other than on ordinary commercial terms. Consistent with the Law applying prior to 1 July 1998, the person to whom the financial assistance is given need not be the person who acquires the shares or unit of shares. The section is directed to the provision of financial assistance to whomsoever given (including the vendor), provided that it be for the purpose of, or in connection with, the acquisition of shares or units of shares.


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Concerning disclosure, the notice of a shareholders’ meeting must include a statement setting out all the information known to the company or body that is material to the decision on how to vote on the resolution under § 260B CA. The company must lodge with ASIC a copy of the notice of the meeting and any document relating to the financial assistance that will accompany the notice of the meeting sent to the members. Furthermore, the company must lodge with ASIC, at least 14 days before giving the financial assistance, a notice in the prescribed form stating that the assistance has been approved. If a company fails to comply with the requirements, neither the financial assistance nor any transaction or contract connected to it is not void or voidable. The company is not guilty of an offence. A person involved in the company’s contravention is liable according to civil penalty provisions, and commits an offence if the involvement is dishonest. 4.2.5.4.4.2 Economic analysis Within our sample of Australian corporations, we have not received any information on financial assistance. 4.2.5.4.4.3 Shareholder and creditor protection Australian law contains provisions with respect to financial assistance concerning shareholders and creditors protection. If a financial assistance entails a “material prejudice” to pay its creditors, than the board could be liable. 4.2.5.4.5 Serious loss of half of the subscribed capital Under Australian law, there is no provision which requires the board of directors to call a shareholders’ meeting in case of a loss of half of the subscribed capital. 4.2.5.4.6 Contractual self protection 4.2.5.4.6.1 Legal framework In Australia, debt arrangements and supplier or other creditor arrangements are negotiated between the lender and an authorised person in the company. Such authorisations are generally delegated to various persons in the company depending upon the size of the commitment and their area of accountability. For example, supplier arrangements will be negotiated with the procurement division. Large debt will be negotiated with the Treasurer or the Chief Financial Officer etc. The documentation in relation to debt is not a prescribed uniform contract, although many contracts contain similar provisions and content as practices have developed over time. Smaller creditors and suppliers do not generally have the means for mitigation of the credit exposure described for the debt providers below. Rather, such suppliers are reliant upon strict billing and collection procedures to ensure amounts are collected within a reasonable time of the goods and services being provided. Banks and other financial institutions that provide debt to corporations negotiate the terms and conditions of the debt directly with the Corporation. Debt providers conduct assessments of the borrower before providing funds and this influences the amount of security or other credit mitigation they will seek to obtain before providing the funds. Broadly speaking, the


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less confidence the lender has in the ability of the company to meet the debt repayments, the more terms and conditions associated with the debt will be sought. In order to protect themselves against losses from the lending to the corporate it is usual to negotiate certain terms and conditions. The terms and conditions negotiated reflect the type of lending provided. The two broad categories of lending and common terms and conditions are (a) cash flow lending (where recovery is based on the profitability and cash flows of the business in order to meet repayments of the debt), and (b) asset lending (where the funds are provided for the purposes associated with a particular asset such as property and plant; accordingly the debt is generally secured by a charge over the asset. A mortgage over the title to the property is a common example). 4.2.5.4.6.2 Economic analysis All Australian companies interviewed have entered into debt arrangements with covenants. These are required by Australian as well as international banks. One company issued debt in the United States. We have not received any information on the specific nature of these covenants. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs - 4.2.5.4.6.3 Shareholder and creditor protection The terms of the credit agreements are negotiated between the corporation and the creditor, and thus reflect a realistic view of what creditors desire for their protection. In addition to the creditors who negotiated the contract, other (weak) creditors lacking adequate bargaining power (e.g. certain trade creditors) benefit from these provisions as well, as long as the covenants are not breached. Even though, debt contracts and financial covenants are not specifically designed for the shareholders’ needs, shareholders might be protected by these contractual agreements indirectly insofar, as they aim at the long-term viability of the corporation. 4.2.5.5 Insolvency 4.2.5.5.1 Legal framework The legislative basis for identifying and managing insolvent companies is the Corporations Act 2001. Under the Act, there are a number of mechanisms that trigger the laws in relation to insolvency. Pursuant to the Corporations Act, the company, a creditor, a contributory, a director, a liquidator, the ASIC or a prescribed agency may apply to the court for a company to be wound up in insolvency. Under Australian law, a person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable (a person who is not solvent is insolvent). In determining, for the purposes of such an application, whether or


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not the company is solvent, the Court may take into account a contingent or prospective liability of the company. The directors of a company must pass a solvency resolution within 2 months after each review date for the company (and at least once every year). The legislative basis for identifying and managing insolvent companies is the Corporations Act 2001. A company is solvent if it is able to pay its debts as and when they fall due – otherwise the company is insolvent. The directors of a company must attest to the solvency of a company each year in accordance with the Act. The decision whether a company should be wound up by the court is a matter for the discretion of the relevant court. The matters that the court might take into account have been discussed in various cases. In one case, the court held that the decision whether or not a winding up order will be made is a matter entirely within the discretion of the judge whose decision cannot be interfered with unless the judge is wrong in law. Further, the court held that where there is a voluntary liquidation in progress and the majority of the creditors oppose the making of a winding up order the court would require the applicant to show special reasons or circumstances why an order should be made. 4.2.5.5.2 Economic analysis All companies indicated that the specific effort of monitoring triggers of insolvency is low. The monitoring takes place via the regular internal reporting of key financial figures. Two companies indicated that the potential insolvency is regarded as one aspect of the solvency declaration that has to be signed by the company’s management twice a year for other purposes.


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4.2.6 New Zealand 4.2.6.1 Structure of capital and shares 4.2.6.1.1 Legal framework New Zealand does not follow the system of a fixed legal capital. The Companies Act 1993 specifically requires that share capital must not have a nominal or par value and therefore shares do not have a stated value. Structure of capital Subscribed capital In New Zealand, the Companies Act clarifies that a share must not have a nominal or par value. However, nothing would prohibit the company from stating that a share will be redeemed at a specified value. Premiums and other forms of equity financing With the introduction of the Companies Act 1993, the legal concept of capital maintenance distributions has been discarded in favour of the solvency test. Therefore a distinction between components of equity is no longer needed unless an accounting standard requires separate disclosure in the financial statements (e.g. retained earnings, fixed asset revaluation reserves). While there is no necessity for a distinction to be made between the components of equity, a company may choose to maintain records of (and report) those components of equity which it deems relevant. Generally, entities that take this option would present consideration received from shareholders as “share capital”. Share capital does not serve as a limit on corporate distributions. Instead, so long as the trading solvency test is met, a company can declare a distribution up to the amount by which its assets exceed its liabilities (balance sheet solvency test). Theoretically, NZ$1 of equity will satisfy that test. In addition, where equity is compartmentalised, there is no requirement that any component of equity must have a credit balance. That is, a component (e.g. retained earnings) may be negative. Contributed capital can be repurchased or redeemed for a greater amount than was originally subscribed. Subject to the constitution of the company, different classes of shares may be issued. These shares may be redeemable, confer preferential rights to distributions of capital or income, confer special, limited, or conditional voting rights or not confer voting rights. The board of directors determines the consideration payable for a share issue. However, unless the constitution or another contract calls for it, no amount is actually payable in respect of the shares issued. The shares will be presented as unpaid, partly paid-up or paid-up share capital depending on the case. Protection of the company's assets In New Zealand, the Companies Act states that the consideration for which a share is issued may take any form and may be cash, promissory notes, contracts for future services, real or personal property, or other securities of the company. The board determines the consideration and the terms on which the shares will be issued. Where consideration is other than cash, the Companies Act requires the directors to determine the reasonable present cash value of the


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consideration, to sign a certificate to this effect, and to file such certificate which must be handed in to the Registrar of Companies. There are no further disclosure requirements in respect of the value at which shares are issued. Structure of shares In New Zealand, the Companies Act specifically requires that share capital must not have a nominal or par value and therefore shares do not have a stated value. 4.2.6.1.2 Economic analysis Practical relevance of capital and structure of shares for an assessment of the viability of a company There is no par value of shares in New Zealand. The companies interviewed do not see a particular merit in a par value of shares. The abandonment of par values is seen as an “improvement” and a reduction in complexity. However, New Zealand companies are appropriating significant amounts to the capital of the company. These amounts can be fairly high in comparison to the market capitalisation of the company. As mentioned above, companies can choose to divide their equity into different components (e.g. share capital, other reserves, retained earnings). However, the separation has no consequence on the distribution capacity. As long as the solvency test is met, a distribution can be made out of all these equity components. The following figures have been accumulated for NZX 10 and NZX MidCap companies: Figure 4.2.6-1: Ratio of share capital to market capitalisation (New Zealand)

New Zealand: Share Capital to Market Capitalisation

23%

26%

11%

3%

37%< 5%5% - 10%10 % bis 20 %20 % bis 30 %> 30 %

Source: One source: Share capital for the FY 2005, market capitalisation as of September 2006 Restriction on distribution As already mentioned, in New Zealand, the capital generally does not serve as a restriction for distributions. As long as the trading solvency test is satisfied, a company can make a distribution up to the amount by which its assets exceed its liabilities. Therefore, a distribution would be lawful if equity of NZ$1 is left.


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Role of the capital in equity financing Even though the capital amounts do not serve as distribution restrictions, the amounts allocated to subscribed capital are quite substantial. The following figures have been accumulated for NZX 10 and NZX MidCap companies: Figure 4.2.6 -2: Ratio of share capital to total shareholder`s equity (New Zealand)

New Zealand: Share Capital to Total Shareholder's Equity

0%

6%

20%

0%

74%

< 5%5% - 10%10 % bis 20 %20 % bis 30 %> 30 %

Source: One source: Share capital for the FY 2005, shareholder’s equity (consolidated) for the FY 2005 Formations The New Zealand companies interviewed are already in existence for a longer period. Therefore, it was neither feasible nor useful to extract data on the initial foundation of these companies. 4.2.6.2 Capital increase 4.2.6.2.1 Legal framework Under New Zealand law, there are provisions concerning capital increases by use of authorised capital including mechanisms to ensure the contribution of capital. Increase of capital New Zealand law allows a company to issue additional shares, as long as the requirements of the constitution are adhered to. If the constitution allows, the board is responsible for issuing new shares. § 42 CA 1993 states that, subject to the Companies Act and the constitution of the company, the board of a company may issue shares at any time, to any person, and in any number it thinks fit. The board must deliver a notice of the issue of the new shares by the company to the Registrar for registration within 10 working days. If the board of a company fails to comply with those requirements, every director of the company commits an offence and is liable on conviction to the penalty set out in the Companies Act.


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In case of a prohibition or limitation in the constitution on the issue of new shares, the shareholders can, by special resolution, authorise the share issue, i.e. the board may issue shares if it obtains the approval for the issue in the same manner as approval is required for an amendment of the constitution that would permit such an issue. The board must ensure that notice of that approval, having been given by the shareholders, is delivered to the Registrar for registration within 10 working days. However, a failure to comply with these requirements does not affect the validity of an issue of shares. In some instances, the company’s constitution may contain a limitation or a restriction in on the issue of new shares. The general way to issue new shares, provided that the requirements of the constitution are adhered, is: • Proposal of the board to issue new shares • Invitation to general meeting • Resolution by shareholders on capital (share) increase • Registration of decision with Registrar • Issue of shares and update of share register • Lodgement of necessary documentation with Registrar A decision regarding the consideration need not to be made when the issued shares are fully paid-up from the reserves of the company and issued to all shareholders of the same class in proportion to the number of shares held by each shareholder. The same applies to the consolidation or division of shares or any class of shares in the company in proportion to their pre-existing number and the subdivision in proportion to those shares. The company has to register a certificate in respect of reasonableness of consideration for shares with the Registrar within 10 working days of the decision. After issuing shares and updating the share register, the board of the company must deliver a notice of the issue by the company in the prescribed form to the Registrar for registration within 10 working days of the issue of shares in case of an amalgamation or an issue of other shares (other than during the formation). If the board of a company fails to comply with these requirements, every director of the company commits an offence and is liable on conviction to a penalty. Mechanisms to ensure the contribution of capital With respect to the subscription of new shares which were issued, generally the same rules apply which New Zealand law provides for the subscription of shares during the formation of the company. This applies to the prohibition of subscriptions of shares by the company itself, the setting of the price of the shares, the design of shares and the information linked to the share. A difference between the subscription of new shares and the subscription of shares during the formation is that the board may issue new shares to any person it thinks fit (barring pre-emption rights and other rules stated in the company’s constitution) while the shares on registration have to be issued to the person or persons named in the application for registration.


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Pre-emption rights New Zealand law acknowledges pre-emption rights. According to the Companies Act, shares issued or proposed to be issued by a company that rank or would rank as to voting or distribution rights, or both, equally with or prior to shares already issued by the company must be offered for acquisition to the holders of the shares already issued in a manner and on terms that would, if accepted, maintain the existing voting or distribution rights, or both, of those holders. The constitution of the company may negate, limit, or modify these requirements. There are no specific time limits on these offers, but the Act requires a “reasonable time” for acceptance. 4.2.6.2.2 Economic analysis None of the companies interviewed have performed regular capital increases in the recent past. Instead we encountered simplified procedures in connection with dividend reinvestment plans and share purchase plans. Practical steps The following practical steps would be necessary, in chronological order, for a capital increase: Figure 4.2.6 -3: Process for the capital increase (New Zealand)

Capital increase

Step 1 Proposal of the board to issue new shares Step 2 Invitation to general meeting Step 3 Resolution by shareholders on capital increase Step 4 Registration of decision with Registrar Step 5 Issue shares The injection of contributions and the valuation process would comprise the following steps: Figure 4.2.6 -4: Process for the injection of contribution (New Zealand)


Step 1 Monitoring if assets can be contributed Step 2 Monitoring of the requirements linked to the payment Step 3 Performance of the valuation process by the board Step 4 Communication to Registrar Step 5 Issue shares and update register Step 6 Lodge documentation with Registrar Analysis Because these processes have not been relevant to the companies interviewed in recent years, we have not received any information on practical cases of regular capital increases including contributions in kind. The companies interviewed had dividend reinvestment plans. Under these plans, shareholders can choose to receive their dividends in the form of cash or in the form of additional shares.


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Fees for external advice arise for the initial set-up of the plan. Once such a plan is implemented the renewal of the plan is a routine process. One company indicated a time frame of approximately 4.5 hours of highly qualified personnel for the plan, including the determination of share prices, the review of the work of an external registrar as well as notification to the stock exchange. In one case, it was stated that the board of directors of the company has an authorisation under the Companies Act and its constitution to issue up to 15% of new shares every year. Beyond that limit a special shareholders’ approval would be needed. Since the companies interviewed have never required such an approval, no time estimate is available. Another extraordinary way to issue capital is a so called “share purchase plan”. Under a share purchase plan, companies are entitled to use a simplified procedure to issue shares. In this context, it is possible to issue shares up to NZ$5,000 to each shareholder. External fees and three weeks of CFO time were spent by one company on such an issue of shares. Incremental Costs HighQ LowQ Other Costs Hours spent 4.5 - - Hourly rate €100 €70 - €450 - - Total costs €450 4.2.6.2.3 Protection of shareholders and creditors Based on the legal analysis, one can draw the following key conclusions concerning the shareholders’ and creditors’ protection of the New Zealand provisions on capital increases. Shareholders are protected in that the board of directors can only increase the capital if the additional shares are covered by the authorised capital set forth in the certificate of incorporation. If all shares covered by the certificate of incorporation have already been issued, the shareholders’ approval is needed to amend the certificate of incorporation. However, it has to be pointed out that a very high authorised share capital can be fixed in the certificate with the consequence that the shareholders will not have to be asked for approval. Under New Zealand law, it is not necessary to draw up a report by an independent expert in the case of contributions in kind. Instead, it is the directors’ duty to determine the consideration for shares. 4.2.6.3 Distribution 4.2.6.3.1 Legal framework In New Zealand, the various distributions which may be made, including dividends, shares instead of dividends, shareholder discounts, reduction of shareholder liability, etc, are subject to a body of rules set out in the constitution of a company and the Companies Act. The most important of these is the requirement that the solvency test must be satisfied before the distribution is made.


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Calculation of the distributable amount Being satisfied on reasonable grounds that the company will satisfy the solvency test immediately after the distribution, the board of a company may, subject to the constitution of the company, authorise a distribution at a time, and of an amount, and to any shareholders it thinks fit. Therefore, the benchmark for making a distribution is whether the solvency test is met. The content of this test is set out in the Companies Act. There are two limbs to the test, and a company must satisfy both. First, the company must be able to pay its debts as they become due in the normal course of business. This aspect of solvency is frequently referred to as trading solvency. Secondly, the value of the company’s assets must be greater than the value of its liabilities including its contingent liabilities, i.e. the company must demonstrate balance sheet solvency. To satisfy the trading solvency test (cash flow solvency test), the company must be able to pay its debts as they become due in the normal course of business. The jurisprudence has established five requirements that have to be fulfilled: (1) the ability to pay its debts must be fulfilled at the present time in consideration of the recent past, especially the company’s position in recent weeks; (2) outstanding debts have to be considered; (3) the liabilities have to become due in the legal sense; (4) non-cash assets may be taken into account if there is a substantial element of immediacy about the ability to obtain cash from non-cash assets; debts which mature while non-cash assets are converted must be considered; and (5) the test of solvency is an objective one. Regarding the balance sheet solvency test, the directors are directed to two mandatory factors for the purposes of determining whether the value of a company’s assets is greater than the value of its liabilities. The directors must have regard to (1) the most recent financial statements of the company that comply with § 10 of the Financial Reporting Act 1993, and (2) all other circumstances which the directors know or ought to know which affect, or may affect, the value of the company’s assets and the value of its liabilities, including its contingent liabilities. In addition, the directors may rely on valuations of assets or estimates of liabilities that are reasonable in the circumstances. However, where the company’s financial statements are subject to audit, the auditor will have to verify that the directors have complied with the requirements of the Companies Act with regard to distributions. There is no concrete guidance for auditors in New Zealand how to audit the solvency test; it is part of the general test of compliance with legislation (enquiry and inspection of records and resolutions/minutes of meetings). The directors who vote in favour of a distribution must sign a certificate stating that, in their opinion, the company will, immediately after the distribution, satisfy the solvency test and the grounds for that opinion. The certificate must be available for inspection by any shareholder of the company. Connection to accounting rules When performing the balance sheet solvency test, directors must have regard to the most recent single financial statements of the company that comply with § 10 of the Financial Reporting Act 1993. Therefore, financial statements prepared under New Zealand GAAP are the basis for the test. New Zealand GAAP is already similar to the International Financial Reporting Standards (IFRS). From periods beginning on or after 1 January 2007, all companies will prepare individual and consolidated financial statements under IFRS.


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In New Zealand, there are only minor modifications of the IFRS as approved by the International Accounting Standards Board (IASB). Those modifications mainly concern specific disclosure requirements. There are limited modifications for differential reporting entities with regard to measurement (essentially they are only exempted from including deferred taxes in their financial statements). Listed entities, however, cannot qualify for differential reporting. The accounting treatment of the shareholders’ equity section (e.g. issued capital and reserves pursuant to IAS 1.68(o), (p)) is of no importance with regard to the distributable amount. Determination of the distributable amount – responsibilities The directors generally have discretion as to the amount to be distributed. While the company may have a dividend policy in place, this normally only acts as a guideline/target for the directors. Dividends paid and proposed are presented in the financial statements. Otherwise under the New Zealand law, there is no requirement for companies to disclose the amount of dividends. The same applies with respect to the solvency certificate which must be available for inspection by any shareholder of the company, but does not have to be disclosed in the notes to the financial statements. Sanctions A director may be personally liable to the company to make good any shortfall in a distribution which cannot be recovered from a shareholder. A director will be personally liable in four circumstances. The first relates to procedural irregularity through failure to follow the procedure set out in law. A director who fails to take reasonable steps to ensure that the requisite procedure is followed is personally liable to repay the company that amount of the distribution which is not recoverable from shareholders. Second, personal liability may follow where there were no reasonable grounds for believing that the company would satisfy the solvency test at the time of execution by the directors of the solvency certificate. A director who signed the certificate in those circumstances is personally liable to repay the company so much of the distribution as is not recoverable from shareholders. Third, the Companies Act deals with the situation where a distribution is deemed not to have been authorised because, after authorisation, the board ceased to be satisfied on reasonable grounds that the company would satisfy the solvency test at the time the distribution was made. In this case, a director who ceased so to be satisfied and who failed to take reasonable steps to prevent the distribution being made is personally liable to repay the company so much of the distribution as is not recoverable from shareholders. Fourth, under the Companies Act a discount paid to a shareholder is recoverable from a director who failed to take reasonable steps to prevent the discount being paid where the discount is deemed in terms of § 55(5) CA 1993 not to have been authorised. This provision applies where the board ceased to be satisfied on reasonable grounds that the company would satisfy the solvency test.


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In some instances, a distribution of a lesser amount would not have caused the company to fail the solvency test. In an action against a shareholder or director in such a case, the court may in effect give the defendant “credit” for the amount which could legitimately have been distributed. Thus, a defendant shareholder may be permitted to retain an amount equal to the value of any distribution that could properly have been made and a defendant director may be relieved from liability to the same extent. The Companies Act creates a discretion. At common law, a dividend improperly paid out of capital is recoverable from shareholders who knew or ought reasonably to have known of the impropriety of the payment. It is likely that the common law rule applies even where the company is not insolvent and there is no immediate prejudice to creditors in the payment of the dividend. In this respect, the common law rules (which are superseded by the Companies Act) are more stringent and permit recovery where the Companies Act does not. Recovery under the Companies Act is dependent upon breach of the solvency test. The Companies Act deals with recovery from a director where a dividend improperly paid under the Act cannot be recovered from a shareholder to whom it was paid. But this does not mean that a company can only recover compensation from a director for a dividend paid in breach of the solvency test. A dividend can be paid without technically infringing the solvency test, for example, in circumstances where the solvency of the company is jeopardised by the payment. At common law, a director may be liable in negligence where a dividend payment merely jeopardises the solvency of the company without actually infringing the rule that dividends may not be paid out of capital. Similarly, it is submitted that a director who authorises a dividend which jeopardises solvency, while not technically infringing the solvency test, does not act with the care, diligence and skill of a reasonable director as required by the Companies Act. 4.2.6.3.2 Economic analysis The fundamental reform of New Zealand dividend distribution provisions in favour of solvency tests in 1993 has become a routine process for New Zealand companies. The testing effort required for the solvency test is relatively low. So far, balance sheet tests have been performed under New Zealand GAAP. Experiences with IFRS will be gathered for the first time in the financial year 2007, by which IFRS will be applicable for individual and consolidated financial statements. As both accounting frameworks are very similar, there is an expectation that there will not be any practical consequences of the application of IFRS with respect to distributions. Practical steps Based on the legal analysis, the distribution process generally requires the following practical steps which are the basis for the economic analysis. Figure 4.2.6 -5: Due process for distributing profits (New Zealand)


Step 1 Decision of the board Step 2 Performance of solvency test Step 3 Certification of solvency Step 4 Disclosure


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Analysis Calculation of the distributable amount From an economic point of view, the management of the companies interviewed base their decisions concerning distributable amounts on consolidated profits. Some companies make modifications to eliminate “exceptional items” and determine “normalised profits” which are the basis for the distribution decision. The dividends paid are also seen as a signalling device for the capital markets. Tax considerations may also play a role in the determination of dividends paid. Concerning the compliance with New Zealand distribution restrictions, the companies interviewed do not suffer from a high compliance burden. The trading solvency test refers to the cash flow situation of the company. Trading solvency is seen as an “obvious” fact based on the current cash situation of the company. Companies may also resort to the regular operational reporting mechanisms. The companies usually monitor cash flows and generally perform cash flow projections for internal management purposes. However, these projections or budgets are not specifically prepared for distribution purposes and, thus, are not formally linked to the dividend distribution process. With respect to the balance sheet solvency test, the companies interviewed verified the envisaged distribution on the basis of the audited single financial statements. The companies in our sample did not perform specific balance sheet revaluations; but one company applied the revaluation option of IAS 16 for property, plant and equipment. The original determination of the level of distributions, however, is primarily based on the consolidated accounts. Concerning subsequent events after financial year end, the board of directors of one of the companies interviewed usually examines management accounts which include a balance sheet and an income statement and a cash flow analysis for the occurrence of such subsequent events up to the time of documentation of solvency tests. But the ultimate decision is primarily based on the year-end financial statements. For interim dividends, it is the half-year accounts. One company explicitly also referred to notes of the financial statements where contingent liabilities and commitments on capital expenditure are included. This helps to take such factors into account when making a dividend distribution decision. The results of a CFO questionnaire sent to New Zealand companies listed on main indices reconfirm the key importance of the consolidated accounts as a determinant of dividend distribution:


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Figure 4.2.6-6: Determinants for the distribution of dividends in the holding company (New Zealand)


4,67

2,782,22

3,003,563,44

3,19

2,26

2,54

3,49

2,78

4,10

1

2

3

4

5

Fin.performance

(groupaccounts)



company)

Dividendcont inuity

Signallingdevice


Tax rules

Determinants

Impo

rtan

ce

New Zealand

Non-EU Average

Source: CFO Questionnaire, September 2007 However, concerning the importance of the current legal restrictions on profit distribution, the CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market led solutions like rating agencies’ requirements or bank covenants. Figure 4.2.6-7: Important deterrents when considering the level of profit distribution (New Zealand)


4,22

2,44

3,56

4,44

3,473,38

2,22

3,93

1

2

3

4

5





Deterrents

Impo

rtan

ce

New Zealand

Non-EU Average



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Concerning the distributions from subsidiaries, the results of a CFO questionnaire show the importance of tax considerations. Figure 4.2.6-8: Determinants for the distribution of dividends by the subsidiaries (New Zealand)


2,29

3,003,29

2,73

3,873,95

1

2

3

4

5


Determinants

Impo

rtan

ce

New Zealand

Non-EU Average

Source: CFO Questionnaire, September 2007 Determination of the distributable amount The board of directors is the key decision-making body concerning the distribution process. The board decisions are not always prepared by means of formal documentation. The board members must sign a solvency certificate. However, there is no specific form of this statement required. We encountered different formats of these certificates. These certificates are kept at the office of the company for inspection. There is no significant incremental burden associated with this and such inspections do not take place frequently. The companies have set up different documentation processes for the determination of solvency. For one company, it was stated that the vice president of finance has to sign a letter that he has made all necessary enquiries to determine solvency. Before he signs this letter he will consult with key personnel of this company in this regard. These consultations include the discussion of contingent liabilities. In each group company, a specific dedicated person must sign a letter that the necessary procedures concerning solvency have been performed. Because New Zealand distribution rules refer to the parent company, there is a necessity to channel-up sufficient profits and cash to the parent company level. Depending on individual circumstances, the efforts by companies interviewed to bring up profits and cash to top company level differs from case to case. The level of personnel involved in the distribution process also depends on the circumstances of the company. The time estimated for the entire dividend distribution process up to the pay-out ranges from 16 to 25 man-hours. In every case, senior management (CEO, CFO, the Audit Committee and other Board members) is heavily involved in determining the range of possible distributions. Additionally, fees for professional tax advice may arise. One company referred to the involvement of the CFO and less qualified staff in the final payout of dividends. Generally, the companies engage an external registry service for the payout of the dividends.


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Sanctions The companies describe the effort spent on monitoring compliance with legislation on distributions (in addition to the efforts described above) as low. The risk of liability in connection with illegal distributions is also seen as low. This may partially stem from the good financial situations of the companies interviewed. In addition to the distribution process, the companies interviewed continuously monitor compliance with bank covenants. This monitoring process may also mitigate the problem of potential violations of legal distribution provisions. Related parties The time spent on monitoring related party transactions depends on the specific situation of a company. The efforts were characterised as medium or low. Nevertheless, this assessment was highly dependant on the absence of significant related parties / related party transactions outside the group of companies. Incremental Costs HighQ LowQ Other Costs Hours spent 16 to 25 - - Hourly rate €100 €70 - €1,600 to €2,500 - - Total costs €1,600 to €2,500 4.2.6.3.3 Protection of shareholders / creditors The decision whether or not to make a distribution generally rests in the discretion of the board of directors of the company. Therefore, the shareholders have no statutory right to decide on a dividend unless the board of directors declares a distribution. However, due to the market forces public companies such as those taking part in the interviews take the shareholders’ expectations into consideration when deciding on measures on dividends or on increasing the value of the shares. Creditors are not explicitly protected by the New Zealand capital system and statutory distribution requirements. In New Zealand, distributions are allowed that leave the company almost without any equity. However, due to the required testing as well as associated liability risks, it does not seem realistic that companies make use of these possibilities. Concerning incentives to comply with distribution restrictions, every director who votes in favour of a distribution must sign a certificate stating that, in his opinion, the company will, immediately after the distribution, satisfy the solvency test and the grounds for that opinion. The solvency certificate could support shareholders and creditors in their assessment of the viability of the company. However, the certificate must be requested from the company’s office and this seems to take place very rarely. Every director who fails to comply commits an offence and is liable on conviction to penalties. In addition, if there were no reasonable grounds to believe that the company will satisfy the solvency test at the time the certificate is signed, every director that signed the certificate is personally liable to the company to repay so much of the distribution as is not recovered from shareholders.


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When a company is placed in liquidation, certain transactions might be set aside. The Companies Act sets out certain provisions that deal with voidable transactions and charges, transactions at an undervalue, and transactions which appear to give an advantage to persons who have a special relationship with the company and that will ensure that persons who have received some advantage at the expense of the company and its creditors in general be made to account for that advantage. Transactions which are set aside under this Part of the Act are for the benefit of creditors generally and not for the benefit of any single creditor and generally relate to a period of up to two years before the company goes into liquidation. New Zealand law also includes a specific Act (the Corporations (Investigation and Management) Act 1989) that applies to any company that is, or may be, operating fraudulently or recklessly or to which it is desirable that this Act applies (1) for the purpose of preserving the interests of the company’s members or creditors, (2) for the purpose of protecting any beneficiary under any trust administered by the company, or (3) for any other reason in the public interest, if those members, creditors or beneficiaries or the public interest cannot be adequately protected under the Companies Act 1993 or in any other lawful way. This Act confers powers on the Registrar of Companies to obtain information and investigate the affairs of companies and to limit or prevent further action and also to enable the Registrar or its agent (called a “statutory manager“) to take over the operation of the company. 4.2.6.4 Capital maintenance New Zealand law concerning the formation and maintenance of the capital relies considerably on the assessment of the cash flow situation of New Zealand companies especially via means of solvency tests. This approach can also be specifically found in the regulation of the acquisition of the company's own shares, capital reductions/share redemptions as well as in financial assistance. In all these proceedings, solvency assessments play a crucial role in duly determining whether the management of a New Zealand company should take such a measure. Other relevant fields such as the contractual self-protection of creditors and insolvency legislation are further pillars in giving incentives to the New Zealand companies to maintain the viability of the company. 4.2.6.4.1 Acquisition by a company of its own shares 4.2.6.4.1.1 Legal framework When a company purchases its own shares, corporate assets flow out to shareholders. In New Zealand, a company is generally allowed to purchase its own shares, hold those shares and resell them. In New Zealand, the requirements for the repurchase of a company's own shares are regulated in the Companies Act. For an acquisition of a company's own shares, the directors of the company must certify that the solvency test is met. That means, firstly, that they have to confirm that the company is able to pay its debts as they become due in the normal course of business, and secondly, that the value of the company's assets is greater than the value of its liabilities including its contingent liabilities. In addition, certain other procedures set out in law must be followed, i.e. the directors have to certify the reasonableness and fairness of the offer and that the acquisition is in the interests of


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the company. They have to send a disclosure document to the shareholders. Finally, the board has to deliver a notice of acquisition or repurchase to the Registrar within 10 working days. Shares listed on the stock exchange may, in certain instances, be acquired without prior notice to shareholders. That is possible when the board resolved that the acquisition is in best interests of the company and shareholders, the terms of and consideration for the acquisition are fair and reasonable, the board is not aware of any information that is not available to shareholders and the number of shares acquired in the preceding 12 months does not exceed 5 % of the shares in the same class at the beginning of that period. Subject to the provisions of the company’s constitution, the Companies Act 1993 and a resolution by directors, shares so acquired can be held by the company. All rights and benefits relating to the shares held by the company are suspended, i.e. the shares will have no voting rights and the company cannot pay dividends in respect of those shares. The normal rules (as set out above) apply when the company so resolves to re-issue such shares unless they are transferred by means of a system that is approved under section 7 of the Securities Transfer Act 1991 (a scripless trading system). The number of shares acquired, when aggregated with shares of the same class held by the company, must not exceed 5 % of the shares in the same class previously issued by the company. Shares which are not acquired in accordance with all the requirements mentioned are deemed to be immediately cancelled on acquisition. As set out above, a shareholder that considers itself prejudiced in the process of acquisition of the company's own shares can apply to the court and the court can issue various orders, including awarding the costs of the proceedings. In general, a share that a company holds may be cancelled by the board of the company resolving that the share be cancelled. 4.2.6.4.1.2 Economic analysis In New Zealand, none of the companies interviewed has repurchased shares recently. Therefore, no measures have been taken regarding the acquisition of the company's own shares and, thus, cost estimates were not feasible. Concerning the performance of the solvency test, the general observations from the distribution process apply concerning incremental burdens for the company. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.2.6.4.1.3 Protection of shareholders and creditors Shareholder and creditor protection is mainly provided by the disclosure document. The offer to repurchase shares, which must be made not less than 10 working days and not more than 12 months after the disclosure document is sent to each shareholder, can be made to all shareholders in proportion to their existing holdings or selectively to one or more


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shareholders, if all shareholders have consented to this in writing or it is expressly permitted by the constitution. Where an offer is made to all shareholders, the offer may also permit the company to acquire additional shares from a shareholder to the extent that another shareholder does not accept the offer or accepts the offer only in part. A shareholder or the company may apply to the court for an order restraining the proposed acquisition on the grounds that it is not in the best interests of the company and for the benefit of the remaining shareholders or the terms of the offer and the consideration offered for the shares are not fair and reasonable to the company and the remaining shareholders. In the case of acquisitions by the company of its own shares under 5 percent of the same class, these protections may not be in place. The suspension of the rights attached to the repurchased shares does not dilute the position of shareholders. This is also true for the cancellation of the unlawfully repurchased shares. 4.2.6.4.2 Capital reduction 4.2.6.4.2.1 Legal framework In a New Zealand company, capital reductions may be performed in different ways. The process of reducing share capital is the same as noted under the acquisition by a company of its shares, under distributions and redeemable shares. Depending on the way in which the transaction is effected, the following must be satisfied: (1) the constitution must allow the transaction to take place, (2) the board must resolve that the solvency test is met, (3) the board must resolve that it is in the best interests of the company and on terms that are fair and reasonable; and (4) proper/detailed disclosures to the shareholders, including the information required by the law. 4.2.6.4.2.2 Economic analysis Within our sample of New Zealand companies, we have not encountered any “regular” capital reductions. Concerning the performance of the solvency test, the general observations from the distribution process apply concerning incremental burdens for the company. 4.2.6.4.2.3 Protection of shareholders and creditors In general, the provisions on capital reductions do not protect shareholders or creditors via an active participation in the process. Protection takes place via the constitution of the company, the requirement that the solvency test must be met and disclosure requirements. 4.2.6.4.3 Share redemption 4.2.6.4.3.1 Legal framework In New Zealand, redemption refers to a forced sale initiated by the company, the shareholders or a fixed date in accordance with the terms of issue or/and the constitution of the company. According to New Zealand law, it is possible to redeem shares. Subject to an entity’s constitution, it may issue redeemable shares and redeem those shares as provided in the terms of issue. Generally, the shares would be redeemable by either the company, the shareholders or both and the consideration would be specified or calculated using a formula or fixed by an independent suitably qualified person.


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The directors must also resolve and certify that the redemption is in the best interests of the company, the consideration is fair and reasonable to the company and the solvency test is satisfied. Depending on which requirement is not fulfilled, either the company or the directors commit an offence and are liable on conviction to a penalty as set out in the Companies Act. When shares are redeemed, they are deemed to be cancelled immediately although they may be reissued in the future. 4.2.6.4.3.2 Economic analysis Within our sample of New Zealand companies, we have not received any information on share redemptions. Concerning the performance of the solvency test, the general observations from the distribution process apply concerning incremental burdens for the company. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.2.6.4.3.2 Shareholder and creditor protection Shareholders and creditors are protected in that the terms of the redemptions have to be stated in the terms of the issuance of shares or/and the constitution of the company. An option by the company to redeem shares should only be exercised if it applies to all shareholders in a class and affects all equally, or in relation to one or more shareholders where all shareholders have consented in writing or the option is expressly permitted by the constitution. If the option is exercised in relation to one or more shareholders and permitted by the constitution, the directors must forward a disclosure document to the shareholders before exercising the option and shareholders should have a period of between 10 and 30 working days after the document has been sent to consider the option. A shareholder or the company may apply to the court for an order restraining the proposed exercise of the option on the grounds that it is not in the best interests of the company or of benefit to the remaining shareholders, or the consideration for the redemption is not fair or reasonable to the company or remaining shareholders. If a share is redeemable at the option of the holder of the share, and the holder gives proper notice to the company requiring the company to redeem the share, the company must redeem the share on the date specified in the notice, or if no date is specified, on the date of receipt of the notice. The share is deemed to be cancelled on the date of redemption and from the date of redemption the former shareholder ranks as an unsecured creditor of the company for the consideration payable on redemption. If a share is redeemable on a specified date, the company must redeem the share on that date and the share is deemed to be cancelled on that date and from that date the former shareholder ranks as an unsecured creditor of the company.


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4.2.6.4.4 Financial assistance 4.2.6.4.4.1 Legal framework New Zealand law deals directly with assistance by a company in the purchase of its own shares. A company may give financial assistance (which includes loans, guarantees or the provision of security) to a person for the purpose of the purchase of a share issued by the company, or by its holding company, whether directly or indirectly, only if the board has previously resolved that the company should provide the assistance, given that the assistance is in the best interests of the company; and the terms and conditions under which the assistance is given are fair and reasonable to the company. In other words, the financial assistance should not disadvantage the ongoing operations or business of the company and should be on terms that would benefit the company or at least leave it in the same position as it would have been in if the assistance was not provided (i.e. a neutral position). Moreover, the company must, immediately after giving the assistance, satisfy the solvency test. The directors who vote in favour of giving the financial assistance must sign a certificate stating that, in their opinion, the company will, immediately after the financial assistance is given, satisfy the solvency test and the grounds for that opinion. In applying the solvency test for financial assistance, “assets” excludes amounts of financial assistance given by the company in the form of loans and “liabilities” includes the face value of all outstanding liabilities, whether contingent or otherwise, incurred by the company at any time in connection with the giving of financial assistance. In addition, one of the following circumstances must apply: (a) all shareholders have consented to giving the assistance; or (b) the board has previously resolved that giving the assistance in question is of benefit for those shareholders not receiving the assistance and that the terms and conditions under which the assistance is given are fair and reasonable to them; (c) or the amount of the financial assistance would not exceed 5 % of the shareholders' funds. The directors who vote in favour of a resolution on financial assistance must sign a certificate which contains that the legal requirements are complied with. If a company fails to comply with those requirements, it commits an offence and is liable to a penalty. Furthermore, every director commits an offence and is liable to a penalty. 4.2.6.4.4.2 Economic analysis Within our sample of New Zealand companies, we have not received any information on financial assistance. Concerning the performance of the solvency test, the general observations from the distribution process apply concerning incremental burdens for the company. 4.2.6.4.5 Serious loss of half of the subscribed capital Under New Zealand law, there is no provision which requires the board of directors to call a general meeting in case of a loss of half of the subscribed capital.


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4.2.6.4.6 Contractual self protection 4.2.6.4.6.1 Legal framework In New Zealand, contractually negotiated self-protection such as the limitation on payment of dividends would only generally be incorporated where a large amount of finance is provided or where another class of shares is issued that ranks behind other creditors. Normal trade terms would apply for smaller creditors. 4.2.6.4.6.2 Economic analysis All New Zealand companies interviewed are subject to covenants. Such covenants were negotiated with US and UK banks as well as Australian banks and their New Zealand branches. In one case, there were specific restrictions with regard to distributions. It was specifically provided that the covenants were not to be violated by means of distributions. Incremental Costs HighQ LowQ Other Costs Hours spent - - - Hourly rate €100 €70 - Total costs No data 4.2.6.4.6.3 Shareholder and creditor protection The terms of the credit agreements are negotiated between the company and the creditor, and thus reflect a realistic view of what creditors desire for their protection. Creditors rely on the future prospects of a company, mainly its profitability and its ability to generate cash necessary to pay the debts when due. In addition to the creditors who negotiated the contract, other (weak) creditors lacking adequate bargaining power (e.g. certain trade creditors) benefit from these provisions as well, as long as the covenants are not breached. Obviously, credit agreements and financial covenants are not specifically designed for the shareholders’ needs. However, shareholders might be protected by these contractual agreements indirectly in that their purpose is the long-term viability of the company. 4.2.6.5 Insolvency 4.2.6.5.1 Legal framework A company which is unable to pay its due debts is insolvent for the purposes of the Act. For determining insolvency, the objective “test of insolvency” has to be executed. If a company passes the test of insolvency, various avenues of approach exist for creditors or shareholders to protect themselves. The test of insolvency is an objective test. The belief or state of mind of the company is irrelevant. In each case, it will be a question of fact to be determined in all the relevant circumstances.


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There is no requirement that the board of directors conduct a solvency analysis. But anyone, including the company, directors and creditors can apply to the courts for the appointment of a liquidator. 4.2.6.5.2 Economic analysis The companies interviewed described their efforts in respect of monitoring triggers of insolvency as medium or high. The focus of the companies in this respect lies on the ongoing analysis of bank covenants. One company has a quarterly (internally generated) report on covenants, another company has an external consultant prepare a report on covenants which is included in the board papers after review by the CFO. It was also stated by one company that it prepares weekly a report of the cash position of the company which includes the position of every subsidiary. Debts are also included into the consideration. One company also states that it regularly monitors insurance coverage and contracts entered into.


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4.2.7 Conclusions for the four non-EU countries The four non-EU countries show a mixture of alternatives to the capital regime used in the EU. These systems have mainly abandoned the concept of legal capital or the importance of legal capital is low. Instead, the emphasis has shifted to increased testing procedures for dividend payments and other kinds of distributions like the repurchase of shares by means of different kinds of solvency and balance sheet tests. In performing the balance sheet test, the audited consolidated accounts are used in some of the jurisdictions due to legal or practical considerations. The distribution decision regularly lies within the discretion of the board of directors. The increased responsibility of the board in this regard translates into a fiduciary duty or personal liability. Furthermore, fraudulent transfer legislation may come into play. From a compliance cost perspective these non-EU systems are also not overly burdensome. Main pillars of the capital regime in the non-EU countries Structure of capital – With the exception of Delaware, all non-EU countries neither prescribe subscribed capital nor a minimum capital. In Delaware, where the traditional legal capital system is still applied, capital, however, does not play an important role in practice. Because Delaware corporations usually issue shares with a very low par value (e.g. US$0.01 and less), capital is negligibly low. Capital increase – The companies incorporated in the non-EU countries have the statutory power to create, value and issue authorised shares. The number of shares authorised for issuance must be stated in the statutes. There is no maximum amount the authorised shares may cover set by law. Distributions – All statutory laws in our sample have a variety of distribution requirements. In addition to a solvency test there are different forms of balance sheet tests which have to be satisfied for lawful distributions. In performing the balance sheet test, the audited consolidated financial statements are frequently used in some of the jurisdictions due to legal or practical considerations. Capital maintenance – The non-EU jurisdictions have various provisions which preserve the company’s contributed capital. In particular, there are statutory provisions on share repurchases, capital decreases, related party transactions and fraudulent transfers. In addition, contractual self protection of creditors is of importance.


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Figure 4.2.7 – 1: Overview on capital regimes in the four non-EU countries USA -

Delaware USA -

California Canada Australia New Zealand

Application of the concept of legal capital

Yes No No No No

(Minimum) subscribed capital

No No No No No

Requirements for share premiums

No No No No No

Mandatory reserves No No No No No

Structure of shares

Par value or no-par value

shares

Not regulated (par value or no-par

value shares

possible)

Only no-par value shares



Distribution rules

Equity insolvency test No Yes Yes Yes Yes

Balance sheet test(s) Yes Yes Yes Yes Yes

Mandatory accounting basis

No US GAAP No IFRS NZ GAAP

Determination of the distributable amount

Board of directors

Board of directors

Board of directors

Board of directors

Board of directors

Restrictions on share repurchases

Distribution rules

Distribution rules

Distribution rules

Distribution rules

Distribution rules

The set-up of the capital regime of the five non-EU jurisdictions can be summarised as follows: USA - Delaware The Delaware General Corporation Law follows traditional legal capital rules and divides shareholders’ equity into two basic categories: capital and surplus. However, capital does not necessarily equal what the shareholders paid for their stock. Instead, a Delaware corporation may, by resolution of its board of directors, determine that only a part of the consideration received by the corporation for the shares issued shall be capital. The amount of capital depends on the design of the stock. A Delaware corporation may issue stock with or without par value. In the case of par value shares, the minimum amount of capital is generally determined by multiplying the number of shares issued by their par value. In the case of no-par shares, capital is that part of the consideration received designated by the directors as capital. Therefore, directors can designate zero to be capital. The excess, if any, of the “net assets” (total assets less total liabilities) of the corporation over the amount so determined to be capital is surplus. The Delaware distribution rules leave a lot of leeway. A corporation may pay dividends not only out of surplus but also out of “current profits” even though there is a deficit in the equity account. Furthermore, the Delaware Supreme Court has made it clear that


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directors may depart from US GAAP accounting and revalue assets at fair market value for purposes of calculating net assets. The Delaware statute does not contain an equity insolvency test. However, directors violate their fiduciary duties to creditors if they make a distribution when the corporation is insolvent. In practice, the distributable amount is frequently derived from the audited consolidated US GAAP financial statements. USA - California California was the first US state to eliminate the traditional concepts of par value and stated capital. Further significant and innovative features of the California Corporations Code are the distribution requirements which are based on (consolidated) financial statements in conformity with US generally accepted accounting principles (US GAAP). The California law applies identical restrictions to the different kinds of distributions (e.g. cash and property dividends, redemptions, and share repurchases). In general, a distribution can only be made out of the retained earnings if, after the distribution, the corporation remains able to pay its debts when due. However, the board of directors may declare a distribution in excess of retained earnings if the equity insolvency test is satisfied and the equity ratio is still at least 20 percent after the distribution has been made. The declaration of distributions generally is within the discretion of the board of directors and protected by the business judgement rule. However, to avoid liability, directors have to obey any restrictions in the articles or bylaws and the applicable statutory provisions. In addition, already at the stage of distributions, the corporations, in general – especially if the economic situation of the corporation is negative –, have to take into account the insolvency law provisions of the federal bankruptcy and statutory laws. Canada The Canada Business Corporations Act (CBCA) which regularly complemented by provincial laws explicitly states that shares shall be without nominal or par value. Canadian federal law applies identical restrictions to the different kinds of distributions (e.g. cash and property dividends, redemptions, and share repurchases). In general, a distribution can only be made if the company can meet the applicable solvency test after the distribution (payment of the dividend). A company is not entitled to declare or pay dividends if there are reasonable grounds for believing that (a) the company is, or would be after the payment is made, unable to pay its liabilities as they fall due; or (b) after payment of the dividend, the realisable value of its assets will be less than the total of its liabilities and its stated capital. Stated capital comprises the contribution for the issued shares. In Canada, there is not a requirement concerning the accounting framework to be used. There is no direction as to the method of valuation but it must be appropriate in the circumstances; accordingly, the going concern assumption is usually most appropriate. The directors generally have the sole responsibility for determining whether a dividend is to be declared and paid. However, shareholders are entitled to challenge a dividend which has been paid in violation of the solvency test. To ensure that legal requirements are met, directors will be personally, jointly and severally liable for repayment of an improper dividend. Australia The Australian Corporations Act 2001 specifically requires that share capital must not have a stated value and therefore shares must also not have a par value. Under the Australian profit distribution rules, any amount can be distributed as long as it is paid out of profits and does not render the corporation insolvent. In addition to the statutory requirements, there are court decisions on distributions. The principles established by case law therefore also have to be taken into consideration, when an Australian company determines the amount of a legal distribution. This series of rules governing the payment of dividends comprises that (1)


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dividends must not be paid if the result is that the company is unable to pay its debts, (2) current revenue profits may be distributed without making good revenue losses of previous periods, and (3) undistributed profits remain profits which can be distributed in later years. Furthermore, there is voluminous case law to guide companies in their distribution decisions. In Australia, the declaration of dividends generally is within the discretion of the board of directors. Pursuant to Australian law, the directors may determine that a dividend is payable and fix the amount, the time for payment and the method of payment. However, directors have to obey any restrictions in the statutes and the applicable statutory provisions as well as the principles derived from case law. All companies in Australia are subject to IFRS as adopted in Australia. The profits/retained earnings determined under these standards form the basis for dividend distributions. A dividend that is paid other than out of profits would result in a reduction of capital. The directors may be liable to the creditors or liquidator of a company for the amount of a dividend paid which exceeds available profits. New Zealand New Zealand does not follow the concept of legal capital. The Companies Act 1993 specifically requires that share capital must not have a nominal or par value and therefore shares do not have a stated value. In New Zealand, the board of a company that is satisfied on reasonable grounds that the company will, immediately after the distribution, satisfy the solvency test may, subject to the constitution of the company, authorise a distribution. Therefore, the benchmark for making a distribution is whether the solvency test is met. There are two limbs to the test, and a company must satisfy both. First, the company must be able to pay its debts as they become due in the normal course of business (trading solvency test). Secondly, the value of the company’s assets must be greater than the value of its liabilities including its contingent liabilities, i.e. the company must demonstrate balance sheet solvency. When performing the balance sheet solvency test, directors must have regard to the most recent single financial statements of the company that comply with New Zealand GAAP. New Zealand GAAP is already similar to the IFRS; from periods beginning on or after 1 January 2007 all companies will be preparing financial statements under IFRS. The contributed share capital does not serve as a limit on corporate distributions. Instead, as long as the trading solvency test is met, a corporation can declare a distribution up to the amount by which its assets exceed its liabilities (balance sheet solvency test). Theoretically, $1 of equity will satisfy that test. The directors who vote in favour of a distribution must sign a certificate stating that, in their opinion, the company will, immediately after the distribution, satisfy the solvency test and the grounds for that opinion. The certificate must be available for inspection by any shareholder of the company. Structure of capital and shares Capital The practical relevance of the capital for an assessment of the viability of a company has generally been seen as low by the companies interviewed in the four non-EU countries. These companies and their “peers” such as banks, rating agencies and analysts rather look at other equity figures like “net equity” and “market capitalisation” as relevant to determine their equity position and to assess their chances of preserving their business and to attract further capital. In Delaware where we have encountered a stated capital based on par value shares, banks as creditors rather relied on cash flow predictions.


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Premiums In the non-EU countries, the concept of “share premium” as a restriction to distributions does not exist. Structure of shares In general, the non-EU countries do not require par value shares. In Delaware, the corporations may issue stock with or without par value. In California, corporations usually issue no-par value shares; they are, however, permitted to state a par value in their statutes if they wish to do so. In New Zealand, Canada and Australia, shares cannot have a par value. In all non-EU countries, the statutes are required to state the authorised number of each class of shares that (or series within a class) the company is permitted to issue. The number of issued shares of each class cannot exceed the number authorised under the statutes. Capital increase The companies interviewed have the statutory power to create, value and issue authorised shares. The number of shares authorised for issuance must be stated in the statutes. There is no maximum amount the authorised shares may cover set by law. If there are not enough authorised shares, the statutes must be amended for new issuances to occur. In order to avoid capital increases and necessary amendments of the statutes as a consequence, the companies interviewed set a high number of authorised share capital. With respect to the subscription of new shares which are issued during a capital increase the same rules apply which are applicable to the subscription of shares during the formation of the company. We have only encountered very few instances of capital increases in the interviews in the five non-EU jurisdictions. Therefore, we have not been able to retrieve sufficient relevant detailed data concerning capital increases. In general, we have been reassured that the bulk of the capital increase burden is due to securities regulation, i.e. costs of prospectuses. Distribution The five non-EU jurisdictions have various distribution requirements. These statutory rules usually apply to all kinds of distributions (e.g. cash and property dividends as well as share repurchase and redemption).


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Table 4.2.7 – 2: Characteristics of balance sheet tests and solvency tests (non-EU countries) USA -

Delaware USA -

California Canada Australia New

Zealand Balance sheet test(s)

Statutory testing requirement

Surplus test: capital shall not be impaired (capital can be zero)

Retained earnings test: distributions can only be made out of retained earnings

Balance sheet test: The realisable value of the assets shall not be less than the total of liabilities and stated capital

Profits test: Dividends may only be paid out of the corporation’s profit

Balance sheet solvency test: assets must exceed liabilities

Mandatory accounting basis

No US-GAAP No IFRS (as adopted in Australia)

NZ-GAAP (with possible modifications)

Practical application - starting base - modifications by directors

(Audited) US-GAAP consolidated accounts Allowed, but seldom; regularly well established criteria

(Audited) US-GAAP consolidated accounts Not allowed

(Audited) Canadian GAAP consolidated accounts Allowed

(Audited) IFRS financial statements Not allowed

(Audited) NZ-GAAP individual accounts Allowed, but seldom; regularly well established criteria

Distribution allowed, if (initial) balance sheet test is not met

No; exception: nimble dividends, “wasting assets corporations”

Yes, but remaining assets tests need to be met

No No No

Nature of exceptions Net profits test (nimble dividends): Corporation may pay dividends out of net profits from the current and/or preceding fiscal year Wasting assets corporations: may determine the net profits without regard to depletion

Remaining assets tests comprises both: a) Quantitative solvency test: Total assets exceed total liabilities by 125%; deduction of certain balance sheet items from assets and liabilities b) Liquidity test: In general, current assets must exceed current liabilities

N/A N/A N/A


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Solvency test (= Equity insolvency test)

Statutory requirements

No (but case law)

Yes Equity insolvency test: Company or subsidiary must be able to meet liabilities as they mature

Yes Solvency test: Company shall be able to to pay liabilities as they fall due

Yes Solvency test: Company must be able to pay its debts

Yes Trading solvency test: Company shall remain able to pay debts as they become due in the course of business

Formal calculation requirements, including minimum projection periods

No No No No No

Implementation in practice

Current cash situation and future cash-flow projections based on internal reporting; intensity of the cash flow analysis depends on the financial health of the company

Current cash situation and future cash-flow projections based on internal reporting; intensity of the cash flow analysis depends on financial health of the company




Solvency certificate No No Yes

(provincial law)

Yes Yes

Audit requirement No No No Yes Yes, if financial

statements are audited

The requirements are laid down in law and relevant jurisprudence. In New Zealand and Canada, company directors must sign a certificate stating that, in their opinion, the company will satisfy the statutory distribution rules and the grounds for that opinion. In the four non-EU countries, the distribution decision lies within the discretion of the boards of directors. The board members, however, regularly have to obey the statutory rules as well as possible additional requirements in the statutes. They usually face personal liability if they declare unlawful distributions. If the company is rendered insolvent by the distribution the board generally also owes a fiduciary duty to the creditors. Companies in the non-EU countries can only make a distribution if, after the distribution, they remain able to pay their debts as they become due in the usual course of business. This so-called equity insolvency test is mandatory because of the statutory law or – in the case of Delaware – because of case law.


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In the United States, Canada and New Zealand, a majority of CFOs believe that dividend levels are better determined via solvency tests. In Australia, this view was opposed. Figure 4.2.7 – 3: CFO survey results: Solvency tests and dividend determination (non-EU countries)

0%10%20%30%40%50%60%70%80%90%

100%

Perc

enta

ge

U SA C anada A ust ral ia N ew Zealand N on EUA verag e

Liquidity-oriented/solvency tests: "Is the ability to pay dividends better determined via liquidity tests that take into account projected future cash-

flows?"

Yes

No

NA

Source: CFO questionnaire, September 2007. In addition to this solvency test, all companies have to perform balance sheet tests. From a legal point of view, these tests significantly differ from country to country. In all jurisdictions, (large) parts or even the whole contribution received from the issuance of the shares can be distributed. In New Zealand, for example, a distribution is possible up to the amount by which the corporation’s assets exceed its liabilities by NZ$ 1. In Delaware, distributions can even lead to a negative equity account. In contrast, a California corporation can only distribute an amount in excess of its retained earnings if, after the distribution, the equity ratio is still at least 20 percent (solvency margin). Another important characteristic of the majority of the non-EU company laws is that significant leeway is provided for with respect to the accounting methods used in determining assets, liabilities, and equity for the purpose of the balance sheet tests. California is the only non-EU jurisdiction which explicitly states what accounting rules have to be the basis of the distribution requirements without allowing companies to adjust these themselves. A California corporation has to use financial statements in conformity with US GAAP (there are only a limited number of mandatory modifications of the US GAAP accounts which are rarely of importance in practice). In the case of a group, the use of consolidated financial statements is required by California law. In this context, CFOs have perceived their accounting standards as sufficiently tailored to adequately determine the level of profit distributions. This may indicate that the CFOs are not dissatisfied with the concept of a balance sheet test and that they consider their audited accounts as a good starting point to determine distributable profits.


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Figure 4.2.7 – 4: CFO survey results: accounting standards and profit distribution (non-EU countries)

0%10%20%30%40%50%60%70%80%90%

100%

Perc

enta

ge

U SA C anad a A ust ralia N ew Zealand N on EUA verage

Balance-sheet-oriented distributions tests: "Are in your opinion the accounting standards applied by your company sufficiently tailored to adequately

determine the level of profit distribtuions?"

Yes

No

NA

Source: CFO questionnaire, September 2007. It has to be pointed out, however, that despite the legal differences the practical approach of the companies in all the non-EU countries shows remarkable similarities: The companies usually use the most recent audited accounts when performing the distribution tests. Even if allowed by law, the companies interviewed do not depart from their audited GAAP financial statements in order to keep the calculations simple and to avoid possible liability risks. The regular practice of the companies interviewed showed that dividend levels are subject to a “political decision” by the company’s management with a view to its share price. This includes aspects like dividend continuity or giving certain signals to the capital market. As general alternative to dividend distribution, it is also regularly considered to repurchase own shares. The starting points for such a decision are the consolidated accounts and consolidated cash flow situation, i.e. decisions are taken from a group perspective. The results of a CFO questionnaire sent to the companies listed in the main indices of the four non-EU countries reconfirm these experiences: Figure 4.2.7 – 5: Determinants of dividends for holding companies (non-EU countries)

1

2

3

4

5

Impo

rtan

ce

U SA C anad a A ust ralia N ewZ ealand

N o n- EUA verag e



Fin. performance (individual accounts of theparent company)Dividend cont inuity

Signalling device


Tax rules



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To bring the parent company’s financial situation in line with the group perspective, the companies interviewed in nearly all cases steer the profits and cash flow situation of the parent company. This is mostly done in a structured planning process over several years, mainly to achieve tax optimisation for intra-group distributions. Again, the results of a CFO questionnaire sent to the companies listed in the main indices of the four non-EU countries show the increased importance of tax rules: Figure 4.2.7 – 6: Determinants to profit distributions for subsidiaries (non-EU countries)

1

2

3

4

5

Impo

rtan

ce


N o n- EUA verag e


Demands f rom the ult imate parentTax rulesOwn investment decisions

Source: CFO Questionnaire, September 2007 By average, the time required amounted to approximately 35h. Capital maintenance Acquisition by the company of its own shares Figure 4.2.7 – 7: Conditions for the repurchasing of own shares (5 non-EU jurisdictions) USA

Delaware USA

California Canada Australia New

Zealand 1. General authorisation for any purpose

Yes Yes Yes Yes Yes

Selected criteria: Resolution by the general meeting

No No No No. if immaterial

(see specific conditions)

No

Maximum percentage of capital

No limitation No limitation No limitation No limitation No limitation

Maximum authorisation period

No No No No No

Performance of a balance sheet test / solvency test

Yes (share

repurchases and dividends

are treated nearly the

same; exception: no

net profits test,

Yes (share

repurchases and dividends

are treated identically)

Yes “company must be able to

pay its creditors”

(=solvency test)

Yes


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no special rule for wasting

assets corporations)

2. Specific conditions for certain situations

- (Federal) securities

regulations: Inter alia: extensive disclosure

requirements of the Securities and Exchange Commission

(SEC)

- (Federal) securities

regulations: Inter alia: extensive

disclosure requirements of

the Securities and Exchange

Commission (SEC)

Inter alia: - issuer bids: application of the regime for related party transactions and takeover

bids rules (disclosure,

formal valuation, pro rata treatment

of all shareholders)

- normal course issuer bids: acquisition of up to 5 % of shares in 12 months; not more than 2 % of shares in 30 days; precondition: timely disclosure report -minimum Canadian share ownership requirement

Inter alia: - buybacks in

excess of 10 % of voting

rights in 12 months requires ordinary

resolution - selective buybacks

require special or unanimous

resolutions

Inter alia: - for listed companies: no prior notice to shareholders required if own shares are less than 5 % of the same class

Share repurchases are allowed in all five non-EU jurisdictions. With limited exceptions, the statutory requirements for legal share repurchases are the same as those for dividends (see above). By average, the time required amounted to approximately 232h. Capital reduction / share redemption As already mentioned, in the non-EU jurisdictions the concept of legal capital has either been abandoned or does not play an important role (e.g. Delaware). Therefore, most of the company laws do not specifically address capital reductions. The companies can, however, distribute assets to shareholders by acquiring outstanding shares through redemption of shares. While a share repurchase is a voluntary buy-sell transaction between the company and a shareholder, redemption refers to a forced sale initiated by the company, in accordance with a contract or the statutes. Such redemption, generally, is subject to the same restrictions imposed on all other kinds of distributions, such as, for example, the solvency and balance sheet tests (see above). We have not been able to retrieve any detailed cost data in the interviews conducted with companies in the five non-EU jurisdictions.


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Contractual self-protection of creditors (covenants) In the non-EU jurisdictions, debt arrangements between the company and major creditors, e.g. banks, are a common phenomenon as we observed in the interviews conducted. In this way, most companies have entered into debt arrangements with covenants. The importance of covenants is supported by the CFO questionnaire sent to the companies listed in the main indices of the four non-EU countries: Figure 4.2.7 – 8: Deterrent for profit distributions (non-EU countries)

1

2

3

4

5

Impo

rtan

ce


N o n- EUA verag e


Distribut ion/Legal capital requirements

Rat ing agencies' requirements

Contractual agreements with creditors(covenants)Possible violat ions of insolvency law

This shows that the legal restrictions concerning profit distribution are considered by the responding CFOs as mostly slightly more important than market-led solutions like rating agencies’ requirements or bank covenants. However, bank covenants play a much more significant role in comparison with the responses from EU jurisdictions. Due to the wide spread practice, we have been able to retrieve some cost data on the necessary compliance effort with regard to these covenants. However, it has be remembered that the costs largely depend on the individual circumstances of the company and how close the reporting requirements for bank covenants are aligned with already existing reporting procedures of these companies. By average, the time required amounted to approximately 876h. Incremental cost table for the five non-EU jurisdictions The following table summarises the incremental costs implied by the national regulations of the five non-EU jurisdictions. A detailed definition of incremental cost can be found in the methodology section of this report.


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Figure 4.2.6 – 9: Summary of incremental cost for the five non-EU jurisdictions USA

Del. €

USA Cal.

€

Canada €

Australia €

New Zealand

€

Non EU Average


No data No data No data €2,000 €450 €1,225

Distribution €100 to €2,000

€2,500 to €5,000

€5,200 €650 to €10,400

€1,600 to €2,500

€3,515


€5,435 €50,000 No data €3.550 to €32.500

No data €24,487

Capital reduction





€8,000 €208,000 €46,800 No data No data €87,600

In considering these averages it needs to be kept in mind that the data was retrieved from companies in good financial health. These figures may change once a company would enter into a more difficult financial situation. Especially with regard to a potential dividend distribution, the non-EU burden may rise as more detailed considerations concerning their financial position would have to take place. Concerning the shareholder and creditor protection arguments please refer to the sections on the individual non-EU jurisdictions.


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4.3 Alternative regimes proposed by literature 4.3.1 High Level Group 4.3.1.1 The proposal 4.3.1.1.1 Outline The core element of the alternative regime proposed by the High Level Group of Company Law Experts chaired by Jaap Winter30 is a two-stage distribution test which serves as a means to determine the maximum amount available for distribution and which should apply to all forms of distributions, namely (interim) dividends, share buy-backs and distributions as part of capital reduction. The two-stage distribution test consists of a balance sheet test and a liquidity test. Further study should, inter alia, consider prescribing a certain solvency margin in order to reinforce the tests. Company assets may be distributed provided that a distribution complies with both tests and that the members of the management board issue a solvency certificate in which they confirm that the proposed distribution complies with the two-stage distribution test. An auditor’s certificate is not required. It is recommended that the solvency certificate to be issued by the management board should be linked to a comprehensive system of sanctions at the centre of which is the personal liability of directors and directors’ disqualification. The alternative regime should, furthermore, be supplemented by insolvency legislation, comprising a European framework rule on wrongful trading which should be extended to “shadow directors” and the concept of subordination of insiders’ (directors and shareholders) claims. Alongside the introduction of a two-stage distribution test and supplementary regulation, the High Level Group proposes the repeal of various provisions concerning the raising of capital, for instance the prohibition to issue true no-par value shares, the prohibition on the contribution of an undertaking to perform work or supply services and the valuation requirements in cases in which shares are issued for a consideration other than in cash. With a view to improving the protection of shareholders it is, furthermore, proposed to prescribe that shares must be issued at fair value. 4.3.1.1.2 Necessary amendments to the 2nd CLD Capital maintenance – distributions to shareholders, share repurchases, financial assistance, redemption of shares, capital reductions In the alternative regime proposed by the High Level Group the two-stage distribution test serves as a means to determine the maximum amount available for distributions to shareholders. It is required for dividend payments and other forms of distributions to shareholders, including share buy-backs and capital reductions – the latter if the concept of a reserve for share capital which is not distributable is retained.31 As a consequence, the substantive restrictions on dividend payments (Art. 15), share buy-backs (Art. 19), redemption of shares (Art. 39) and reductions in capital (Art. 32) will be replaced: Any requirement for an enhancement of a simple net assets test by requiring the establishment of a reserve for the aggregate nominal value of the subscribed capital (Art. 15), will be abolished.

30 High Level Group of Company Law Experts, Report on a Modern Regulatory Framework for Company Law in Europe of 4 November 2004 (available under http://europa.eu.int/comm/internal_market/company/ docs/modern/report_en.pdf). 31 High Level Group (2004), p. 87.


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The statutory regulation on share buy-backs (Art. 19) can be limited to prescribing that an authorisation of the general meeting is required. It is proposed to facilitate financial assistance for the acquisition of the company’s own shares (Art. 23) as it is now possible due to the changes introduced by Directive 2006/68/EC32.33 Whether in the alternative regime financial assistance should be permitted up to the distributable amount determined on the basis of the two-stage distribution test, is not explicitly stated, but can be assumed. In the alternative regime, the obligation to set up a capital redemption reserve in cases in which redeemable shares are redeemed (Art. 39), can be repealed. The statutory regulation concerning the reduction of subscribed capital can be limited to prescribing that an authorisation of the general meeting (Art. 30) is required. The creditors’ right to object to capital reductions (Art. 31) can, therefore, be abolished. The High Level Group, furthermore, recommends extending the possibility of compulsory withdrawal of shares when a shareholder has acquired 90% of the capital as an exception to the provision of Art. 36 that the compulsory withdrawal of shares is only permissible if this is provided in the deed of incorporation or the statutes.34 Raising of capital – contributions, issuance of shares, increase of share capital, pre-emption rights Alongside the changes that concern the capital maintenance regime provisions of the 2nd Company Law Directive, it is recommended that the provisions concerning the raising of capital be repealed as they are thought to be costly, not entirely effective and impede business: The minimum capital requirement (Art. 6) should be retained.35 The prohibition on the contribution of an undertaking to perform work or supply services (Art. 7 s. 2) should be repealed.36 In the alternative regime, the valuation requirements of the 2nd CLD in cases in which shares are issued for a consideration other than in cash should be replaced. Share issues for a consideration other than in cash should be subject to a shareholders’ resolution and the management board shall be required to certify the appropriateness of the issue in exchange for the contribution in view of the fair value of shares. In this connection, it is also suggested that an appropriate protection of minorities be provided.37 The prohibition on the issue of true no-par value shares (Art. 8 (1)) should be abandoned.38

32 Directive 2006/68/EC of the European Parliament and of the Council of 6 September 2006, OJ L 264 of 25 September 2006, pp. 32. 33 High Level Group (2004), p. 85. 34 High Level Group (2004), p. 85 et seq. 35 High Level Group (2004), p. 82. 36 High Level Group (2004), p. 82 et seq. 37 High Level Group (2004), p. 89. 38 High Level Group (2004), p. 83.


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The general rule that equity issues for a cash consideration must be subject to pre-emption and that any withdrawal or restriction of pre-emption rights is subject to a general meeting authorisation based on objective criteria (Art. 29 (4), (5)) shall be retained in the alternative regime.39 Beyond that, in order to better prevent dilution, it should be provided that shares must be issued at fair value. For listed companies the market price should be an indication of the fair value. The High Level Group suggests that the market price is calculated as the average market price in a period immediately preceding the new capital issue. A limited scope for issues below the market price should be allowed for a marketable discount and underwriting activities. With respect to unlisted companies, it is suggested that the rule that the value of shares derived from the audited annual accounts is presumed to be the minimum price for which shares can be issued, be introduced. The presumption should only be rebutted on the basis of clear evidence of a lower fair value of shares at the time of the proposed issue of new shares. In cases in which accounts are not audited, the directors should be required to certify the appropriateness of the consideration for the shares to be issued and the shareholders’ meeting should explicitly agree.40 4.3.1.1.3 Distributions Overview The two-stage distribution test proposed by the High Level Group consists of a balance sheet test and a liquidity test. Further study should consider prescribing a certain solvency margin in order to reinforce the tests.41 Both tests constitute substantive restrictions on distributions: company assets may only be distributed to shareholders if the distribution complies with both tests. Hence, in cases in which the balance sheet test indicates that the proposed distribution is not covered by net assets whereas according to the liquidity test the company is solvent, a distribution may not take place. In cases in which the two-stage distribution test has been performed on the basis of accounts which have not been drawn up in accordance with generally accepted accounting methods and have not been audited, a distribution is prohibited if the audited accounts of the company indicate that the proposed distribution does not comply with the two-stage distribution test.42 Balance sheet test According to the simple balance sheet test, a distribution is permissible if the assets fully cover or exceed the liabilities after the proposed dividend payment or distribution.43 Hence, only the surplus of assets over liabilities including provisions as shown in the company’s accounts is available for distributions. Unlike the balance sheet test of the 2nd Company Law Directive, the balance sheet test does not require a margin in a way that the net assets balance must be sufficient to cover the subscribed capital. The accounts which form the basis of the balance sheet test need not be drawn up in accordance with a generally accepted accounting method, namely national GAAP, the source of which is the 4th Directive, or IFRS. The High Level Group recommends that such valuation

39 High Level Group (2004), p. 84. 40 High Level Group (2004), p. 89. 41 High Level Group (2004), p. 87 et seq. 42 High Level Group (2004), p. 88. 43 High Level Group (2004), p. 87 et seq.


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method should be applied which is justified by the position the company is in (going concern, liquidation).44 However, further study should take place in order to develop the valuation methods to be used and the relationship with valuation methods applied in the audited accounts of the company.45 The result of permitting companies to use various accounting methods is that the net assets may vary depending on the accounting/valuation method used. For instance, as under IFRS fair value accounting is permissible, to an increasing extent book profits are shown in the accounts and are, thus, also taken into account when applying the balance sheet test. The High Level Group does not state whether the going concern assumption should be applied. The relevance of the going concern concept should be considered in a further study. The management board has little discretion when applying the simple balance sheet test besides the regular options contained in the accounting framework. Distributions may only be made if and to the extent there is a surplus of assets over liabilities. The proposal of the High Level Group does not explicitly state how long-term liabilities (e.g. pensions) are to be treated. However, it follows from the format of the test that, where the application of a specific accounting method requires recognizing long-term liabilities in the accounts, they are to be taken into account when applying the test. Liquidity test or current assets/current liabilities test The liquidity test proposed by the High Level Group constitutes a short term liquidity requirement. According to the liquidity test, a distribution is permissible if the company has sufficient liquid assets to pay liabilities as they fall due in the following period, e.g. the forthcoming twelve months.46 The test is not, in the strict sense, cash-flow based as it arguably requires the management board to refer to a balance sheet ratio. In order to determine whether the company will be solvent in the period following the distribution, the current assets are to be compared to the current liabilities (current ratio). Although the proposal does not explicitly state what is understood under liquid assets/current, such assets and liabilities are arguably to be derived from the company’s individual accounts. The High Level Group does not state whether reference is to be made to a specific accounting method.47 According to the form and wording of the test, only liquid assets are to be taken into account when applying the liquidity test. The proposal does not explicitly state what is understood under liquid assets. However, it follows from the title of the test (“current assets/current liabilities”) that liquid assets constitute current assets as shown in the accounts. Off-balance sheet items, such as contingent or prospective assets, are not, therefore, taken into account. The use of invested capital that can be transformed into liquid assets in time is possible insofar as it constitutes current assets, e.g. inventories. According to the test, liabilities which fall due in the period following the distribution need to be taken into account when applying the test. The proposal does not explicitly state what is understood under those liabilities. However, from the wording and the title of the test (“current liabilities”), it follows that current liabilities as shown in the accounts must be taken

44 High Level Group (2004), p. 87 et seq. 45 High Level Group (2004), p. 88. 46 High Level Group (2004), p. 88. 47 High Level Group (2004), p. 88.


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into account. Therefore, off-balance sheet items, such as contingent and prospective or future liabilities are ignored. The liquidity test has to cover the “period following the distribution”. According to the High Level Group, a period of twelve months is adequate.48 The members of the management board have no discretion when applying the liquidity test. This is inherent in the format of the test: The liquidity test is an objective test in that, when applying the test, the management board may take resort to a balance sheet ratio, namely the current ratio. If the liquid assets do not cover the current liabilities, a distribution may not be made. Solvency margin According to the proposal of the High Level Group, a further study should consider reinforcing the two-stage distribution test by requiring a certain solvency margin. The purpose of a solvency margin is to integrate legal and statutory reserves into a regime in which there is no legal capital. In the opinion of the High Level Group, the functions performed by reserves are more effective than under the current capital maintenance regime established by the 2nd Company Law Directive as the balance sheet test is reinforced by an additional solvency margin.49 A solvency margin would ensure that the assets, after the proposed distribution, exceed the liabilities by a certain margin and/or current assets, after the distribution, exceed current liabilities by a certain margin.50 The proposal of the High Level Group does not state what - in this respect - is understood under liabilities, current assets and current liabilities. Nor does the proposal state whether they are to be derived from the consolidated or individual accounts. The question of whether a specific accounting method is to be referred to also remains unanswered. The proposal does not give details of the concrete form of such a solvency margin. It should be noted that solvency margins already form part of distribution rules in other legal systems. For instance, the California Corporation Code (§ 500 (b) (1)) prescribes that a distribution may only be made "if immediately after giving effect thereto the sum of the assets of the corporation (exclusive goodwill, capitalised research and development expenses and deferred charges) would be at least equal to 1 ¼ times its liabilities (not including deferred taxes, deferred income and other deferred credits)." The observance of a solvency margin may also depend on whether creditors in the preceding fiscal years were exposed to default risks, e.g. pursuant to § 500 (b) (2) CCC, if the average of the earnings of the corporation before taxes on income and before interest expense for the two preceding fiscal years was less than the average of the interest expense of the corporation for those fiscal years, a distribution may only be made if the current assets would be at least equal to 1 1/4 times its current liabilities. 48 High Level Group (2004), p. 88. 49 High Level Group (2004), p. 88. 50 High Level Group (2004), p. 88.


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Responsibility for performing the test, solvency certificate, relevance of audited accounts, consultation of an accountant According to the proposal of the High Level Group, the management board is responsible for performing the two-stage distribution test.51 The members of the management board are required, on the basis of the tests, to issue a solvency certificate in which they explicitly confirm that the proposed distribution meets the two-stage distribution test. A valid distribution can only be made when the directors have issued a solvency certificate. In cases in which the audited accounts of the company indicate that the proposed distribution cannot meet the two-stage distribution test, directors should not be allowed to issue a solvency certificate.52 The proposal of the High Level Group does not state whether the solvency certificate should also be published. Under the alternative regime proposed by the High Level Group, the two-stage distribution test need not be certified by an accountant. Liability of management or shareholders The High Level Group recommends implementing a comprehensive system of sanctions: The proposal does not give particulars of whether recipients of unlawful dividends/distributions are obliged to return them, but is exclusively concerned with proposing rules concerning the liability of members of the management board. Members of the management board should be responsible for the correctness of the solvency certificate and EU Member States should impose proper sanctions if the certificate is proven to be misleading. As proper sanctions, personal liability of directors and director’s disqualification which should be extended to “shadow directors”, are proposed.53 The proposal does not give particulars as to the extent of the personal liability, particularly as to which standard of care should apply. The criteria for disqualification of a person from serving as a director of companies are not given, either. According to the High Level Group, the introduction of director’s disqualification at EU level should operate as a strong deterrent against misconduct by directors which in practice is not achieved by criminal and civil sanctions that are often difficult to enforce.54 Link of insolvency legislation to the alternative regime The High Level Group argues for implementing a European framework rule on wrongful trading to enhance responsibility of directors when the company is threatened with insolvency.55 A European framework rule on wrongful trading should hold directors, including “shadow directors”, accountable for permitting the company to continue to do business when it should be foreseen that it will not be able to pay its debts.56 The wrongful trading rule is thought to protect creditors without restricting companies and their directors as they can and must make a choice in the case of foreseeable, not yet actually imminent,

51 High Level Group (2004), p. 88. 52 High Level Group (2004), p. 88. 53 High Level Group (2004), p. 88. 54 High Level Group (2004), p. 69. 55 High Level Group (2004), p. 88. 56 High Level Group (2004), p. 68 et seq.


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insolvency whether to attempt to rescue the company or to put it into liquidation. According to the High Level Group, a general obligation to file for insolvency in case of actual insolvency usually comes too late. That is the reason why liability should be imposed on directors for misconduct prior to insolvency. It should, however, be noted that in Britain, where the offence of wrongful trading is in place, no reported case has turned on pre-insolvency duties of directors. Rather, judges usually regard the company’s cash flow insolvency as the starting point of wrongful trading.57 According to the High Level Group, in order to enhance creditor protection, the introduction of the concept of subordination of insiders’ (directors and shareholders) claims should also be considered as part of the alternative regime where the assets of the company are deemed insufficient for the company’s activities.58 Further particulars are not, however, given in this respect. 4.3.1.2 Economic analysis The High Level Group proposal fundamentally changes the overall concept of the 2nd CLD and its implementation requires changes to nearly all basic elements of capital regimes. Areas with no specifically mentioned substantial changes encompass: - Capital increases (certification of contributions in kind by the board of directors and shares issue at the market price). - Financial assistance - Contractual self-protection of creditors Consequently, the following analysis will not elaborate either on potential burdens for companies or on shareholder and creditor protection in this regard. Structure of capital and shares Analysis The High Level Group proposal foresees the abolishment of the concept of legal capital as such yet retains the minimum capital requirement. This circumstance as such does not have an immediate effect on the equity financing of companies as the capital in most cases only represents an insignificant fraction of the company’s total equity as the analysis of the five EU countries has shown. The structure of shares is fundamentally changed by the abolition of the par value concept for shares. The complete changeover may cause a once-off burden which concerns the update of the company’s statutes and the actual change of the format of the shares. Subsequently, the abolition of par values may lead to less complexity in the administration of shares. However, we do not have reliable data or estimates to assess the associated costs, as companies having to apply par-value consider such a situation as hypothetical. 57 For an analysis of court decisions cf. Bachner, 5 EBOR (2004), pp. 293, 300 et seq.; Habersack/Verse, ZHR 168 (2004), pp. 174, 184 et seq. 58 High Level Group (2004), p. 92.


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Protection of shareholders and creditors In view of the individual company, the position of shareholder and creditors is negatively affected by the fact that the distribution could also be made out of the proceeds of the share issue of the company if the solvency test allowed for this. The 2nd CLD as such only protects the subscribed capital, not the share premiums from distributions. Under the High Level Group proposal the subscribed capital is not protected if the solvency test allows for this. The introduction of a solvency margin could help to overcome this issue. To counteract this, the High Level Group proposal provides for an increased level of formalised solvency testing by the company’s management. However, this is a consideration based on current ratios which does not take into account the future obligations of a company. Therefore, the question can be raised whether this test helps to assess the long term viability of the company. Distribution Analysis Calculation of the distributable amount The proposal of the High Level Group does not fundamentally change the procedure for the distribution of profits. The key element that is changed concerns the compliance test as to whether a distribution is actually feasible. Currently, this is a very light touch procedure in the EU Member States concerned. The balance sheet test as proposed by the High Level Group refers to a surplus which does not necessarily need to be determined on the basis of the annual accounts prepared under the 4th CLD or IFRS. The company is rather free to decide whether a different valuation method should be applied which is justified by the position the company is in. To this end, the High Level Group suggests that the development of valuation methods to be used should be the subject of further study. The acceptance of the application of valuation methods other than those provided for by national GAAP or IFRS is not in line with current EU practice where a majority of EU Member States directly use the unaltered annual accounts. Therefore, in cases in which different valuation methods are used, the associated costs may rise for the companies concerned. The costs will depend on the extent these valuation methods will differ from national GAAP valuation methods. The final costs can only be determined if this basic issue has been resolved. The liquidity test as foreseen by the High Level Group is an additional formal testing element which is currently not required in EU Member States. The test obviously relies on certain current accounting ratios. If these current accounting ratios can be immediately derived from the external financial reporting of the company, this procedure would be very light and associated with very low burdens within the range of a few hours of highly qualified personnel. In any case, this part of the test will cause additional burdens. Furthermore, the High Level Group has suggested studying the possibility of a solvency margin. However, it is not clear how high such a solvency margin should be and how this should be exactly calculated. A high solvency margin may impede potential distributions and cause additional incremental efforts for the companies concerned to mobilise sufficient profits and cash from subsidiaries to allow for distributions. In this way, the actual impact of


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solvency margins on companies is not clear. The associated burden will depend on the chosen level of a solvency margin and cannot be exactly determined at this stage. The calculation whether a solvency margin is met by the company concerned seems to be easily performed and will range within a few hours of highly qualified work. Determination of the distributable amount The High Level Group proposal does not change the manner in which the distributable amount is determined. An additional element is a solvency certificate by the board. This declaration should regularly be a by-product of the above mentioned testing procedures and is not likely to cause major burdens in its preparation. The main burdens in EU Member States, i.e. the preparation of the proposal and the actual payment of the dividend, will remain unchanged. This also concerns the necessity to channel-up profits and cash to the parent company. Sanctions The High Level Group proposal requires a comprehensive system of sanctions which includes the personal liability of directors and director’s disqualification. Depending on how rigid this system actually is, the directors will take certain measures that will secure them from potential sanctions. The level of measures will reflect the level of legal certainty needed for their actions. Concerning the introduction of a solvency test which is based on current ratios, there is a high degree of legal certainty for directors when the performance of such a test satisfies their legal diligence obligations. Related parties The High Level Group proposal does not specifically touch on the question of the monitoring of the relationships with third parties. Protection of shareholders and creditors The departure from the audited accounts for purposes of performing the balance sheet test will bring more uncertainty to shareholders and creditors as to whether the calculation of the distributable amount is factually correct. The liquidity test as an additional testing element requires a conscious formal assessment by management whether there is sufficient cash to justify the dividend distribution. However, the reference to current ratios may raise doubts whether future developments are adequately reflected in the assessment by management and, thus, are effective. The conclusions would need to be confirmed by the management in the format of a solvency certificate which will be publicly available. By means of this solvency statement, shareholders and creditors may receive additional information on the viability of the company from a cash flow perspective. However, as this statement refers to current balance sheet ratios future cash-flows – especially longer term payment obligation – may not be adequately reflected. The potential use of a solvency margin may help to increase the certainty for shareholders and creditors that the company will not distribute dividends too excessively. Depending on the size of the margin, this amount would be increased. However, it has to be noted that a very


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high solvency margin could also impede potential dividends to shareholders and may further limit the flexibility for the company’s management to determine dividends. Shareholders and creditors may benefit from a comprehensive system of sanctions. Capital maintenance Acquisition by the company of its own shares Analysis Under the High Level Group proposal, the testing procedures applied for distribution have also to be applied in the case of repurchases of the company's own shares. There is a continued need to authorise the buy-back decision by the general meeting. In this way, the basic elements of the buy-back process still persist while the restriction of share repurchases is, according to the proposals of the High Level Group, subject to a testing procedure by the management board. The management board should communicate the results of its testing via a solvency certificate to the shareholders. Compared to the system enforced by the 2nd CLD, there are only additional costs to the extent that the testing procedures cause burdens for the company. Protection of shareholders and creditors The solvency test concerned with the aspect of the company’s short-term liquidity ensures a conscious formal assessment by management whether there is sufficient cash to justify the dividend distribution. So far, such assessments would be rather part of actual management practice concerning the preparation of distributions. Accordingly, both shareholders and creditors are provided with a higher level of confidence concerning the current cash situation. The long-term viability may not be adequately addressed. Furthermore, the net assets as a protective cushion against excessive dividend distributions are not part of this protection concept. However, the introduction of a solvency margin may provide protection of a similar kind. Capital reduction / withdrawal of shares Economic analysis The High Level Group proposes to facilitate capital reduction by applying the testing procedures to capital reduction and withdrawal of shares. The formal requirements concerning capital reductions, namely the authorisation by the general meeting, will continue to apply. The companies interviewed in the survey have not regularly been using the instrument of capital reduction. Therefore, we have not been able to assemble relevant cost data associated with capital reductions. However, it is evident that the additional solvency test would constitute an additional burden for the companies. On the other hand, costs associated with the right of creditors to object to reductions will fall away. Whether the proposed measure will give incentives to companies to reduce capital remains to be seen.


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Protection of shareholders and creditors Shareholders and creditors may benefit from an insight into the current cash situation of the company. The position of creditors worsens due to the fact that their right to object to capital reductions would be abolished. The extended possibility to withdraw shares from minority shareholders would take away rights from the shareholders. Serious loss of half of the subscribed capital Analysis The 2nd CLD requires that a general meeting be called in the case of a loss of half of the subscribed capital. The High Level Group proposal remains unclear how it deals with this alert function. It could be assumed that this requirement should be waived due to the fact that the High Level Group intends to abolish the concept of minimum legal capital. Shareholder and creditor protection The provisions dealing with the serious loss of the subscribed capital have a shareholder and also creditor protective character, as the general meeting has the possibility of deciding on safeguarding measures. A transition to a capital regime without legal capital would render this protection ineffective and redundant. Insolvency Economic analysis The High Level Group argues for implementing a European framework rule on wrongful trading to increase the level of responsibility of directors when the company is threatened with insolvency. It should hold directors accountable for permitting the company to continue to do business when it is foreseeable that it will not be able to pay its debts. Depending on how rigid this system actually is, the directors will take certain measures that will secure them from potential sanctions. The level of measures will reflect the level of legal certainty needed for their actions. As the precise sanctioned behaviour as well as the intended level of sanctions are not very clear, it is not possible to make estimations on associated burdens for companies at this stage. Shareholder and creditor protection Shareholders and creditors may benefit from a comprehensive and consistent EU framework for a system of sanctions. However, any European system would need to be consistent with EU Member States’ legal systems.


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4.3.2 Rickford Group 4.3.2.1 The proposal 4.3.2.1.1 Outline The core element of the alternative regime proposed by the Interdisciplinary Group on Capital Maintenance chaired by Professor Jonathan Rickford59 is a two-stage distribution test which serves as a means of determining the maximum amount available for distribution and which should be applied to all forms of distributions to shareholders, that is (interim) dividends, share buy-backs and distributions as part of a capital reduction. The two-stage distribution test consists of a solvency test and a complementing balance sheet net assets test. Company assets may be distributed provided that a distribution complies with the solvency test. The balance sheet net assets test does not, by contrast, constitute a substantive restriction on distributions but prescribes additional disclosure and specification requirements. If, according to the balance sheet test, the distribution is not covered by net assets, the management board may still make a distribution provided it states the reasons why it is of the opinion that a distribution is nevertheless justified. The management board is required to provide and publish a solvency certificate in which it declares that in its assessment, after an enquiry into the affairs and the prospects of the company proper for the purpose, the distribution complies with the requirements. A mandatory auditor’s certificate is not required. Yet, in respect to large companies whose accounts must be audited, the proposal of the Rickford Group follows an audit-based approach insofar as the audit report for the financial year in which the distribution has taken place must consider the legality of the distribution and, in cases in which there are doubts as to the lawfulness of distributions, members of the management board are required to consult an auditor prior to the distribution. The Rickford Group recommends linking the solvency certificate to be issued by the management board to a comprehensive system of remedies and sanctions, which should include the personal liability of directors and directors’ disqualification. It is emphasised that the efficacy of the alternative regime depends in part on fiduciary duties of the members of the management board which should apply where legal rules have not been established. To the extent that such fiduciary duties do not exist in EU Member States, they should be introduced. Furthermore, it is recommended that the alternative regime should be supplemented by insolvency legislation, namely a wrongful trading standard at EU level. Alongside the introduction of a two-stage distribution test and supplementary regulation, the Rickford Group proposes that various provisions concerning the raising of capital, for instance the minimum capital requirement, the prohibition to issue true no-par value shares and the valuation requirements in cases in which shares are issued for a consideration other than in cash, be repealed. In essence, only the 2nd Company Law Directive’s rules on shareholder and minority protection should remain intact. 4.3.2.1.2 Necessary amendments to the 2nd CLD Capital maintenance – distributions to shareholders, share repurchases, financial assistance, redemption of shares, capital reductions In the alternative regime, the two-stage distribution test serves as a means of determining the maximum amount available for distributions to shareholders and should be applied to all forms of distributions, that is (interim) dividend payments, share buy-backs and distributions

59 Rickford, Reforming Capital, 15 EBLR (2004), pp. 919 et seq.


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as part of a capital reduction. As a consequence, the substantive restrictions on dividend distributions (Art. 15), share buy-backs (Art. 19), redemption of shares (Art. 39) and reductions in capital (Art. 32) will be abolished whereas the special rules on shareholder and minority protection will remain. Any requirement for an enhancement of a simple net assets test by requiring that a reserve for the aggregate nominal value of the subscribed capital (Art. 15) be set up, will be abolished.60 The statutory regulation on share buy-backs (Art. 19) can be limited to prescribing that a general meeting authorisation for the purchases of acquiring the company’s own shares is required. The 10% limit in the purchase regulation – which was still in force at the time the proposal of the Rickford Group was published – can be abolished alongside the required reserve (Art. 19).61 It is recommended that the prohibition on giving financial assistance for the acquisition of the company’s own shares as part of company law (Art. 23) which had not been relaxed at the time the proposal of the Rickford Group was published, be repealed. Special risks arising from market abuse, for example inappropriate share buy-backs and financial assistance transactions, should be addressed by properly focused and targeted securities regulation.62 The obligation to set up a capital redemption reserve in cases in which redeemable shares are redeemed (Art. 39) can be abolished.63 The statutory regulation concerning the reduction in subscribed capital can be limited to prescribing that an authorisation of the general meeting (Art. 30) is required. The creditors’ right to object to capital reductions (Art. 32) can be repealed.64 The application of the two-stage distribution test in cases in which a company distributes company assets as part of capital reduction is thought to provide sufficient protection for creditors. The general meeting authorisation requirement for the reduction in capital by compulsory withdrawal of shares (Art. 37) and for the redemption of capital without reduction (Art. 35), should remain.65 In the alternative regime, the 4th Directive’s rules on accounting reserves to be set up in order to prevent distributions in cases in which the company exercises a specific accounting option (Art. 33 (2), Art. 34), will disappear.66 Raising of capital – contributions, issuance of shares, increase of share capital, pre-emption rights Alongside the changes that concern the capital maintenance provision of the 2nd Company Law Directive, the Rickford Group recommends repealing various provisions concerning the raising of capital as they are thought to be costly, not to be entirely effective and to impede business.

60 Rickford (2004), p. 983. 61 Rickford (2004), pp. 983 and 986. 62 Rickford (2004), p. 986. 63 Rickford (2004), p. 983. 64 Rickford (2004), p. 986. 65 Rickford (2004), p. 986. 66 Rickford (2004), p. 983.


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Subscribed capital as a mandatory requirement, including the minimum capital requirement (Art. 6), should be abolished. As a result, the rules on the publicity for subscribed capital (Art. 2 lit. c, Art. 3 lit. b) should be repealed.67 The prohibition on issuing shares at a discount (Art. 8 (1)) and related rules about commissions and discounts, should be repealed.68 The prohibition on the issue of true no-par value shares (Art. 8 (1)), should be abolished. The prohibition on the contribution of an undertaking to perform work or supply services (Art. 7 s. 2), should be repealed. The valuation requirements in cases in which shares are issued for a consideration other than in cash on formation and in subsequent capital increases (Art. 10, Art. 27) - which were relaxed after the proposals of the Rickford Group were published - should be abolished.69 It is proposed that the function of these rules should be achieved by transparency regulation, namely the requirement to disclose at the companies register the relevant contracts in writing and the consideration given. Furthermore, the fiduciary duty of members of the management board to act in the best interests of the company – a duty which already exists under common law - should apply. If a director’s breach of duty results in the dilution of capital, shareholder remedies shall be provided for to sanction these breaches.70 The general meeting authorisation requirement for capital increases (Art. 25) and for any departure from the general rule that equity issues for a cash consideration must be subject to pre-emption rights (Art. 29 (4), (5)), should remain.71 4.3.2.1.3 Distributions Overview The two-stage distribution test proposed by the Rickford Group consists of a solvency test and a balance sheet net assets test.72 The solvency test requires an assurance of the company’s short-term liquidity and, in addition to this, an indefinite assurance of the company’s viability. Only the combination of a strict short-term liquidity requirement and the assurance of the company’s positive prospects for the longer term, is thought to be of real value for creditors. Only the solvency test serves as a substantive restriction on distributions. Company assets may only be distributed to shareholders if the distribution complies with both solvency tests.73 By contrast, the balance sheet net assets test does not constitute a substantive distribution requirement. If, by application of the balance sheet net assets test, the proposed distribution is not covered by net assets whereas, according to the solvency test, the company is solvent, the

67 Rickford (2004), p. 986. 68 Rickford (2004), p. 983. 69 Rickford (2004), p. 983. 70 Rickford (2004), p. 987. 71 Rickford (2004), p. 986. 72 Rickford (2004), pp. 985 et seq. 73 Rickford (2004), p. 986.


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management board is still allowed to make a distribution provided it states the reasons why it is of the opinion that a distribution is nevertheless justified.74 The reason why the balance sheet test does not constitute a substantive restriction on distributions is that a mere mechanical application of a calculation of balance sheet net assets is not thought to make proper allowances for the quality of the company’s assets and liabilities, their volatility and linkage over time and the quality of the company’s performance.75 In the alternative regime, the balance sheet net assets test serves as an additional formal requirement in that it stipulates disclosure and specification requirements. It should function as a measure to discipline the management.76 Solvency test Short-term liquidity requirement The first part of the solvency test as proposed by the Rickford Group consists of a short-term liquidity requirement and is cash-flow based. Pursuant to the proposal, a distribution may only take place if the directors certify that, having regard to their intentions and the resources in their view likely to be available, for the year immediately following the distribution the company will be able in the ordinary course of business to meet all its debts as they fall due as a going concern throughout the year.77 Debts to be taken into account in this context comprise liquidated claims, contingent liabilities and prospective liabilities.78 A contingent liability means a liability which is vested – in the sense that the legal relationship which may give rise to an obligation to pay exists – but which may or may not mature into an obligation to pay, according to whether some contingency occurs. Contingent liabilities are, for example, a liability on a guarantee agreed, an insurance policy underwritten by the company or a claim on a warranty given by the company. A prospective liability means a liability which has already accrued or is substantially certain to do so.79 Examples are a liability for rent under a lease, a liability under a non-matured bill of exchange or a liability for progress payments on a construction contract yet to be assessed. Therefore, also off-balance sheet items need to be taken into account when applying the test. With respect to the liquid funds to be taken into account in the context of the short-term liquidity test, not only the liquid funds that exist at the time of the distribution are relevant. But the management board may also take into account the future influx of liquid funds, as, for example, the funds arising from a realisation of assets or income from investments.80 For this purpose also future and contingent assets may be taken account of.81 Extraordinary circumstances are, by definition of the short-term liquidity test (“in the ordinary course of business”), not to be taken into account. A definition of the term “extraordinary circumstances” does not, however, exist. The period the solvency test has to cover is the year following the distribution.82 74 Rickford (2004), p. 980. 75 Rickford (2004), p. 975. 76 Rickford (2004), p. 980. 77 Rickford (2004), p. 980. 78 Rickford (2004), p. 978. 79 Rickford (2004), p. 978. 80 Rickford (2004), p. 980: “[…] the resources in their view likely to be available […].” 81 Rickford (2004), p. 979. 82 Rickford (2004), p. 980.


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The members of the management board have discretion when applying the short-term liquidity test. This is intrinsic to the form of the test. The short-term liquidity requirement is not an objective test in that, when applying the test, the management board may resort to a balance sheet ratio. Instead, the board’s subjective perspective is relevant when assessing the company’s solvency for the year immediately following the distribution (“in their view”) and, in doing so, contingent and prospective circumstances not yet shown in the accounts are also to be taken account of when assessing whether the company will have sufficient funds available to be able to pay its debts when they are due. Whether the company has actually resources available to remain a going concern, is to be assessed on the balance of probabilities (“likely”). This also grants discretion to the management board. The proposal does not expressly state how long-term liabilities are treated. Yet, it follows from the nature of the short-term liquidity test that only those liabilities are to be taken into account which mature into obligations to pay within the period of one year immediately following the distribution. Hence, long-term liabilities need not be taken into account in the context of the short-term liquidity test. Indefinite assurance of the company’s viability The second part of the solvency test requires an indefinite assurance of the company’s viability. This test is also in essence cash flow based. Pursuant to the proposal, the members of the management board are required to certify that, in their view, for the reasonably foreseeable future, taking into account the company’s expected prospects in the ordinary course of business, it can reasonably be expected to meet its liabilities.83 Beyond the liabilities which are to be taken into account in the context of the short-term liquidity test, namely liquidated claims, contingent and prospective liabilities, the liabilities that the company will incur in the future in the course of normal trading must also be taken into account in the context of the viability test. By of the same reasoning, future assets arising in the ordinary course of business may also be considered apart from the assets which are to be taken into account in the context of the short-term liquidity test, namely liquid funds, contingent and prospective assets.84 In the context of the viability test, extraordinary circumstances are, by definition of the test (“in the ordinary course of business”), not to be taken into account. The proposal does not give an exact definition of what extraordinary circumstances are. Following from the wording of the viability test, extraordinary circumstances are those which do not occur in the ordinary course of business. From the statement of reasons of the proposal it can, furthermore, be concluded that extraordinary transactions in connection with assets are those which are too contingent and remote to be eligible for consideration, e.g. the prospect of a capital increase may not be taken into account.85 The period the solvency test has to cover is, according to the wording of the test, “the reasonably foreseeable future”. It is, therefore, indefinite.

83 Rickford (2004), p. 979. 84 Rickford (2004), p. 979. 85 Rickford (2004), p. 979.


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When applying the viability test, the members of the management board also have discretion. This is due to the form of the test. Firstly, the viability test is not an objective test in that reference cannot be made to balance sheet ratios when determining the company’s viability. Instead, the management board’s subjective perspective is relevant when determining the company’s viability (“in their view”) and in doing so, to an substantial degree, off-balance sheet items are to be taken into account, namely contingent, prospective and future liabilities and assets. Secondly, the question whether the company will be able to meet its liabilities is to be assessed on the standard of reasonable expectation (“it can reasonably be expected”). The standard of reasonable expectation should, according to the proposal, be the normal one of the balance of probabilities taking the situation and the prospects of the business as a whole. This also grants discretion to the management board. The fact that the viability test is indefinite (“for the reasonable foreseeable future”) requires that the test is by nature more judgmental, thus also leaving the management board with wider discretion than in the context of the short-term liquidity test. The proposal does not explicitly state how long-term liabilities, such as pensions, are treated. However, it follows from the form of the viability test that long-term liabilities are also to be taken into account as they will mature into obligations to pay in the “foreseeable future”. In this connection, it is important to note that the viability test does not require a strict reference to balance sheet items. The consequence is that, for example, pension liabilities shown in the company’s accounts at the time of the distribution do not necessarily need to be considered provided that the company’s prospects of solvency are not otherwise in doubt.86 Rather, the management board may consider changes in the value of pension liabilities which are likely to occur in the course of the years until the liability matures into an obligation to pay. Balance sheet net assets test According to the proposal of the Rickford Group, in issuing the solvency certificate, the members of the management board are required to take account of the company’s accounts and annual report as a whole.87 In this connection, they need to apply the balance sheet net assets test. According to the balance sheet net assets test, a distribution is permissible if, immediately after the distribution, the assets cover the liabilities.88 Hence, the net assets i.e. the surplus of assets over liabilities including provisions as shown in the company’s accounts, may be distributed. Preferential shareholders’ claims are also treated as liabilities by way of a default rule, variable in the terms of issue or by agreement.89 Unlike the balance sheet test of the 2nd Company Law Directive, the balance sheet net assets test does not require an additional margin, e.g. the net assets balance does not need to be sufficient to cover the subscribed capital or subscribed capital plus an accumulating margin of up to 10 or 20 percent of such capital.90 The proposal does not explicitly prescribe which accounting method is to be applied when drawing up the company’s accounts which form the basis of the balance sheet test. However,

86 Rickford (2004), p. 980. 87 Rickford (2004), p. 980. 88 Rickford (2004), pp. 969 and 980. 89 Rickford (2004), p. 982. 90 Rickford (2004), pp. 982 et seq.


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as reference is to be made to the “financial statements of the company”91, the accounting methods to be used will arguably be either those based on the 4th Directive or IFRS. The management board has discretion when applying the balance sheet net assets test. If the result of the application of the balance sheet net assets test is that a distribution is not covered by net assets whereas the result of the application of the solvency test is that the company is solvent, the management board may still make a distribution provided it states the reasons why it is of the opinion that a distribution is justified.92 The balance sheet net assets test must, therefore, be applied. However, a distribution may be permissible even if it does not comply with the balance sheet test. If the application of national GAAP or IFRS requires long term liabilities (e.g. pensions) to be stated in the accounts, they are also taken into consideration when applying the balance sheet net assets test. However, it follows from the nature of the balance sheet net assets test that long-term liabilities included in the accounts are not material for the question whether distributions are permissible. The ultimate test is the solvency test. Responsibility for performing the test, solvency certificate, consultation of an accountant According to the proposal of the Rickford Group, the management board is responsible for performing the two-stage distribution test.93 The members of the management board are required to provide and publish a certificate in which they state that, in their view, after enquiry into the affairs and the prospects of the company proper for the purpose, the distribution complies with the requirements of the tests. Where the solvency test and the balance sheet net assets test diverge, the certificate should include explanations why the management board is of the opinion that a distribution is justified. The form of the enquiry requirement takes account of the fact that a full enquiry into the affairs and prospects of the company is not necessary in all cases, e.g. in cases in which the company has massive liquid resources and current profits which greatly exceed the proposed distribution. It is also emphasised that such an enquiry does not provide an absolute guarantee of ongoing solvency.94 Under the alternative regime proposed by the Rickford Group, a mandatory auditor’s certificate is not required. However, in respect to large companies whose accounts must be audited, the proposal of the Rickford Group follows an audit-based approach insofar as the audit report for the financial year in which the distribution has taken place must consider the legality of the distribution and the directors’ “going concern assurances”. In cases in which there are doubts as to the lawfulness of distributions, the members of the management board are, furthermore, required to consult an auditor prior to the distribution.95 In respect to small companies whose accounts need not be audited, such requirements are not applicable. Liability of the management or shareholders The Rickford Group proposes a comprehensive system of sanctions, emphasising that the alternative system depends in part on the existence of the availability of effective sanctions.

91 Rickford (2004), p. 986. 92 Rickford (2004), p. 980. 93 Rickford (2004), p. 980. 94 Rickford (2004), pp. 980 et seq. 95 Rickford (2004), p. 981.


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Along the lines of sec. 277 CA 85, civil liability for recipients of unlawful distributions should be based on fault. Hence, recipients of unlawful payments are liable to return the payment if they knew or had reasonable grounds to believe that the distribution was irregular. Members of the management board are responsible for the correctness of the solvency certificate and should be held personally liable if fault is present. The criteria for fault liability should be that applicable to the normal director’s duty of care, skill and diligence. Directors exercising normal standards of care are required to make an enquiry into the affairs and the prospects of the company proper for the purpose when providing the solvency certificate. In large companies whose accounts must be audited, directors exercising normal standards of care will also have to consult the auditors in case of doubt as to the legality of the distribution.96 Furthermore, it is proposed that members of the management board should be liable under criminal law for unlawful distributions. According to the proposal, the directors at fault should also be disqualified along the lines of the British Company Directors Disqualification Act 1986 (CDDA 86).97 A disqualification order of the court prohibits a person from being a director of a company and from being otherwise concerned with a company’s affairs (sec. 1 (1) CDDA 86). Under current law, a disqualification is made against directors of insolvent companies whose conduct of the company has made them unfit to be concerned in the management of the company (sec. 6 CDDA 86). Matters for determining unfitness of directors include misfeasance or breach of fiduciary duties (para. 1 Part I Schedule 1 CDDA 86), misapplication of company money or property (para. 2 Part. I Schedule 1 CDDA 86) and the extent of the director’s responsibility for the company becoming insolvent (para. 6 Part. II Schedule 1 CDDA 86). Judging from the case law at hand, courts make disqualification orders in cases of “incompetence and negligence to a very marked degree”98. By contrast, courts are not prepared to make disqualification orders in cases of commercial misjudgement. Link of insolvency legislation to the alternative regime Against the background that the alternative system depends in part on the existence of the availability of effective sanctions, the Rickford Group recommends that the solvency test should be supported by properly sanctioned general behavioural standards covering wrongful trading and non-commercial or unfair transactions in conditions of insolvency or anticipated insolvency.99 To this end, it is suggested that the concepts of wrongful trading and fraudulent trading law along the lines of the British Insolvency Act 1986 (IA 86) be introduced at EU level.100 Fraudulent trading refers to cases in which liability is imposed on directors where, in the course of the winding-up of a company, it appears that a director has carried on the business of the company with the intent to defraud creditors of the company (sec. 213 IA 86).

96 Rickford (2004), p. 980. 97 Rickford (2004), p. 980. 98 Re Stanford Services Ltd [1987] 3 BCC 326, 334; Re Churchill Hotel (Plymouth) Ltd [1988] BCLC 341; Re Sevenoaks Stationers (Retail) Ltd [1991] Ch 164, 184, CA. 99 Rickford (2004), p. 984. 100 Rickford (2004), p. 984.


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Wrongful trading imposes liability on the directors in cases in which the company has gone into insolvent liquidation and at some time before the commencement of the winding-up of the company the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation and the director did not take every step he ought to have taken to minimise the potential loss to the company’s creditors (sec. 214 IA 86). The earliest point at which a director may become personally liable for wrongful trading is, therefore, some time before the onset of material insolvency, namely when the prognosis of the company staying solvent is negative. It should, however, be noted that no reported case in Britain has yet turned decisively on such pre-insolvency duties of directors.101 Judges usually fix as the starting point of wrongful trading, the company’s cash-flow insolvency. 4.3.2.2 Economic analysis The Rickford proposal fundamentally changes the overall concept of the 2nd CLD and its implementation requires changes to nearly all basic elements of capital regimes. Areas with no substantial changes include: - Capital increases and pre-emption rights - Contractual self-protection of creditors Consequently, the following analysis will not elaborate either on potential burdens for companies or on shareholder and creditor protection in this regard. Structure of capital and shares Analysis The Rickford proposal foresees the abolition of the minimum capital requirement. This circumstance as such does not have an immediate effect on the equity financing of companies as the subscribed capital in most cases only represents an insignificant fraction of the company’s total equity as the analysis of the five EU countries has shown. The structure of shares is fundamentally changed by the abolition of the par value concept for shares. The complete changeover may cause a once-off burden which concerns the update of the company’s statutes and the actual change of the format of the shares. Subsequently, the abolishment of par values may lead to less complexity, specifically in the administration of shares. However, we do not have reliable data or estimates to assess the associated costs as companies having to apply par-value consider such a situation as hypothetical. Protection of shareholders and creditors The position of shareholders and creditors is negatively affected by the fact that the distribution could also be made out of the contributions received from shareholders of the company if the solvency test allowed for this. The balance sheet test can be overruled. As a remedy, the Rickford proposal foresees an increased level of formalised solvency testing by the company’s management concerning both the company’s short-term liquidity and its 101 For an analysis of court decisions cf. Bachner, 5 EBOR (2004), pp. 293, 300 et seq.; Habersack/Verse, ZHR 168 (2004), pp. 174, 184 et seq.


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viability in the long term. Both tests are linked to a system of sanctions at the centre of which is the personal liability of the directors. In implementing such a system, it would be crucial whether the threat of sanctions to directors serves as means to discipline the management to act prudently. Under the envisaged format of the solvency test, the directors are partly required to make highly judgmental decisions about the prospects of the company. This may result into legal uncertainty for directors. Therefore, the actual design of the test and the format of the certification by the company’s directors will be decisive in determining the right balance between the legal uncertainty for directors and the interest of stakeholders in a viable company. Distribution Analysis Calculation of the distributable amount The proposal of the Rickford Group makes fundamental changes concerning the procedure for the distribution of profits. Under the Rickford proposal, the particular emphasis switches from the balance sheet to the solvency tests because, under certain conditions, companies could make distributions even if a balance sheet test was not passed. The solvency test is the core testing element which is, by statute, not currently required in EU Member States. We have encountered in our interviews that the management of companies distributing dividends will regularly consult with the treasury department whether there is cash available for distribution and this will normally be planned at least a year ahead of the actual distribution. However, the actual calculation will be based on internal cash flow reporting standards. Concerning the actual practice of performing the test, the Rickford Group does not specify exact requirements to allow for an ultimate assessment of the associated burdens. The solvency test consists of a short-term liquidity requirement and, in addition, an indefinite assurance of the company’s viability. In the context of the solvency test, off-balance sheet items are also to be taken into account. The foreseeable future that has to be taken into account, is not further defined. The solvency test is subject to a formal certification by the company’s management. The intensity of this burden depends on how detailed the prescribed calculation methods are and how much they deviate from internal practices at the companies concerned. Accordingly, the way the calculation is conducted will heavily influence the workload associated with this test. Determination of the distributable amount The Rickford proposal does not change how the distributable amount is determined. An additional element is a solvency certificate by the board. This declaration should normally be a by-product of the above mentioned testing procedures and is not likely to cause major burdens in its preparation. However, the board has to inquire into the affairs and prospects of the company to an extent deemed adequate for the purpose. The associated burdens associated with this enquiry obligation depend on the financial state the company is in. Furthermore, there is a need to consult the auditors in case of doubt as to the legality of the distribution. Again, the engagement of the auditors specifically for this purpose will invoke specific financial burdens for the company.


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The other main burdens in EU Member States, i.e. the preparation of the proposal and the actual payment of the dividend will remain unchanged. This also concerns the necessity to channel-up profits and cash to the parent company. Sanctions The Rickford proposal requests a comprehensive system of sanctions which includes the personal liability of, as well as criminal sanctions for, directors. As such, the Rickford proposal requires explicit judgment on future developments concerning the cash flow of the company. This may lead to legal uncertainties with directors whether, in performing their assessment, they comply with their legal obligations. Depending on how rigid this system actually is, the directors will take certain measures that will secure them from potential sanctions. The level of measures will reflect the level of legal certainty needed for their actions. As the ultimate level of sanctions is not very clear, it is not possible to estimate the associated burdens for companies. Related parties The Rickford proposal does not specifically touch on the question of the monitoring of the relationships with third parties. Protection of shareholders and creditors The departure from the audited accounts, for the purpose of performing the balance sheet test, will cause more uncertainty to shareholders and creditors as to whether the calculations are in fact correct. The “solvency test”, which is the core testing element, requires a conscious assessment by management as to whether there is sufficient cash to justify the dividend distribution. So far, such assessments are rather part of actual management practice concerning the preparation of distributions. The management will usually also make such assessments to allow its accounts to be prepared under the going concern assumption. Nevertheless, projections into the future may always lead to higher uncertainties than calculations with actual figures. The conclusions would need to be confirmed by the management in the format of a solvency certificate which will be publicly available By means of this solvency statement, shareholders and creditors may receive additional information on the viability of the company from a cash flow perspective. Shareholders and creditors may benefit from a comprehensive system of sanctions depending on its actual enforcement in practice. Capital maintenance Acquisition by the company of its own shares Analysis Under the Rickford proposal, the solvency test procedures applied to distribution also have to be applied in the case of repurchases of shares. There is a continued need to authorise the buy-


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back decision by the general meeting. In this way, the basic elements of the buy-back process still persist while the restriction of share repurchases is under the Rickford proposal subject to the solvency testing procedure by the management board. The management board will communicate the results of its testing via the solvency certificate to the shareholders. Compared to the system enforced by the 2nd CLD, there are additional costs to the extent that the solvency test causes burdens for the company. Protection of shareholders and creditors Under the Rickford proposal, the buy-back process as foreseen under the current 2nd CLD will be subject to a solvency test not yet required. The testing ensures a conscious formal assessment by management whether there is sufficient cash to justify the share repurchase. So far, such assessments would be rather part of actual management practice concerning the preparation of distributions. Accordingly, both shareholders and creditors may benefit from a higher level of confidence concerning the viability of the company from a cash-flow perspective. It is a matter of the effectiveness of this test whether there is a positive or negative impact on the protection of shareholders and creditors. The effectiveness is mainly determined by systems of sanctions foreseen in the Rickford proposal which is intended to discipline the management to act prudently. Capital reduction / withdrawal of shares Analysis The Rickford Group proposes to facilitate capital reductions by applying the solvency test procedures to capital reductions and the withdrawal of shares in case the concept of a reserve for share capital which is not distributable is retained at EU level. The formal requirements concerning capital reductions, namely authorisation by the general meeting, will continue to apply. The companies interviewed in the survey have not regularly been using the instrument of capital reduction. We have not, therefore, been able to assemble relevant cost data associated with capital reductions. However, it is clear that the additional solvency test would constitute an additional burden for the companies. Costs associated with the right of creditors to object to reductions will fall away. Whether the proposed measure will give incentives to companies to reduce capital remains to be seen. Protection of shareholders and creditors The solvency test may help shareholders and creditors to assess whether the company is a going concern from a cash-flow perspective for at least one year.


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Financial assistance Analysis The Rickford Group proposal does not explicitly address the question whether the solvency test procedures are to be used for distribution purposes for financial assistance transactions. Shareholder and creditor protection The solvency test procedures may give shareholders and creditors certainty about the viability of company from a cash flow perspective, and not affected by outflowing money which is lent to shareholders. It is a matter of the effectiveness of this test whether there is a positive or negative impact on the protection of shareholders and creditors. The effectiveness is mainly determined via the actual design of the tests filling certain gaps in the Rickford proposal. Serious loss of half of the subscribed capital Analysis The 2nd CLD requires that a general meeting be called in the case of a loss of half of the subscribed capital. The Rickford proposal remains unclear how it deals with this alert function. It could be assumed that this requirement should be waived due to the fact that the Rickford Group intends to abolish the concept of minimum legal capital. Instead fiduciary duties of directors could apply. Shareholder and creditor protection The provisions dealing with the serious loss of the subscribed capital have a shareholder and also creditor protective character, as the general meeting has the possibility of deciding on safeguarding measures. A transition to a capital regime without minimum legal capital would make this protection ineffective and redundant. Instead, safeguarding measures will be subject to the discretion of the management board. Insolvency Analysis The Rickford Group recommends that the solvency test should be supported by a European framework of properly sanctioned general behavioural standards covering wrongful trading and non-commercial or unfair transactions in conditions of insolvency or anticipated insolvency. Depending on how rigid this system actually is, the directors will take certain measures that will secure them from potential sanctions. The level of measures will reflect the level of legal certainty needed for their actions. As the precise sanctioned behaviours as well as the intended level of sanctions are not very clear, it is not possible to give estimates of associated burdens for companies at this stage.


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Shareholder and creditor protection Shareholders and creditors may benefit from a comprehensive and consistent EU framework for a system of sanctions. However, any European system would need to be suitable to EU Member States’ legal systems.


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4.3.3 Lutter Group 4.3.3.1 The proposal 4.3.3.1.1 Outline The Expert Group on “Legal Capital in Europe” chaired by Professor Marcus Lutter (“Lutter-Group”) comes to the conclusion that abolishing the legal capital regime is not recommendable as long as the function and effectiveness of the proposed alternative regimes are tested. Such a test is still owing. The mere reference to other jurisdictions, such as the US state laws, is of limited help since the legal surroundings (e.g. enforcement of directors’ duties) differ materially. 4.3.3.1.2 Necessary amendments to the 2nd CLD For these reasons, the members of the Expert Group recommend not to repeal the Second Company Law Directive as recently amended with one exception: Art. 15 of the Directive dealing with the identification of the distributable amount should be reconsidered. 4.3.3.1.3 Distributions The Expert Group recognises the problem of the identification of profits due to new accounting standards (IFRS) that brought changes regarding the principles of realisation and imparity.102 In particular, the declaration of unrealised profits is regarded as a serious danger. Different methods were contemplated and considered as unconvincingly (an extra balance sheet is considered as being too costly; countermeasures with an additional cushion are too restrictive; the solvency test alone would abolish the legal capital system and permit the distribution of capital at the expense of creditor protection). Therefore, the Group comes to the conclusion that a dual solution should be introduced: Either the company advances a balance sheet according to commercial accounting principles that is reviewed and certified or it draws up the IFRS balance sheet which is reviewed by an auditor and certified by the management plus an additional solvency test. This solvency test should be based on current information summarised in a financial budget and on a longer- term capital budget document that the intended distribution will highly likely leave the firm with sufficient funds to meet liabilities as they become due for one to two years. The management should be liable for the test. 102 Cf. Lutter in: Lutter (Ed.), Legal Capital in Europe, ECFR Special Volume 1, 2006, p. 9 and in detail Pellens/Sellhorn, ibid., p. 364-393.


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4.3.3.2 Economic analysis

As the Lutter proposal maintains the overall concept of the 2nd CLD and focuses on the treatment of IFRS for profit distribution purposes. For the remaining basic elements of a capital regime, there will be no changes in terms of burdens for the companies concerned. These areas with no substantial change encompass: - Structure of capital and shares - Capital increases - Acquisition of own shares - Capital decrease - Withdrawal of shares - Financial assistance - Serious loss of subscribed capital - Contractual self-protection - Insolvency Therefore, the position of shareholder and creditors in this regard will not change. Distribution With respect to distributions the proposal differentiates between the calculation of the distributable amount, the determination of the amount to be distributed, sanctions and related parties. Calculation of the distributable amount As already embedded in the current 2nd CLD, the distributable amount shall be determined on the basis of the audited financial statements through a combination of balance sheet net assets test and a combination of profit and loss account test. This testing will not continue the current practices of companies in this respect and will not change the burden. If a company prepares its individual accounts under IFRS, the company will have to perform an additional “solvency test” covering a projective period of one to two years. This obligation does not concern other individual accounts prepared under national GAAP, respectively the 4th CLD. We have encountered in our interviews that the management of companies distributing dividends will regularly consult with the treasury department whether this is available cash for distribution and this will normally be planned at least a year ahead of the actual distribution. However, the actual calculation will be based on internal cash flow reporting standards. Concerning the actual practice of performing the test, the Lutter proposal does unfortunately not specify exact requirements to allow for an ultimate assessment of the associated burdens. The intensity of this burden depends on how detailed the prescribed calculation methods are and how much they deviate from internal practices at the companies concerned. Accordingly, the way of how the calculation is conducted will heavily influence the workload associated with this test. Another issue of the Lutter Group concerns the burdens of the company resulting from their financial reporting. The Lutter Group argues that by the use of a combination of IFRS individual accounts and solvency tests the necessity to prepare individual accounts under the


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4th CLD may fall away. However, there are still EU Member States where the accounts under the 4th CLD play a significant role in taxation. The benefit of lighter accounting burdens could only be realised if there were parallel changes in the taxation of these EU Member States. For the time being and for the purposes of this study this benefit cannot be taken into account. Determination of the distributable amount The Lutter proposal does not change the way how the distributable amount is determined. An additional element is a solvency declaration by the board. This declaration should normally be a by-product of the above mentioned testing procedures and is not likely to cause high burdens in its preparation. The other main burdens in EU member states, i.e. the preparation of the proposal and the actual payment of the dividend will remain unchanged. This also concerns the necessity to channel up profits and cash to the parent company. Sanctions The Lutter proposal maintains the responsibility of management. This responsibility is extended to the solvency declaration. The solvency test will be founded on projections into the future that in certain cases may be subject to a high degree of subjective assessment. In general, it can be stated that a prognosis is usually associated with a higher liability risk due to the uncertainties attached. This prognosis element depends on the actual design of the solvency test. Also the solvency declaration will require a certain level of representation from the management’s side. These representations by management and the connected uncertainty concerning the validity of the predictions may have an effect on the sanctions. Therefore, potential additional burdens from compliance efforts can only be determined if the design of the solvency test and the concept of representation by management are clarified. Furthermore, it is a matter of the litigation culture in the respective country whether it is easy to sue members of the company’s management. Protection of shareholders and creditors Due to the fact that the proposal only concerns IFRS individual accounts, there only effects on the position of shareholders and creditors whose company actually prepares IFRS accounts. In these cases, the “solvency test” is an additional testing element which requires a conscious assessment by management whether there is sufficient cash to justify the dividend distribution. So far, such assessments are rather part of actual management practice concerning the preparation of distributions. The management will regularly also make such assessments to allow its accounts to be prepared under the going concern assumption. The conclusions would need to be confirmed by the management in the format of a solvency declaration which will be publicly available. By means of this solvency statement, shareholders and creditors may receive additional information on the viability of the company from a cash flow perspective.


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4.3.4 Dutch Group 4.3.4.1 The proposal 4.3.4.1.1 Outline The core element of the alternative regime proposed by the Dutch Group chaired by J.N. Schutte-Veenstra103 is a two-stage distribution test which serves as a means to determine the maximum amount available for distribution and which should be applied to all forms of distributions to shareholders, namely (interim) dividends, share buy-backs and distributions as part of a capital reduction. The two-stage distribution test consists – similar to that proposed by the Rickford Group and the High Level Group – of a balance sheet test and a liquidity test. Company assets may be distributed provided that a distribution complies with both tests and that the members of the management board issue and publish a solvency statement in which they declare that, in their assessment, the distribution complies with the requirements. An auditor’s certificate is, by contrast, not required. The proposal does not contain any specifications as to whether the solvency statement to be issued by the management board should be linked to the personal liability of directors. Unlike the High Level Group and the Rickford Group, the Dutch Group does not propose that the alternative regime should be supplemented by insolvency legislation, e.g. a European framework rule on wrongful trading. Alongside the introduction of a two-stage distribution test, the Dutch Group proposes the repeal of various provisions concerning the raising of capital, for instance the minimum capital requirement and the payment obligation for shares, including the valuation requirements in cases in which shares are issued for a consideration other than in cash on formation or in subsequent capital increases. It is, furthermore, proposed to abolish the nominal value of shares and to introduce true no-par value shares. 4.3.4.1.2 Necessary amendments to the 2nd CLD Capital maintenance – distributions to shareholders, share repurchases, financial assistance, redemption of shares, capital reductions In the alternative regime, the two-stage distribution test serves as a means to determine the maximum amount available for distribution and should be applied to all forms of distributions to shareholders, namely (interim) dividend payments, share buy-backs and distributions as part of a capital reduction.104 As consequence, the 2nd Company Law Directive’s substantive restrictions on dividend distributions (Art. 15), share buy-backs (Art. 19) and reductions in capital (Art. 32), will be repealed: Any requirement for an enhancement of a simple net assets test by requiring that a reserve for the aggregate nominal value of the subscribed capital be established (Art. 15), will be abolished. The statutory regulation on share buy-backs (Art. 19) can be limited to prescribing that the acquisition by the company of its own shares is subject to an authorisation by the general meeting and to prescribing the criterion for payment of the acquisition price of the shares. The 10 percent limit in the purchase regulation - which was still in force at the time of the proposal of the Dutch Group - can either be eased to e.g. 50 % or repealed.105 103 Boschma/Lennarts/Schutte-Veenstra, Alternative Systems for Capital Protection, Final Report 2005. 104 Boschma/Lennarts/Schutte-Veenstra (2005), p. 72. 105 Boschma/Lennarts/Schutte-Veenstra (2005), p. 72.


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It is also recommended that the separate regulation for the provision of financial assistance for the acquisition of the company’s own shares be abolished (Art. 23). The risks linked to giving financial assistance should instead be addressed by the fiduciary duties of directors who are obliged to assess whether such a transaction is in the company’s interest or not and to check whether the company, after giving financial assistance, is still in a position to meet the claims of its creditors. If the management board does not fulfil its duty adequately, it incurs liability risks. If a separate regulation for the provision of financial assistance will, nevertheless, continue to exist for the giving of financial assistance for the acquisition of the company’s own shares, the balance sheet test and liquidity test should be applicable to these transactions.106 Hence, financial assistance could be given up to the limit at which the company’s solvency would be affected by the transaction. The creditors’ right to object to a capital reduction (Art. 32) can be abolished.107 The application of the two-stage distribution test in cases in which a company distributes company assets as part of a capital reduction is thought to provide sufficient protection for creditors. Raising of capital – contributions, issuance of shares, increase of share capital, pre-emption rights Alongside the changes that concern the capital maintenance provisions of the 2nd Company Law Directive, the Dutch Group proposes the repeal of various provisions concerning the raising of capital as they are thought to overreach their objective, namely creditor protection, and impose unnecessary costs on businesses: The minimum capital requirement (Art. 6) should be abolished.108 The prohibition on the contribution of an undertaking to perform work or supply services (Art. 7 s. 2) should be repealed. The risks associated with the contribution of work or supply of services in the future - the risk is that work or services is not carried out because the contributor is no longer in a position to do so - should instead be calculated in the determination of the economic value of such considerations unless the shareholder provides security by way of a bank guarantee or takes out insurance to cover these risks with itself as a beneficiary.109 The provisions regarding the payment obligation for shares (statement of the bank that cash consideration is paid) should be abandoned. The valuation requirements in cases in which shares are issued for a consideration other than in cash on formation or in subsequent capital increases (Art. 10, Art. 27) – which have, after the submission of the proposal of the Dutch Group, been relaxed but not abolished110 – should be repealed.111

106 Boschma/Lennarts/Schutte-Veenstra (2005), p. 73. 107 Boschma/Lennarts/Schutte-Veenstra (2005), p. 73. 108 Boschma/Lennarts/Schutte-Veenstra (2005), p. 64. 109 Boschma/Lennarts/Schutte-Veenstra (2005), pp. 64 et seq. 110 Cf. Directive 2006/69/EC of the European Parliament and of the Council of 6 September 2006, OJ L 264 of 25 September 2006, pp. 32 et seq. 111 Boschma/Lennarts/Schutte-Veenstra (2005), p. 64.


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The Dutch Group recommends the abolition of the criterion of nominal value of shares which should be replaced by other measures variable in the concrete case. In this context, it is also proposed to abolish the prohibition of the issue of no-par value shares (Art. 8 (1)). If the nominal value of shares is abolished, the introduction of true no-par value shares should be made compulsory. In the Dutch Group’s opinion it is conceivable that two systems, par value shares and no-par value shares, will continue to exist alongside each other.112 The possible abolition of the provision concerning subsequent formation is also proposed (Art. 11).113 4.3.4.1.3 Distributions Overview The two-stage distribution test proposed by the Dutch Group consists of a balance sheet test and a liquidity test. Whereas the liquidity test serves to assess the company’s solvency for a relatively short term, the balance sheet test serves to take into account the company’s financial position for a longer term.114 The combination of the tests is thought to offer creditors a reasonable prospect that, after the distribution, the company will be able to pay its debts as they fall due. Both tests constitute substantive restrictions on distributions: company assets may only be distributed to shareholders if the distribution complies with both tests.115 Hence, in cases in which the balance sheet test indicates that the proposed distribution is not justified by sufficient net assets whereas according to the liquidity test the company is solvent - or vice versa - a distribution may not take place. Balance sheet test According to the balance sheet test, a distribution is permissible if the company’s equity is not negative as a result of the distribution to shareholders.116 Hence, after the distribution, the assets of the company must at least be equal to the liabilities including provisions. Distributions may only be made if and to the extent there is a surplus. Unlike the balance sheet test of the 2nd Company Law Directive, the balance sheet test of the Dutch Group does not require a margin in a way that the net assets balance must be sufficient to cover the subscribed capital. Whether the requirement of the balance sheet test is met is to be assessed on the basis of the information set out in the annual accounts.117 It is not clear if the term "annual accounts" also comprises the company’s consolidated accounts.118 When drawing up the accounts which form the basis of the balance sheet test, companies must apply the accounting methods which they are allowed to use according to the legislation in force at the time of the decision to distribute company assets.119 Accordingly, companies may 112 Boschma/Lennarts/Schutte-Veenstra (2005), pp. 73 et seq. 113 Boschma/Lennarts/Schutte-Veenstra (2005), p. 64. 114 Boschma/Lennarts/Schutte-Veenstra (2005), p. 72. 115 Boschma/Lennarts/Schutte-Veenstra (2005), p. 72. 116 Boschma/Lennarts/Schutte-Veenstra (2005), p. 70. 117 Boschma/Lennarts/Schutte-Veenstra (2005), p. 70. 118 Boschma/Lennarts/Schutte-Veenstra (2005), p. 71. 119 Boschma/Lennarts/Schutte-Veenstra (2005), p. 71.


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use national GAAP the source of which is the 4th Directive and may, inter alia depending on the legislation in force in the EU Member State concerned, also apply IFRS. Hence, the valuation methods a company may use will be those which are permissible under national GAAP and IFRS. The management board has no discretion when applying the balance sheet test except for potential options included in the accounting framework applied. It may only make distributions if and to the extent the result of the balance sheet test is that there is a surplus of assets over liabilities including provisions. So far as the application of national GAAP or IFRS requires recognizing long-term liabilities (e.g. pensions) in the accounts, they are also taken into account when applying the test. Liquidity test The Dutch Group proposes to prescribe a liquidity test alongside the balance sheet test.120 The content and details of the liquidity test have not been defined. The Dutch Group proposes that the actual requirements which the liquidity estimate must meet be established in consultation with accounting organisations.121 Hence, at this stage it is unknown whether the test will actually be cash flow based or will resort to an accounting ratio, what payments and debts are to be included in the liquidity test, whether the debts must be paid out of the liquid assets or if invested capital that can be transformed into liquid assets can be used, whether it is possible not to take extraordinary circumstances into account and whether the management board has discretion when applying the test. At this stage, it is only defined that the period the liquidity test has to cover is twelve months following the distribution.122 In respect to the treatment of long-term liabilities, such as pensions, becoming due after the twelve months period, it follows from the short-term requirement that those will not be taken into account. Responsibility for performing the test, solvency statement, consultation of an accountant According to the proposal of the Dutch Group, the management board is responsible for performing the two-stage distribution test.123 The members of the management board are required to provide and publish a solvency statement in which they declare that, in their assessment, the distribution complies with the applicable requirements. In legal systems in which the company’s profits are at the disposal of a company body other than the management board, the members of the management board should only be allowed to implement a resolution passed by the other company body concerning the payment of the dividend amount on the condition that the management board provides such solvency statement.124

120 Boschma/Lennarts/Schutte-Veenstra (2005), pp. 71 et seq. 121 Boschma/Lennarts/Schutte-Veenstra (2005), p. 72. 122 Boschma/Lennarts/Schutte-Veenstra (2005), p. 72. 123 Boschma/Lennarts/Schutte-Veenstra (2005), p. 67. 124 Boschma/Lennarts/Schutte-Veenstra (2005), pp. 67 et seq.


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The solvency statement does not need to be certified by an auditor.125 Liability of the management or shareholders Unlike the proposals of the Rickford Group and the High Level Group, the Dutch Group’s proposal for an alternative regime does not contain any details concerning the consequences of distributions that are made contrary to the rules, namely the liability of shareholders and board members. Link of insolvency regulation to the alternative regime The proposal of the Dutch Group does not provide for insolvency legislation geared towards supplementing the solvency test, e.g. a wrongful trading standard. 4.3.4.2 Economic analysis The Dutch Group proposal fundamentally changes the overall concept of the 2nd CLD and its implementation requires changes to nearly all basic elements of capital regimes. Areas with no specifically mentioned substantial changes encompass: - Capital increases - Serious loss of half of the subscribed capital - Contractual self-protection of creditors - Withdrawal of shares - Insolvency Consequently, the following analysis will not elaborate either on potential burdens for companies or on shareholder and creditor protection in this regard. Structure of capital and shares Analysis The Dutch group proposal foresees the abolition of minimum capital requirements. This would not have an immediate effect on companies as their equity is normally higher than the minimum amount foreseen by law. Furthermore, the Dutch group proposes the abolition of the par value of shares. This may happen gradually with the co-existence of both systems in the way that only no-par value shares could be issued in the future. By administering different systems, the administrative burden would be slightly increased based on the experience from our interviews. The complete changeover may cause a once-off burden with no significant changes in burdens for the future.

125 Boschma/Lennarts/Schutte-Veenstra (2005), p. 68.


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Protection of Shareholders and Creditors In general, the position of shareholder and creditors is negatively affected by the fact that the distribution could also be made out of the subscribed capital and premiums of the company if both the balance sheet and the liquidity test allowed for this. To counteract this, the Dutch Group proposal foresees an increased level of formalised solvency testing by the company’s management concerning the viability of the company. It is a matter of the effectiveness of this test whether there is a positive or negative impact on the protection of shareholders and creditors. The effectiveness is mainly determined via the actual design of the tests filling certain gaps in the Dutch Group proposal. Distribution Analysis Calculation of the distributable amount The proposal of the Dutch group does not fundamentally change the procedure for the distribution of profits. The key element that is changed concerns the compliance testing whether a distribution is actually feasible. Currently, this is a very light touch procedure in the EU Member States concerned. The balance sheet test refers to a surplus which must be determined on the basis of the annual accounts prepared under the 4th CLD or IFRS. This is basically in line with current EU practice where a majority of EU Member States directly use the annual accounts. Therefore, there is no change in the costs associated with this part of the testing. The liquidity test is an additional testing element which is not currently required in EU Member States. We have encountered in our interviews that the management of companies distributing dividends will regularly consult with the treasury department whether there is sufficient cash available for distribution and this will normally be planned at least a year ahead of the actual distribution. However, the actual calculation will be based on internal cash flow reporting standards. Concerning the actual practice of performing the test, the Dutch group does not, unfortunately, specify exact requirements to allow for an ultimate assessment of the associated burdens. Instead, the Dutch group proposes to establish these requirements in consultation with accounting organisations. It is only defined that the period will need to cover the twelve months following the distribution. This could point to a requirement for a cash flow projection, even though it could also be assumed that certain current accounting ratios would also suffice. Experiences in other non-EU countries have shown that such tests can take both forms. In any case, this test will cause additional burdens. The intensity of this burden depends on how detailed the prescribed calculation methods are and how much they deviate from internal practices at the companies concerned. Accordingly, how the calculation is conducted will heavily influence the workload associated with this test. Determination of the distributable amount The Dutch proposal does not change how the distributable amount is determined. An additional element is a solvency declaration by the board. This declaration is a by-product of


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the above mentioned testing procedures and is not likely to cause major burdens in its preparation. The main burdens in EU Member States, i.e. the preparation of the proposal and the actual payment of the dividend, will remain unchanged. This also concerns the necessity to channel-up profits and cash to the parent company. Sanctions The Dutch proposal does not contain any specifications concerning changes in the sanctioning of incorrect distributions. Therefore, from an economic point of view there is no change to be expected. Related parties The Dutch proposal does not specifically touch on the question of the monitoring of the relationships with third parties. Protection of shareholders and creditors The liquidity test provides a conscious formal assessment by management whether there is sufficient cash to justify the dividend distribution. However, it is not clearly determined how such a liquidity test would work and, thus, its effectiveness remains unclear. So far, such assessments are rather part of actual management practice concerning the preparation of distributions. The management will regularly also make such assessments to allow its accounts to be prepared under the going concern assumption. The conclusions would need to be confirmed by the management in the format of a solvency statement which will be publicly available. By means of this solvency statement, shareholders and creditors may receive additional information on the viability of the company from a cash flow perspective. Capital maintenance Acquisition by the company of its own shares Analysis Under the Dutch Group proposal, the testing procedures applied for distribution have also to be applied in the case of repurchases of the company's own shares. There is a continued need to authorise the buy-back decision by the general meeting. In this way, the basic elements of the buy-back process still persist with the addition of the testing procedure by the management board. However, the protective cushion of net assets may fall away as net assets would not have to be secured against distributions. It is not clear how the management board should communicate the results of its testing to the shareholders. Therefore, there are only additional costs to the extent that the additional testing causes burdens for the company.


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Protection of shareholders and creditors The additional testing ensures a conscious formal assessment by management as to whether there is sufficient cash to justify the dividend distribution. So far, such assessments would be rather part of actual management practice concerning the preparation of distributions. Accordingly, both shareholders and creditors are provided via a formalised assessment by the management with a higher level of confidence concerning the viability of the company from a cash-flow perspective. However, it is a matter of the effectiveness of this test whether there is a positive impact on the protection of shareholders and creditors. The effectiveness is mainly determined via the actual design of the tests filling the gap of the Dutch Group proposal. Capital reduction Analysis The Dutch group proposes to facilitate the capital reduction by applying the testing procedures (balance sheet test in combination with a liquidity test) to distributions. It remains unclear whether the remaining requirements concerning capital reductions have been applied (approval of the general meeting). One key element is the abolition of the right of creditors to object to a capital reduction which may save the companies costs for potential legal battles with creditors. Again, we are not able to confirm that these costs are substantial due to lack of company data. The companies interviewed in the survey are normally not using the instrument of capital reduction. Therefore, we have not been able to assemble cost data associated with capital reductions. Whether these proposed measures will give incentives to companies to reduce capital remains to be seen. Protection of shareholders and creditors Due to the abolition of the right to object to capital reductions, the legal position of creditors would suffer. This could partly be made good by a higher certainty that the company is a going concern from a cash flow perspective for at least one year. Indications for this can be derived from the required additional testing. Financial assistance Economic analysis The Dutch Group proposes to abolish the separate regulation for the provision of financial assistance for the acquisition of the company’s own shares. The risks linked to giving financial assistance should instead be addressed by the fiduciary duties of directors who are obliged to assess whether such a transaction is in the company’s interest or not and to check whether the company, after giving financial assistance, is still in a position to meet the claims of its creditors. As the new provisions on financial assistance of the 2nd CLD have not been implemented in the EU Member States, we have not been able to gather relevant cost data with companies on


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financial assistance. Therefore, we are not able to assess potential relief of burdens by further liberalising the financial assistance by only referring to fiduciary duties of directors. In order to achieve legal certainty, directors would have to take certain measures to ensure that financial assistance is based on proper grounds. It remains to be seen how actual practice would develop if such liberalisation took place. Shareholder and creditor protection Shareholders as well as creditors would suffer a reduced level of protection by a further liberalisation of financial assistance because such assistance would be completely left in the hands of the directors. A potential liability of directors will only help if it is certain that claims against directors can actually be enforced.


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4.3.5 Conclusion on regimes proposed by literature The four theoretical models discussed (High Level Group, Rickford Group, Lutter Group and Dutch Group) show different levels of impact on the capital regime as currently embedded in the 2nd CLD. The main focus of all proposals lies on changes to the way distributions to shareholders are restricted. All systems differ as to how this affects the overall set-up of the capital regime. The Lutter Group proposal largely sticks to the current system of the 2nd CLD and only changes provisions on the distribution of profits to accommodate the use of IFRS in the individual financial statements. The remaining three theoretical models intend to fundamentally change the current capital regime by abolishing the concept of legal capital in favour of additional distribution testing by means of additional solvency/liquidity tests. The latter goes hand-in-hand with the transition from a par-value concept of shares towards a true no-par value share concept. All four models are to certain extent incomplete in their suggestions on how to exactly conduct changes to the 2nd CLD. The existing gaps in these models partly allow for a wide interpretation and can immensely influence the associated burdens for the companies concerned. One significant example is the impact of different designs of solvency/liquidity tests. The effects of the four models on the basic elements of capital regimes can be summarised as follows: Structure of capital and shares Three of the four models foresee the abolishment of the concept of minimum legal capital and the introduction of true no-par-value shares. One of the three, the High Level Group, considers introducing the concept of a solvency margin. The Lutter Group Model does not change the current approach of the 2nd CLD. Overall, the cost implications of the administration of different structures of capital or shares seem rather insignificant for the companies concerned. The abolition of par values as such may lead to less complexity in the administration of shares. However, companies interviewed assessed these simplifications to be rather insignificant. We have not been able to collect reliable data or estimates to assess the associated costs in situations where companies apply the no-par value concept. Where the concept of minimum capital is abolished, shareholder and creditor protection suffer from the loss of a distribution restriction to the extent that the minimum capital represents an additional cushion that restricts distributions. This minimum capital protection is replaced by the extended testing efforts concerning distributions (balance sheet plus an additional solvency/liquidity test). Capital increase None of the four models significantly changes the concept of capital increases including pre-emption rights. Thus, the basic compliance costs of today’s systems essentially remain. Three of the four models foresee the abolition of the requirement of an expert opinion for contributions in kind. However, there was no reliable data on the cost of such expert opinions.


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However, it can be assumed that the board of directors will seek some kind of reassurance that the valuation is legally valid. Accordingly, we assume no significant change in the total burdens associated with capital increases. Shareholder protection is maintained by means of the approval of the general meeting of any capital increase. With the exception of the Lutter Group proposal, expert opinions for contributions in kind as an element of shareholder and creditor protection are given up. Distribution All four models basically aim at changing how distributions are legally restricted to allow for capital maintenance. The Lutter Group only addresses an add-on for the situations where IFRS are used for individual financial statements. This limits the number of companies where these provisions have to be applied to IFRS users. Regardless of the effects of the accounting concept on distributions, the three other models fundamentally change the approach to the necessary testing as they abolish the concept of legal capital. The core element that is added in all four models is solvency/liquidity tests. The High Level Group favours current balance sheet ratios. The Rickford Group and the Lutter Group apply cash flow projections. The Dutch Group does not specify the general approach to solvency tests. However, none of the four models specifies in detail the design of these tests. Accordingly, it seems impossible to estimate the cost impacts of these tests. Nevertheless, it is clear that the actual design and the detail of the provisions will heavily influence the costs for the companies when they substantially deviate from existing internal reporting rules of the companies concerned. The balance sheet tests remain important in all models, except for the Rickford Group where there is a possibility to override the balance sheet test. The High Level Group explicitly offers additional flexibility for companies by potentially allowing departures from the GAAP used for financial reporting purposes. The other three models stick to the current accounting framework based on the 4th CLD or IFRS. Shareholder and creditor protection suffers from the fact that the distribution restrictions of the legal capital are explicitly removed in three of the four models (exception: Lutter Group model). Instead, the shareholder and creditors may receive comfort about the viability of a company via the solvency/liquidity tests if the testing procedures are effective. Repurchase of shares Concerning the repurchasing of the company's shares, the fundamental processes remain intact in all four models. This is especially true for the main compliance cost factors like the shareholder approval with the preparation of proper proposals. Three of the four models foresee the addition of a solvency/liquidity test. Here the same considerations concerning cost aspects apply as for distribution processes. Shareholder and creditor protection may benefit from the solvency/liquidity test for these three models. However, especially under the Rickford proposal, but also in the other two models which abolish the minimum legal capital, the net assets of a company would not be protected.


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Capital reduction/withdrawal of shares For capital reductions and withdrawals of shares, the authorisation of the general meeting, which most likely represents the main cost factor, is still required. However, in our interviews we have not been able to secure cost data on capital reductions as these are normally not used in practice. Three of the four models which foresee the abolition of legal capital ask for the performance of an additional balance sheet/solvency test as used for distribution purposes. Therefore, the cost considerations from the distribution process apply for this case as well for these three models. Shareholder and creditor protection may benefit from the additional solvency/liquidity test for these three models. However, these three models also foresee the abolition of the right of creditors to object to the capital reduction. Financial assistance On financial assistance, only two of the four models foresee explicit changes. The Dutch Group wants to further liberalise financial assistance by resorting to fiduciary duties of directors. Due to the lack of implementation of the provisions in EU Member States, we were not able to get cost data on the impacts of newly introduced provisions. Accordingly, it is not possible to estimate potential reliefs by further liberalisations. The High Level Group explicitly adds the balance sheet/solvency test to the necessary precautions for allowing financial assistance. Shareholder and creditor protection may worsen if a further liberalisation of financial assistance takes place in favour of fiduciary duties of directors. The addition of a balance sheet/solvency test may benefit shareholders and creditors in helping them to assess the viability of a company after financial assistance, if the testing procedure is effective. Loss of subscribed capital The Lutter Group is the only model which maintains the immanent preconditions for the effectiveness of this alert function – the minimum legal capital. The other three models do not touch explicitly on this issue. However, it could be assumed that this monitoring duty could fall away in those three models where the minimum legal capital is abolished. Nevertheless, from our interviews with EU companies, it has become clear that there is no specific effort required for the monitoring of this provision. This is regularly monitored via the internal reporting mechanisms of the companies which do not constitute any incremental burden for the companies concerned. Shareholder and creditor protection aspects of this alert function would vanish in those systems where there is no legal capital required. Instead they may benefit from solvency/liquidity tests to assess the viability of the company.


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Covenants/contractual self-protection Covenants are not directly affected by any of the four models. It remains to be seen whether the negotiation of covenants would be affected by the different models. Shareholder and creditor protection remains unchanged. Insolvency Two of the four models foresee the creation of new EU wrongful trading rules. The cost effects depend on the rigidity of the systems and how much effort companies have to invest in order to achieve a satisfying level of legal certainty that the directors are not in breach of legal duties in this regard. Shareholder and creditor protection may benefit from an EU framework. However, the basic question remains whether this could fit into national legal environments. Incremental cost table for the alternative models The previous analysis has made it evident that the main cost factors of the existing models under the 2nd CLD will still remain, e.g. costs for the preparation of a shareholder assembly. Concerning the question which additional significant costs will arise largely depends on the design of solvency tests. As pointed out before, the costs cannot reliably determined as the complete requirements are not clear. We also have not been able to make references to experiences from the non-EU countries in this regard. Therefore, the following overview uses the current average incremental cost of the five EU Member States as a starting point and lists additional requirements on a factual basis.


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Figure 4.3.5 – 1: Estimated incremental burdens of theoretical models EU

Average High Level

Group Rickford Group

Lutter Group

Dutch Group

Capital Increase

€27.774 €27.774 Plus: • No

substantial changes

€27.774 Plus: • No

substantial changes

€27.774 Plus: • No change

€27.774 Plus: • No substantial

changes

Distri-bution

€15.596 €15.596 Plus: • Solvency /

liquidity test • Solvency

margin • (solvency

certificate)

€15.596 Plus: • Solvency test • (solvency

certificate) • Additional

need to consult auditors (possibly)

€15.596 Plus: • Solvency

test • (solvency

declaration)

€15.596 Plus: • Liquidity test • (solvency

declaration)

Acqui-sition of own shares

€26.570 €26.570 Plus: • Similar

additional testing procedure as applied for distribution

€26.570 Plus: • Similar





Capital reduc-tion

No data No data Plus: • Application

of the same testing procedures

No data Plus: • Application


No data Plus: • No change

No data Plus: • Application of

the same testing procedures

Redemp-tion /With-drawal of shares

€750 €750 Plus: • Application


€750 Plus: • Application

of he same testing procedures

€750 Plus: • No change

€750 Plus: • No substantial

changes proposed

Contrac-tual Self -Protec-tion

No data No data Plus: • No change





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4.4 Conclusions on comparative analysis Concerning the five EU Member States, the 2nd CLD sets the guiding framework for capital regimes in the European Union. Key features of the current capital regime of the European Union are: Concept of a legal capital - The subscribed capital is protected from distribution. The concept of subscribed capital is also extended to the 2nd CLD’s approach to capital maintenance, namely how the acquisition by a company of its own shares, capital reductions, the withdrawal of shares and financial assistance are restricted. Balance sheet test - Any distribution under the 2nd CLD is based on a balance sheet test. The balance sheet profit is the profit realised for the financial year after setting off losses and profits brought forward as well as sums in mandatory and optional reserves. The accounting framework from which the realised profits are derived is either national GAAP harmonised to a certain degree by the 4th CLD or IFRS. Involvement of the general meeting - The decision making authority of the general meeting concerns all matters relating to an amendment of the subscribed capital or fundamental decisions concerning transactions linked to capital maintenance issues. Deviations of importance also with respect to the costs were rather seldom and were found in particular with respect to the use of IFRS and the question of what can be understood by realised profits. The compliance cost concerning the 2nd CLD company law requirements are generally low for companies interviewed throughout the five EU Member States; significant costs rather arise outside the area of the core company law requirements, specifically with regard to securities legislation (e.g. capital increases; acquisition of own shares). For the individual EU Member States, our analysis of the incremental costs associated with company law provisions delivered the following results for key processes: Figure 4.4 – 1: Incremental costs in the five EU Member States France

€ Germany

€ Poland

€ Sweden

€ UK €

EU Average


€12,260 to €16,750

€8,500 to €42,000

€55,634 No data €7,603 to €23,806

€27,774

Distribution €1,600 to €2,700

€1,000 to €15,000

€210 to €5,443

€3,000 to €4,000

€3,000 to €120,000

€15,596


€53,300 to €55,400

€50,300 to €50,500

€2,800 to €11,060

No data €1,200 to €12,000

€26,570

Capital reduction



No data €500 to €1,000 No data No data No data €750




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The four non-EU countries show a mixture of alternatives to the capital regime used in the EU. These systems have mainly abandoned the concept of legal capital or the importance of legal capital is low. Instead, the emphasis has shifted to increased testing procedures for dividend payments and other kinds of distributions like the repurchase of shares by means of different kinds of solvency and balance sheet tests. In performing the balance sheet test, the audited consolidated accounts are used in some of the jurisdictions due to legal or practical considerations. The distribution decision regularly lies within the discretion of the board of directors. The increased responsibility of the board in this regard translates into a fiduciary duty or personal liability. Furthermore, fraudulent transfer legislation may come into play. From a compliance cost perspective these non-EU systems are also not overly burdensome. Figure 4.4 – 2: Incremental costs for the five non-EU jurisdictions

EU Average

USA Del. USA Cal.

Canada Australia New Zealand

Capital Increase

€27.774 No data No data No data €2.000 €450

Distribution €15.596 €100 to €2.000

€2.500 to €5.000

€5.200 €650 to €10.400

€1.600 to €2.500


€26.570 €5.435 €50.000 No data €3.550 to €32.500

No data

Capital reduction



€750 No data No data No data No data No data


No data €8.000 €208.000 €46.800 No data No data

A direct comparison of the averages of incremental compliance costs in EU and non-EU jurisdictions re-emphasises the previous assessment: Figure 4.4 – 3: Comparison of the average EU and non-EU incremental costs EU

Average Non-EU Average

Capital Increase

€27.774 €1.225

Distribution €15.596 €3.515


€26.570 €24.487

Capital reduction

No data No data


€750 No data


No data €87.600


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In considering these averages it needs to be kept in mind that the data was retrieved from companies in good financial health. These figures may change one a company would enter into more difficult financial situation. Especially with regard to a potential dividend distribution, the non-EU burden may rise as more detailed considerations concerning their financial position would have to take place; in the EU, the results from a balance sheet test is rather easily determined. The starting point of the four theoretical proposals in literature (High Level Group, Rickford Group, Lutter Group, Dutch Group) are the potential changes to the way distributions to shareholders are restricted. These proposals vary from partial to full scale reform of the 2nd CLD capital regime. All systems differ as to how this affects the overall set-up of the capital regime. The Lutter Group proposal largely sticks to the current system of the 2nd CLD and only changes provisions on the distribution of profits to accommodate the use of IFRS in the individual financial statements. The remaining three theoretical models (High Level Group, Rickford Group, Dutch Group) discuss a fundamental change the current capital regime by abolishing the concept of legal capital in favour of distribution testing by means of additional solvency tests. The latter goes hand-in-hand with the transition from a par value concept of shares towards a true no-par value share concept. The economic effects of these theoretical models are not fully clear; the most burdensome incremental aspects of the 2nd CLD are still intact. As the four models are in differing degrees incomplete in their suggestions on how to exactly conduct changes to the 2nd CLD, the existing gaps in these models partly allow for a wide interpretation and can immensely influence the associated burdens for the companies concerned. One significant example is the impact of different designs of solvency tests. A comparison of the incremental cost implications of the four theoretical models in literature shows that the additional incremental burden to be expected will primarily stem from the design of solvency tests. The starting point for the assessments is the current average incremental cost of the five EU Member States:


314

Figure 4.4 – 4: Comparison of the average EU incremental costs with estimated incremental burdens of theoretical models EU

Average High Level

Group Rickford Group

Lutter Group

Dutch Group

Capital Increase

€27.774 €27.774 Plus: • No

substantial changes

€27.774 Plus: • No

substantial changes


€27.774 Plus: • No substantial

changes

Distri-bution

€15.596 €15.596 Plus: • Solvency /

liquidity test • Solvency

margin • (solvency

certificate)

€15.596 Plus: • Solvency test • (solvency

certificate) • Additional

need to consult auditors (possibly)

€15.596 Plus: • Solvency

test • (solvency

declaration)

€15.596 Plus: • Liquidity test • (solvency

declaration)

Acqui-sition of own shares

€26.570 €26.570 Plus: • Similar







Capital reduc-tion

No data No data Plus: • Application


No data Plus: • Application



No data Plus: • Application of

the same testing procedures

Redemp-tion /With-drawal of shares

€750 €750 Plus: • Application


€750 Plus: • Application

of he same testing procedures

€750 Plus: • No change

€750 Plus: • No substantial

changes proposed

Contrac-tual Self -Protec-tion

No data No data Plus: • No change




Overall, the cost analysis of the existing models in five EU Member States and four non-EU countries has shown that the incremental burdens of company law in this regard for the companies in all jurisdictions are not overly burdensome and, thus, cannot play a decisive role in determining whether the transition to an alternative system would actually benefit EU business by lowering administrative burdens. However, incremental burdens can be of considerable relevance when considering the implementation of certain measures in a jurisdiction. This is especially true of the design of solvency tests. Moreover, aspects of shareholder and creditor protection have to be considered.


315

5 Impacts of IFRS on profit distribution 5.1 Introduction Profit and net assets are the current basis for determining the distributable amounts under Article 15 of the 2nd CLD. Accordingly, accounting rules form the starting point for determining such amounts. In the European Union, the accounting rules have been harmonised to a certain degree by means of the 4th and 7th CLD for all limited liability companies. In the year 2002, the European Union introduced the requirement for listed companies to prepare their consolidated financial statements according to International Financial Reporting Standards (Regulation 1606/2002). For group accounts of non-listed companies and for the individual financial statements as a whole, the EU Member States have been granted an option to permit or require the use of IFRS as accounting rules. Since annual accounts are currently the basis for dividend distributions, the use of IFRS in individual accounts may show significant impacts on distributable profits. Due to the fact that fair value measurements increasingly play a role in the IASB standard setting, the question arises whether the valuation of assets and liabilities at fair value should result in distributable revaluation gains. This analysis is split into two parts. The first part provides a brief overview of the current situation on profit distribution for all 27 EU Member States. The second part covers a more detailed analysis of certain accounting areas for the five EU Member States which form the core part of our analysis. Part I Based on discussions with the European Commission, a questionnaire was designed and sent to KPMG member firms in all 27 Member States of the European Union. This questionnaire focuses on two fields of study:

Determination of distributable profits and Specific areas of accounting.

Concerning the determination of distributable profits, this part of the study examines how far IFRS are either optionally or mandatorily applied within the European Union. Furthermore, the questionnaire aims at giving an overview of whether distributions are currently allowed based on accounts prepared under IFRS and of whether these accounts have to be modified in order to assess the distributable amounts. The specific areas of accounting include: o Investment Property, o Post-employment Benefits, and o Financial Instruments. This selection was based on an initial assessment of accounting areas where significant divergence between national accounting rules and IFRS could take place. Furthermore, these areas contain fair value measurements or other measurement rules that may be relevant in determining distributable amounts. This initial selection was supported by the European Commission. The analysis of deviations between national accounting rules and IFRS has reconfirmed the selection made.


316

Reference model for all the analyses is the relevant IFRS. This indirectly provides a picture of the state of harmonisation of accounting rules in Europe and directly makes it directly possible to see whether a change from national accounting rules towards IFRS may lead to differing distributable amounts. Part II In order to achieve a more detailed understanding of the “accounting mechanics” and the link to distributable amounts, a more in-depth analysis was performed for the core five EU Member States being subject to the study project. The reader of this part of the study should be aware that the results only refer to the current status of IFRS and national accounting rules. Future changes to IFRS and national accounting rules may significantly change the conclusions drawn. Accordingly, this part of the study can only give an insight into the current state of both accounting regimes.


317

5.2 Overview on 27 EU Member States – part I 5.2.1 Introduction For the accounting part of the study it was neither intended nor required to have a full analysis of all differences in accounting regimes in the different countries. A stocktaking of the implementation of IFRS in different countries was also not the major objective of the questionnaires sent. The idea of the following analysis is to get an impression of how the harmonisation of dividend distributions based on accounting results is proceeding. Realised profits are one prerequisite for distributions according to the 2nd CLD as well as the net asset position of companies. Other aspects of dividend distributions, such as mandatory legal reserves, solvency requirements and any other impacts on distributable amounts are outside of the scope of this part of the study. Against the background of the requirements of the EU IAS-Regulation 1606/2002, it is important to analyse whether (individual) IFRS financial statements may be the basis for dividend distributions in different EU Member States. Closely connected to this question is whether national (legal) requirements distinguish between accounting profits and “realised profits” for distribution purposes. The questionnaire tried to get a feel for the differences between the national accounting rules and IFRS. If there were no major deviations, then the question whether IFRS or the national accounting rules apply for determining profits would play no role at all. Since the total amount of equity is also important in determining distributable amounts according to the 2nd CLD, we also tried to get an idea of the impact of national accounting rules versus IFRS on the net asset position of a company. Then three other accounting topics were selected, which – based on the currently applicable IFRS – are likely to have a major impact on financial statements. The measurement at fair values and the related question of realisation of profits also guided the selection. The sample areas include:

Investment property Post-employment benefits, and Financial instruments.

A more in-depth analysis is provided in part II of this study section on IFRS impacts. Those interested in a more detailed description of underlying accounting rules and deviations of national accounting rules versus IFRS should therefore refer to this part of the study. It must be noted that some issues in the questionnaire that were the basis for the following analysis needed a high degree of subjective assessment. Furthermore, country-specific as well as company-specific individual legal and economic requirements and conditions may impair the comparability of the results of the country-specific answers. These caveats need to be remembered when interpreting the results of this part I of the study section on IFRS impacts.


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5.2.2 Determination of distributable profits 5.2.2.1 Application of IFRS in the European Union The first question raised dealt with the choice of implementing IFRS companies not directly covered by the scope of the EU’s IAS-Regulation 1606/2002 and in individual financial statements. This should give a first impression of how far IFRS are applicable within the European Union. Since individual financial statements are currently the basis for dividend distributions, the question of whether IFRS may be applied in the individual accounts shall be of interest for the design of an alternative system of profit distribution. The following table contains the percentages of EU Member States (based on a total number of 27) that face one of the possibilities given. The results are based on the responses received from KPMG member firms in the 27 EU Member States. A detailed analysis may lead to much more complex results since the application of IFRS may depend on company sizes or other criteria. Furthermore, some EU Member States apply IFRS as well as their national accounting rules. Therefore, the percentages are simply an indication of the potential size of a problem caused by the application of IFRS for distribution purposes. In the legislation of some EU Member States, a distinction may be made between large and small/medium-sized companies. Therefore for one segment of companies IFRS may be allowed whereas for the other segment of companies it may be optional (e.g. in Bulgaria). The numbers in the following table are rounded to full percentages. Figure 5.2 – 1: Mandatory and permitted application of IFRS Consolidated Accounts Annual Accounts

(individual financial statements) National

GAAP IFRS National

GAAP IFRS

Publicly Traded Companies The mandatory application of IFRS is guided by Regulation 1606/2002.

Required 44% Allowed 37%


Non-publicly Traded Companies





Especially relevant for the topics analysed in this study is the question of whether IFRS are required or permitted for use in the individual financial statements. In a major part of EU Member States, IFRS are optionally or mandatorily applicable in individual financial statements (see list below). In all these countries, the determination of distributable profits under IFRS is an issue or may be an issue.


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The following countries permit or require the application of IFRS in their individual financial statements:

Bulgaria Cyprus Czech Republic Denmark Estonia Finland Greece Ireland Italy Latvia Lithuania Malta Netherlands Poland Portugal Slovakia Slovenia United Kingdom

5.2.2.2 Determination of distributable profits based on IFRS Furthermore, the IFRS questionnaire aimed at finding out whether it is actually permitted or required to determine distributable amounts based on financial statements prepared under IFRS. If it is permitted or required, it needed to be stated whether the amounts (net profit or loss/net asset position) recorded in the IFRS financial statements are regarded as distributable or whether modifications of these amounts are required. The question of whether modifications are required may be perceived from different points of view. Therefore, the corresponding explanation of that modification is stated further below when applicable. Figure 5.2 – 2: Survey on 27 EU Member States: Profit distribution based on IFRS, modification requirements Country Profit distribution based on IFRS-

financial statements mandatory/possible?

Modifications if IFRS-profit required?

Austria No N/A Belgium No N/A Bulgaria Yes No modification required. Cyprus Yes No modification required. Czech Republic Yes No modification required. Denmark Yes Some form of “modification”

required. (see below) Estonia Yes No modification required. Finland Yes No modification required. France No N/A Germany No N/A Greece Yes Some form of “modification”

required. (see below) Hungary No N/A Ireland Yes Some form of “modification”

required. (see below) Italy Yes Some form of “modification”


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required. (see below) Latvia Yes No modifications required. Lithuania Yes No Modifications required. (see

below) Luxembourg No N/A Malta Yes Some form of “modification”

required. (see below) Netherlands Yes Some form of “modification”

required. (see below) Poland Yes No substantial form of

“modification” required. (see below)

Portugal Yes No modifications required. Romania No N/A Slovakia Yes No modification required. Slovenia Yes No modification required. Spain No N/A Sweden No N/A United Kingdom Yes. Some form of “modification”

required. (see below) In 17 of the 27 EU Member States a distribution based on IFRS is mandatory or permitted. Only in some EU Member States, the IFRS amounts must be modified to determine distributable profits; e.g. Ireland and the United Kingdom have developed a practice of distinguishing between accounting profits and distributable profits (for details, please see the table below). In other EU Member States, such as France and Germany, it is not permitted to make dividend distribution based on IFRS accounting profits in individual financial statements. Therefore, it can be concluded that there is currently broad divergence throughout the European Union in how relevant profits are determined as the basis for dividend distributions. The following comments have been received from KPMG offices concerning the required modifications: Denmark The distribution of profits is mainly determined by using the distributable reserves in the annual accounts (which could be prepared in accordance with IFRS), though the financial position at the group level should also be taken into consideration when determining the acceptable level of dividend payments. If the annual accounts are prepared in accordance with IFRS, the distributable reserves will be determined based on IFRS figures. There are though some modifications based on the Danish legislation, primarily in the Danish Companies Act and The Danish Financial Statement Act. Those modifications primarily relate to profits related to non-realised revaluations to fair value. Those revaluations will not be distributable until the underlying asset is realised. As an exemption, all fair value adjustments of financial assets and liabilities will be a part of the distributable profit. Greece Under Greek company law, no modifications to accounting profits are required in determining distributable profits. However, with the adoption of IFRS there were no changes in determining distributable profits despite the fact that previous Greek GAAP, in general, did not permit the recognition of ‘unrealised profits’. There is a view that in determining distributable profits, unrealised gains should be deducted, but this is not binding.


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Ireland The requirements under Irish company law in respect of distributable profits continue to apply for companies preparing their financial statements under both Irish GAAP and IFRS. A company’s profits available for distribution are defined by law (section 45(2) of Companies (Amendment) Act 1983) as its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made. Though the term ‘realised’ is not defined by the Companies Acts, it is generally taken to mean profit is arising from transactions where or other readily marketable assets is received by an entity. Irish companies refer to interpretive guidance issued by the ICAEW in the UK where the definition of distributable profits is identical. Specifically, the ICAEW have released two technical releases on this topic, ‘Guidance on the determination of realised profits and losses in the context of distributions under the Companies Act 1985’ (Tech 7/03) which has been finalised and ‘Distributable profits: Implications of IFRS’ (Tech 21/05) which has been exposed in draft form for comment. Italy Modifications are required. Again, distribution of profits is regulated by articles 6 and 7 of the Legislative Decree n. 38/2005. Briefly described, some FTA adjustments and some fair value effects may not be distributed and should be classified in dedicated non distributable reserves. Lithuania The Lithuanian response formally answered “no” to the question “Is it permitted/required to determine distributable profits based on financial statements prepared according to IFRS?”. In this context, the following additional explanation was given: “Please note, however, that IFRS is a statutory reporting framework for publicly traded companies, therefore their distributable profits are based on IFRS financial statements (without further modifications).” For this reason we changed the answer from a substance over form point of view. Malta In Malta, the starting point for the determination of distributable profits is the IFRS result. Any profits not realised at the balance sheet date (and hence not available for distribution) are transferred to a non distributable reserve. Netherlands There are modifications required in the Netherlands. Based on Dutch legal requirements, legal reserves should be recorded. These result in a lower distributable profit compared to the net profit according to IFRS. Poland There is only a limitation under the Polish Commercial Code that there should not be uncovered losses from previous years. United Kingdom In the UK, the amounts of distributable profits are a matter of law. A distribution is justified by reference to a set of accounts, the “relevant accounts” (Companies Act 1985 section 270). Generally, the relevant accounts are the last annual accounts which were laid in respect of the last preceding accounting reference period in respect of which accounts so prepared were laid. The amount of a distribution that may be made is determined by reference to specified items (i.e. profits, losses, assets, liabilities, provisions, share capital and reserves) as stated in those relevant accounts. --- When a company elects to prepare its annual accounts in accordance


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with IFRS as adopted by the EU, it is the amounts stated in those accounts that are relevant for the purpose of justifying a distribution. ---However, the net profit or loss in accordance with IFRS (or UK GAAP) is only the starting point for the determination of distributable profits. --- Instead, a company's profits available for distribution are defined as 'its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made' (CA 1985 section 263(3)). Realised profits and realised losses are defined as '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' (CA 1985 section 262(3) as applied by section 742(2). --- In the UK, a number of the 'principles generally accepted' are set out in a series of Technical releases (Techs) issued by the UK's Institute of Chartered Accountants in England and Wales (ICAEW) and the Institute of Chartered Accountants in Scotland. These Techs give guidance on whether a gain or loss is realised or unrealised as follows: --- Tech 07/03 (revised 2007) Guidance on the Determination of Realised Profits and Losses in the Context of Distributions under the Companies Act 1985 --- Tech 50/04 Guidance on the Effect of FRS 17 'Retirement Benefits' and IAS 19 'Employee Benefits' on Realised Profits and Losses --- Tech 64/04 Guidance on the Effect on Realised and Distributable Profits of Accounting for Employee Share Schemes in Accordance with UITF Abstract 38 and Revised UITF Abstract 17 --- Tech 02/07 Distributable Profits: Implications of recent accounting changes --- This guidance is considered to be authoritative and indicative of accepted practice. The guidance does not deal with certain aspects of the requirements relating to investment companies. --- Consistent with these principles generally accepted, gains and losses that are included in net profit or loss may or may not be realised; gains and losses that are recognised elsewhere (i.e. in the statement of recognised income and expense) may be realised and certain profits recognised directly in equity may or may not also be realised. --- A UK public company (plc) is subject to an additional 'net assets test' when making a distribution (CA 1985 section 264). A public company may make a distribution at any time only if, at that time, the amount of its net assets is not less than the aggregate of its called-up share capital and undistributable reserves and then only if, and to the extent that, the distribution does not reduce the amount of the company's net assets to below that aggregate. --- Additionally, there are fiduciary (eg solvency) and common law requirements in the UK that additionally may apply to distributions. --- Investment companies have the option of following the normal rules relating to distributions (above) or of following the special rules for investment companies (CA 1985 section 265). For all practical purposes, the special rules apply only to listed investment trust companies. 5.2.2.3 Deviations between national accounting rules and IFRS The IFRS questionnaire also aims to identify the difference between national accounting rules and IFRS. The purpose is the identification of major deviations when either IFRS or national accounting rules are applied for determining profits/net assets. Based on the different IFRS standards, the participants from KPMG offices in the 27 EU Member States assessed the difference on a scale between 1 (similar) and 5 (dissimilar). The assessment was intended to take the practical aspects of applying the different accounting frameworks into account. The following tables present the average value of the responses per country for the standards analysed as well as the total average of all EU Member States per IFRS standard analysed. In interpreting the results, it must be remembered that the analysis contains a portion of subjective assessment of the individual respondents and the responses


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could potentially differ between different respondents from the same jurisdiction. The analysis is intended to give an informed estimate of the deviation between national accounting rules and IFRS in accounting areas which have an impact on the determination of profit or loss. Figure 5.2 – 3: Survey on 27 Member States: average deviation of IFRS from national GAAP Country Average deviation of IFRS from

national GAAP Austria 3.6 Belgium 3.8 Bulgaria 1.0 Cyprus 1.0 Czech Republic 3.2 Denmark 2.4 Estonia 1.6 Finland 3.1 France 2.8 Germany 3.6 Greece 3.2 Hungary 3.1 Ireland 2.8 Italy 3.7 Latvia 3.1 Lithuania 1.1 Luxembourg 2.5 Malta 1.0 Netherlands 2.3 Poland 2.7 Portugal 2.7 Romania 3.3 Slovakia 2.3 Slovenia 1.0 Spain 3.3 Sweden 2.4 United Kingdom 2.0 The results of this analysis are twofold. Some EU Member States, such as Cyprus and Malta, apply IFRS as their national GAAP and therefore a deviation is not identifiable; in all other EU Member States the deviation ranges approximately between 1.6 and 3.8. This seems to imply that in general IFRS are not really similar to national GAAP but that the deviations are not very great. Furthermore, it can be recognised that under IFRS the accounting results may deviate from those determined under national accounting rules thus resulting in different distributable amounts. The extent of the deviations cannot be generally determined since they depend on the specific facts and circumstances of the companies affected. Furthermore, possible (national) modifications of accounting profits and net assets would have to be considered as well. Accordingly, it can only be stated that deviations of distributable amounts that were determined under IFRS and under national accounting rules are likely to arise but the full extent of this effect can only be determined in individual circumstances.


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Figure 5.2 – 4: Survey by IFRS standard: average deviation from national GAAP Standard Analysed Average deviation from national GAAP IAS 2 – Inventories 1.7 IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors

2.5

IAS 11 – Construction Contracts 2.6 IAS 12 – Income Taxes 2.8 IAS 16 – Property, Plant and Equipment 2.2 IAS 17 – Leases 2.7 IAS 18 – Revenue 2.2 IAS 19 – Employee Benefits 2.9 IAS 20 – Accounting for Government Grants and Disclosure of Government Assistance

1.7

IAS 21 – The Effects of Changes in Foreign Exchange Rates

2.1

IAS 23 – Borrowing Costs 1.9 IAS 27 – Consolidated and Separate Financial Statements

2.0

IAS 28 – Investments in Associates 1.9 IAS 29 – Reporting in Hyperinflationary Economies

3.0

IAS 31 – Interests in Joint Ventures 2.1 IAS 36 – Impairment of Assets 2.4 IAS 37 – Provisions, Contingent Liabilities and Contingent Assets

2.1

IAS 38 – Intangible Assets 2.6 IAS 39 – Financial Instruments: Recognition and Measurement

3.1

IAS 40 – Investment Property 3.3 IFRS 2 - Share-based Payment 3.5 IFRS 3 – Business Combinations 3.2 IFRS 5 – Non-current Assets held for Sale and Discontinued Operations

3.4

According to this analysis, the major deviations from national accounting rules arise in the following areas.

IAS 19 – Employee Benefits IAS 29 – Reporting in Hyperinflationary Economies IAS 39 – Financial Instruments IAS 40 – Investment Property IFRS 2 – Share-based payment IFRS 3 – Business Combinations IFRS 5 – Non-current Assets held for Sale and Discontinued Operations

This confirms the sample of accounting areas identified for a more detailed analysis in PART II of this study section on IFRS impacts. This detailed analysis focuses on employee benefits, investment property and financial instruments. Furthermore, the participants were asked to identify whether the IFRS would have a tendency to results into an increase or a decrease or have no impact on equity when compared to national accounting rules. The following table summarises the responses received.


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Figure 5.2 – 5: Survey by IFRS standard: impact on equity Standard Analysed Impact on Equity (Information in %) Increase Decrease No impact IAS 2 – Inventories 25.9 3.7 70.4 IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors

0 0 100.0

IAS 11 – Construction Contracts 40.7 14.8 44.5 IAS 12 – Income Taxes 25.9 25.9 48.2 IAS 16 – Property, Plant and Equipment

40.7 7.4 51.9

IAS 17 – Leases 22.2 11.1 66.7 IAS 18 – Revenue 11.1 14.8 74.1 IAS 19 – Employee Benefits 11.1 37.4 44.5 IAS 20 – Accounting for Government Grants and Disclosure of Government Assistance

0 3.7 96.3

IAS 21 – The Effects of Changes in Foreign Exchange Rates

22.2 0 77.8

IAS 23 – Borrowing Costs 14.8 0 85.2 IAS 27 – Consolidated and Separate Financial Statements

11.1 3.7 77.8

IAS 28 – Investments in Associates 14.8 3.7 74.1 IAS 29 – Reporting in Hyperinflationary Economies

3.7 0 88.9

IAS 31 – Interests in Joint Ventures 7.4 0 88.9 IAS 36 – Impairment of Assets 0 44.4 55.6 IAS 37 – Provisions, Contingent Liabilities and Contingent Assets

29.6 14.8 55.6

IAS 38 – Intangible Assets 55.6 11.1 33.3 IAS 39 – Financial Instruments: Recognition and Measurement

33.3 7.4 44.4

IAS 40 – Investment Property 48.2 3.7 44.4 IFRS 2 - Share-based Payment 0 22.2 77.8 IFRS 3 – Business Combinations 51.9 3.7 33.3 IFRS 5 – Non-current Assets held for Sale and Discontinued Operations

18.5 3.7 77.8

(Note: Not all lines add up to 100% since the respondents in some jurisdictions could not indicate a tendency. The bases for the percentages are always 27 EU Member States.) The overall assessment taking into account all IFRS standards results into an estimated increase of equity of 21.3%. On the other hand, the assessment concerning a decrease in equity amounts to 10.3%, and the assessment of no major impact amounts to 65.7%. This result is remarkable as it obviously cannot be generally presumed that the total impact of the application of IFRS automatically results in a “major increase” in profits or in equity. However, it needs to be remembered that the number and size of such impacts is not immediately measurable and that, in general, any impact on accounting profits in one period will usually be reversed in another accounting period.


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5.2.3 Specific areas of accounting 5.2.3.1 Investment property The initial question of the IFRS questionnaire on investment property concerned the issue whether local GAAP distinguish between “investment property” and other (owner-occupied) real property. The following countries (48% of all EU Member States) make that specific distinction:

Bulgaria Cyprus Denmark Estonia Ireland Latvia Lithuania Malta Netherlands Poland Slovenia Sweden United Kingdom

The number of EU Member States can just be seen as the identification of a specific accounting problem. Such kinds of problems may be addressed in a number of ways, e.g. by specific recognition rules or by disclosures in the notes. Therefore, this result has no direct impact on the primary subject of this study section, the determination of distributable profits. Nevertheless, it is an indication that this accounting problem is a relevant issue. The specific relevance of this issue lies in the recognition of upward-revaluations to fair value that may be regarded as unrealised profits for distribution purposes. In the 92.6% of all EU Member States investment property must be or can be measured at depreciated cost. A fair value measurement with an immediate impact on net profit is permitted or required in the following nine EU Member States:

Bulgaria Cyprus Denmark Estonia Latvia Lithuania Malta Netherlands Slovenia

A fair value measurement with an impact on net equity without any immediate impact on net profit is either permitted or required in the following EU Member States:


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Hungary Poland Romania

In Hungary, the following treatment is specified: “Investment property is not distinguished from owner-occupied property. Generally, the cost model is required for all property, plant and equipment. However, any excess of fair value over the carrying amount of an item of property, plant and equipment can be recognised as a separate asset in the balance sheet (called valuation adjustment) with a corresponding increase directly in the equity. Such valuation adjustment is not depreciated and reassessed on a yearly basis against equity.” For Poland, the situation can be described as follows: “A company has a choice of accounting models. There are divergent views on whether recognition of revaluations in the income statement is allowed/required, rather than directly in equity. In our view, this is not allowed. The accounting law is however expected to change during 2007 to allow/require this.” A fair value measurement with an impact on a specific performance statement is required in Ireland. In the United Kingdom the following specific accounting treatment applies: “Under UK GAAP (SSAP 19) changes in the value of the investment property, other than permanent diminutions, are credited or charged directly through the statement of total recognised gains and losses (STRGL, the equivalent of the IFRS SORIE) to an investment revaluation reserve within shareholders’ equity. Permanent diminutions are charged to the profit and loss account.” Based on the assessment that a fair value measurement could cause problems in determining “realised profits” and equity for dividend distribution purposes, it becomes obvious that the issue is not just relevant under IAS 40 “Investment Property”, which optionally allows the fair value measurement of investment property, but that the issue also arises under national accounting rules. A harmonisation in distinguishing investment property as well as the measurement and recognition of gains or losses on re-measurement to fair value has so far not been achieved in the European Union. 5.2.3.2 Post-employment benefits A provision for all defined benefits plans is required in 63% of all EU Member States. The following EU Member States installed some exceptions to this rule:

Belgium Czech Republic Estonia Finland France Germany Greece Latvia Luxembourg Romania


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For some EU Member States, it was indicated to us that defined benefit plans are not common or known and have not received specified answers in that section of the questionnaire. (The EU Member States are Italy, Latvia and Romania). Nevertheless, the percentages in the calculations below are based on 27 EU Member States. The following statements were made on methods generally applied in determining the obligation under a post employment benefit plan. The point of reference was the Projected Unit Credit Method applied under IAS 19 “Employee Benefits” Figure 5.2 – 6: Survey for 27 EU Member States: accounting method under a post employment benefit plan Projected Unit Credit

Method Not Specified / Free

Choice Austria X Belgium X Bulgaria X Cyprus X Czech Republic X Denmark X Estonia X Finland X France X Germany X Greece X Hungary X Ireland X Italy ---- ---- Latvia ---- ---- Lithuania X Luxembourg X Malta X Netherlands X Poland X Portugal X Romania ---- ---- Slovakia X Slovenia X Spain X Sweden X United Kingdom X Number of Countries 9 15 When using the projected unit credit method as a point of reference, it becomes clear that harmonisation has not yet been achieved in the EU in respect to how provisions for defined employee-benefit plans are determined. Therefore, it is not feasible to determine the total impact due to this lack of harmonisation. The impact can only be determined on an individual company basis. But given the fact that the application of IAS 19, compared to national accounting rules, is assessed to have a negative impact on equity in 33.3% of the countries surveyed (please refer to the earlier analysis in this section of the report), it is likely that in individual cases this issue may be of relevance in determining distributable amounts. In 44.4% of the EU Member States it is permitted to offset plan assets with plan liabilities. In 33.3% of the EU Member States, it is allowed to measure plan assets at fair value. In the UK, there is a similar measurement approach. Not all EU Member States have a concept or a


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practice of setting up plan assets. Whereas the presentation of plan assets is not immediately relevant for determining distributable amounts, the fair value measurement of plan assets may, however, again raise questions on how distributable amounts are determined. The following table contains results of the IFRS questionnaire relating to the identification of parameters which are generally taken into account to calculate the post-employment benefit obligation. Figure 5.2 – 7: Relevance of parameters to calculate a post-employment benefit obligation Parameter Number of

Countries Percentage of Countries (based on 27 countries)

Number of Countries with answers No / Free Choice / Optional

A market rate of interest is used for discounting.

12 44.4 12

Mortality is taken into account. 15 55.6 8 Actual/expected return on plan assets is taken into account.

11 40.7 12

Estimated future salary increases are taken into account.

12 44.4 11

Future benefit increases are taken into account.

11 40.7 12

Labour turnover rates are mandatorily/optionally taken into account.

13 48.2 10

The results generally show a separation between optional applications and a mandatory application of parameters. Furthermore, some EU Member States do not address all specific situations so that not all questions were answered by the participants of the study (i.e. responses do not add up to 27 EU Member States). However, the results allow drawing a picture concerning the current situation within the European Union. Again, it must be noted that it is evident that there is a lack of harmonisation in the European Union concerning the determination of pension liabilities. Even though the impact on the financial statements can only be determined on a company-individual basis, general experience shows that the impact of applying different parameters in actuarial calculations usually have a major impact on the financial position of companies. IAS 19 “Employee Benefits” contains a variety of ways of how actuarial gains and losses126 may be recognised. It is possible to apply the so-called corridor-approach under which actuarial gains or losses are recognised in profit or loss over future periods according to specific rules. Any spreading that is faster than the “standard solution” is possible as well. Recently, a new option was added to IAS 19, i.e. it is possible to fully recognise actuarial gains and losses directly in equity.

126 “Actuarial gains and losses comprise:

(a) experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred); and

(b) the effects of changes in actuarial assumptions.” (IAS 19.7)


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Actuarial gains or losses are recognised in the following ways throughout the European Union: Figure 5.2 – 8: Method of recognition of actuarial gains or losses Method of recognition of actuarial gains or losses

Number (percentage) of countries

Immediately in profit or Loss 17 (63.0) Traditional 10% Corridor Approach (like IAS 19) 10 (37.0) Recognition in equity without recycling through profit or loss (like IAS 19)

6 (22.2)

Other methods 7 (25.9) In 6 EU Member States (which equals 22.2%), a special “statement of recognised income and expense” is used to present actuarial gains or losses. Unrecognised actuarial losses generally represent an “under-valuation” of liabilities and therefore have an impact on equity and, if the effect is to be recognised through profit or loss, on profits. Therefore especially unrecognised actuarial losses may have an impact on the determination of distributable profits in a sense that the amounts determined may be overstated. On the other hand unrecognised actuarial gains may, subject to an analysis of individual situations, be regarded as an understatement of potentially distributable amounts. The assessment of overstatement and understatement is based on the assumption that the equity and profits form an immediate basis for the determination of distributable amounts. Based on the considerations above, the issue of unrecognised actuarial gains and losses arose in a significant number of EU Member States and could therefore be subject to further harmonisation efforts. 5.2.3.3 Financial instruments The responses received to the financial instruments question were diverse, and the KPMG respondents from a considerable number of EU Member States saw the need to deviate from question formulated in the IFRS questionnaire. Due to the diversity and complexity of financial instruments accounting, it is only possible to specify the number of EU Member States in which several standard accounting treatments for financial instruments are applied. The following table indicates in how many EU Member States a specific accounting treatment can be found. The accounting treatments only refer to non-derivative financial instruments:


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Figure 5.2 – 9: Accounting treatment for non-derivative financial instruments Accounting Treatment Number of Countries Percentage of

Countries Recognition of financial instruments at cost 16 59.3 Recognition of financial instruments at amortised cost

21 77.8

Recognition of financial instruments at fair value with immediate impact on profit and loss

9 33.3

Recognition of financial instruments at fair value with immediate recognition of the effect in equity – effect is later on recycled through profit and loss

10 37.0

Recognition of financial instruments at fair value with immediate recognition of the effect in equity – effect is not recycled through profit and loss

1 3.7

If financial instruments are carried at fair value with an immediate impact on profit or loss, it can be debated whether profits recognised in this manner could be regarded as realised for distribution purposes. A similar discussion may ensue on the “realisation” of losses and the potential understatement of distributable amounts. If a fair value measurement immediately impacts on equity, this may have a similar impact on distributable profits. Based on the results presented above, a major percentage of EU Member States face fair value measurements on financial instruments. Therefore, it may be advisable to find a harmonised solution for the European Union. The following results were received on the recognition and measurement of derivative financial instruments: Figure 5.2 – 10: Recognition and measurement of derivative financial instruments Recognition / Measurement Number of Countries Percentage of

Countries Not recognised at all 2 7.4 Only recognised in case of a loss contract (i. e. no assets recognised)

8 29.6

Recognised at Fair Value (with a gain or loss impacting net income)

15 55.6

Recognised at Fair Value (with a gain or loss impacting equity directly)

3 11.1

Otherwise 5 18.5 Note: Depending on the facts and circumstances in some EU Member States, more than one option may be possible. The findings concerning derivative financial instruments represent the divergence in practice in recognising and measuring derivative financial instruments. But it is evident that the recognition of derivatives at fair value is an accounting treatment applied in several jurisdictions. This accounting treatment raises the same questions, as discussed above, for non-derivative financial instruments.


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If derivative financial instruments are recognised at fair value, a special “statement of recognised income and expenses” is used in presenting the recognition of these gains and losses in five EU Member States. Concerning the application of hedge accounting, the responses showed the following results. However, it must be noted that any indication concerning the existence of a specific kind of hedge accounting does not automatically translate into the application of the corresponding IAS 39 - hedge accounting model. Figure 5.2 – 11: Forms of hedge accounting Forms of Hedge Accounting Number of Countries Percentage of

Countries Fair Value Hedges 16 59.3 Cash Flow Hedges 16 59.3 Hedges of a Net Investment in a Foreign Entity 16 59.3 Other Models 10 37.0 No Hedge Accounting Permitted 2 7.4 Hedge accounting may immediately impact net income, similar to fair value hedge accounting according to IAS 39, or may directly impact equity, similar to cash flow hedge accounting according to IAS 39. In a majority of EU Member States hedge accounting models apply. The results above indicate that a harmonisation in this area is currently not achieved. For more accurate results, a more in-depth analysis would have to be conducted. But for the purposes of this study, the results suffice in the way that it is evident that hedge accounting is a debatable issue throughout the European Union. The magnitude of the problem can only be determined on a case by case analysis. 5.2.4 Conclusion on overview of 27 EU Member States Based on our analysis, it is evident that IFRS are not only applied in the European Union for consolidated financial statements under EU Regulation 1606/2002. Several EU Member States allow or require the application of IFRS in consolidated and/or single financial statements. Some countries have even adopted IFRS as their national GAAP. As the individual IFRS financial statements also serve for profit distribution under the 2nd CLD, the questions arises whether the profits determined under this accounting framework can be considered as “realised” for distribution purposes. Moreover, there is an issue concerning the treatment of amounts immediately recognised in equity under IFRS for dividend distribution purposes. The results of our analysis do not show a uniform picture for the European Union in this regard. In 17 EU Member States, it is permitted or required to distribute dividends based on individual IFRS financial statements. Some Member States require modifications of the IFRS financial statements in order to determine distributable amounts. Our analysis has shown that there is a general lack of harmonisation in the European Union concerning the accounting basis for dividend distributions. This also includes the question whether a modification of the accounting profits is necessary. With the exception of those EU Member States immediately applying IFRS, the measured total deviations from national GAAPs to IFRS range around the mid-point of the scale defined


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for this study purpose. The IFRS for which deviations from national accounting rules have been assessed as significant are as follows:

IAS 19 – Employee Benefits IAS 29 – Reporting in Hyperinflationary Economies IAS 39 – Financial Instruments IAS 40 – Investment Property IFRS 2 – Share-based Payment IFRS 3 – Business Combinations IFRS 5 – Non-current Assets Held for Sale and Discontinued Operations

This has underpinned the selection of IFRS which have been subsequently analysed for all 27 EU Member States:

Investment property Post-employment benefits Financial instruments

Investment property The majority of EU Member States do not distinguish investment property from other real estate under their local GAAPs. But the distinction itself has no immediate impact on determining profits and distributable amounts. In 13 EU Member States, it is permitted or required to revalue investment property to fair value. This may impact net profit or loss or equity immediately. Concerning this revaluation, it is questionable whether for the purpose of determining distributable these revaluation gains could be considered as “realised”. It equally arises when gains are recognised either in the net profit or loss or, alternatively, in equity. A similar discussion could take place concerning the “realisation” of losses. It is evident that national accounting practices concerning the accounting for investment property still differ throughout the European Union. There are in some cases deviations from IAS 40 “Investment Property” which optionally allows a cost-based model as well as a fair value model that has an immediate impact on profit or loss. Post-employment benefits In some EU Member States, defined benefit plans do not play an important role and therefore do not create a problem. In several EU Member States, it is admitted to not recognise all defined benefit pension schemes as liabilities. This raises the issue of whether distributable amounts may currently be overstated in these EU Member States. National accounting practices are not aligned concerning the measurement of defined benefit liabilities and plan assets, the actuarial valuation methods applied as well as parameters that are used in the actuarial calculations. Therefore, the impacts of defined benefits on distributable amounts can only be assessed on a case by case basis. A further area of significant deviation is the treatment of actuarial gains and losses which may cause considerable changes in distributable profits under different accounting frameworks for the field of defined benefit pension schemes. Under circumstances where actuarial losses are not recorded, the distributable amounts may be overstated. When actuarial gains are not recorded, an “understatement” of distributable amounts could be assumed.


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Financial instruments The accounting treatment of derivative financial instruments as well as non-derivative financial instruments is very complex. Based on our survey, national accounting practices still significantly deviate throughout the European Union. In a significant number of EU Member States, the measurement of financial instruments at fair value is permitted or required. Like for investment property, a fair value measurement also raises questions concerning the generation of distributable amounts. A similar assessment can be made for hedge accounting since the accounting policies are perceived not to be harmonised within European Union. In total, it must be concluded that there is already a lack of harmonisation concerning a consistent accounting basis for the determination of dividend distributions in the European Union. The 4th CLD provides a minimum basis for harmonisation which does, however, not address all significant accounting areas in order to achieve a consistent basis for profit determination. Concerning the impact of a transition to IFRS, our survey showed that it cannot be automatically assumed that the application of IFRS will result into a major increase in profits or in equity. However, the specific circumstances at a company prevail and situations may arise where the transition may show major impacts. In the end, when comparing different accounting frameworks any difference in the impact on the accounting profits in one period will be reversed in another accounting period as total profits or losses over the lifetime of a company will usually be the same under any accounting framework.


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5.3 Detailed country analysis - part II 5.3.1 France 5.3.1.1 Introduction In France, individual financial statements must be prepared under French GAAP. This is also the case for the individual financial statements of listed companies. Therefore any assumption about the impact of the application of IFRSs on the distributable profit is purely hypothetical under the current French situation. In France, distributable profit is defined as profit or loss for the period in separate financial statements prepared under French GAAP plus or minus profit or loss transferred from previous periods. The only limitation relates to the ‘legal reserve: in France a company must allocate to such a reserve 5% of the profit for the period until the amount of this reserve reaches at least 10% of the issued capital of the company. Since this analysis focuses on distributable profits, disclosures and presentation issues are not taken into account. The analysis focuses on major French GAAP areas of accounting congruence or divergence for the following three accounting areas: • Investments properties; • Employee benefits; and • Financial instruments, including hedging. 5.3.1.2 Investment property The legal basis of the French accounting rules for investment properties can be found in the French Commercial Code (C. com. art. D 7-1/2/3, C. com. L 123-18, C. com. art. D 7-5, C. com. art. D 12, al. 4). Briefly described, the most significant differences between French national accounting rules and IFRS in the area of investment properties concern the following issues: • Investment property is accounted for as property, plant and equipment. • Investment property may be revalued only when all long-term financial instruments and

property plant and equipment are revalued. • Any revaluation surplus is credited directly to equity. Under French GAAP, there are no accounting rules similar to IFRS, and investment property is accounted for as property, plant and equipment. Accordingly, investment property generally is valued at depreciated cost except in the event of a revaluation of all long-term financial instruments and property, plant and equipment of the enterprise, in which case investment property is revalued to fair value. The revaluation surplus is credited directly to equity. Such revaluations are not required to be updated regularly. For specialised enterprises disclosure is required of the fair value of property. 5.3.1.3 Employee benefits The basis of the French accounting rules concerning employee benefits is as follows: C. com. art. L 123-13, CRC 99-02 § 300, CU 00-A, R 03-1.


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The most significant difference between French national accounting rules and IFRS in the area of employee benefits concerns the fact that under French GAAP it is not mandatory to recognise a liability for post-employment employee benefits except in a business combination. In France most retirement plans are state-sponsored and supplementary benefits are offered to a relatively small number of employees. Contributions in respect of state-sponsored plans are set annually by the government and are expensed by an enterprise as incurred. The preferred treatment in the consolidated financial statements is for the costs of supplementary retirement and related benefits (e.g. severance payments, supplementary retirement allowances, medical coverage, long-service recognition, sickness and provident benefits) granted to both active and retired personnel and chargeable to the enterprise, to be provided for systematically in the income statement over the working lives of the employees. A recommendation has been issued by the French accounting standard setter CNC in 2003. It is a translation of IAS 19 into French language as it was in force at that time. However, it is not mandatory to recognise a liability for post-retirement employment benefits and the Commercial Code gives companies the option of disclosing the liability in the notes or providing for the amount either fully or partially in the financial statements. In this case benefits are expensed as incurred. Therefore, the French accounting practice in this area varies to a large extent. Irrespective of whether the parent enterprise provides for post-employment retirement benefits in its consolidated financial statements, in the event of a business combination the liability relating to the retirement benefits of the acquired enterprise must be recognised. However, there is no specific guidance on the method of valuation except for the guidance included in the recommendation of the CNC. 5.3.1.4 Financial instruments, including hedging The basis of the French accounting rules concerning employee benefits is as follows: CRC 99-03 art. 372-1, avis CNC n.29/86, avis CNC n.32/87, CU 98-B, D art. D 248-8-h. The most significant difference between French national accounting rules and IFRS in the area of employee benefits concerns the following issues: • Transaction costs are recognised in the income statement as incurred. • Financial instruments are not classified into the same categories as under IFRS, and are

not fair valued except in very limited circumstances. • Generally only “permanent” impairments are recognised. • A financial asset is derecognised only when legal title is transferred. • Any liability discount or premium may be amortised on a straight-line basis. • An issuer’s financial instruments may be classified on the basis of their legal form. • Compound instruments are not split-accounted. • A liability may be derecognised on the basis of in-substance debt defeasance. • Derivatives usually are not shown in the balance sheet other than for the premiums paid

and received; only unrealised losses on derivatives are accounted for in the income statement in the absence of hedge accounting.

• Hedge accounting is permitted more frequently than under IFRSs.


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Scope Financial instruments as defined under IFRSs have no equivalent under French GAAP. The French definition of financial items is restricted to shares, bonds, securities and futures contracts. Initial recognition Different from IFRSs, financial items are recorded at cost. However, transaction costs are recognised in the income statement when incurred rather than being capitalised. There is no discussion under French GAAP of trade date versus settlement date accounting, and practice varies. Long-term investments Long-term investments are those shares which the enterprise sees a benefit in holding for the long term. Investments in subsidiaries, jointly controlled entities and associates, which are not included in the scope of consolidation, are classified as such. Long-term investments are stated at depreciated cost. Short-term investments At the balance sheet date, investment securities should be valued at the lower of cost and either the average price for the final month of the period if they are quoted, or their expected realisable value if they are not quoted. Unrealised losses should be recognised in the income statement. Futures, options and other derivatives Current accounting rules separate speculative transactions from hedges (see below) and organised market transactions from other (over-the-counter) transactions. Where speculative derivative transactions take place on organised markets and changes in price are paid / received, the derivative is stated at market value and gains and losses are taken to the income statement. On over-the-counter speculative derivative transactions, realised losses and realised gains are taken to the income statement. Unrealised losses are taken to the income statement on a portfolio basis. Unrealised gains are not recognised. Impairment In determining whether it is necessary to record an impairment loss against the carrying amount of a long-term investment, reference should be made to the current market price (if one exists), the investee`s net assets, profitability and prospects, the economic climate and any


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other factors that may be known. If it is felt that there is a permanent diminution in value, then an impairment must be recorded with a corresponding charge to the income statement. However, unrealised gains are not recognised, nor is it possible to offset gains and losses on different investments. Impairment losses on short-term investments are recognised automatically when any write-down to market price or expected realisable value occurs (see above). Impairment losses are reversed if circumstances change and the write-down is no longer required. De-recognition of financial assets Unlike IFRSs an investment is de-recognised when legal title is transferred even if control is retained by the transferor. Liabilities Financial liabilities are not defined precisely under French GAAP. They represent all external resources provided to the enterprise in return for remuneration. They include long-term loans, short-term bank borrowings such as overdrafts and accrued interest on loans. The borrowing itself is recorded as a liability at its par value. In a difference from IFRSs, any discount on issue or premium on repayment is recorded as a separate asset and is amortised over the life of the loan either pro rata to interest payable (preferred method), or on a straight-line basis. Classification as a liability or equity An option is available to classify an instrument according to its substance, i.e. as a liability when it contains an obligation to transfer resources. However, in practice an instrument usually is classified according to its legal form, which means that most shares are included in equity. There are no provisions in French GAAP for split-accounting a financial instrument between its liability and equity components. Under the above-mentioned option to record an instrument based on its substance, when cash is received under agreements where the lender cannot require repayment, such instrument is recorded as either: • equity where, in the event of insufficient earnings, no dividend or interest is due; or • a separate category in liabilities, but outside financial debt, where a mandatory minimum

interest is due even in the event of insufficient earnings. Debt with share purchase warrants Debt with share purchase warrants, whether detachable or not, is accounted for entirely as debt, which is different from IFRSs.


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Convertible debt As noted above, split-accounting is not used in French GAAP. The classification of convertible debt would follow the normal rules outlined above. Extinguishments and restructurings of liabilities A liability is extinguished following the same conditions as under IFRSs. However, unlike IFRS, in-substance debt defeasance also results in the de-recognition of a financial liability under the following conditions when securities are set aside in a separate legal entity to provide for the repayment of a liability: • The transfer of securities to a third party legal entity is irrevocable; • The securities transferred:

- are assigned exclusively to servicing the debt payable; - are risk-free with respect to their amount, term to maturity and payment of principal

and interest; - are issued in the same currency as the debt payable; and - have terms of maturity for principal and interest such that the cash flows service fully

• The debt payable; and the third party entity ensures exclusive assignment of the securities received by it to redemption of the amount of debt payable.

Unlike IFRSs, where a liability is restructured or refinanced, whether terms are substantially modified or not, it is accounted for as an extinguishment of the old debt, with a consequent gain or loss; the new debt is recognised at its par value. Troubled debt restructuring The above rules on restructurings of liabilities apply even where the borrower is in financial difficulties. Hedging To qualify as a hedge a financial instrument must have the following characteristics: • contracts or options bought or sold have the effect of reducing the risk of change in value

affecting the hedged item; • the hedged item may be an asset, a liability, an existing commitment or future transaction

as long as the transaction is precisely defined and likely to occur; and • a correlation is established between changes in the value of the hedged item and the value

of the hedging contract or the underlying financial instrument where options are concerned.

In practice many banks hedge a portion of their net exposure and assess the effectiveness of hedges on this basis (“macro hedging”). Written options qualify for hedge accounting only in exceptional cases. Contracts that qualify for hedging are identified and treated for accounting purposes as such from the outset, and retain this qualification until their maturity date or closure.


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All hedges, whether cash flow hedges or fair value hedges, are accounted for similarly. Changes in the value of hedge contracts or options are not recognised immediately in the income statement. The carrying amount of the hedged item is not adjusted for cumulative gains or losses. Instead, any gains or losses first are recorded in a balance sheet account “short term financial instruments”, then transferred to the income statement over the residual term of the hedged item. When the hedged item is realised, the hedging derivative must subsequently be accounted for as a speculative transaction (see above). A hedge of an investment in an autonomous subsidiary is accounted for similar to IFRSs. Specialised industry guidance There is specialised industry guidance in respect of financial instruments.


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5.3.2 Germany 5.3.2.1 Introduction The following analysis is based on the assumption that any difference between an accounting treatment according to local GAAP and IFRS that has a potential impact on net profit or loss for the period does – at a specific point in time – change the distributable profit. The consequence of this assumption is that generally any impact on profit or loss in one period reverses in another period; i. e. over the life of an entity generally the cumulated profit does not change because of different accounting treatments. So any impact assessment can be given only for a specific point in time. Additionally it is assumed that any profit or loss recognised directly in equity is not distributable unless explicitly stated otherwise. The following analysis does not explicitly take the effects of deferred taxes into account. Deferred taxes can reduce the primary impact effect of an accounting difference. This should also be kept in mind. Furthermore the German government recently announced a modification of the German Commercial Code that would be converging with IFRS in some areas. For example, a fair value measurement of some financial assets is intended, and some modifications of the rules for accounting for pension plans were announced. This proposal, which has not been published as at October 21, 2007, has not been taken into account in the following analysis. In Germany the distributable profit is generally determined as the profit that is recognised in the individual financial statements prepared according to the German Commercial Code (“Handelsgesetzbuch”/HGB). This profit is modified or reduced in only a few cases when the company recognises certain items as “assets” which do not fulfil the HGB definition of assets. There is only a limited number of these items that are explicitly allowed, and they do not have an immediate impact on the areas analysed in this paper. Therefore it can be said that generally the accounting under HGB is the basis for determining distributable profits. Furthermore some reserves have to be set up under certain circumstances; e. g. for the “offset” of treasury shares. These legal rules are, in general, not immediately accounting related and are therefore not to be taken into account. Since this analysis focuses on distributable profits, note disclosures and presentation issues have also not been not taken into account. Note that it is not necessary to analyse all deviations between German GAAP and IFRS in detail. The analysis focuses on major areas of accounting congruence or divergence. 5.3.2.2 Investment property Separate identification of investment property IAS 40 “Investment property” defines investment property as being land or a building — or part of a building — or both held by the owner or by the lessee under a finance lease for the purpose of earning rent or for capital appreciation or both, rather than for: a) use in the production or supply of goods or services or for administrative purposes [so called “owner-occupied property”]; or b) sale in the ordinary course of business” (IAS 40.5). IAS 40 contains a measurement option for investment property. A company may apply the “fair value model” or the “cost model” for subsequent measurement. The cost model refers to IAS 16 “Property, Plant and Equipment” and to IFRS 5 “Non-Current Assets Held for Sale


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and Discontinued Operations” (IAS 40.56). Owner-occupied property is accounted for according to IAS 16. The German Commercial Code does not distinguish between investment property and owner-occupied property. Therefore the accounting treatment for both does not differ. Measurement of investment property Initial measurement According to IFRS investment property is initially measured at cost including the transaction cost (IAS 40.20 et. al.). “The cost of a purchased investment property comprises its purchase price and any directly attributable expenditures” (IAS 40.21). The cost of a self-constructed asset includes “any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management” (IAS 16.16(b)). This means that they also include “a systematic allocation of fixed and variable production overheads” but not general and administration overheads (IAS 40.22/IAS 16.22/IAS 2.12 et. al.). This measurement will be called “full cost” in the following analysis. Under the German Commercial Code, all real property is also initially measured at cost. There is generally no major deviation in determining the cost of a purchased asset except in cases where “the costs of dismantling and removing the item and restoring the site” form part of the cost of an asset under IFRS. In these cases the obligation is generally recognised as an expense spread over the useful life of the asset without any impact on the cost of the asset. For self-constructed buildings there may be a difference. According to § 255 II HGB, it is permitted to measure cost at direct material and production cost; consequently no material or production overhead is allocated to the assets. This overhead may optionally be allocated to the asset. Furthermore it is also permitted to recognise general administration overhead as part of the cost of an asset. This means that on the one hand it is possible to measure buildings below “full cost”; on the other hand it is permitted to measure buildings slightly above full cost. In those cases where all “overhead” is immediately expensed under the German Commercial Code, it is possible that during the construction periods the profits under IFRS may exceed the profits under HGB. With reference to borrowing cost, § 255 III HGB has a similar free choice as IAS 23 “Borrowing cost” has. It is optionally permitted to capitalise “borrowing cost” when qualifying assets have been identified. Comparison of national accounting rules with the “Cost Model” Not taking the rules of IFRS 5 into account, investment property is – according to IAS 16 – carried at cost less accumulated depreciation and accumulated impairment losses, if any (IAS 16.30). For depreciation purposes, the depreciation method “shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity” (IAS 16.60), and the useful life represents “the period over which an asset is expected to be available for use by an entity …” (IAS 16.6). Any impairment loss is determined under IAS 36 “Impairment of Assets”. Should a so-called “triggering event” arise, the carrying amount of an asset is compared with its recoverable amount, i. e. the higher of the fair value less costs to sell and the value in use (see IAS 36.6 et. al.). Assets that are used for a longer period of time are classified as fixed assets according to § 247 II HGB. Real property that is classified as a fixed asset is carried at cost less depreciation and write downs (§ 253 I + II HGB). The accounting treatment under German GAAP


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therefore resembles the cost model under IFRS. In practice there may be a couple of deviations. The depreciation method as well as the useful lives of buildings may be derived from tax rules and may be used for accounting purposes. This means that depreciation methods and useful lives may differ from the methods and terms that have to be used under IFRS. The impact on profit or loss can not be generally determined; but tax rules tend to lead to a “faster” depreciation when compared with IFRS. Furthermore companies have to write fixed assets down to a kind of “market value” (“beizulegender Wert”) in such cases when impairment is permanent. The German Commercial Code does not give any guidance on how to determine the “market value”. It appears possible that the market value is similar to the fair value used under IAS 36 so that the amount of impairment losses may be similar. In practice there may be differences, e. g. when the “market value” is determined as replacement cost or when the value in use is applied under IAS 36. Additionally the permanency of an impairment is irrelevant under IFRS. No general effect on the profit or loss can be determined in this case. Since the prudence principle is a very essential principle under the German Commercial Code, it may be assumed that generally the impairment losses recognised under HGB exceed the losses recognised under IFRS. Comparison of national accounting rules with the “Fair Value Model” As an alternative to the cost model, IAS 40 grants the option to measure all investment property at fair value. The changes in fair value are recognised in profit or loss for the period (IAS 40.33 et. al.). A measurement at fair value is not on option under the German Commercial Code since assets are not allowed to be measured above (depreciated) cost (§ 253 I HGB). However, if a loss is deemed permanent, the fair value may be an indication of the “market value”. This means that if fair values increase, the profits under IFRS may exceed the profits determined under the German Commercial Code. If fair values decrease, the results under HGB and IFRS may be similar if the loss is permanent, or if the losses recognised under IFRS may exceed the losses recognised under HGB if the loss is not permanent. Specific rules for determining distributable profits There are no rules in Germany under which net income is modified to determine distributable profits; i. e. net income according to the German Commercial Code represents the profit to be distributed. There are no similar rules in IFRS. Overall impact assessment on distributable profits The impact on the net profit or loss arising from accounting deviations in the field of investment property depends on several factors. One is the choice of options granted under HGB and IFRS, and the second are market and valuation influences. On initial recognition, it is permitted to recognise more expense in profit or loss under the German Commercial Code, which results in reducing the distributable profits. The cost model under IFRS resembles the HGB-model. Deviations generally stem from details, and a general statement on the effect on distributable profits appears impossible. If the fair value model is chosen under IFRS and it is assumed that all reductions in fair values are permanent, distributable profits under IFRS may be higher than under the German Commercial Code since increases in fair values can only be recognised under IFRS, whereas decreases may be recognised under both accounting regimes.


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5.3.2.3 Defined benefit plans (DBP) Identification of DBP and the need to recognise a provision Under IAS 19 “Employee benefits”, a company has to recognise a “liability” (or an ”asset”) for all defined benefit plans127, no matter whether they are funded or unfunded and no matter whether there is a legal or constructive obligation (IAS 19.49 et. al.). Under the German Commercial Code, an entity has generally to provide for any third party obligations (§ 249 I HGB), but there are two “exceptions” for pension benefits. Benefits granted before January 1, 1987 are grandfathered, i. e. there is a free choice to provide for these grants (Art. 28 I EG-HGB). Further the entity may opt to recognise any “indirect grant”, i. e. generally a grant where the primary obligor is an external fund and the entity is secondarily liable and other similar direct grants in its financial statements (Art. 28 II EG-HGB). Should entities choose not to recognise a provision (liability), this generally increases cumulated distributable profits in comparison to IFRS. Indirect grants are generally to be accounted for under IAS 19; the assets of the fund may qualify as defined benefit plan assets. Measurement of the (net) obligation Valuation of the obligation Under IFRS the relevant measure of the obligation is defined as being the “present value of a defined benefit obligation” (DBO; IAS 19.6). This obligation is calculated by applying the so-called “Projected Unit Credit Method” (IAS 19.64 et. al.). Furthermore several actuarial assumptions – based on the market expectations at the balance sheet date – are needed to calculate the DBO, for example (IAS 19.72 et. al): Demographic assumptions - Mortality - Rates of employee turnover, disability and early retirement The proportion of plan members with dependants who will be eligible for benefits Financial assumptions - The discount rate (by reference to market yields at the balance sheet date on high quality corporate bonds) - Future salary and benefit levels (Medical benefits do not play a role in Germany and are therefore not considered) Under the German Commercial Code, there is no guideline on the measurement of the obligation. Traditionally the majority of companies applied the guidance of the German Tax Law to determine the obligation. Currently a method similar to IAS 19 may be regarded as being appropriate as well. The tax model will be used as the point of reference in the following analysis. According to German Tax Law, the method for determining obligation and the current expense is called “Teilwertverfahren” (or going concern procedure). This method is different from the Projected Unit Credit Method. Based only on this difference, it is not clear whether the IFRS method or the German method lead to a higher calculated obligation. This also depends on the age structure of the workforce.

127 For a definition of defined benefit plans cf. IAS 19.7.


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Both standards are similar in how they consider mortality rates and relevant dependants. But under German Tax Law, employee turnover is not taken into account in determining the liability. This effect may broadly be offset by the fact that under this law the earliest possible age for the recognition of a provision is 28. No such limit exists under IFRS. The discount rate in German Tax Law is set at 6% and not adjusted. For accounting purposes, different or lower discount rates may be acceptable. The effect of this discount rate on the obligation in comparison to that in IFRS depends on the discount rate for high quality corporate bonds. In previous years this discount rate was below 6% and thus lead to an increase of the obligation under IFRS with reference to this factor. For tax purposes as well as for accounting purposes in Germany, it is generally not deemed acceptable to take future salary and benefit increases into account. Since these increases are taken into account under IFRS, this may lead to significantly higher calculated obligations under IFRS and consequently to a reduction in the cumulated distributable profits. The overall impact of the different methods in determining the obligation cannot be generalised. But especially the analysis of the applied actuarial assumptions tends to lead to higher obligations under IFRS. This could quite likely be underpinned with the experience stemming from several IFRS conversions. Treatment of plan assets IAS 19.7 defines plan assets as being assets that are held by a long-term employee benefit fund or qualifying insurance policies. The main characteristics are that the respective funds can only be used to pay benefits, are not available to the companies’ creditors (even in bankruptcy), and can generally not be returned to the entity. Plan assets are offset with the “defined benefit obligation” (DBO; IAS 19.54). IAS 19 also refers to reimbursement rights that cannot be offset with the DBO but are otherwise treated in the same way (IAS 19.104A et. al.). Plan assets are measured at fair value (IAS 19.54 / IAS 19.102 et. al.). Under the German Commercial Code, there is no definition for plan assets. For the indirect grants described above, it is permitted to recognise the net obligation, generally under funded, as a liability. The assets of the external fund are measured according to German GAAP. This means that losses have to be anticipated whereas unrealised profits cannot be taken into account (§ 252 I No. 4 HGB). This principle is supported by the rule that assets are not allowed to be carried above (depreciated) cost. Permanent impairments of fixed assets and both permanent and temporary impairments for current assets result in write downs of the assets (§ 253 HGB). Based on further analysis, the fair value of the assets may be regarded as a basis for determining the impairment loss in these cases. This means that if the fair value of plan assets increases, a gain is recognised under IFRS which is not recognisable under HGB. If the fair value of plan assets decreases, i. e. when a loss is recognised under IFRS, it does not appear to be unlikely that a loss will also be recognised under the German Commercial Code. The amount of the recognised loss, however, may slightly differ. This means that a tendency towards earlier recognition of distributable profits under IFRS may be assumed. Treatment of actuarial gains and losses Under IFRS actuarial gains or losses may arise. Actuarial gains or losses comprise “experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred); and … the effects of changes in actuarial assumptions” (IAS 19.7). These gains and losses do not have to be recognised immediately. It is permitted to apply the so-called “corridor approach” meaning that the amount of cumulated


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actuarial gains and losses exceeding the greater of 10% of the DBO and 10% of the fair value of the plan assets has to be spread over the remaining working lives of the employees. Any method leading to a faster recognition of the gains/losses is acceptable as well (IAS 19.92 et. al.). Recently the IASB has added an additional option for the recognition of the actuarial gains and losses. Optionally it is allowed to recognise all actuarial gains and losses directly in equity (retained earnings) immediately. No “recycling” of these gains and losses through profit or loss in later periods is required or allowed (IAS 19.93A et. al.). Under the German Commercial Code, it appears inappropriate not to recognise all actuarial gains and losses immediately. This means that at year end the “full (net) obligation” is recognised. Any adjustments made to the provisions have to be recognised in profit or loss for the year, i. e. neither the corridor approach nor the immediate recognition of actuarial gains or losses directly in equity are allowed under IFRS. The immediate recognition of actuarial gains/losses is also an option under IAS 19. If this option is used, no difference arises in this respect. Indeed if we assume that the adjustment of retained earnings according to the new option under IFRS has an impact on distributable profits, there is also no difference between the distribution potential according to the German Commercial Code and IFRS in respect of actuarial gains and losses. If any other method (corridor approach) of IAS 19 is applied, the general effect on distributable profits in comparison to the German Commercial Code cannot be generalised. The effect depends on the circumstances: Is there a cumulative actuarial gain or a cumulative actuarial loss? A gain means a higher distribution potential under the German Commercial Code, a loss means less distributable profits under the German Commercial Code. Specific rules for determining distributable profits There are no rules in Germany under which net income is modified to determine distributable profits; i.e. net income according to the German Commercial Code represents the distributable profit. There are no similar rules in IFRS. Overall impact assessment on distributable profits It is impossible to make a general statement on differences in the impact on cumulated distributable profits between using the German Commercial Code and IFRS. There are several tendencies that contradict in part. For example, the consideration of salary and benefit increases leads on its own to higher liabilities under IFRS; thus resulting in a decrease in cumulated distributable profits. On the other hand, the measurement of plan assets at fair value tends to increase distributable profits under IFRS when compared with HGB. Furthermore due to several factors, the impact on distributable profits depends on the individual circumstances, e.g. the interest rate applied or the recognition of actuarial gains or losses. Experience from several past HGB to IFRS conversion projects shows that in general, the provisions for defined benefit plans do increase with a (theoretical) simultaneous decrease in cumulated distributable profits. 5.3.2.4 Financial instruments Identification and classification of financial instruments Under IFRS there is a broad definition for financial instruments that includes financial assets and financial liabilities. Financial instruments comprise debt as well as equity instruments (of


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other entities). Financial instruments also include derivative financial instruments (see IAS 32.11). According to IAS 39, financial instruments have to be classified into the following categories with a consequential effect on their accounting treatment (see IAS 39.9): ⇒ Loans and receivables ⇒ Held-to-maturity Investments ⇒ Financial Instruments at Fair Value Through Profit or Loss ⇒ Available-for- ale Financial Instruments ⇒ Financial Liabilities Amongst other exceptions, investments in subsidiaries, associates and joint ventures are not within the scope of IAS 39 (IAS 39.2). The most relevant distinction with relevance for measurement purposes under the German Commercial Code is the distinction between fixed assets and current assets. Fixed assets are assets that are intended to serve the business operations on the long term. All other assets are current assets (§ 247 I + II HGB). Even though it is not permitted to match the IFRS financial asset categories with the German distinction between fixed and current assets exactly, the following assumptions can be made. Held-to-maturity investments correspond to fixed assets. At Fair Value through Profit or Loss assets correspond to current assets. Loans and receivables as well as available-for-sale financial assets can be classified as fixed or current assets, based on the individual circumstances. Under IAS 39 financial instruments are initially recognised at fair value (generally including transaction costs; IAS 39.43). Under the German Commercial Code, financial assets are initially recognised at cost and financial liabilities at their settlement amount (§ 253 HGB). In practice this difference is unlikely to cause any major deviations. Financial asset de-recognition IAS 39 contains specific rules on financial asset de-recognition and financial liability de-recognition (IAS 39.15 et. al.). Under the German Commercial Code there is no explicit guidance on this issue. As a result there may be different accounting treatments in practice. The major problem of financial asset de-recognition very often boils down to the question of whether a financial asset should be replaced by liquid funds received or whether the financial asset should not be derecognised and the receipt of liquid funds instead leads to an increase in liabilities. This is mainly a presentation issue with no major impact on profit or loss (unless for financial institutions). Therefore this area has not been analysed any further. Subsequent measurement of financial instruments (excluding derivatives) Loans and receivables Loans and receivables are carried at amortised cost according to IAS 39.46. If there is any objective evidence that such a financial asset or group of financial assets is impaired, “the amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset’s original effective interest rate (i.e. the effective interest rate computed at initial recognition; IAS 39.58/IAS 39.63 et. al.). Under IAS 39, the assessment of impairments is done first “for financial assets that are individually significant, and individually or collectively for financial assets that are not individually significant”. The


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grouping is based on credit risk characteristics (IAS 39.64). A subsequent reversal of the impairment may be required (IAS 39.65). Under the German Commercial Code, these assets are also carried at (amortised) cost. However, the rules for impairment may differ. For a fixed asset, an impairment generally has to be recognised if it is permanent. If it is only temporary, the company generally has an option to recognise the impairment loss (§ 253 II HGB/§ 279 I HGB). The assets are written down to a kind of “market value” (“beizulegender Wert”). The determination of this value is not clearly defined (§ 253 II HGB). For current assets, an impairment loss has to be recognised even for temporary impairments. The benchmark for determining an impairment loss is generally also a “market value”; preferably derived from an active market. In practice especially the impairment rules may result in differences. For example in Germany accounts receivables are often reduced by individual allowances as well as general allowances that may take interest effects into account. The groupings for general allowances may not be based on credit risk. It can be assumed that the German impairments may be more conservative. This is underpinned by the need to recognise impairment losses even for temporary impairments. This means that distributable (net) profits may arise later under the German Commercial Code. Held-to-maturity investments Held-to-maturity Investments are also carried at cost (IAS 39.46). Held-to-maturity Investments are generally fixed assets under the German Commercial Code. The statements made above covering fixed assets are also true for held-to-maturity investments. Financial instruments at fair value through profit or loss (excluding derivatives) There are two ways of classifying a financial instrument at fair value through profit or loss. One way is holding the instrument for trading, i.e. normally short term profit making, or designating the instrument into this class of assets at initial recognition (the possibilities of designation are limited; IAS 39.9 et. al.). Financial instruments in this category are measured at fair value with fair value changes recognised in profit or loss (IAS 39.46 et. al.). Under German GAAP, financial assets are usually current assets. They are carried at the lower of cost and “market value” as described above. It is not permitted to recognise unrealised gains, i. e. it is not possible to measure assets above cost (§ 253 HGB). Therefore if the fair value increases, gains are recognised under IFRS, which may not be booked under German GAAP. For losses, an impairment loss has to be recognised under the German Commercial Code – where applicable even for temporary losses (§ 253 II + III HGB). The market value according to German law quite likely corresponds to the fair value according to IAS 39. This means that the deviation is quite likely not a major issue for losses. Liabilities are measured at the settlement amount under German GAAP (§ 253 I HGB). They may not be measured at fair value. Accordingly, any changes in the fair value of liabilities designated as at fair value through profit or loss according to IFRS are generally not recognised under German GAAP. For example, this is also true for losses caused by a decrease in the refinancing interest rate. Therefore the deviation in the area of liabilities depends on the current circumstances.


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Available-for-sale financial assets Available-for-sale financial assets are carried at fair value. Changes in the fair value are recognised directly in equity. Upon the realisation of profits or losses, the gain or loss recognised in equity is “recycled” through net profit or loss for the period (IAS 39.46 et. al.). “When a decline in the fair value of an available-for-sale financial asset has been recognised directly in equity and there is objective evidence that the asset is impaired …, the cumulative loss that had been recognised directly in equity shall be removed from equity and recognised in profit or loss …” (IAS 19.67 / for details see IAS 19.67 et. al.). As described above, a measurement above cost is not permitted under German GAAP either for fixed or for current assets. Where the gains recognised directly in equity are not distributable, there is no impact on distributable profits. Under German GAAP, temporary losses have to be recognised for current assets and may be recognised for fixed assets. For permanent impairments, an impairment loss has also to be recognised for fixed assets. To simplify a complex matter, it may be assumed that temporary impairments do not lead to the recognition of decreases in fair values in profit or loss whereas permanent impairments do under IFRS. This would mean that impairments recognised under IFRS are also always recognised in profit or loss under German GAAP. But temporary impairments have to be recognised in profit or loss under German GAAP and but not under IFRS. This leads to the conclusion that the distribution potential under German GAAP tends to be lower than the cumulated distributable profits under IFRS. There are specific rules for reversals of impairments losses under IFRS. For debt instruments, the reversals impact on profit or loss. For equity instruments the increase in fair value impacts on equity (IAS 39.69 et. al.). Under the German Commercial Code, a reversal of impairments losses is required and impacts on profit or loss in all cases (§ 280 I HGB). Financial liabilities Financial liabilities are generally recorded at amortised cost under IFRS. The effective interest method is applied (IAS 19.47). German GAAP requires liabilities to be recognised at their settlement amount (§ 253 I HGB). Sometimes liabilities are issued at a discount. This discount may be expensed immediately or recognised as prepaid expenses and spread over the term of the liability (§ 250 III HGB). The second option may be identical or at least similar to the effective interest method. If the first option is used, this reduces distributable profits under the German Commercial Code at the time of initial recognition. Investments in subsidiaries, associates and joint ventures IAS 27 applies to interests in subsidiaries, associates and joint ventures in, individual financial statements. These may be carried at cost or according to IAS 39 (IAS 27.37). If they are carried according to IAS 39, they are principally to be regarded as available-for-sale financial assets. In this respect please see the analysis above. These investments may also be carried at cost. This is similar to the accounting treatment under the German Commercial Code. There is an other “class” of financial assets as well that is carried at cost less impairment loss under IAS 39: “…investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured …” (IAS 39.46 et. al./IAS 39.AG80 et. al.). The accounting treatment is similar to the German Commercial Code as


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described above. But it may be possible for fixed assets or required for current assets to write the assets down in case of a temporary impairment which may, subject to specific analyses, not be appropriate under IFRS. Furthermore under the German Commercial Code, reversals of write downs are required (§ 280 I HGB). But under IFRS reversals of write downs for these specific assets are prohibited (IAS 39.66). Accounting treatment of derivative financial instruments Derivative financial instruments, as defined in IAS 39.9, are generally within the scope of IAS 39. They are automatically classified as being traded and therefore accounted for “at fair value through profit or loss”. As described above, this means that all derivative financial instruments are recognised at fair value in an IFRS balance sheet, and any changes in the fair value of those assets / liabilities are recognised within profit or loss for the period. Under the German Commercial Code, there is a non-codified rule that executory contracts are generally not recognised in the balance sheet. Normally derivative financial instruments have to be identified as executory contracts. This means that derivatives are generally not recognised according to German GAAP. This is supported by the fact that positive fair values are regarded as unrealised gains that may not be anticipated (§ 252 I No. 4 HGB). Nevertheless, onerous contracts have to be recognised according to the German Commercial Code (§ 249 I HGB / § 252 I No. 4 HGB). An onerous derivative contract usually corresponds with a negative fair value of the derivative. Therefore in cases of negative fair values of a derivative, a provision is usually recognised under the German Commercial Code. The measurement of the provision may slightly deviate from time to time from the negative fair value, e.g. discounting is generally not allowed under HGB (§ 253 I HGB). This means that losses / negative fair values tend to be recognised under German GAAP as well as under IFRS. Gains may only be “anticipated” under IFRS. This shows a tendency that distributable profits may be recognised earlier under IFRS. Hedge accounting IAS 39 distinguishes three kinds of hedging relationships: cash flow hedges, fair value hedges and hedges of a net investment in a foreign operation128 (IAS 39.86). To be eligible to apply hedge accounting, several required prerequisites have to be fulfilled (IAS 39.88 et. al.). Cash flow hedges are used to hedge (potential) variations in future cash flows. Any gain or loss on a (derivative) hedging instrument is recognised directly in equity until the hedged item affects profit or loss, directly or in the form of a basis adjustment of the hedged item (see IAS 39.88 / IAS 39. 95 et. al.). Fair value hedges are used to hedge the risk of changes in the fair value of a recognised asset or liability or a firm commitment. The gain or loss of the (derivative) hedging instrument is recognised in profit or loss. In addition the hedged item is revalued with regard to the hedged risk as well, and any results of this revaluation are also recognised in profit or loss. Ideally the gain/loss of the hedging instrument is fully offset by the loss/gain from the revaluation of the hedged item (see IAS 39.88 et. al.). Under the German Commercial Code, there is no guidance on hedge accounting. In practice and in accounting literature it is possible to establish “units of account”. This means that the hedged item and the hedging instrument are artificially linked to one unit that leads to offsetting gains and losses. For example it is permitted to link a foreign currency receivable and foreign currency forward to a “unit of account”. As a result, the foreign currency 128 Since cash flow hedges and fair value hedges are the most relevant kinds of hedging relationships in individual financial statements in dividual financial statements only those will be analysed further.


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receivable is always translated at the forward rate, or it is permitted to link a liability with an interest rate swap. As a result, the “cash flows” are recognised as incurred, i. e. neither the liability nor the swap is revalued. The prerequisites for this kind of hedge accounting are also not specified. Therefore it appears to be easier to be eligible for hedge accounting under the German Commercial Code. A full analysis of hedge accounting under the German Commercial Code appears impracticable due to divergence in practice. The objective of hedge accounting under German GAAP is similar to the objective under IFRS. The profit or loss should not be affected if two items are in substance closely linked but would, due to “inappropriate” basic accounting rules, be treated differently. In Germany unrealised losses have to be anticipated whereas unrealised gains cannot be recognised. If hedge accounting were not applied, the loss of one item would affect net profit before the gain of the other item could be realised; thus this would potentially impact the true and fair view of the financial statements. Therefore hedge accounting is applied. Under IFRS the objective is similar. The need for hedge accounting may even be increased by the fact that derivatives – in general hedging items – are always measured at fair value. A detailed analysis of the impact of the hedge accounting rules is almost impracticable. But since it is perhaps easier to be eligible for hedge accounting under the German Commercial Code and given the analysis of freestanding derivatives, the whole set of rules may tend towards an earlier recognition of distributable profits under IFRS. Specific rules for determining distributable profits There are no rules in Germany under which net income is modified to determine distributable profits; i.e. net income according to the German Commercial Code represents the distributable profit. There are no similar rules in IFRS. Overall assessment of the impact on distributable profits It is difficult to assess the overall impact on distributable profits in the field of financial instruments. Under IFRS fair value measurements are often applied. This is generally not allowed under the German Commercial Code when fair values of assets exceed (amortised) cost. On the other hand, a decrease in fair values to below cost leads in most cases to a write down of assets under HGB. Therefore gains may not be “anticipated”, whereas potential losses have to be anticipated. The prudence principle is the overarching major principle within the accounting rules. In view of conservatism as a general rule, we could conclude that German financial statements tend to recognise distributable profits later than IFRS financial statements.


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5.3.3 Poland 5.3.3.1 Introduction The following analysis is based on the assumption that any difference between an accounting treatment according to local GAAP and IFRS that has a potential impact on net profit or loss for the period does – for a specific point in time – change the distributable profit. In making this assumption, one has to keep in mind that generally any impact on profit or loss in one period reverses in another period; i.e. over the lifecycle of a company the accumulated profit generally does not change because of different accounting treatments. Therefore, any impact assessment can only refer to a specific point in time of this lifecycle. Moreover, it is assumed that any profit or loss recognised directly in equity is not distributable unless explicitly stated otherwise. The following analysis does not explicitly take the effects of deferred taxes into account. Deferred taxes can reduce the primary impact on an accounting difference. In Poland the distributable profit is generally determined as the profit that is recognised in the separate financial statements prepared according to the Polish Accounting Act dated 29 September 1994 (“the Act”) and to related bylaws. This profit, however, might not be fully eligible for distribution. The rules are as follows: - the amount eligible for distribution includes the entire profit for the current year and retained profits; - after deducting the value of treasury shares; - after deducting amounts that, in accordance with laws and regulations or provisions of the Company’s statutes need to be allocated to reserve capital, and; - after covering accumulated losses. The amount of retained earnings that, for joint-stock companies, needs to be allocated to reserve capital based on the Commercial Companies’ Code is the equivalent of at least 8% of the net profit for the year, until the reserve capital equals one third of the share capital. There is no such requirement in relation to limited liability companies. Since this analysis focuses on distributable profits, note disclosures and presentation issues have not been not taken into account. Furthermore it is not necessary to analyse all deviations between Polish GAAP and IFRS in detail. The analysis focuses on major areas of accounting congruence or divergence. 5.3.3.2 Investment property Separate identification of investment property IAS 40 “Investment property” defines investment property as being land or a building, or being part of a building or bothheld by the owner or by the lessee under a finance lease for the purpose of earwing rent or for capital appreciation or both, rather than for: c) use in the production or supply of goods or services or for administrative purposes [so called “owner-occupied property”]; or d) selling in the ordinary course of business” (IAS 40.5). IAS 40 contains a measurement option for investment property. A company may apply the “fair value model” or the “cost model” for subsequent measurement. The cost model refers to


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IAS 16 “Property, Plant and Equipment” and to IFRS 5 “Non-Current Assets Held-for-sale and Discontinued Operations” (IAS 40.56). Owner-occupied property is accounted for according to IAS 16. The Polish Accounting Act does not differ significantly from IAS 40 with respect to the identification of investment property, except for the fact that according to the Act, the property needs to be “acquired” for the purpose of earning rent or for capital appreciation or both. If this requirement is interpreted literally, an entity may not reclassify property, plant and equipment when its usage changes. Measurement methods are similar to ones offered by IAS 40 – cost model and fair value model. There is no direct equivalent of IFRS 5 in the provisions of the Act. Measurement of investment property Initial measurement According to IFRS, investment property is initially measured at cost including transaction costs, (IAS 40.20 et. al.). “The cost of a purchased investment property comprises its purchase price and any directly attributable expenditure.…” (IAS 40.21). The cost of a self-constructed asset includes “any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management” (IAS 16.16(b)). This means that they also include “a systematic allocation of fixed and variable production overheads” but no general and administration overheads (IAS 40.22/IAS 16.22/IAS 2.12 et. al.). This measurement will be called “full cost” in the following analysis. Under the Act, the investment property is initially measured at cost. There is generally no major deviation in determining the cost of a purchased asset, except for borrowing costs capitalisation and except where “costs of dismantling and removing the item and restoring the site” form part of the cost of an asset under IFRS. In these cases based on the Act, the obligation is generally recognised as an expense over the useful life of the asset without an impact on the cost of the asset. With reference to borrowing costs, the Act requires capitalisation of all such costs incurred during the period of construction, assembly, preparation or improvement. The borrowings need to be obtained with the purpose of financing the construction; they may not be general borrowings. In addition, any foreign exchange differences arising from the borrowings in the period mentioned above, regardless of their amount and regardless of whether these are gains or losses, are required to be capitalised. No general conclusion can be drawn as to the impact of these differences. Other factors, such as the treatment adopted under IFRS (benchmark or alternative), the type of financing used by the Company, as well as the type of assets (and length of the “construction, assembly etc.” period), - can also have different an impacts on the distributable profits; these may be either positive (an increase) or negative (a decrease). Comparison of national accounting rules with the “Cost Model” Despite the rules of IFRS 5, investment property is, according to IAS 16, carried at cost less accumulated depreciation and accumulated impairment losses, if any (IAS 16.30). For depreciation purposes, the depreciation method “shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity” (IAS 16.60) and the useful life represents “the period over which an asset is expected to be available for use by an


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entity …” (IAS 16.6). Any impairment loss is determined under IAS 36 “Impairment of Assets”, which states that should a so-called “triggering event” arise, the carrying amount of an asset is compared with its recoverable amount, i. e. the higher of the fair value less costs to sell and the value in use (see IAS 36.6 et. al.). In accordance with article 28 of the Act, the investment property is carried either at cost less depreciation and impairment charges or at fair value. The accounting treatment under Polish GAAP therefore resembles the treatment under IFRS. In practice there may be several deviations. The depreciation method under Polish GAAP once selected may not be altered. Useful lives of the assets may not be changed during the accounting period; therefore any adjustments to depreciation rates may be applied prospectively from the financial year subsequent to the one, when the change of useful life took place. The impact on profit or loss generally cannot be determined. Furthermore, if impairment occurs (i.e. when “it is likely, that an asset controlled by an entity will not bring, in whole or in part, expected economic benefits in the future”), companies have to write fixed assets down to the net selling price or “otherwise determined fair value”. The Act does not give any detailed guidance on how to determine the fair value, except for the general definition that the fair value is “an amount for which a given asset could be exchanged, and a liability settled, in an arm’s length transaction, between willing, well-informed and non-related parties”. The Act makes reference to consideration of “value in use” in determining the amount of impairment loss, as required under IFRS; however this term is not defined. No general effect on the profit or loss can be determined in this case. Comparison of national accounting rules with the “Fair Value Model” As an alternative to the cost model, IAS 40 grants the option to measure all investment property at fair value. The changes in fair value are recognised in profit or loss for the period (IAS 40.33 et. al.). A measurement at fair value is also an acceptable option under the Polish Accounting Act based on article 28.1 point 1a). The changes in the fair value are recognised as follows (art. 35.4 of the Act): - increases of fair value are recognised in a revaluation reserve in equity (see also below); - decreases – up to an amount previously recognised in equity due to increases in fair value –

are recognised as a debit in the revaluation reserve. Other decreases are recognised in profit or loss for the period;

- reversal of a decrease in fair value recognised in profit or loss is also recognised in profit or loss.

It should be noted that changes proposed in the Polish Accounting Act and expected to be effective as from 1 January 2008 are expected to be in line with the treatment under the IFRS Fair Value Model. Specific rules for determining distributable profits Except for rules described in point 1 of the Introduction of this analysis, there are no other rules in Poland under which net income is modified for determining distributable profits. None of these rules relates to investment property.


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Overall impact assessment on distributable profits The impact on the net profit or loss arising from accounting deviations in the field of investment property depends on several factors. One is the choice of options granted under the Act and IFRS, and the second is market and valuation influences. Upon initial recognition, the differences might occur in relation to capitalizing borrowing, dismantling, or restoration costs. However, the effect on distributable profits (a decrease or an increase comparable to IFRS) depends on facts and circumstances, thus no general statement can be made. The cost model of subsequent measurement under Polish GAAP is similar to the one in IFRS. However, differences impacting distributable profits may arise due to possibilities of changes in the amortisation method under IFRS (not possible under Polish GAAP), moment of changes in the useful lives of the investments, and differences in calculating impairment losses under both reporting frameworks. In this regard it is also not possible to make a general statement on the direction of differences between distributable profits under Polish GAAP and IFRS. The fair value model differences relate primarily as to how the change in fair value is recognised – under IFRS P&L, under Polish GAAP – either in profit or loss or in equity, depending on the direction of the changes and the history of the changes. The distributable profits will therefore be lower under Polish GAAP in a situation of increases in fair value, and may be higher in a situation of fair value decline. 5.3.3.3 Defined benefit plans (DBP) Identification of DBP and the need to recognise a provision Under IAS 19 “Employee Benefits”, a company has to recognise a “liability” (or an ”asset”) for all defined benefit plans129; no matter whether they are funded or unfunded and no matter whether there is a legal or constructive obligation (IAS 19.49 et. al.). Under the Polish Accounting Act, an entity has generally to provide for any third-party obligation (art. 35d.1). There are, however, no specific rules for calculating or recognising defined benefit plan provisions. On that basis the entity may opt to choose an accounting treatment as defined in IFRS although it has no obligation to do so. Measurement of the (net) obligation Valuation of the obligation Under IFRS the relevant measure of the obligation is defined as the “present value of a defined benefit obligation” (DBO; IAS 19.6). This obligation is calculated by applying the so-called “Projected Unit Credit Method” (IAS 19.64 et. al.). Furthermore several actuarial assumptions, based on the market expectations at the balance sheet date, are needed to calculate the DBO, for example (IAS 19.72 et. al):

129 For a definition of defined benefit plans cf. IAS 19.7.


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Demographic assumptions - Mortality - Rates of employee turnover, disability and early retirement - The proportion of plan members with dependants who will be eligible for benefits Financial assumptions - The discount rate (by reference to market yields at the balance sheet date on high quality corporate bonds) - Future salary and benefit levels (Medical benefits do not play a role in Poland and are therefore not considered). Under the Polish Accounting Act, there is no guideline for measuring the obligation. The obligation has simply to be measured “reliably” (art. 28.1 point 9 of the Act). The overall impact of the differences between IFRS and Polish GAAP in relation to determining the obligation cannot be generalised. Treatment of plan assets IAS 19.7 defines plan assets, which are assets that are held by a long-term employee benefit fund or qualifying insurance policies. The main characteristics are that the respective funds can only be used to pay benefits are not available to the companies’ creditors (even in bankruptcy) and can generally not be returned to the entity. Plan assets are offset with the DBO (IAS 19.54). IAS 19 also refers to reimbursement rights which cannot be offset with the DBO but are otherwise treated in the same way (IAS 19.104A et. al.). Plan assets are measured at fair value (IAS 19.54 / IAS 19.102 et. al.). Under the Polish Accounting Act, there is no definition for plan assets. Entities may opt to choose the accounting treatment as defined in IFRS; however they have no obligation to do so. Treatment of actuarial gains and losses Under IFRS actuarial gains or losses may arise. Actuarial gains or losses comprise “experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred); and … the effects of changes in actuarial assumptions” (IAS 19.7). These gains and losses do not have to be recognised immediately. It is permitted to apply the so-called “corridor approach” meaning that the amount of cumulated actuarial gains and losses exceeding the greater of 10% of the DBO and 10% of the fair value of the plan assets has to be spread over the remaining working lives of the employees. Any method leading to a faster recognition of the gains/losses is acceptable as well (IAS 19.92 et. al.). Recently the IASB added an additional option for the recognition of the actuarial gains and losses. Optionally it is allowed to recognise all actuarial gains and losses directly in equity (retained earnings) immediately. No “recycling” of these gains and losses through profit or loss in later periods is required or allowed (IAS 19.93A et. al.). Under the Polish Accounting Act, it appears inappropriate not to recognise all actuarial gains and losses immediately. This means that at year end the “full (net) obligation” is recognised. Any adjustments made to the provisions have to be recognised in profit or loss for the year.


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Neither the corridor approach nor the immediate recognition of actuarial gains or losses directly in equity is allowed under IFRS. The immediate recognition of actuarial gains/losses is also an option under IAS 19. If this option is used, no difference arises in this respect. Indeed if we assume that the adjustment of retained earnings according to the new option under IFRS has an impact on distributable profits, there is also no difference between the distribution potential according to the Polish Accounting Act and IFRS in respect to actuarial gains and losses. If any other method (corridor approach) of IAS 19 is applied, the general effect on distributable profits when compared with the Polish Accounting Act cannot be generalised. The effect depends on the circumstances: Is there a cumulative actuarial gain or a cumulative actuarial loss? A gain means a higher distribution potential under the Polish Accounting Act; a loss means less distributable profits under the Polish Accounting Act. Specific rules on determining distributable profits As mentioned above, except for some general rules described in the introductory paragraph of this analysis, there are no rules in Poland under which net income is modified to determine distributable profits. Overall impact assessment on distributable profits It is impossible to make a general statement about the differences between the Polish Accounting Act and IFRS concerning the impact on accumulated distributable profits. There are several tendencies that in part contradict each other, and there are several areas for which no clear accounting rules exist under the Polish Accounting Act. The differences also cannot be generalised because they are based on experience. 5.3.3.4 Financial instruments Identification and classification of financial instruments Under IFRS there is a broad definition for financial instruments. They include financial assets and financial liabilities. Financial assets comprise debt as well as equity instruments (of other entities). Financial instruments also include derivative financial instruments (see IAS 32.11). According to IAS 39, financial instruments have to be classified into the following categories with a consequential effect on their accounting treatment (see IAS 39.9): ⇒ Loans and receivables ⇒ Held-to-maturity Investments ⇒ Financial Instruments at Fair Value Through Profit or Loss ⇒ Available-for-sale Financial Instruments ⇒ Financial Liabilities Amongst other exceptions, investments in subsidiaries, associates and joint ventures are not within the scope of IAS 39 (IAS 39.2). In Polish GAAP the presentation and the measurement of financial instruments are regulated in detail in the Ministry of Finance Decree on recognition, measurement, presentation and related disclosures of financial instruments, dated 12 December 2001 (“the decree”). The decree was based on the versions of IAS 32 and IAS 39 applicable at that time, therefore the


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primary differences arising between Polish GAAP and IFRS in this respect results from changes in IFRS that have been made since 2001. Financial instruments are classified in one of the following categories: - Financial assets or financial liabilities held for trading - Loans granted and receivables - Assets held to maturity - Assets available for sale - Other financial liabilities Under IAS 39, financial instruments are initially recognised at fair value (generally including transaction costs; IAS 39.43). Under Polish GAAP, financial assets are initially recognised at cost and financial liabilities at fair value of the assets received (§ 13.1 of the Decree). In practice this difference is unlikely to cause any major deviations. Financial asset de-recognition IAS 39 contains specific rules on financial asset de-recognition and financial liability de-recognition (IAS 39.15 et. al.). Although the guidance on this issue is less comprehensive in Polish GAAP than in IFRS, the same principles as in IFRS are followed. The asset is derecognised when the entity no longer has control of it (§ 11 of the Decree). The Decree includes almost the same de-recognition criteria as those in IFRS, and we do not expect any differences having an impact on distributable profit in this regard. Subsequent measurement of financial instruments (excluding derivatives) Loans and receivables Loans and receivables are carried at amortised cost according to IAS 39.46. If there is any objective evidence that such a financial asset or group of financial assets is impaired, the amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset’s original effective interest rate (i.e. the effective interest rate computed at initial recognition; IAS 39.58/IAS 39.63 et. al.). Under IAS 39, the assessment of impairments is done first “for financial assets that are individually significant, and individually or collectively for financial assets that are not individually significant”. The grouping is based on credit risk characteristics (IAS 39.64). A subsequent reversal of the impairment may be required (IAS 39.65). Under Polish GAAP, these assets are also carried at amortised cost (§16 of the Decree). There are practically no differences between Polish GAAP and IFRS in this regard. Held-to-maturity investments Held-to-maturity Investments are also carried at amortised cost under IFRS (IAS 39.46) and Polish GAAP (§16 of the Decree). The statements made under 4.3.1. are also true for held-to-maturity investments.


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Financial instruments at fair value through profit or loss (excluding derivatives) There are two ways of classifying a financial instrument. One is at fair value through profit or loss and the other way is that the instrument is held for trading, i.e. normally short term profit making, or the instrument is designated into this class of assets at initial recognition (the possibilities of designation are limited; IAS 39.9 et. al.). Financial instruments in this category are measured at fair value with fair value changes recognised in profit or loss (IAS 39.46 et. al.). Under Polish GAAP, there is no direct equivalent of “instruments at fair value through profit or loss”. Only part of this category (instruments held for trading) is separated. There will be no impact on distributable profits in relation to instruments held for trading. Other instruments under Polish GAAP, which can be designated as fair value with changes through profit or loss under IFRS, will need to be classified either as loans granted and receivables, held to maturity, or assets available for sale. Except for this presentation impact, the described difference between IFRS and Polish GAAP will however impact distributable profits in relation to the valuation of items meeting the definition of loans and receivables under Polish GAAP (and therefore measured as amortised cost; refer to 4.3.1 above) or available-for-sale (and – although measured at fair values - the changes in fair values may be accounted for directly in equity; refer to 4.3.4 below) that could be designated through profit and loss under IFRS (i.e. measured at fair value, with changes recognised in profit or loss). Given the fact that the changes in fair value may either positively or adversely impact distributable profits, no general statement can be made with regards to the direction of differences between profits recognised under IFRS and under Polish GAAP in relation to financial instruments classified as fair value through profit and loss. Available-for-sale financial assets Available-for-sale financial assets are carried at fair value. Changes in the fair value are recognised directly in equity. Upon realisation of profits or losses, the gain or loss recognised in equity is “recycled” through net profit or loss for the period (IAS 39.46 et. al.). “When a decline in the fair value of an available-for-sale financial asset has been recognised directly in equity and there is objective evidence that the asset is impaired …, the cumulative loss that had been recognised directly in equity shall be removed from equity and recognised in profit or loss …” (IAS 19.67 / for details see IAS 19.67 et. al.). Under Polish GAAP, financial assets available for sale are also measured at fair value. Fair value changes as at the year end may be recognised either in profit and loss or in the revaluation reserve, depending on the accounting policy adopted by the entity (§ 21 of the Decree). There are specific rules for reversals of impairment losses under IFRS. For debt instruments, the reversals impact profit or loss. For equity instruments, the increase in fair value impacts equity (IAS 39.69 et. al.). Under Polish GAAP, a reversal of impairment loss is required and is recognised in the profit and loss. The reversal of impairment loss may be made only up to the value of financial assets at the date of the impairment loss reversal that would be used had the impairment not taken place (§ 24.4 of the Decree).


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Financial liabilities Financial liabilities are generally recorded at amortised cost under IFRS. The effective interest method is applied (IAS 19.47). Financial liabilities, with the exception of those held for trading (primarily derivative instruments), are recognised at amortised cost under Polish GAAP (§ 18.1 of the Decree). Financial liabilities held for trading are measured at fair value, as described above. The fair value option for financial liabilities other than those classified as held for trading is not available under Polish GAAP. Investments in subsidiaries, associates and joint ventures IAS 27 applies to interests in subsidiaries, associates and joint ventures in individual financial statements. These may be carried at cost or according to IAS 39 (IAS 27.37). If they are carried according to IAS 39, they are principally to be regarded as available-for-sale financial assets. In this respect please refer to 4.3.4. These investments may also be carried at cost. Under Polish GAAP, interests in subsidiaries, associates and joint ventures are regulated through the Accounting Act. Based on art. 28.1 of the Act, they are measured either at cost less impairment losses, at fair value, or under the equity method, depending on the accounting policy chosen and adopted by the entity. There is an other “class” of financial assets as well which is carried at cost less impairment loss under IAS 39: “investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured …” (IAS 39.46 et. al./IAS 39.AG80 et. al.). No such class of financial assets is mentioned under Polish GAAP. However, given a broad range of accounting measurement methods allowable under Polish GAAP (above), valuation of this item should not itself cause any differences between IFRS and Polish GAAP, except for the issue of impairment losses and their reversals in relation to this “class” of assets. Under IFRS reversal of any impairment loss recognised for this class of assets is prohibited (IAS 39.66), while under Polish GAAP such an impairment loss may still be reversed (the Act, art. 35c). Accounting treatment of derivative financial instruments Derivative financial instruments, as defined in IAS 39.9, are generally within the scope of IAS 39. They are automatically classified as being traded and therewith as “at fair value through profit or loss”. As described above, this mans that all derivative financial instruments are recognised at fair value in an IFRS balance sheet and any change in the fair value of those assets / liabilities is recognised within profit or loss for the period. There will be no differences on the impacts on distributable profits between IFRS and Polish GAAP in this regards since under Polish GAAP derivative financial instruments are classified as financial assets/liabilities held for trading and measured at fair value, with fair value changes recognised in profit or loss (§ 21 of the Decree). Hedge accounting IAS 39 distinguishes three kinds of hedging relationships: cash flow hedges, fair value hedges and hedges of a net investment in a foreign operation130 (IAS 39.86). To be eligible to apply 130 Since cash flow hedges and fair value hedges are the most relevant kinds of hedging relationships in individual financial statements only those will be analysed further.


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hedge accounting, several required prerequisites have to be fulfilled (IAS 39.88 et. al.). Under Polish GAAP, the same hedging relationships are defined (§ 27 of the Decree). Cash flow hedges are used to hedge potential variations in future cash flows. Any gain or loss on a derivative hedging instrument is recognised directly in equity until the hedged item affects profit or loss, directly or in the form of a basis adjustment of the hedged item (see IAS 39.88 / IAS 39.95 et. al.). Fair value hedges are used to hedge the risk of changes in the fair value of a recognised asset or liability or a firm commitment. The gain or loss of the derivative hedging instrument is recognised in profit or loss. In addition the hedged item is revalued with respect to the hedged risk as well, and any results of this revaluation are also recognised in profit or loss. Ideally the gain or loss of the hedging instrument is almost fully offset by the loss or gain from the revaluation of the hedged item (see IAS 39.88 et. al.). The hedge accounting requirements under Polish GAAP mirror the requirements of IAS 32 and IAS 39 effective in 2001 and have not been updated since despite the evolution of these two standards since that time. Accordingly, Polish GAAP, for example, does not allow fair value hedges of firm commitments. In addition, the fair value option is not available in relation to financial liabilities which may impact the application of hedge accounting in certain circumstances. In addition, Polish GAAP does not address the use of hedge accounting from a group perspective. Given the nature of the IFRS / Polish GAAP differences and the optional application of hedge accounting, no general statement can be made with regards to the direction of differences between profits recognised under IFRS and under Polish GAAP in relation to hedge accounting. Specific rules on determining distributable profits Specific rules on determining distributable profits are described in detail in point 1 of the Introduction of this analysis. Overall impact assessment on distributable profits As mentioned above, a general statement on the impact on accumulated distributable profits under Polish GAAP and IFRS with regard to financial instruments is impossible to make. Generally there are no significant differences influencing the distributable profits, however it is not possible to generalise the direction of the differences (i.e. whether the distributable profits under Polish GAAP would be lower or higher than under IFRS due to the differences).


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5.3.4 Sweden 5.3.4.1 Introduction The Companies Act (CA) provides rules for the maintenance of capital and the related matter of profit distribution in Sweden. The main rule is that a company cannot return restricted equity to its shareholders except by a reduction of capital sanctioned by the court. The CA contains a number of restrictions for dividend distributions. A company may only distribute unrestricted capital. A company is further restricted by the company’s capital requirements, which are based on an assessment of the kind and scope of business. The distribution is also restricted by the company’s liquidity, financial position and other aspects. A parent company is also restricted by the group’s capital requirements, the group’s liquidity, financial position, and other aspects. What a company or group reports as unrestricted capital is governed by standards from Redovisningsrådet (Swedish Financial Accounting Standards Council) or Bokföringsnämnden (BFN, Swedish Accounting Standards Board) depending on the type of company it is. Redovisningsrådet’s standards RR 1 – RR 29 must be applied by entities of such a size that they attract public interest, but they are neither publicly listed nor do they voluntarily use IFRS. The other unlisted companies must apply the standards according to BFN. Sometimes the standards prescribe different rules for the separate or individual financial statements and the consolidated financial statements. In addition, BFN’s standards sometimes prescribe different rules for larger limited liability companies compared to smaller ones. Listed companies and those applying IFRS voluntarily in the consolidated accounts must follow the rules in RR 32 of the Redovisningsrådet in the individual financial statements. Subsidiaries within a group applying IFRS in the consolidated financial statements may also apply RR 32 in the individual financial statements. 5.3.4.2 Investment property Separate identification of investment property RR 32 (for listed companies) refers to RR 24, which is Redovisningsrådet’s separate standard for investment properties. However, companies applying Redovisningsrådet account for investment properties in the same way as they do for owner-occupied properties. The difference is simply the disclosures. BFN has no separate standard for investment properties. Measurement of investment property Initial measurement Under Swedish GAAP, all property is initially measured at cost. There is generally no major deviation in determining the cost of a purchased asset, except in cases where “costs of dismantling and removing the item and restoring the site” form part of the cost of an asset under IFRS. These costs are not included as costs of the asset according to Swedish GAAP for separate or individual financial statements. With reference to borrowing costs, Swedish GAAP has a free choice similar to that in IAS 23 “Borrowing cost” , where it is optionally permitted to capitalise “borrowing costs” for qualifying assets. [A further analysis of this subject appears to be of no further material merit.]


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Comparison of national accounting rules with the “Cost Model” The cost model is the only alternative allowed according to Swedish GAAP. The component approach is normally not applied as strictly as IFRS requires; normally the building is seen as being only one component. (In the consolidated financial statements nearly all companies use the fair value method.) The impact on profit and loss cannot be generally determined. Redovisningsrådet has a standard on the impairment of assets, which is in agreement with IAS 36. BFN has no standard on the impairment of assets. BFN has issued an exposure draft on a range of accounting issues applicable to smaller companies that might come into force as of the 1 January 2008. According to the draft, the depreciation method, as well as the useful life of buildings, may be derived from tax rules and in turn may be used for accounting purposes. This means that depreciation methods and the useful life of an asset according to BFN may differ to those methods and terms that have to be used under IFRS. The impact of the BFN method of accounting on profit or loss will mean less profit than under IFRS. By the end of June 2008, a governmental investigation will have been finished and may result in a change in the tax and accounting rules that makes it possible for companies to apply the fair value model in the separate or individual financial statements. However, that possibility will only be a choice for publicly listed companies, for companies voluntarily applying IFRS in their consolidated financial statements, and for subsidiaries of either of these types of companies. Comparison of national accounting rules with the “Fair Value Model” As an alternative to the cost model, IAS 40 grants the option to measure all investment property at fair value. The changes in fair value are recognised in profit or loss for the period (IAS 40.33 et. al.). A measurement at fair value is not an option under Swedish GAAP, see above. This means that if fair values increase, the profit under IFRS exceeds the profit determined under Swedish GAAP. If fair values decrease, the results under Swedish GAAP may be similar if the loss is permanent (unlisted companies), or the losses recognised under IFRS may be the same (companies following RR 32). Specific rules on determining distributable profits There are no rules in Sweden under which net income is modified in any predetermined way in order to calculate how much the company can distribute to its shareholders. However, as mentioned above, the company is not only restricted by the size of the unrestricted equity, but also by the company’s capital requirements based on an assessment of the kind and scope of business. The distribution is furthermore restricted by the company’s liquidity, financial position and other aspects. A parent company is also restricted by the group’s capital requirements, the group’s liquidity, financial position, and other aspects.


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Overall impact assessment on distributable profits The impact on the net profit or loss arising from accounting deviations in the field of investment property depends on several factors. The main factor is the change in fair value, see above. 5.3.4.3 Defined benefit plans (DBP) Identification of DBP and the need to recognise a provision Under IAS 19 “Employee benefits”, a company has to recognise a “liability” (or an ”asset”) for all defined benefit plans, no matter whether they are funded or unfunded and no matter whether there is a legal or constructive obligation (IAS 19.49 et. al.). Under the Swedish Annual Accounts Act (AAA), an entity has generally to provide for any third-party obligations. However, AAA does not require an employer to account for its pension liability. On the contrary, all significantly defined benefit pension plans (ITP and similar) which are regulated by agreements between parties on the labour market, require the employer to account for benefits on an accrual basis. Therefore, “pay-as-you-go” accounting is available only to the extent that the employer has granted employees post-employment benefits in excess of the nation-wide plans. Practice varies from company to company. If accrual accounting is not applied, a contingent liability is disclosed. If entities do not recognise a provision (liability), this generally increases the unrestricted equity. As stated before, what a company can distribute is, however, also influenced by the company’s capital requirements etc. The fact that the company has an obligation, even if it has not been accounted for, has to be taken into consideration. RR 32, dealing with accounting in the separate or individual financial statements for publicly listed companies, refers to FAR SRS RedR4. This standard taken from FAR SRS is also considered to be GAAP for unlisted companies. The standard states that the AAA does not require accrual accounting, but the standard “strongly” recommends pension obligations to be recognised. Measurement of the (net) obligation Valuation of the obligation Under IFRS, the relevant measure of the obligation is defined as the “present value of a defined benefit obligation” (DBO; IAS 19.6). This obligation is calculated by applying the so-called “Projected Unit Credit Method” (IAS 19.64 et. al.). Furthermore several actuarial assumptions – based on the market expectations at the balance sheet date – are needed to calculate the DBO, for example (IAS 19.72 et. al): Demographic assumptions - Mortality - Rates of employee turnover, disability and early retirement - The proportion of plan members with dependants who will be eligible for benefits


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Financial assumptions - The discount rate (by reference to market yields at the balance sheet date on high quality corporate bonds) - Future salary and benefit levels (Medical benefits do not play a role in Sweden and have therefore not been considered). All Swedish companies are required to apply Tryggandelagen (a law about pensions) in the separate or individual financial statements in order to gain tax deductions for their pension costs. Tryggandelagen requires the present value of the defined benefit obligation to be determined by assuming that at each balance sheet date the employee is entitled to a benefit that can be established by pro-rating the years of actual service to the number of years from vesting to retirement. This method is different from the Projected Unit Credit Method. Unlike IFRS, specific actuarial assumptions to be used are stated in Tryggandelagen and also in binding rules issued by the Swedish Financial Supervisory Authority (FI). The basis for calculating the defined benefit obligation is the current level of salaries at the balance sheet date, rather than also reflecting expected future salaries, as required by IAS 19. The actuarial assumptions do not permit future salary increases to be taken into account. The FI prescribes what discount rate is to be used. In previous years this discount rate was below the discount rate for high quality corporate bonds, thus leading to a higher obligation than under IFRS, when only referring to this factor. The overall impacts of the different methods for determining the obligation cannot be generalised. Treatment of plan assets IAS 19.7 defines plan assets as being assets that are held by a long-term employee benefit fund or qualifying insurance policies. The main characteristics are that the respective funds can only be used to pay benefits, that they are not available to the companies’ creditors (even in bankruptcy), and that they generally cannot be returned to the entity. Plan assets are offset with the DBO (IAS 19.54). IAS 19 also refers to reimbursement rights which cannot be offset with the DBO but are otherwise treated in the same way (IAS 19.104A et. al.). Plan assets are measured at fair value (IAS 19.54 / IAS 19.102 et. al.). In Sweden, assets held by a pension fund can be returned to the employer only to reimburse the employer for employee benefits already paid and only to the extent that they are in surplus to what is required to meet the obligation to be paid by the fund. When determining to what extent a surplus is available, assets are measured at fair value. Companies can have assets in a pension fund in which the fair value of the assets is higher than the present value of the pension liability. In these cases the company is not required to record this surplus as an asset according to Swedish GAAP, even if they fulfil the requirements for doing so under IFRS. Treatment of actuarial gains and losses Under IFRS, actuarial gains or losses may arise. Actuarial gains or losses comprise “experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred); and … the effects of changes in actuarial assumptions” (IAS 19.7). These gains and losses do not have to be recognised immediately. It is permitted to apply the so-called “corridor approach”, which means that the amount of


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cumulated actuarial gains and losses exceeding the greater of 10% of the DBO and 10% of the fair value of the plan assets has to be spread over the remaining working lives of the employees. Any method leading to a faster recognition of the gains/losses is acceptable as well (IAS 19.92 et. al.). Recently the IASB has added an additional option for the recognition of the actuarial gains and losses. Optionally, it is allowed to recognise all actuarial gains and losses immediately and directly in equity (retained earnings). No “recycling” of these gains and losses through profit or loss in later periods is required or allowed (IAS 19.93A et. al.). Unlike IFRS, Swedish GAAP does not defer recognition of actuarial gains and losses, as is done for investment gains or losses by using a corridor or other deferred mechanism. This means that any adjustments made to the provisions have to be recognised in profit or loss for the year, i. e. neither the corridor approach nor the immediate recognition of actuarial gains or losses directly in equity are allowed under Swedish GAAP. If IFRS were to be applied in the separate or individual financial statements, then the effect on distributable capital would depend on the circumstances: Is there a cumulative actuarial gain or a cumulative actuarial loss? A gain means higher distributable capital under Swedish GAAP. A change to IFRS and application of the corridor approach could lower the distributable capital. However, as stated before, what a company can distribute is also influenced by the company’s capital requirements, its liquidity, financial position, and other aspects. Specific rules for determining distributable profits There are no rules in Sweden under which net income is modified in any predetermined way to calculate how much the company can distribute to its shareholders. However, as mentioned above, besides the size of the unrestricted equity the company is further restricted by the company’s capital requirements based on an assessment of the kind and scope of business. The distribution is also restricted by the company’s liquidity, financial position and other aspects. A parent company is also restricted by the group’s capital requirements and the group’s liquidity, financial position and other aspects. Overall impact assessment on distributable profits It is impossible to make a general statement on the impact on cumulated distributable profits when comparing accounting treatments between Swedish GAAP and IFRS. There are several – partly contradicting – tendencies. For example, the consideration of future salary and benefit increases leads, on its own, to higher liabilities under IFRS; thus resulting in a decrease in cumulated distributable profits. On the other hand, the recording of a surplus in plan assets above the present value of the defined benefit obligation tends to increase distributable profits under IFRS compared how they are accounted for under Swedish GAAP. Furthermore, owing to several factors, the impact on distributable profits depends on the individual circumstances, e.g. the discount rate applied or the method applied in recognising actuarial gains or losses. Experience from several Swedish GAAP to IFRS conversion projects in the past shows that it is impossible to say anything in general about the over all effects.


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5.3.4.4 Financial instruments Introduction to financial instruments Swedish GAAP does not have a comprehensive accounting standard for financial instruments. Publicly-listed-companies have to apply RR 32 in their separate or individual financial statements. This means that they generally have to apply IAS 39, but there are exceptions due to tax reasons and because the Annual Accounts Act (AAA) must be applied. This has the result that a company can only measure a financial asset or a financial liability at fair value through profit or loss under subparagraph b in IAS 39 paragraph 9 according to the “Definition of Four Categories of Financial Instruments” if the AAA permits measurement of a financial instrument at fair value. The AAA can also set restrictions on when to apply IAS 39 paragraph 11A. According to the relationship between taxes and accounting, companies can choose not to apply IAS 39 in some specific situations related to hedge accounting. If they decide not to apply IAS 39 in these specific hedging situations, they have to apply Swedish GAAP and not IAS 39 all kinds of financial instruments. Non-listed companies, on the other hand, can choose between applying Swedish GAAP or an option under the AAA, which is based on the version of IAS 39 that was issued in 2000. This option means that companies can measure certain financial instruments at fair value. For some financial instruments, fair value adjustments are recognised in profit or loss, and for other financial instruments, those adjustments are recognised in equity with recycling. When recognised in equity, they are included in unrestricted equity, which means that they are distributable if the conditions for that have been fulfilled. Identification and classification of financial instruments Under IFRS, there is a broad definition for financial instruments. They include financial assets and financial liabilities. Financial assets comprise debt as well as equity instruments (of other entities). Financial instruments also include derivative financial instruments (see IAS 32.11). According to IAS 39, financial instruments have to be classified into the following categories with a consequential effect on their accounting treatment (see IAS 39.9): ⇒ Loans and receivables ⇒ Held-to- maturity investments ⇒ Financial Instruments at fair value through profit or loss ⇒ Available-for-sale financial instruments ⇒ Financial liabilities Amongst other exceptions, investments in subsidiaries, associates and joint ventures are not within the scope of IAS 39 (IAS 39.2). Under Swedish GAAP, measurement depends on classification. Swedish GAAP uses different classification and measurement guidance than IFRS. Long-term investments are measured at amortised cost. Financial assets classified as short-term investments are measured at the lower of amortised cost or net realisable value. Financial liabilities generally are measured at amortised cost. However, as mentioned above, the AAA includes an option to measure certain financial instruments at fair value. For some financial instruments, fair value adjustments are


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recognised in profit or loss, and for other financial instruments, those adjustments are recognised in equity. Financial asset de-recognition IAS 39 contains specific rules on financial asset de-recognition and financial liability de-recognition (IAS 39.15 et. al.). Under Swedish GAAP, there is no specific guidance on this issue. Subsequent measurement of financial instruments (excluding derivatives) Loans and receivables Loans and receivables are carried at amortised cost according to IAS 39.46. If there is any objective evidence that such a financial asset or group of financial assets is impaired, “the amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset’s original effective interest rate (i.e. the effective interest rate computed at initial recognition; IAS 39.58/IAS 39.63 et. al.). Under IAS 39, the assessment of impairments is first done “for financial assets that are individually significant”, and then “individually or collectively for financial assets that are not individually significant”. The grouping is based on credit risk characteristics (IAS 39.64). A subsequent reversal of the impairment may be required (IAS 39.65). Under Swedish GAAP, loans and receivables that are classified as long-term investments (fixed assets) are measured at amortised cost. If they are classified as short-term investments, they are measured at the lower of amortised cost or net realisable value. For long-term investments, impairment has to be recognised if it is permanent. The impairment test is to be done item by item. Loan receivables and receivables that are derived by the company and are not held for trading are not covered by the option under the AAA, i.e. cannot be measured at fair value. Held-to-maturity investments Held-to-maturity Investments are also carried at cost (IAS 39.46). Held-to-maturity Investments are generally fixed assets under Swedish GAAP, see above, thus they cannot be measured at fair value. Financial instruments that are held-to-maturity instruments and have not been designated as hedging instruments are not covered by the option under the AAA, thus they cannot be measured at fair value. Financial instruments at fair value through profit or loss (excluding derivatives) There are two ways of classifying a financial instrument at fair value through profit or loss. One way is that the instrument is held for trading, i. e. normally short-term profit making, or the instrument is designated into this class of assets at initial recognition (the possibilities of designation are limited; IAS 39.9 et. al.). Financial instruments in this category are measured at fair value with fair value changes recognised in profit or loss (IAS 39.46 et. al.).


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As mentioned above, the AAA includes an option for measuring certain financial instruments at fair value. If the option is chosen, then it must be applied to all financial instruments covered by the option. The option does not apply to financial liabilities unless they are held for trading or are a derivative. Available-for-sale financial assets Available-for-sale financial assets are carried at fair value. Changes in the fair value are recognised directly in equity. Upon realisation of profits or losses, the gain or loss recognised in equity is “recycled” through net profit or loss for the period (IAS 39.46 et. al.). “When a decline in the fair value of an available-for-sale financial asset has been recognised directly in equity and there is objective evidence that the asset is impaired …, the cumulative loss that had been recognised directly in equity shall be removed from equity and recognised in profit or loss …” (IAS 19.67 / for details see IAS 19.67 et. al.). [It is assumed that the gains and losses recognised in equity have no impact on distributable profits!] Under Swedish GAAP, the measurement depends on whether it is a short-term or long-term investment (see above). Regarding impairment, see above. If the option to measure at fair value under the AAA is chosen, then companies can choose to recognise the fair value adjustments either in profit or loss or in equity. The companies have to be consistent in their choice. When the fair value adjustments are recognised in equity, they are included in unrestricted equity, which means that they are distributable if the conditions for that have been fulfilled. Financial liabilities Financial liabilities are generally recorded at amortised cost under IFRS. The effective interest method is applied (IAS 39.47). Under Swedish GAAP, financial liabilities are generally measured at amortised cost. The option under the AAA to measure at fair value is not applicable to financial liabilities, except for those liabilities that are included in a trading portfolio or are hedging instruments. Investments in subsidiaries, associates and joint ventures IAS 27 applies to interests in subsidiaries, associates and joint ventures in individual financial statements. These may be carried at cost or according to IAS 39 (IAS 27.37). If so, they are principally to be regarded as available-for-sale financial assets. Under Swedish GAAP, interests in subsidiaries, associates and joint ventures are carried at cost. The option under the AAA to measure at fair value is not applicable. In addition publicly listed companies that apply RR 32 have to carry these kinds of investments at cost. Accounting treatment of derivative financial instruments Derivative financial instruments, as defined in IAS 39.9, are generally within the scope of IAS 39. They are automatically classified as being traded and thus are accounted for “at fair value through profit or loss”. As described above, this means that all derivative financial


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instruments are recognised at fair value in an IFRS balance sheet, and any change in the fair value of those assets / liabilities is recognised within profit or loss for the period. Under Swedish GAAP, all derivatives other than those designated as hedges are recognised in the balance sheet and measured at the lower of cost or at net realisable value. The lower of cost or net realisable value concept may be applied on a portfolio basis for marketable securities. However, the AAA includes an option for measuring derivatives at fair value. The changes in fair value are to be recognised in profit or loss. Hedge accounting IAS 39 distinguishes three kinds of hedging relationships: cash flow hedges, fair value hedges and hedges of a net investment in a foreign operation131 (IAS 39.86). To be eligible to apply hedge accounting, several strict prerequisites have to be fulfilled (IAS 39.88 et. al.). Cash flow hedges are used to hedge (potential) variations in future cash flows. Any gain or loss on a (derivative) hedging instrument is recognised directly in equity until the hedged item affects profit or loss. When this happens, the gain or loss of the hedging instrument is accounted for either directly in profit or loss or in the form of a basis adjustment of the hedged item (see IAS 39.88 / IAS 39.95 et. al.). Fair value hedges are used to hedge the risk of changes in the fair value of a recognised asset or liability or a firm commitment. The gain or loss of the (derivative) hedging instrument is recognised in profit or loss. In addition, the hedged item is revalued with respect to the hedged risk as well, and any results of this revaluation are also recognised in profit or loss. Ideally the gain/loss of the hedging instrument is (almost) fully offset by the loss/gain made by revaluing the hedged item (see IAS 39.88 et. al.). Under Swedish GAAP, fair value hedges, cash flow hedges and hedges of a net investment in a foreign entity are applicable. Guidance on hedge accounting is limited, and there are no explicit rules for documenting and testing hedge effectiveness. Therefore some hedges that qualify for hedge accounting under Swedish GAAP but may not qualify under IFRS. Just as in IFRS, the type of hedge accounting applied depends on whether the hedged exposure is a fair value exposure, a cash flow exposure or a currency exposure on a net investment in a foreign operation. However, hedge accounting is applied differently under Swedish GAAP, and hedges of future transactions are generally off the balance sheet until the hedged transaction occurs. Specific rules for determining distributable profits There are no rules in Sweden under which net income is modified in any predetermined way for calculating how much the company can distribute to its shareholders. However, as has already been mentioned (see Introduction), the company is not only restricted by the size of the unrestricted equity, but also by the company’s capital requirements based on an assessment of the kind and scope of business. The distribution is also restricted by the company’s liquidity, financial position, and other aspects. A parent company is also restricted by the group’s capital requirements, the group’s liquidity, financial position, and other aspects. 131 Since cash flow hedges and fair value hedges are the most relevant kinds of hedging relationships in single financial statements only those will be analysed further.


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When fair value adjustments are recognised in equity, they are included in unrestricted equity, which means that they are distributable if the conditions for that have been fulfilled. Overall assessment of the impact on distributable Profits The impact on distributable profits arising from deviations in the field of financial instruments depends, amongst other things, on whether a company applies the option under the AAA or not. If the option is applied, the impact on distributable profits compared to IFRS is not as huge as when the option is not applied. To sum up, it is not possible to make a general statement on the impact on distributable profits between the differing accounting treatments according to either Swedish GAAP or to IFRS.


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5.3.5 United Kingdom 5.3.5.1 Overview of UK legal position on distributable profits Before considering the impact of accounting under UK GAAP and IFRS in the three selected areas on distributable profits, it is necessary to outline, in broad terms, the legal framework which is used within the UK in order to determine what constitutes distributable profits. The earned surplus test UK companies legislation, in section 263(3) of the Companies Act 1985 (or s830(2) of the Companies Act 2006 when it is implemented to replace the Companies Act 1985), defines a company’s profits available for distribution as “its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses so far as not previously written off in a reduction or reorganisation of capital duly made”. Realised profits and losses are defined as “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”. Section 270 of the Companies Act 1985 (s836 of the Companies Act 2006) requires a company’s individual accounts to be used as the basis for determining the amount of a distribution which can be made, but is only the starting point. Under UK Companies legislation, there is only a requirement for the consolidated accounts of listed companies to be prepared using IFRSs adopted by the EU. There is an option, but not a requirement, to prepare other accounts, including individual accounts, using IFRSs adopted by the EU, subject to certain provisions regarding the consistency of framework used for individual accounts within a group. A number of key points should be noted as arising from the legal requirements: • The starting point for the determination of distributable profits is taken as being

the published accounts. • This encompasses those companies which prepare their individual accounts under

IFRS as well as those applying UK GAAP (including those UK GAAP preparers which have been required to, or have taken the option, to apply FRS 26 (the UK Accounting Standard which largely mirrors IAS 39). It should also be noted that some profits are specifically considered to arise in law, even though they are not recognised as such in accounting (e.g. capital contributions).

• There are some accounting profits or losses which are not considered to be profits or losses in law (e.g. interest on share capital which is considered as debt under IAS 32)

• Not all profits are necessarily realised. It is apparent from the words “falls to be treated as realised” (rather than simply “realised”) that the concept of a realised profit is intended to be dynamic. The Institute of Chartered Accountants in England and Wales (ICAEW) and the Institute of Chartered Accountants of Scotland (ICAS) jointly issue guidance, in the form of technical releases, regarding what constitutes distributable profits and the interpretation of “realised


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profits”. Such Guidance is regarded as authoritative as to how principles referred to in the Act should be interpreted at the current time. Current ICAEW/ICAS Technical Releases in issue in respect of distributable profits are as follows: Tech 02/07 – Distributable Profits: Implications of recent accounting changes Tech 64/04 – Guidance on the effect on realised and Distributable Profits of

Accounting for Employee Share Schemes in Accordance with UITF Abstract 38 and Revised UITF Abstract 17

Tech 50/04 – Guidance on the effect of FRS 17 ‘Retirement Benefits’ and IAS 19 ‘Employee Benefits’ on realised profits and losses.

Tech 07/03 (revised 2007) – Guidance on the determination of realised profits and losses in the context of distributions under the Companies Acts 1985

Under UK common law, a company cannot lawfully make a distribution out of capital. In addition, directors are subject to fiduciary duties in exercise of the powers conferred on them. The directors must therefore consider, amongst other things, whether the company will still be solvent following a proposed distribution. The directors should therefore consider both the immediate cash flow implications of a distribution and the continuing ability of a company to pay its debts as they fall due. It should be noted that although distributable profits are based upon published accounts, the legal requirement for distributable profits to be “realised” is making the use of accounting as the basis for determining distributable profits increasingly problematic, as accounting under both UK GAAP and IFRS is moving away from the concept of realisation as a recognition test. It should also be appreciated that the legal requirement to base distributable profits on those which are realised in response to the original EU 2nd and 4th CLD (77/91/EEC and 77/660/EC). Article 15 of the 2nd CLD contains the requirement that distributions to shareholders may not exceed the amount of “profits” at the end of the last financial year end plus any profits brought forward and sums drawn from reserves available for the purpose, less any losses brought forward and sums placed to reserve in accordance with law or statutes. With regard to defining what constitutes “profits” in this context, reference is made to Article 31, paragraph 1 (c) of the 4th CLD which only permits “profits made” to be reflected in the asset valuations that flow through the profit and loss account, and reference to the original French text, makes it clear that “profits made” in this context are meant to be “realised profits”. This is further referred to by Article 33, paragraph 2(c) of the 4th CLD which makes it clear that no part of a revaluation reserve may be distributed, either directly or indirectly, unless it represents gains actually realised. Taking all of this together, a distinction has been drawn between the different types of profits/gains made, viz those that are realised and available for distribution and those that are not. The net assets test A further restriction is placed on distributions by public companies under section 264 of the Companies Act 1985 (section 831 of Companies Act 2006), reflecting the requirements of the 2nd CLD. A public company is only allowed to make distributions if after the distribution has taken place, the amount of its net assets is not less than the aggregate of its called up share capital and undistributable reserves as shown in its accounts.


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The following are undistributable reserves: - share premium account; - capital redemption reserve; - the excess of accumulated unrealised profits, so far as not previously utilised by

capitalisation, over the accumulated unrealised losses, so far as not previously written off in a reduction or reorganisation of its share capital; and

- any other reserve which the company is prohibited from distributing by any enactment, or by its memorandum or statutes (or equivalent).

This means that, in calculating the amount available for distributions, a public company must deduct from the amount of its net realised profits the amount of its net unrealised losses. Once again, the basis – or starting point – for the application of this test is amounts as stated in the individual accounts (section 270 of Companies Act 1985, section 836 of the Companies Act 2006). Realised profits - the general principles The basic principle as to what constitutes realised profits is set out in Paragraph 10 of Tech 07/03 and is in turn based upon the UK Accounting Standard FRS 18: Accounting policies, which sets out the generally accepted principle that profits are only realised when in the form of “cash or other assets the ultimate cash realisation of which can be assessed with reasonable certainty”. FRS 18 also states that in this context “realised may also encompass profits relating to assets that are “readily realisable”. Based upon this general principle, Tech 07/03 (as revised in 2007) details a number of specific circumstances in which it considers profits to be realised. - a transaction where the consideration received by the company is 'qualifying

consideration', or - the recognition in the financial statements of a change in fair value, in those cases

where fair value has been determined in accordance with the fair value measurement guidance in the relevant accounting standards, and to the extent that the change is ‘readily convertible to cash’.

- the translation of: - a monetary asset which comprises qualifying consideration, or - a liability denominated in a foreign currency, or - the reversal of a loss previously regarded as realised, or - a profit previously regarded as unrealised (such as amounts taken to a revaluation

reserve, merger reserve or other similar reserve) becoming realised as a result of: - consideration previously received by the company becoming 'qualifying

consideration', or - the related asset being disposed of in a transaction where the consideration received

by the company is 'qualifying consideration', or - a realised loss being recognised on the scrapping or disposal of the related asset, or - a realised loss being recognised on the write-down for depreciation, amortisation,

diminution in value or impairment of the related asset,


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- the distribution in specie of the asset to which the unrealised profit relates, in which case the appropriate proportion of the related unrealised profit becomes a realised profit; or

- the receipt of a dividend in the form of qualifying consideration when no profit is recognised because the dividend is deducted from the book value of the related investment (e.g. as required by IAS 27 in the case of dividends out of the pre-acquisition profits of subsidiaries)

The above criteria for the recognition of realised profits apply irrespective of whether the accounts are prepared under UK GAAP or IFRS (Para 11 of Tech 7/03). It should be noted that the guidance considers that “realised profits” may arise irrespective of whether they have been recognised through the profit and loss account or directly in reserves. This is of particular relevance when considering fair value accounting when fair value gains may be directly recognised in the available for sale or similar reserves. Qualifying consideration As can be seen, a key concept underlying realised profits is that of “qualifying consideration”. For this purpose “qualifying consideration” is defined as comprising: - cash, or - an asset that is readily convertible to cash (see definition below), or - the release, or the settlement or assumption by another party, of all or part of a

liability of the company, unless - the liability arose from the purchase of an asset that does not meet the definition of

qualifying consideration and has not been disposed of for qualifying consideration, and

- the purchase and release are part of a group or series of transactions or arrangements that fall within Paragraph 12(*) of this guidance; or

- an amount receivable in any of the above forms of consideration where: - the debtor is capable of settling the receivable within a reasonable period of time;

and - there is a reasonable certainty that the debtor will be capable of settling when called

upon to do so; and - there is an expectation that the receivable will be settled. (Paragraph 18, Tech 07/03) *This requires that when assessing whether a company has a realised profit, transactions and arrangements should not be looked at in isolation. A realised profit will only arise where the overall commercial effect on the company satisfies the definition of a realised profit set out in the guidance. Thus a group or series of transactions or arrangements should be viewed as a whole, particularly if they are artificial, linked (whether legally or otherwise) or circular. The aim of this provision is to ensure that profits which are in reality ‘unrealised’ are not treated as ‘realised’. This ‘anti-avoidance’ provision is in practice, likely to be of application more in the case of intra-group transactions. In situations, where an asset is sold partly for qualifying consideration and partly for other consideration (for example, a mixed consideration of cash and a freehold property), any profit arising is a realised profit to the extent that the fair value of the consideration received is in


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the form of qualifying consideration. This approach is sometimes referred to as 'top-slicing'. (Example: fair value of consideration received is 10, of which 4 is cash and 6 is freehold property. If the depreciated historical cost of the asset sold is 5, the total gain is 5 but the realised profit is limited to 4.) Readily convertible to cash As can be seen from the above, it is particularly important when considering whether changes in fair value give rise to realised profits to determine if the change recognised is “readily convertible to cash”. For this purpose “readily convertible to cash” is defined as follows: An asset, or change in the fair value of an asset or liability, is considered to be “readily convertible to cash” if: - a value can be determined at which a transaction in the asset or liability could occur, at

the date of determination, in its state at that date, without negotiation and/or marketing, to either convert the asset, liability or change in fair value into cash, or to close out the asset, liability or change in fair value; and

- in determining the value, information such as prices, rates or other factors that market

participants would consider in setting a price is observable; and - the company’s circumstances must not prevent immediate conversion to cash or close

out of the asset, liability or change in fair value; for example, the company must be able to dispose of, or close out the asset, liability or the change in fair value, without any intention or need to liquidate, to curtail materially the scale of its operations, or to undertake a transaction on adverse terms.

(Paragraph 19, Tech 07/03) Realised losses Accounting losses should be regarded as realised losses except to the extent that the law, accounting standards, or the provisions of Tech 07/03 provide otherwise. A loss that represents the reversal of an unrealised profit does not lead to a reduction of cumulative realised profits. Even if the loss is treated as a realised loss, for example because it represents an impairment, the unrealised profit will become realised in such situations. Cumulative net losses arising on fair value accounting are considered to be unrealised only if both the profits on remeasurement of the same asset or liability would be unrealised and the losses would not have been recorded other than pursuant to fair value accounting.


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Amounts recognised as realised profits as a matter of law There are certain amounts which may, as a matter of law, be regarded as profits even though they would not necessarily be reflected as accounting profits. Such profits then need to be tested as to whether they are realised. These include the following: • Gratuitous contributions of assets from the owners in their capacity as such , which

as they represent transactions with shareholders in their capacity as such do not constitute profits under either the UK GAAP or IFRS accounting frameworks. Any contribution received would need to be tested to ensure that it meets the definition of “qualifying consideration” before it could be considered as a realised profit.

• Amounts that are taken to a so-called “merger reserve” reflecting the extent that relief is obtained under sections 131 or 132 of the Companies Act 1985 from the requirement to recognise a share premium account. Under UK companies’ legislation, when share for share transactions are used for acquiring at least 90% of the equity share capital of a non group company or for group reorganisation, then it is possible, in some circumstances, to allocate part of the amount recorded for the new equity issued to a “merger reserve” rather than to the share premium account (which would be non-distributable). The amounts initially recognised in the “merger reserve” will initially represent an unrealised profit and therefore are not to be available for distribution. They will however be considered as being subsequently realised if for example the original investment acquired is disposed of for qualifying consideration, a realised loss is recognised as a result of the investment being impaired or if a dividend is received which is paid of the pre-acquisition profits of the investee.

• (*)A reduction or cancellation of capital (ie, share capital, share premium account or capital redemption reserve) which results in a credit to reserves where the reduction or cancellation is confirmed by the court, except to the extent that, and for as long as, the company has undertaken that it will not treat the reserve arising as a realised profit, or where the court has directed that it shall not be treated as a realised profit, or

• (*)A reduction or cancellation of capital (ie, share capital, share premium account or capital redemption reserve) which is undertaken by an unlimited company without confirmation by the court and which results in a credit to reserves, in which case the amount so credited represents a realised profit to the extent that the consideration received for the capital:

• was qualifying consideration; or • has subsequently become qualifying consideration; or • has subsequently been written off (for example, by way of depreciation) and the

loss arising has been treated as realised; or • was originally paid up either by a capitalisation of realised profits or by a

capitalisation of unrealised profits or reserves which, had they not been capitalised, would subsequently have become realised.

(*) Expected to be changed when the Companies Act 2006 and related statutory instruments all come into force; it is expected that the instruments will provide that all reserves arising from capital reductions are, as a matter of statute law, to be regarded as realised profits (unless, e.g. the court orders otherwise).


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Linked transactions As noted above, when considering qualifying consideration, it is important to emphasise that when looking at transactions and arrangements which are linked, (which may often be the case with intra-group transactions but is not confined to such transactions) the approach adopted when considering whether any gains or losses arising are realised is to assess the overall impact of the linked transactions, rather than looking at separate transactions in isolation. We will now consider how the general requirements and further specific guidance set out in Technical releases is applied to determine the impact on UK distributable profits of accounting for investment properties, defined benefit pension schemes and fair value accounting. In each case, there will also be a short assessment of how the accounting requirements of UK GAAP and IFRS differ in each area, followed by an analysis as to the extent of such profits and losses being realised. 5.3.5.2 Investment property How UK GAAP (SSAP 19) differs from IAS 40 The UK GAAP standard relating to Investment Properties, SSAP 19, has a number of differences from IAS 40: Investment Properties, of which the most significant is that IAS 40 allows a choice between using either a fair value through profit and loss or a cost model, while SSAP 19 requires investment properties to be carried at open market value, with no depreciation charged (except for short leases). Under SSAP 19, in contrast to IAS 40, no changes in the value of the investment property, other than permanent diminutions, are reflected though profit and loss but are instead credited or charged directly through the statement of total recognised gains and losses (STRGL, the equivalent of the IFRS SORIE) to an investment revaluation reserve within shareholders’ equity. Under UK GAAP, permanent diminutions are charged through the profit and loss account. Other areas where UK GAAP differs significantly from IAS 40 include the following: • Although the definition of an investment property is similar to IAS 40, it is also

necessary that any rental income be negotiated on an arm’s length basis. • Property leased within a group cannot be investment property in either the single

entity or group accounts. IAS 40 would require the property to be treated as an investment property in the single entity accounts but as owner occupied in the consolidated accounts.

• Leasehold property that meets the definition of an investment property is treated as such under SSAP 19. There are no specific additional requirements for such properties. Under IAS 40, if a property is held by a lessee under an operating lease, it may be classified as an investment property if the rest of the definition of investment property is met and if the lessee measures all its investment properties at fair value.

• Under UK practice, a portion of a dual-use property need not be capable of separate disposal to be classified as an investment property, as is required under IAS 40 subject to the portion of the property used for own use being insignificant.

• Investment properties are not depreciated under SSAP 19, except that investment properties held on leases may be depreciated and must be depreciated if the unexpired term of the lease is 20 years or less. Under IAS 40, depreciation is only


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permitted when using the cost model, and in such cases is determined in accordance with IAS 16.

Guidance on realised profits/losses Recognised gains on investment properties are not considered as realised profits regardless of whether they are recognised in the income statement in accordance with IAS 40 or through the STRGL in accordance with SSAP 19. The ICAEW/ICAS Guidance permits changes in the fair value of assets determined in accordance with fair value measurement guidance in relevant accounting standards to be treated as realised profits, subject to the condition that the change recognised is readily convertible to cash. However, in the case of investment property any increase in the fair value of investment property would not, in nearly all circumstances, be considered as readily convertible to cash since a period of marketing and/or negotiation would be required to dispose of the property, and therefore it would not be considered as being readily convertible to cash at the date of determination. The exception to this principle would be in rare cases when the process of marketing and negotiation is complete at the date of determination and legal completion of the disposal occurs shortly afterwards. Under both UK GAAP and IFRSs, any write down or impairment of an investment property below the amount recognised initially would be considered to be a realised loss, and any subsequent reversal of such a write down or impairment would be considered as a realised profit to the extent that it did not exceed cumulative realised losses already recognised on the property. The only situation where IFRS and UK GAAP will give rise to a different level of realised profits in respect of investment properties, will be where a company preparing IFRS accounts adopts the cost model and the property is therefore subject to depreciation, which is considered to be a realised loss which reduces the level of realised profits. Under UK GAAP, depreciation is not ordinarily charged on investment property, and hence there would be no resulting reduction in the level of realised profits. Overlaid over this, however, is the point that in some cases IFRS will classify more properties as investment property and in some cases fewer properties. 5.3.5.3 Defined benefit schemes How UK GAAP (FRS 17) differs from IAS 19 The UK standard relating to the accounting for defined benefit pension schemes, FRS 17 Retirement benefits, is consistent with IAS 19 in most respects. The significant differences are as follows: • FRS 17 requires actuarial gains and losses to be recognised immediately, in full, in the

STRGL. IAS 19 allows a similar treatment with actuarial gains/losses being recognised in SORIE, but also permits an option for actuarial gains/losses which exceed a “corridor” to be recognised in profit or loss over the average remaining working life of the employees in the plan, with faster recognition being allowed on a systematic basis.

• Plan assets that are quoted securities are valued at mid market price under FRS 17. This contrasts with the practice under IFRSs that the fair value of quoted securities after initial recognition should be based on bid price. With effect from periods


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commencing on or after 6 April 2007, FRS 17 is to be amended so that quoted securities are required to be valued on the same basis as IAS 19.

• A wider multi-employer exemption is permitted under FRS 17 than under IAS 19. Multi-employer plans are plans that pool the assets contributed by various entities to provide benefits to employees of more than one entity. In addition to the exemption under IAS 19, which allows employers participating in multi-employer defined benefit schemes to use defined contribution accounting where there is insufficient information to allow the employer to identify its share of the underlying assets and liabilities in the scheme, FRS 17 also allows such accounting when the individual employers’ contributions are set in relation to the current service period only, i.e. they are not affected by any surplus or deficit in the scheme relating to past service of its own employees or any other members of the scheme.

• In situations where there is a contractual agreement between a multi-employer plan and its participants that determines how the surplus in the plan will be distributed (or the deficit funded), IAS 19 requires that participants which account for the plan on a defined contribution basis are also required to recognise the asset or liability that arises from the contractual agreement and the resulting income or expense in profit and loss. There is no equivalent provision within FRS 17.

• Under IAS 19, unlike FRS 17, employer defined benefit schemes which cover members of the same group, or other entities under common control, cannot be considered to be multi-employer schemes. In the case of such common control schemes, it is still possible for individual group members to use defined contribution accounting in their accounts if certain conditions are met, but in such situations the group company that is legally the sponsoring employer for the plan would be required to reflect the defined benefit cost for the entire scheme (net of any contributions receivable) and to reflect the overall scheme surplus/deficit on its balance sheet. Thus in the UK it is possible that no individual company in a group adopts defined benefit account, but under IFRS one of them must do so. As will be seen, this is likely to have a significant impact on the level of realised profits of that particular company.

• There is no equivalent to IFRIC 14 under UK GAAP. Under IAS 19, scheme surpluses may only be recognised to the extent that it is possible to recover a surplus either through reduced contributions in the future or through refunds from the scheme. Under IFRIC 14, the recognition of a surplus in a scheme is restricted to the extent that there is an unconditional right to a refund from the scheme and/or a reduction in future contributions. UK schemes will not necessarily have an unrestricted right to a refund and/or a reduction in future contributions because the agreement of the scheme trustees may be required beforehand. In the cases where there are minimum funding requirements, such as might be imposed in the UK by the pensions regulator, IFRIC 14 might also give rise to the requirement to recognise an additional liability, akin to an onerous contract, which would be above and beyond the liability which would be required to be recognised under IAS 19.

Guidance on realised profits/losses In order to establish the impact that a defined benefit scheme surplus or deficit has on a company’s realised profits under both FRS 17 and IAS 19, it is necessary to: 1) Establish the extent to which a cumulative net debit or credit taken to reserves in respect of a pension scheme is realised or unrealised; and 2) Identify the cumulative net gain or loss taken to reserves in respect of the pension surplus or deficit.


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Status of a net cumulative debit or credit A cumulative net debit in reserves in respect of a pension scheme is considered to be a realised loss as it results from the creation of, or increase in, a provision for a liability or loss resulting in an overall reduction in net assets. A cumulative net credit in reserves in respect of a pension scheme only constitutes a realised profit to the extent that it is represented by an asset agreed to be recoverable by agreed refunds and that the refunds will take the form of qualifying consideration. To the extent that a cumulative net credit to reserves exceeds any such agreed refunds, it is unrealised, but it becomes realised in future periods to the extent that it offsets subsequent net debits to reserves being recognised as realised losses in respect of the pension scheme (i.e. as the cumulative net credit reduces). Determining the amount of the cumulative debit or credit Although the various elements making up the change in the overall defined benefit asset or liability are disclosed separately and in different performance statements, it is the net cost that is taken to represent the cost to the company of its pension promise. Thus it is the cumulative net gain or loss taken to reserves that falls to be classified as realised or unrealised. There is no need to distinguish that cumulative balance between amounts charged or credited to profit and loss and those recognised in the STRGL/SORIE (dependent on the framework being used). This is demonstrated by the following example in respect of a scheme set up at the start of the year. For simplicity, current and deferred tax is ignored. The scheme has a surplus of 4 at the end of the year that would be reported on the company's balance sheet as an asset, BUT there has been a cumulative charge of 16 to reserves that would fall to be treated as realised. Figure 5.3 -1: Example deferred taxes (UK)

Increase/ (decrease) in pension asset

(Reduction) in cash balance

Amount debited/ (credited) to reserves

B/F 0

Debited to profit and loss account

(20)

20

Credited to STRGL 4 (4)

Contributions paid 20 (20) -

C/F 4 (20) 16 The net effect on the balance sheet in the above example is: Debit Pension asset

DR 4

CR

Debit Reserves 16

Credit Cash 20


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It is the cumulative loss of 16 in the above example that has been debited to reserves in respect of the pension scheme that falls to be assessed as realised or unrealised, rather than any notional "credit" relating to the asset of 4. The cumulative net gain or loss taken to reserves, and which needs to be considered in determining realised profits/losses, will differ from the balance sheet asset/liability recognised as a result of any contributions paid to, or more rarely refunds from, the scheme and any scheme asset/liability introduced to the company as a result of a business acquisition/scheme transfer. A consequence of this is where there is a surplus on a scheme, it is not readily possible to identify how much of the surplus can be considered as representing realised or unrealised profits. It should also be noted that for companies applying IFRS that the cumulative net gain or loss taken to reserve will need to take into account the affect of any adjustments required by IFRIC 14, and hence may result in the recognition of a smaller cumulative net gain or a larger cumulative loss than might be the case under UK GAAP. In practice, it can be difficult to identify past cumulative contributions paid to the scheme and/or the impact of business acquisitions especially in the case of long standing company pension schemes. This is particularly the case since the accounting required by FRS 17/IAS 19 is a relatively recent introduction within the UK, and hence it is often not practical to identify how much of a scheme surplus/deficit recognised on implementation of FRS 17/IAS 19 could be considered to represent realised profits/losses arising from the cumulative impact of net gains or losses taken to reserves determined on the basis of FRS 17/IAS 19. In order to address this problem, the ICAEW/ICAS Guidance permits an alternative approach, whereby the cumulative net credit or debit in reserves for a pension scheme at the transition date to FRS 17/IAS 19 is taken as being equal to the amount of the surplus or deficit recognised before taking account of deferred tax, adjusted for: - Identified cumulative net contributions less any refunds (which it is assumed will

always be identifiable given their rare occurrence); and - In the rare cases in which the company has recognised a pension asset or liability in its

individual accounts (e.g. on the acquisition of an unincorporated business or a scheme transfer), the amount initially recognised.

The alternative approach is prudent in that its effect will be to understate realised losses (or to overstate unrealised profits) on the adoption of FRS 17/IAS 19, when compared with the precise effect (see example below). If the estimate of realised losses is understated, compared with the precise effect, then this has the effect on restricting the amount of realised profits that may be recognised in the future on the basis that they represent a reversal of previously realised losses. For example, in its December 2005 financial statements, a company adopts IAS 19 in full. It wishes to determine its realised or unrealised reserves as at that date of switching from the previous UK standard to IAS 19. Its total net contributions made to the scheme since it started were 90. The scheme has an IAS 19 surplus of 20 at 30 June 2005, and there is no ceiling on the company's ability to recognise this amount as an asset. If the company is able to identify the entire 90 of contributions, under the precise approach the effect of IAS 19 on the company's reserves can be calculated as follows:


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IAS 19 asset 20 Net contributions (90) Precise net (loss) in reserves (70)

This loss will be a realised loss. As a result, the first 70 of net gains that the company reports on its pension scheme after adoption of IAS 19 as at 30 June 2005 will reduce the cumulative net loss in reserves and therefore effectively be treated as realised gains. Say that the company could identify only (i) 20; or (ii) 65 of the contributions made prior to 30 June 2005. Under the alternative approach, the effect of IAS 19 on reserves would be as follows: Identify

20 Identify

65

IAS 19 asset 20 20 Contributions identified (20) (65) Estimated net (loss) in reserves

0

(45)

(i)Since the cumulative effect on reserves as at 30 June 2005 is estimated to be nil, any net gains that the company reports thereafter will lead to a net cumulative gain which will be unrealised. The net cumulative gain will therefore have to be deducted from total reserves as part of the company's calculation of the amount of realised reserves available for distribution. (ii)More of the total contributions made prior to 30 June 2005 can be identified in this case and the estimated net loss at that date is 45. Therefore, the first 45 of net future gains will have the effect of reducing the cumulative net loss in reserves, and no adjustment in respect of pensions will be needed to total reserves in arriving at realised reserves. If the cumulative amount of future gains exceeds 45, the excess would be a cumulative net gain in reserves, which would be unrealised. At that time, the company may wish to investigate whether it can identify more contributions made prior to 30 June 2005 (up to the ceiling of 90). If it can, the estimated effect of adopting FRS 19 can be recalculated. 5.3.5.4 Financial instruments Principal differences between UK GAAP and IFRS The presentation requirements contained in IAS 32 in respect of the debt/equity classification of financial instruments and the off-setting of financial assets and liabilities are applied in UK GAAP through FRS 25 to all entities other than those applying the Financial Reporting Standard for Smaller Entities (FRSSE). The FRRSE can only be applied to small companies or small groups as defined by Companies Acts, or entities that would qualify as such if they had been incorporated under companies legislation (excluding building societies, which are authorised mutual credit institutions); we do not comment on the position of entities within the FRSSE. Over and above those companies that choose to adopt IFRS in their individual accounts, the recognition and measurement requirements contained in IAS 39 are applied in UK GAAP through FRS 26 which is applicable to the following entities:


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• Any individual company only accounts of any listed entity, or • Other entities which prepare their accounts in accordance with the fair value rules

which were incorporated into the Companies Act 1985 (Section D of Schedule 4) to implement the EU Fair Value Directive.

Under the fair value accounting rules, UK Companies which prepare their accounts under UK GAAP are permitted to value certain financial instruments, including derivatives, at fair value with the gains/losses arising being accounted for on a consistent basis with that required under IAS 39 (i.e. fair value through the profit and loss accounting, available for sale accounting or hedge accounting). However, due to the legal constraints of the 4th Directive, the fair value accounting rules of the Companies Act place a number of restrictions as to when fair value accounting is permitted by the Companies Act even though such accounting would be permitted by FRS 26 (and thus IAS 39), in certain circumstances. In particular, it is not permitted to apply fair value accounting in respect of the following (i.e., the legal rules prevent certain of the FRS 26 choices being taken): • Any financial liabilities, other than those that are held as part of a trading portfolio

or which are derivatives; • Loans and receivables originated by the company and not held for trading

purposes; • Interests in subsidiary undertakings, associated undertaking and joint ventures

(IAS 27.37, IAS 28.35 and IAS 31.46 all contain options that permit valuation in accordance with IAS 39)

• Contracts for contingent consideration in a business combination (while IAS 39.2(f) excludes contracts for contingent consideration from its scope for the acquirer they are within the scope of IAS 39 for the seller, and hence the seller could designate such contracts to be accounted for at fair value under IAS 39/FRS 26)

If an entity does not elect to apply fair value accounting, and hence does not apply FRS 26, then it will usually carry financial instruments at cost and generally only recognise any fair value losses which are considered permanent. Any such losses will be considered as realised losses for distributable profits purposes. Under the “alternative accounting rules” of paragraphs 31 to 34 of Schedule 4 of the Companies Act 1985 , it is permitted to revalue fixed asset investments and current asset investments, with the valuation being on the basis of market value determined at the last valuation date or a valuation determined on any basis which appears to the directors to be appropriate in the circumstances of the company, in respect of fixed asset investments, or at current cost (i.e. replacement cost) in respect of current asset investments. Any cumulative gains arising on revaluation are required to be reflected directly though a revaluation reserve and not through the profit and loss account. When considering whether the gains arising on the revaluation reserves represent distributable profits, the same considerations need to be applied as when considering whether gains arising from fair value accounting represent realised profits (see below). “Fixed asset investments” under the Companies Act 1985 include shares in group undertakings, loans to group undertakings, participating interests, loans to undertakings in which a company has a participating interest, other investments other than loans and other loans. “Current asset investments” include shares in group undertakings, other investments and own shares.


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A “participating interest” means an interest held by an undertaking in the shares of another undertaking which it holds on a long-term basis for the purpose of securing a contribution to its activities by the exercise of control or influence arising from or related to that interest. A holding of 20 per cent or more of the shares of an undertaking is presumed to be a participating interest unless the contrary is shown. Guidance on realised profits Fair value accounting In determining whether gains arising from fair value accounting are realised profits, particular attention needs to be paid to whether the gains can be considered as “readily convertible to cash” as defined by paragraph 19 of Tech 07/03. The general position – setting aside hedging for the moment - is fair value gains on financial instruments will usually be considered as representing realised profits in circumstances where the fair value is based on readily available prices in a liquid market and there are no restrictions, specific to the company concerned, which would prevent it from disposing of the financial instrument. However, outside of these circumstances, differences may be thrown up as between profits recognised in the accounts and as a sub-set of that, realised profits. The manner in which a fair value gain is reflected in the financial statements e.g. as fair value through profit and loss, or directly to equity as in the case of available-for-sale financial assets and cash flow hedges, has no bearing on whether the gains are considered to represent realised profits. The overview section, above, defines “readily convertible to cash”, but Tech 07/03 provides more detailed guidance on application of the definition of “readily convertible to cash” in specific situations where fair value is used, the key features of which are summarised below. Valuation of the financial instrument Where financial instrument is traded in an active market, it is usually likely that it will be possible to enter into a transaction, at prices assessed in active markets, to convert the change in value to cash at short notice without any period of marketing and/or negotiation, and hence the gain arising can be considered as “readily convertible to cash” and hence, as a realised profit, subject to the general test in paragraph 19 (c ) of TECH 7/03 that the company’s current circumstances do not prevent immediate conversion to cash or close out of the asset, liability or change in fair value, without any intention or need to liquidate, to curtail materially the scale of its operations or to undertake a transaction on adverse. If for example, an entity was required to retain a certain financial asset for regulatory purposes, then this might lead to a restriction on the ability to consider any fair value gains on such an asset as representing realised profits. Close out A financial asset, financial liability or change in the fair value of a financial asset or liability may be capable of being readily convertible to cash for the purposes of applying condition (a) of paragraph 19 of revised TECH 07/03 if it could be immediately closed out i.e. the relevant contract or underlying market risk position is capable of being immediately offset in the market and normal market practice would be to close out a position in this way. For example


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risks in a derivative may be eliminated by taking out other financial instruments, including derivative contracts, with an offsetting risk profile. While the above addresses the ability to close out a transaction, it is still necessary to address whether the valuation of the close out instrument is based on observable market data, whether the company’s circumstances would prevent close out (i.e. are conditions b) and c) of para 19 of revised TECH 07/03 being satisfied) and whether the cash flows from the close out instrument meet the definition of qualifying consideration (in particular para 18(d) of TECH 07/03 re the settlement of any debtor balances.) Embedded derivatives Where there is bifurcation, and the embedded derivative is fair valued separately from the host contract, profits arising from changes in fair value of the embedded derivative only constitute a realised profit if the derivative component can be closed out so as to meet the readily convertible to cash tests, described above, or if the host contract and embedded derivative together meet the tests. Unquoted equity investments Increases in fair value of unquoted equity investments will not generally meet the “readily convertible to cash test” since, for example, a period of marketing and negotiation would generally be required to dispose of such investments. Strategic investments Where companies hold investments for strategic purposes, they are not readily disposable in the sense to meet condition c) of the definition of “readily convertible to cash” test of paragraph of TECH 7/03, as a company’s strategy cannot be readily changed so as to allow the investment to be realised immediately at the date of determination. Hence any gains on such investments would not be considered as realised profits. For example, such investments would include investments which qualify to be accounted for as joint ventures and associates but where the company has elected under IAS 28/31 to account for the investment at fair value under IAS 39. A similar analysis would apply to other holdings of investments that are held to meet regulatory requirements, since a company cannot readily change its regulatory compliance to allow realisation at the date of determination. Own credit When liabilities (eg bank debt or bond issues) and over-the-counter derivative contracts are measured at fair value, their value may be affected by the reporting company’s own credit worthiness. Consequently, a profit may arise where a company’s own credit worthiness is deteriorating, that is, the fair value of the liability is decreasing. In such cases, it is necessary to consider whether the company would be able to realise the profit by settling the liability at its fair value. This may not be possible, particularly if the company is experiencing financial difficulties, and the relevant profit will therefore not be a realised profit. However, in most circumstances where a company is not in financial difficulties and it would be able to settle the debt at fair value, there will be no need to analyse the fair value changes between the amount attributable to marginal changes in the creditworthiness of the liability and changes due to movements in interest rates and other market factors.


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It should be noted, however, that the tests set out in paragraph 19 of Tech 7/03 are wider than solely the ability to settle at fair value and must all be met. For example, the company must be able to settle on the date of determination without negotiation or marketing. Thus where a large volume of debt is under consideration, this is akin to a question of whether the company could refinance that large volume of debt on that date without negotiation, which would often not be the case. Block discounts for securities traded in an active market FRS 26 and IAS 39 require certain financial instruments to be valued on a basis that does not take account of the size of the holding. That is to say that the valuation included in the accounts uses the published price quotation in an active market as the best estimate of fair value and does not reflect any “block discount” that might apply if the entire holding was disposed of at the date of determination. In the case of assets (e.g. investments) that are traded on an active market, it may be possible to dispose of the entire holding at the date of determination, but it is necessary to recognise that the proceeds may be less than the value recognised in the balance sheet in accordance with FRS 26/IAS 39, and as a consequence the amount of any “block discount” reflected in the carrying valuation of the investment would need to be considered as representing an unrealised profit. Holdings in financial assets traded in an active market that might be regarded as relatively small (e.g. less than 1% of a company’s share capital) may nevertheless be large in relation to the volume of business done in that company’s shares on a typical day in the market. For example, some such investments held by investment companies and other financial institutions fall into this category. Such investments are rarely, if ever, disposed of in a single block but are instead disposed of in a number of smaller blocks either all on the same day or over a short period of time, in accordance with normal market practice, to reduce or eliminate the effect of any block discount. In these limited circumstances, the effect of any block discount on realised profits may be calculated on such a basis rather than on the assumption that the entire holding is disposed of in a single block on the date of determination. This is a limited departure from the principle established in paragraph 19(a) above. Losses The general principal is that all losses should be regarded as realised except to the extent that the law, accounting standards, or the guidance provides otherwise (para 17 of Tech 7/03). Accordingly, losses arriving from fair value accounting should be treated as realised losses, where profits on the remeasurement of the same financial asset/liability would be treated as realised profits in accordance with the guidance issued by the ICAEW/ICAS. A loss that represents the reversal of an unrealised profit will not reduce cumulative realised profits. Even if the loss is treated as a realised loss, for example because it represents an impairment, the previously unrealised profit will become realised.


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When cumulative net losses arise on an asset through fair value accounting, these will generally be realised. However, such losses on assets will be unrealised losses where both of the following apply: - profits on remeasurement of the same asset would be unrealised; and - the losses would not have been recorded had the asset been measured on the basis

of historical/amortised cost less impairment provisions. Similarly, cumulative fair value losses on a liability will be unrealised if both: - profits on the same liability would be unrealised, and - the losses would not have been recorded otherwise than on a fair value basis (e.g.

would not have been recorded either on an amortised cost basis under IAS 39 or as an onerous contract liability under IAS 37).

It is expected that situations where cumulative net losses on assets and liabilities measured at fair value do not give rise to a realised losses are likely to be relatively rare, but such unrealised losses might, for example, arise in a situation where a financial asset carried at fair value, is carried at a value less than historical/amortised cost less impairment provisions, because the diminution in the fair value of the asset is not considered to be permanent and hence is not reflected in the amount of the impairment provision. The Guidance makes it clear that all such cases should be considered on their merits, and where there is doubt, losses should be treated as realised. Hedge accounting The general principle contained within the Guidance (paragraph 33 of TECH 07/03) is that where hedge accounting is undertaken in accordance with relevant accounting standards (including IAS 39 and FRS 26, as well as existing UK GAAP) then it is necessary to consider the combined effect of both sides of the hedging relationship to determine whether there is a realised profit or loss. The application of this principle to different types of hedge accounting is described below. Fair value hedge accounting In the case of fair value hedges under IAS 39/FRS 26, the gross profits and losses on remeasuring the hedging instrument and the hedged item for the hedged risk are both recognised in profit or loss. In many instances both the profit on one and the loss on the other will be realised by reference to the readily convertible to cash and other criteria. In such cases, no special consideration of hedging aspects is required (including hedge effectiveness or ineffectiveness). In some cases, however, the profit on either the hedged item or the hedging instrument may, absent consideration of the hedging aspect, be unrealised (e.g. if a fair value movement is not readily convertible to cash). The following paragraphs explain how the general principle set out in respect of hedge accounting should be applied in circumstances where the profit is not realised. Where the hedge accounting relationship results in a net loss, this amount will generally be treated as a realised loss. For example, consider the situation where there is an unrealised profit on the hedged item of £90 and a realised loss on the hedging instrument of £100. The


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net loss of £10, which arises from hedge ineffectiveness, is recognised in the profit and loss account and is treated as a realised loss. Due to the hedge accounting relationship, the remaining £90 of the gross loss on the hedging instrument is not treated as a realised loss and is set off against the unrealised profit on the hedged item. Where there is a net profit, it will be necessary to consider whether that profit is a realised profit. This will depend on the relationship between the gross components. For example, if there is an unrealised profit of £100 and a realised loss of £90, only the net profit of £10 will be treated as unrealised. This approach applies irrespective of whether the profits or losses in question arise from changes in fair value of open contracts or from settled transactions. For example, the hedge accounting policy may designate a series of rolling derivatives as the hedging instrument, some of which have already been settled in cash, whereas there have been no past settlements in respect of the hedged item. Cash flow hedge accounting In the case of cash flow hedges under IAS 39/FRS26, the portion of the profit or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in equity through the statement of changes in equity/statement of recognised gains and losses. Such profits and losses are unrealised and become realised only when the hedged transaction affects profit or loss (or IAS 39 otherwise requires the gain or loss to be recycled through profit or loss). This is based on the principle, set out above, that it is necessary to have regard to the combined effect of both sides of the hedge accounting relationship to determine whether there is a realised profit or loss. To the extent that the profit or loss is recognised directly in equity (or, later on, added to the cost of a non-financial asset) in accordance with IAS 39, it must arise in connection with a valid hedge accounting relationship. It would therefore be inappropriate to consider this profit or loss in isolation from the hedged item. To the extent that any ineffective element of the profit or loss on the hedging instrument is recognised in profit or loss, that element should be assessed as to whether it is realised in accordance with normal principles (e.g. the “readily convertible to cash” test). The hedging principle above applies irrespective of whether the profits or losses in question arise from changes in fair value of open contracts or from settled transactions. The amounts taken direct to equity may, for example, include profits or losses on short-term derivative contracts that form part of a rolling-hedge strategy but which have matured. Such profits and losses should be treated as unrealised provided that IAS 39 requires them still to be deferred in equity as part of a cash flow hedge accounting relationship. Net investment hedge accounting Under IAS 39/FRS 26, net investment hedge accounting policies will generally arise only in the context of consolidated financial statements. Those financial statements are not relevant for the purposes of justifying distributions. However, it is possible that in some instances, in accordance with IAS 21(of FRS 23 the UK GAAP equivalent for companies subject to FRS 26), a branch may be treated as a foreign operation in the individual accounts of a company. In this case, net investment hedge accounting may be relevant to the individual accounts of a company. A net investment hedge under IAS 39 is accounted for similarly to a cash flow hedge.


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In such cases whether the hedged item (i.e. the branch assets and liabilities reflected in the company’s balance sheet) gives rise to realised profits needs to be determined by an analysis according to the nature of the assets and liabilities on which the translation difference arises and taking into account the changes in the composition of assets during the period. Amortised cost accounting Although differences exist in the methodologies required under IAS 39/FRS 26 and pre-existing UK GAAP, which applies to non FRS 26 adopters, in respect of the determination of amortised cost, which largely apply to the calculation of impairment provisions and the amortisation of premiums and discounts, it is not considered that these have an impact on realised profits and losses. Under both frameworks all impairment/bad debt provisions would be considered as representing realised losses and any amortisation of premiums and discounts would give rise to realised profits or losses. Issues arising from IAS 32 (and its equivalent FRS 25) Under both IFRS and UK GAAP, since the introduction of FRS 25, financial instruments are presented according to the substance of the contractual arrangement determined by the rules in IAS 32/FRS 25. This may differ from their legal form. Prior to 1 January 2005, under UK financial instruments, which met the statutory definition of share capital, were previously accounted for according to their legal form. As a general principle, it is still the legal form of share capital which is of relevance in considering what constitutes realised profits and losses and needs to be considered in relation to ensuring compliance with any legal requirements in respect of distributions. The accounting for certain capital instruments as debt under IAS 32/FRS 25, rather than on the basis of their legal form, creates a number of complications when considering the impact of such instruments on realised profits and restrictions on the distribution of realised profits. The latter is particularly the case for public companies which in addition to the general restriction applying to all companies “that a company’s profits available for distribution are limited to its cumulative realised profits, less its accumulated realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made” (Section 263(3) of the Companies Act 1985 or section 830 (2) of the Companies Act 2006), also have to comply with Section 264 of the Companies Act 1985 which states that a company may only make a distribution at any time: • if at that time the amount of its net assets is not less than the aggregate of its

called-up share capital and undistributable reserves; and

• if, and to the extent that, the distribution does not reduce the amount of those assets to less than that aggregate.

TECH 02/07 provided detailed guidance, and examples, as to issues arising from

IAS 32. Although the guidance is complex, it is largely driven by the following two main principles:

• Distributions or capital repayments on instruments which have the legal form of

share capital are not as a matter of law a loss, notwithstanding that they may be presented for accounting purposes as an interest charge, and consequently they


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should be considered as a distribution at the time that they actually occur rather than as a reduction of realised profits at the time the amount is booked (which may be earlier); and

• When public companies consider the net asset test of Section 264 of the

Companies Act 1985 (Section 831 of Companies Act 2006), it should be noted that each of net assets and share capital (and defined, undistributable reserves) is determined as presented in the accounts, which might for example show shares as a debt payable or show a commitment to buy-back shares as a debt payable.

The latter point can mean, for example, where there is a debit to equity arising from the advanced recognition of a future distribution or capital repayment in respect of equity shares, and the recognition of a corresponding financial liability (say a commitment to buy-back own shares), the application of the above principle restricts the amount of profits available for distribution by public companies in accordance with Section 264 of the Companies Act 1985 (Section 831 of Companies Act 2006). That is net assets are reduced but share capital (and defined, undistributable reserves) are not reduced (the debit to equity is not part of share capital and defined, undistributable reserves).


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5.3.6 Conclusions on detailed analysis for selected EU Member States The 2nd CLD contains the following rules in Article 15 for distributions: “1. (a) Except for cases of reductions of subscribed capital, no distribution to shareholders may be made when on the closing date of the last financial year the net assets as set out in the company's annual accounts are, or following such a distribution would become, lower than the amount of the subscribed capital plus those reserves which may not be distributed under the law or the statutes. (b) … (c) The amount of a distribution to shareholders may not exceed the amount of the profits at the end of the last financial year plus any profits brought forward and sums drawn from reserves available for this purpose, less any losses brought forward and sums placed to reserve in accordance with the law or the statutes. (d) The expression "distribution" used in subparagraphs (a) and (c) includes in particular the payment of dividends and of interest relating to shares. 2. … “ This current regime of distributions refers to the annual financial statements of companies. The rules for these financial statements are harmonised to a certain degree based on the 4th CLD. Furthermore, as described above, it is also possible under Regulation 1606/2002 for EU Member States to require or to permit that annual financial statements are prepared according to IFRS. The following discussions are based on the assumption that the current distribution arrangement in the European Union is maintained and that the distribution regime under Article 15 of the 2nd CLD has not been altered towards another system of determining distributable amounts, e.g. a solvency test. The above description of the situation in the different EU Member States can only be a “snapshot” of the current status concerning accounting rules and local law. Both, the IASB as well as national standard-setters and legislators continue to develop the accounting frameworks that companies are operating in. Therefore, any conclusions are just accurate as of the current date, and the situations may significantly change over time. The answers received show a diverse picture of how the companies have to determine profits according to national accounting frameworks as compared to IFRS. Furthermore, several approaches can be noted under which “realised” profits/losses are determined as the basis for dividend distributions. In Germany, for example, the profits determined under the German Commercial Code are regarded as “realised” and distributable. No distinction is made between accounting profits and distributable profits. On the other hand, there is much (at least theoretical) effort spent in the United Kingdom to distinguish accounting profits from realised profits. This is true for UK GAAP profits as well as for IFRS profits since UK companies are allowed to apply IFRS in their annual accounts. The discussion makes it evident that there is an issue in differentiating between accounting profits and distributable profits for distribution purposes. For example, when comparing the German accounting rules with the UK accounting approach, two different solutions to the same problem may be seen. In Germany, the prudence principle is seen as a dominating principle in accounting. Based on this principle, Germany conceptually tries to already eliminate “unrealised profits” at the level of the single financial statements. In the UK, the “elimination” of “unrealised profits” for distribution purposes is performed in a separate step after preparing the single financial statements. The determination


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of “realised profits” for distribution purposes is only one issue in determining distributable amounts. As, for example, described for Poland, some “reserves” may have to be set up to represent non-distributable amounts. However, these rules are not part of the accounting analysis. Other considerations may also have to be taken into account when distributable amounts are determined. For Sweden, the following applies: “The Companies Act contains a number of restrictions for dividend distributions. A company may only distribute unrestricted capital. A company is further restricted by the company’s capital requirements, which are based on an assessment of the kind and scope of business. The distribution is also restricted by the company’s liquidity, financial position and other aspects (“prudence rule”). A parent company is also restricted by the group’s capital requirements, the group’s liquidity, financial position, and other aspects.” These rules, generally, also go well beyond a simple consideration of accounting rules and are embedded in company law. Overall, in the current system in the 2nd CLD, the determination of distributable profits is based on accounting rules. A balancing element which allows for a cautious assessment of distributions is introduced into this determination at different levels. In Germany, prudence is introduced at the financial statement level by means of an emphasis on prudence in the basic accounting principles, i. e. the generally distributable accounting profits are determined on a prudent basis. In the United Kingdom, the realised profits are determined as another layer subsequent to the determination of accounting profits. In Sweden, additional considerations by management based on the economic viability of the company and on the related group of companies come into play after the determination of accounting profits. Therefore, different approaches toward a cautious determination of distributable amounts by management exist in some way. There is currently no harmonised approach to introduce an element of caution into the process. This is true for local accounting rules as well as for IFRS, where applicable. It can be seen from the descriptions above that the use of fair values in accounting may, at least, be one of the major points of discussion with respect to “realised profits”. Fair values were traditionally used in some jurisdictions just to determine the need for unscheduled write downs of assets and similar situations. This is simply a conservative way of using fair value. But in some countries it is possible or required to apply fair values in both directions and to recognise a gain on the re-measurement of balance sheet items. In practice a tendency towards fair value measurements can also be found within IFRS. The areas of study, for example, focus on some of the issues involving an increased use of fair values. For investment property, it is possible to measure property at fair value (according to IAS 40) and to recognise losses as well as gains in net profit for the period. In the area of financial instruments, many fair value measurements are required according to IAS 39. All derivative financial instruments as well as many non-derivative financial instruments are recorded at fair value. Gains and losses are recognised in profit or loss immediately or are to be recorded first in equity – as the case may be. With respect to pension accounting, no immediate fair value measurement is possible, but IAS 19 tries to include a wide variety of parameters for determining the defined benefit liability. It has to be mentioned that some of the so-called actuarial gains and losses are not to be recorded within profit or loss for the year. IFRSs as published by the International Accounting Standards Board are not designed for determining distributable profits. The primary focus of the IASB is to set up accounting standards that lead to financial statements that are useful to their users in making economic decisions. Consequently, the objective of the IASB is to gain information about the economic situation of a company. The Preface of the IFRS explicitly states: “IFRSs apply to all general purpose financial statements. Such financial statements are directed towards the common information needs of a wide range of users, for example, shareholders, creditors, employees


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and the public at large. The objective of financial statements is to provide information about the financial position, performance and cash flows of an entity that is useful to those users in making economic decisions.” Even though the Framework for the Preparation and Presentation of Financial Statements lists the determination of distributable profits and dividends as being one economic decision that is based on financial statements, this is not to be regarded as being the general purpose of financial statements and thus the IASB cannot focus on this specifically. Prudence or conservatism itself is not and cannot therefore be a virtue for the Board. With the recognition of gains on the measurement of assets or liabilities at fair value or the lack of immediate recognition of actuarial losses, it is evident that an element of caution and consequently the prevention of “unrealised losses” are at least not specifically set forth in IFRS at the individual financial statement level. Therefore, since IFRS can potentially form the basis for distributions in any EU Member State, a discussion similar to the UK may be indicated as to the way to deal with “unrealised” IFRS accounting profits in order to allow for a certain degree of harmonisation concerning the distribution regime throughout the European Union. Many accounting areas, which could be discussed from a realisation point of view, may not even impact the distributable amounts of certain companies. The impact of accounting rules on the accounting profits of companies depends on the individual facts and circumstances of that company. A general conclusion on the impact of accounting rules cannot be drawn. This has become evident through all of the detailed analyses above. In addition, fair value measurement does not always lead to the recognition of gains; losses may have to be recognised as well. That means that the impact on distributable amounts can finally only be determined in the context of a specific situation under consideration. Nevertheless, if the current distribution model of the 2nd CLD which is exclusively based on a balance sheet test is to be maintained, there needs to be a solution for significant differences between accounting profits under IFRS and the “realised” profits/losses for distribution purposes. It has to be borne in mind that the determination of the realisation of a profit or loss is a matter of judgement. There is no red thread in making that determination as the different solutions presented above evidence. Ultimately, a profit realisation can only be determined upon the termination and liquidation of a company. However, this over-conservative approach would seem to be inappropriate towards the interests of the shareholders. It should also be noted that Poland, for example, faces a situation that accounting rules for investment property and financial instruments are very similar to IFRS and that no modification of the profits has to be made for determining distributable amounts. This system is obviously operational as well. Possible remedies for potential differences between IFRS accounting profits and realised profits could be twofold. A first option is to maintain the current distribution model of the 2nd CLD and to determine realised profits/losses in the context of the IFRS accounting framework. The description of the UK approach makes it evident that distinguishing accounting profits from distributable profits may become in certain situations very complex. For the interview experience with UK companies please refer to section 4.1.5. A second option is to amend or completely change the current distribution model of the 2nd CLD, i.e. to introduce a solvency test which could at least form a corrective element to the balance sheet test or could lead to a situation where a distribution regime did not substantially rely on the IFRS accounting framework.


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6 Introduction of a new regime 6.1 Introduction As part of this study project, we have been specifically asked to explain concrete effects of the introduction of a new regime. This section is therefore intended to show the European Commission an array of options how the system of the 2nd CLD could be adjusted in order to introduce an alternative to the current regime of the 2nd CLD. The previous analysis of the existing models in five EU Member States and five non-EU jurisdictions has shown that the incremental burdens of company law for the companies in all jurisdictions are not overly burdensome and, thus, do not play a decisive role in determining whether an alternative system is needed. However, incremental burdens can be of high relevance when considering the implementation of certain measures in a jurisdiction. One specific example which has been discussed for the theoretical models proposed is the issue of the design of solvency tests. The introduction of IFRS as a potential basis for profit distribution poses a definite challenge for the European Union as a legislator and it can be questioned whether the 2nd CLD in its current format is sufficiently prepared for this challenge. The analysis conducted in this study whether IFRS can be used under the current capital and distribution regime only provides a snapshot of IFRS, as IFRS are still developing and this specifically in the direction of an increased use of fair value measurements. However, it is absolutely clear that the objectives under which the IFRS are developed are not intended to produce standards which mainly serve as a basis for a prudent distribution policy which aims at warranting the future viability of a company. It may therefore be argued that the use of IFRS, at least under the current distribution regime, must accommodate a higher degree of flexibility for companies to determine their level of dividends. Such flexibility could help companies to address specific situations in which a certain accounting framework like IFRS may deliver accounting profits that are not adequate in view of a cautious assessment of distributable profits. The focal point of the following analysis is therefore the question in which ways the current capital regime of the 2nd CLD can be transformed in order to achieve this flexibility for the companies. To this end, it is intended to show the different degrees of reform to the current 2nd CLD by structuring these into various dimensions. A discussion of these dimensions may help to develop a sensible approach to a possible alternative that will not be overly burdensome for companies. These dimensions are - amendments to the basic model of legal capital of the 2nd CLD - distributions from a group perspective - design of solvency tests - introduction of true “no-par value” shares


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6.2 Legal Capital 6.2.1 Amendments to the 2nd CLD’s basic model of legal capital 6.2.1.1 Overview With a view to allowing more flexibility to EU companies concerning possible effects of different accounting standards on their distribution possibilities, we have analysed in chapter 4 of this study report different existing and theoretical models that offer alternatives to the current capital regime of the 2nd CLD. The analysis covered four non-EU countries which have chosen different approaches to restricting excessive dividend payments and maintaining a company’s capital. Similar approaches can also be found in the four theoretical models presented by the High Level Group, the Rickford Group, the Lutter Group and the Dutch Group. Also these models show in differing degrees, how to transform the current 2nd CLD capital regime in order to allow for more flexibility. But also the actual practice in the five EU Member States shows certain possibilities to reform the 2nd CLD. We have grouped possible approaches into five main categories with specific regard to the degree of change to the 2nd CLD. The range of models starts with adjustments to the distribution model in Article 15 of the 2nd CLD and ends with a full scale reform of the 2nd CLD.


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The following table provides an overview of the five basic approaches to adjust the legal capital system which will be subsequently explained in more detail: Figure 6.2 – 1: Five Approaches for amendments to the basic model of the 2nd CLD

Model Main Features Legal changes Scope; time

Legal capital

Balance sheet test

Solvency test

1A – „Company option“

Companies decide on deviations from audited accounts; definition of “realised profit” [PLUS: solvency test]

Remains Deviation from GAAP allowed

Necessary Adaptation of distribution provision or interpretation of „realised profit“

Voluntary; 2 years

1B - „Regulator option“

Regulators decide on deviations from audited accounts; definition of “realised profit”

Remains Deviation from GAAP allowed

Not necessary

Adaptation of distribution provision or interpretation of „realised profit“

Companies using „regulated acc. treatments“; 5 years

2 – „IFRS solvency add-on“

Additional solvency test for IFRS individual accounts

Remains No deviation from GAAP allowed

Necessary for IFRS individual accounts

Adaptation of distribution provision; introduction solvency test and certificate; review by an auditor; sanctions

Individual IFRS accounts; 9 years

3 – „On equal terms“

Combination of solvency and balance sheet test; both have to be met

Abolished / solvency margin

No deviation from GAAP /solvency margin

Necessary Adaptation of distribution provision; introduction of two stage distribution test and certificate, possibly introduction of solvency margin; own shares, redemption of shares; sanctions; no-par value shares; raising capital; financial assistance; wrongful trading

All companies; 10 years

4 – „Solvency test pre-dominance“

Combination of solvency and balance sheet test; finally, only solvency test needs to be met

Abolished No deviation from GAAP; test is submerged

Necessary and pre-dominant

Adaptation of distribution provision; introduction of two stage distribution test and certificate; probably review by an auditor; own shares; redemption of shares; reduction of capital; sanctions; no-par value shares; raising capital; financial assistance; wrongful trading

All companies; 12 years

6.2.1.2 Model 1A- „Company option” Under the “Company option” approach, the companies could continue to use their balance sheets prepared under their national GAAP or IFRS. The board of directors could decide whether the balance sheet prepared under either accounting standard is adequate to present the basis for distribution. If deemed necessary, the board of directors would be entitled to adjust individual balance sheet items in order to determine the realised profits to be used for distributions. In order to protect shareholders and creditors, the company’s directors would need to be subject to a fiduciary duty to be established in company law in this regard. This fiduciary duty could also include an assessment whether the current and/or prospective cash flow situation of the company allows for the distribution.


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The question of whether the accounting standards currently used by the companies in the five EU Member States under consideration are sufficiently tailored to determine the level of distributions asked in a a CFO questionnaire sent to companies in the five EU countries listed on the main indices produced the following results: Figure 6.2 – 2: CFO survey results: accounting framework and profit distribution

Balance-sheet-oriented distributions test: "Are in your opinion the accounting standards applied by your company

sufficiently tailored to adequately determine the level of profit distributions?"

80%

19%

1%

Yes

No

NA

Source: CFO Questionnaire, September 2007 Our interviews conducted in Poland, where IFRS have already been introduced for individual accounts, have not pointed to specific problems with the use of IFRS for distributions. In general, however, specific problems with IFRS may specifically arise where companies heavily use fair value based standards. A similar approach is taken in the current practice of Delaware corporations in this regard. Even though not bound to specific accounting rules, Delaware corporations regularly refer to their audited consolidated accounts under US GAAP and would only deviate from these audited accounts in very few exceptional circumstances. One specific reason why deviations are not popular is potential liability exposure for directors. The companies we have interviewed did not make changes to their audited accounts to justify their distribution assessment. Furthermore, based on jurisprudence, the Delaware companies are obliged to perform a solvency test. As the solvency test is not bound to specific requirements, the companies mainly referred to current balance sheet ratios to justify their decision. However, depending on the specific circumstances of the company, the documentation for this purpose could have differed. Another European jurisdiction where a similar concept of fiduciary duty has been recently enacted is Sweden. Sweden has introduced, in its new Companies Act 2006, the concept of value transfer. With regard to distributions also, Swedish boards of directors must apply a “prudence rule” whereby they have to assess whether the dividend based on the balance sheet test is justifiable bearing in mind the type and size of the business and the risks involved.


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Necessary legal changes Two ways of adapting the 2nd CLD may be considered: As a first alternative (“legal solution”), the distribution provisions in Article 15 could be amended so that a fiduciary duty on the board of directors to prudently review the financial statements as to whether they can be used for distributions purposes is introduced. If deemed necessary, adjustments could be made to the results of the financial statements based on business judgment taking into account solvency aspects. The legislative process for such an amendment of the 2nd CLD takes at least two years. The introduction of a new fiduciary duty may also result in subsequent jurisprudence depending on the legal preciseness of the requirement. As a second alternative (“interpretation”), a reference to the UK experience, which has shown that from a practical point of view a distinction between accounting profits and realised profits may be a way forward, could be made. Based on this interpretation, companies could be offered the possibility to individually determine “realised profits”. To ensure that the directors act in the best interests of shareholders, a fiduciary duty must be foreseen, again with an obligation to take into account solvency aspects. Individual Member State laws may implicitly already provide a fiduciary duty for directors to act in this regard. If not, either the European or national legislator would need to introduce such a fiduciary duty. Impact on companies It would be up to the board of directors to act on this requirement. For a company with a good earnings and cash position, this requirement would not require a high effort, as compliance could be considered as a given. The experience with Delaware companies underpins this. In exceptional cases, especially with regard to a heavy reliance on IFRS fair value measurements, the additional burdens could become significant in individual cases. 6.2.1.3 Model 1B – “Regulator option” For the “regulator option”, it would be necessary that a central authority at EU or Member State level would introduce, for distribution purposes, mandatory adjustments for certain accounting treatments under IFRS. The centrally determined adjustments would need to identify IFRS accounting treatments which were considered as producing “unrealised profits/losses” for distribution purposes. The central authority at EU or Member State would need to ensure on a continuous basis that all relevant IFRS accounting treatments will be subject to mandatory adjustments. This approach is currently followed in the United Kingdom. For UK GAAP, the Institute of Chartered Accountants in England and Wales (ICAEW) and the Institute of Chartered Accountants in Scotland (ICAS) have issued various pieces of authoritative accounting guidance in relation to determining what profits are realised. Interviews with UK companies have shown that this practice can, in some cases, result in significant administrative burdens. Other UK companies are not affected as they do not use adjustable accounting practices or have a comfortable earnings/cash position. However, we have been made aware that the ICAEW itself would rather prefer to break the link between accounting profits and dividends. The argument for this opinion is the increasing use of fair values in modern accounting. Therefore, a fundamental reform of the 2nd CLD is


400

considered favourably by the ICAEW in order to reduce or remove the necessity of a central authority constantly updating the necessary adjustments. Necessary legal changes In his context, adaptation of distribution provisions in Article 15 which clarify that there needs to be a central authority either at EU or Member State level to determine adjustments to certain IFRS accounting treatments for distribution purposes, could be considered. The legislative process for such an amendment of the 2nd CLD takes at least two years. The implementation of the amended provisions of the 2nd CLD and the development of central guidance may, altogether, take up to three years.. Alternatively, current UK practice could be followed and the term „realised profit“ be interpreted in a way that such central guidance was necessary. Accordingly, it would be a matter of discussion between the EU and Member State level how such central guidance was organised. Impact on companies All companies using IFRS for individual accounts could be affected. For a company with no or very limited use of IFRS fair value measurements, this requirement would not require a high effort as compliance could be considered as a given. In exceptional cases, especially with regard to a heavy reliance on IFRS fair value measurements, the additional burdens could become significant in individual cases. The experience with UK companies interviewed underpins this and can be referred to concerning cost implications. 6.2.1.4 Model 2 – „IFRS solvency add-on“ Another approach for a limited amendment of the 2nd CLD is to maintain the 2nd CLD in its current format and to introduce an additional solvency test for IFRS individual accounts. This obligation does not generally concern other individual accounts prepared under national GAAP and the 4th CLD, respectively. However, based on our conclusion concerning the lack of harmonisation of the realisation principle of the 4th CLD, this could also be considered for companies reporting under the 4th CLD. The solvency test needs a formal certification by the board of directors. The management should be liable for the test. The certification could be reviewed by an auditor. Necessary legal changes For the introduction of the solvency test and the necessary certification by the board, Article 15 concerning the distribution provisions needs to be changed. The legislative process for such an amendment of the 2nd CLD takes at least two years. The implementation of the amended provisions of the 2nd CLD and the development of new jurisprudence may take up to seven years, altogether, however, depending on the design of the solvency test and the clarity of the newly established legal provisions. Impact on companies All companies using IFRS for individual accounts could be affected. The burdens associated with the approach are closely linked to the actual practice of performing the solvency test.


401

The requirements will result from the format of the solvency certificate. The intensity of this burden depends on how detailed the prescribed calculation methods are and how much they deviate from internal practices at the companies concerned. Accordingly, the way the calculation is conducted will heavily influence the workload associated with this test. 6.2.1.5 Model 3 – „On equal terms“ The “On equal terms” model requires a full scale reform of the 2nd CLD abolishing the current concept of legal capital. Under this approach, a two-stage distribution test consists of a balance sheet test and a solvency test which both have the same importance. Such an approach has been suggested by the High Level Group and the Dutch Group. Furthermore, a certain solvency margin could be introduced in order to reinforce the balance sheet test as proposed by the High Level Group. Both tests constitute substantive restrictions on distributions: company assets may only be distributed to shareholders if the distribution complies with both tests. Hence, in cases in which the balance sheet test indicates that the proposed distribution is not covered by net assets whereas, according to the solvency test, the company is solvent, a distribution may not take place. In cases in which the two-stage distribution test has been performed on the basis of accounts which have not been drawn up in accordance with generally accepted accounting methods and have not been audited, a distribution is prohibited if the audited accounts of the company indicate that the proposed distribution does not comply with the two-stage distribution test. A solvency margin would ensure that the assets, after the proposed distribution, exceed the liabilities by a certain margin and/or current assets, after the distribution, exceed current liabilities by a certain margin. The US State of California has the only solvency margin actually existing. This solvency margin only comes into play when the California incorporated company does not meet the first stage of the distribution test. Accordingly, we have not encountered any California company that had practical experience in applying the solvency margin. It is therefore important to consider how high such a solvency margin should be and how it should be exactly calculated. A high solvency margin may impede potential distributions and cause additional incremental efforts for the companies concerned to mobilise sufficient profits and cash from subsidiaries to allow for distributions. To this extent, the actual impact of solvency margins on companies is not clear. The board of directors is responsible for performing the two-stage distribution test. The board members are required, on the basis of the tests, to issue a solvency certificate in which they explicitly confirm that the proposed distribution meets the two-stage distribution test. Necessary legal changes This approach requires a full scale reform of the 2nd CLD. The central part is the two-stage distribution test which serves as a means to determine the maximum amount available for distributions to shareholders and a solvency certificate for which the board is responsible. This test is required for dividend payments and other forms of distributions to shareholders, including share buy-backs and – if the concept of a reserve for share capital which is not distributable is retained - capital reductions. As a consequence, the substantive restrictions on dividend payments (Art. 15), share buy-backs (Art. 19), redemption of shares (Art. 39) and possibly reductions in capital (Art. 32) will be repealed. Furthermore, the prohibition on the issue of true no-par value shares (Art. 8 (1)) should be abandoned and a comprehensive


402

system of sanctions with respect to the board members responsible for the solvency certificate should be introduced. In addition, the introduction of a solvency margin is discussed. Furthermore, the High Level Group recommends, for example, that the provisions concerning the raising of capital (Art. 7, 10), be repealed and that an alternative regime on financial assistance (Art. 23) and a European framework on wrongful trading, be introduced. Beyond this, the High Level Group proposes that the minimum capital requirement (Art. 6) as well as the pre-emption rights (Art. 29) be retained. The legislative process for such an amendment of the 2nd CLD takes at least two years. The implementation of the amended provisions of the 2nd CLD and the development of new jurisprudence may take up to eight years or longer, as it is a full scale reform. Impact on companies All EU companies falling under the 2nd CLD would be concerned. Again, the burdens associated with this approach for the companies are closely linked to the actual practice of performing the solvency test. The requirements will result from the format of the solvency certificate. The intensity of this burden depends on how detailed the prescribed calculation methods are and how much they deviate from internal practices at the companies concerned. Accordingly, how the calculation is conducted will heavily influence the workload associated with this test. 6.2.1.6 Model 4 – „Solvency test predominance“ The “Solvency test predominance” approach constitutes the most far reaching reform of the current 2nd CLD model. The Rickford Group proposes this approach. However, we have not encountered a similar approach in any of the existing jurisdictions under consideration. In this scenario, a two-stage distribution test serves as a means of determining the maximum amount available for distribution. It also applies to all forms of distributions to shareholders, that is dividends, share buy-backs and distributions as part of a capital reduction. The two-stage distribution test consists of a solvency test and a complementing balance sheet test. Company assets may be distributed provided that a distribution complies with the solvency test. The balance sheet test does not, by contrast, constitute a substantive restriction on distributions but prescribes additional disclosure and specification requirements. If, according to the balance sheet test, the distribution is not covered by net assets, the management board may still make a distribution provided it states the reasons why it is of the opinion that a distribution is nevertheless justified. The management board is required to provide and publish a solvency certificate in which it declares that in its assessment, after an enquiry into the affairs and the prospects of the company proper for the purpose, the distribution complies with the requirements. A mandatory auditor’s certificate is not required. Necessary legal changes This approach requires a full scale reform of the 2nd CLD. The central part is the two-stage distribution test which serves as a means to determine the maximum amount available for distributions to shareholders (the balance sheet net assets test does not constitute a substantive restriction on distributions) and a solvency certificate for which the board is responsible and which could be reviewed by an auditor. This test is required for dividend payments and other forms of distributions to shareholders, including share buy-backs and, if still applicable,


403

capital reductions. As a consequence, the substantive restrictions on dividend payments (Art. 15), share buy-backs (Art. 19) and reductions in capital (Art. 32) will be repealed. Furthermore, the subscribed capital, the mandatory reserves and the prohibition on the issue of true no-par value shares (Art. 8 (1)) should be abandoned and a comprehensive system of sanctions with respect to the board members who are responsible for the solvency certificate should be introduced. Furthermore, the Rickford Group recommends several further amendments. It recommends, for example, that the provisions dealing with the raising of capital (Art. 7, 10) and the financial assistance (Art. 23), be repealed. In addition, a European framework on wrongful trading is recommended, and the retention of the resolutions of the general meeting on share buy backs, share issues and the exclusion of pre-emption rights, is proposed. The legislative process for such an amendment of the 2nd CLD takes at least two years. The implementation of the amended provisions of the 2nd CLD and the development of new jurisprudence may take up to ten years or longer, as it is a full scale reform and the jurisprudence with the inclusion of the predominance of the solvency test may take longer to develop as the distribution concept is fundamentally changed. Impact on companies All EU companies falling under the 2nd CLD would be concerned. Again, the burdens associated with the approach for the companies are closely linked to the actual practice of performing the solvency test. The requirements will result from the format of the solvency certificate. The intensity of this burden depends on how detailed the prescribed calculation methods are and how much they deviate from internal practices at the companies concerned. Accordingly, how the calculation is conducted will heavily influence the workload associated with this test.


404

6.2.2 Capital maintenance in groups of companies 6.2.2.1 Overview One interesting result of the interviews conducted with companies in the EU and outside the EU is the fact that companies mainly referred to their consolidated accounts as a starting point for the determination of dividends. Necessary cash flow considerations have also been conducted at group level, i.e. decisions are taken from a group perspective, not the individual legal entity. Subsequent to these assessments, dividend levels are subject to a “political decision” by the company’s management with a view to its share price. This includes aspects such as dividend continuity or giving certain signals to the capital market. The results of a CFO questionnaire sent to the companies listed in the main stock exchange indices of the five EU Member States reconfirm these experiences: Figure 6.2 – 3: CFO survey results: Determinants for dividend distributions by holding companies

1

2

3

4

5

Impo

rtan

ce

F rance Germany Poland Swed en U K EUA verage



Financial performance (individual accounts ofthe parent company)Dividend continuity

Signalling device


Tax rules

Source: CFO Questionnaire, September 2007 Due to the fact that individual legal entities are decisive for aspects like dividend payments or taxation, companies have to take further measures. To bring the parent company’s financial situation in line with the group perspective, the companies interviewed in nearly all cases steer the profits and cash flow situation of the parent company. This is mostly done in a structured planning process over several years, mainly to achieve tax optimisation for intra-group distributions. Some UK companies, in particular, have pointed to high expenditures in this regard. A potential reappraisal may therefore give regard to the consolidated view applied in the determination of distributable profits.


405

To this end, the following three alternatives may be considered: Figure 6.2 - 4: Three approaches concerning dividend distributions in groups of companies

Model Action Comment Legal changes

1 – „Do nothing“ None Single legal entities are decisive.

No change

2 – „Add-on“ Creation of additional element

Current approach of single legal entity complemented by group dimension.

Additional elements in the distribution process.

3 – „Pure consolidated view“

Fundamental change of approach

Radical change to consolidated figures for the whole group.

Fundamental legal reform; not only company law but also insolvency and tax law.

6.2.2.2 Model 1 – “Do nothing” As already mentioned, under the current 2nd CLD, profit distribution and capital maintenance are conducted from a single legal entity perspective. The legal framework in which this happens is consistent, as responsibilities in other regards (e.g. insolvency legislation or tax law) are also mainly directed towards this single legal entity. It could therefore be argued from a legal point of view that further reflections concerning a group relationship are not as such necessary. 6.2.2.3 Model 2 – “Add-on” To reflect the economic reality, the group situation may be taken into account in a way to additionally test the economic situation of a group when making a dividend distribution decision. The current testing model based on the individual accounts could be extended by an additional formal test of the consolidated accounts A specific example where the consolidated view is already taken up in such a way is Sweden. Sweden has integrated this in its current legislation. For groups of companies, the distributable amount for dividend payment is determined as the lesser of distributable amounts available at the parent company’s level or the distributable amount of the group accounts. Moreover, the group view seems to be embedded in the “prudence rule” for the board of directors when assessing the financial position of the company, especially in view of cash flows. Furthermore, a similar suggestion to take the group view into account has come from individual members of the Lutter Group, Pellens/Sellhorn132. 6.2.2.4 Model 3 – “Pure consolidated view” The most daring approach is the transition of the distribution scheme from the perspective of the individual legal entity to the group perspective. However, this approach would neglect the 132 Cf. Pellens/Sellhorn, in: Lutter (Ed.), Legal capital in Europe, ECFR Special Volume 1, p. 364-393.


406

individual legal entity in its existence and would rather protect the company solely from a group perspective. For this reason, a legal solution that would only focus on profit distribution is not sufficient to solve the remaining legal problems caused by the fact that it is the single legal entity which is subject to legal requirements, not the group. Significant examples are the question of insolvency law and group taxation and the issue of the limitation of the liability to a single legal entity. Both issues need to be resolved before a comprehensive group view could be taken on the issues of profit distribution and capital maintenance. Another significant barrier may come into play for all groups operating outside the European Union. Even if a harmonised solution is found for the European Union, a lack of convergence with other non-EU jurisdictions may prevent an effective approach to a group view. One specific jurisdiction where the group perspective is used in legislation is the US State of California. However, the requirements only refer to the use of group financial statements and group’s cash flows which is an expression of how the consolidated accounts of the group are perceived – as the financial statements of the parent company. The individual financial statements are only relevant at subsidiary level. Even though the group perspective is used with regard to the assessment of the financial position of the parent company, the California legislation does not basically change the legal obligations for directors as they are still directed towards the single legal entity.


407

6.2.3 Design of the solvency test 6.2.3.1 Overview One essential element of alternative capital regimes already used in other non-EU jurisdictions as well as in the theoretical models are so called “solvency tests” that aim at ensuring the liquidity of companies after a dividend distribution. Solvency tests may also be employed in other situations where company assets are transferred, e.g. repurchase of shares, capital reductions. Experience from our interviews conducted in EU and non-EU jurisdictions showed that cash flow considerations play a decisive role. It is a matter of diligent behaviour of the company’s management to assess, with the help of the corporate treasury function, whether dividends can actually be paid from the current cash flows of the company/group. Furthermore, longer term cash flow prognosis may be needed if certain levels of dividends should be paid on a sustainable basis; mostly, a cut in dividends is considered a bad signal to capital markets. A typical internal monitoring effort in the corporate treasury regularly shows the following pattern: detailed cash flow forecasting is performed for a period of at least one year; this is followed by a mid-term cash flow planning spanning 3 years, at maximum 5 years. The mid-term period is already less detailed and the basis for the prognosis is considered to be less reliable due to uncertainties concerning the actual development of the business of a company. In some cases, cash flow planning is conducted even over longer periods, of up to ten years. Whether such planning makes sense depends on the nature of the business and whether this allows for a reliable projection of cash flow and revenue/expense streams. Concerning the question whether companies in the five EU Member States see the use of solvency tests as an effective means to determine their ability to pay dividends, the CFO questionnaire sent to listed companies on the main stock indices in the five EU Member States delivered the following results: Figure 6.2 – 5: CFO survey results: use of liquidity tests

0%10%20%30%40%50%60%70%80%90%

100%

Perc

enta

ge

F rance Germany Po land Sweden U K EU A verag e

Liquidity-oriented/solvency tests: "Is the ability to pay dividends better determined via liquidity tests that take into account projected future cash

flows?"

Yes NoNA

Source: CFO questionnaire, September 2007 Except for Germany, there is always at least a slight majority of CFOs of listed companies who believe that a solvency test is better positioned to determine the level of dividends. A solvency test in this sense refers to projected future cash flows.


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From a legal point of view, the requirements regarding a solvency tests are to be set out in law. This can be done in a more or less precise manner. A starting point could be the wording of a solvency certificate to be signed by the company’s management. In the course of our interviews, we found in New Zealand a framework in which the companies set up their own wording. In Canada, solvency certificates are subject to provincial laws which could differ in detail but cause companies concerned to seek interpretation of the exact meaning of legal terms. In essence, experience has shown that the clearer the legal terminology, the more there is legal certainty for companies concerned which have to prepare the relevant documentation. On the other hand, business judgement in the interpretation may help to find workable solutions to find an adequate cost benefit ratio for legal compliance. For example in Canada, the lack of clearness of certain legal terms allows the documentation already prepared for the purpose of bank covenants to be used in one case. To this end, the following basic options may be used to determine an adequate design of such solvency tests: Figure 6.2 – 6: Four approaches concerning the design of solvency tests

Model Method Predictability Burden

1 – „Leave it to the companies“

No intervention (best practice)

Depends on model chosen by company

Depends on model chosen by company

2 – „Current ratios“

Liquidity assessment based on current balance sheet ratios

No projection required; „certain“

Rather insignificant

3 – „Short-term projection“

Cash flow projection for one year (plus known future payments)

Medium level of certainty Depends on deviation from current practice

4 – „Mid-term projection“

Cash flow projection from two to five years (plus known future payments)

High level of uncertainty Depends on deviation from current practice

6.2.3.2 Model 1 – “Leave it to the companies” Under a “Leave it to the companies” approach, the legislator could introduce a specific fiduciary duty of the management board to ensure that the company justifies the distribution from a cash flow perspective without exactly prescribing the contents of such a liquidity test. Such a fiduciary duty could be required via a solvency certificate which sets out the exact requirements of the test. In such a situation, a company could decide which instruments it intends to use to document its decision in this regard. Experiences from the interviews have shown that companies can flexibly adapt their documentation. For the Delaware companies interviewed, the documentation referred to current balance sheet ratios as the companies obviously had sufficient cash at hand to make distributions. In New Zealand, the companies individually prepared their wording of a solvency test. In Canada, one company, for the solvency certificate prescribed by provincial law, used the documentation already prepared for the bank covenants. In this way, the incremental efforts of these companies were minimised and could be adapted to their individual financial situation.


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6.2.3.3 Model 2 – “Current ratios” The “current ratio” approach refers to the current situation of a company which could be determined by a comparison of current assets to current liabilities based on the audited financial statements of a company. This is also foreseen by the High Level Group proposal. Such an approach could be easily complied with and convey a high level of legal certainty to those who were charged with performing the test. However, such an approach would neither look into the short-term nor medium to long-term future. Therefore, substantial known future developments could be intentionally ignored. 6.2.3.4 Model 3 – “Short-term projection” An approach where a short term projection would be the basis of the solvency test is another alternative. A short term projection would cover the next 12 months of a company’s life and could be attested via a solvency certificate. The Rickford Group proposes such a design for the next year; the Lutter Group for the next one to two year period. This corresponds to the actual practice of companies where the most detailed and reliable projection takes place for the next financial year. This is our experience from the interviews with companies inside and outside the EU. However, it depends on the exact format prescribed whether such a requirement would require a substantial effort by the companies concerned to comply with the requirement. The closer the required format to the actual company practice, the easier the compliance. However, such a prognosis always requires a subjective assessment by those who are charged with the preparation and the format of the certificate would need to take this uncertainty into account. In the case of a one year projection, the projection is more certain than over a longer projection period. Another important element of such an approach would be the inclusion of long term commitments already foreseeable at the time of the preparation of the projection. This element ensures that known future developments are not ignored. Such an element can also be found in the proposals of the Rickford and Lutter Groups. 6.2.3.5 Model 4 – “Mid-term projection” A “Mid-term projection” would cover the next three to five years of a company’s life and could also be attested via a solvency certificate. From our experience with the companies interviewed inside and outside the EU, the length of the projection period stretches to the boundaries of the companies’ practices and ability to project cash flows in most cases. Again, it depends on the exact format prescribed whether such a requirement would require substantial effort by the companies concerned to comply with the requirement. The closer the required format to the actual company practice, the easier the compliance. Especially in this case, the prognosis requires a subjective assessment by those who are charged with the preparation and the format of the certificate would need to take this uncertainty into account. In the case of a mid term projection the degree of subjectivity is very high and less reliable than a short term projection over one year. Another important element of such an approach would be the inclusion of long term commitments already foreseeable at the time of the preparation of the projection. This element ensures that known future developments are not ignored. Such an element can also be found in the proposals of the Rickford and Lutter Groups.


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6.3 True no-par value shares The question of whether and to what extent the introduction of shares without any reference to either nominal or fractional value would constitute a significant change in the system of the 2nd CLD is examined below. 6.3.1 Introduction The 2nd CLD at present recognises only par value shares and shares with an accountable par ("pseudo no-par value shares"). While the 2nd CLD does not expressly provide for the admission of no-par value shares, it can be concluded from an overall view of various provisions of the 2nd CLD that true no-par value shares conflict with the current concept of the 2nd CLD, because all shares are linked back to the subscribed capital. While the 2nd CLD in Art. 3 c admits the subscription of shares without stating the nominal value, it also prescribes that companies must have subscribed capital (Art. 2 c) and also uses at various places (for example in the description of the minimum issue price in Art. 8 ss. 1 and the minimum contribution for shares in Art. 9 ss. 1) the term accountable par which corresponds to the nominal value, meaning the amount of the subscribed capital attributable to each single share. Par value shares are characterised by direct reference of the shares to the subscribed capital of the company. Each share is stated to represent an amount in Euro, the sum of which makes up the entire subscribed capital. In the case of pseudo no-par value shares, a mathematical amount of the subscribed capital can be attributed to each share by way of division. Because the subscribed capital is protected against distributions, it remains in place so that the par value can also remain. Changes to these items are possible only by formal procedures, for example by capital increases, in which additional income leads to an increase in subscribed capital, the increased amount being again divided into nominal value. In the case of true no-par value shares, this reference to the subscribed capital is absent. The systems in which they exist, do not provide for any subscribed capital or there is no connection between subscribed capital and number of shares issued. The question of no-par value shares therefore is always connected to the question how the proceeds from a share issue are handled if not included in the subscribed capital. In this connection reference is to be made to the fact that the par value has nothing to do with the real value of the shares. Accordingly, the question of the introduction of true no-par value shares depends on how the basic set-up of the capital regime in which the no-par value shares are to be included, is designed in detail. It must be distinguished between models in which the current capital regime differentiating between subscribed capital and premiums is replaced by a similar system which abolishes this distinction, and such models which either partially or wholly reject the association of the capital or the proceeds from the issues of the shares.133

133 cf. special edition of the European Company and Financial Law Review (2006) „Legal Capital in Europe“ recently published by Marcus Lutter.


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6.3.2 Concepts for the introduction of true no-par value shares As has already been stated, there is no definitive overall system for the introduction of true no-par value shares, but a number of models come under consideration. They are distinguished initially mostly according to the extent the proceeds from the issue of the shares are protected against distribution. The lesser the protection in this context the greater the need for adjustment in relation to the provisions of the 2nd CLD, which relate precisely to the protection of these proceeds and, based thereon, pursue the nominal capital concept. As to be shown in detail, various models can be considered. Model 1 maintains as far as possible the provisions of the 2nd CLD and places all proceeds from the issue of shares under protection similar to that applicable to subscribed capital. Model 2 assumes variable capital. According to Model 3, the proceeds from the share issue are used initially to make up the amount of subscribed capital and then reserves, so that there is a mixture of uses involved. Models 4 and 5 protect the proceeds of the share issue not by the prevention of distributions but by admitting its distribution under certain conditions, namely a balance sheet and/or solvency test or solvency margins. 6.3.2.1 Model 1: Protection of all proceeds from share issues True no-par value shares can firstly be introduced without repealing the existing provisions on capital contributions and capital maintenance by introducing instruments comparable to those of the subscribed capital system. A specific working group on European Company Law also headed by the German Professor Lutter supports the view in this respect that, with the introduction of true no-par value shares, the concept of legal capital need not necessarily be given up but its implementation can be ensured in a different technical manner.134 A similar model is also investigated by Böckli135 and discussed by Rickford.136 The details of such a system might be as follows: Replacement of subscribed capital by equity capital In this model137 “subscribed capital”, the fixed nominal capital (subscribed capital) is given-up. An “equity capital” position remains on the balance sheet, but is no longer divided between subscribed capital and premiums but contains a statement that the company has achieved certain proceeds.138 A uniform balance sheet item in “equity capital” therefore arises as “contributed capital” which is made up of the total of capital contributions received i.e. the present subscribed capital and the premium, and serves as a reference dimension. In this model, access to the subscribed capital by distributions is replaced by a prohibition against repayment of contributions as they are stated in the balance sheet.139 In this connection it is to be seen that EU law contains no prohibition on the distribution of premiums but of subscribed capital in the 4th CLD, that the premiums are to be entered as equity capital with the further consequence that the premiums in various jurisdictions – unlike, for example in the UK - are subject to a less restrictive bond than the subscribed capital. For example, premiums in Germany and Poland where they ought to be shown as 134 copied in ZIP (2002), pp. 1310, 1317. 135 Böckli in Festschrift Druey (2002), pp. 331, 341 et seq. 136 Rickford, Reforming capital , 15 EBLR (2004), p. 930. 137 cf. opinion of the European Company Law working group of March 2003 on the final report of the High Level Group, ZIP (2003), pp. 863, 872. 138 Böckli in Festschrift Druey (2002), pp. 331, 341 et seq. 139 cf. also Weiß, Aktionärs- und Gläubigerschutz im System der echten nennwertlosen (Stück-)Aktie, Diss. 2007, pp. 186 et seq. in connection with the English proposal.


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capital reserves can be used under certain conditions to make up annual losses or losses carried or for conversion into subscribed capital. They are usually bound for the protection of present and future shareholders against agiotage. On the contrary, they can, in France and Sweden, be distributed to shareholders140. If now however the entire contribution capital (contributions plus premiums) are bound, this possibility is lost because the entire amounts contributed are bound. This model therefore results in improved protection for creditors by binding the assets more strictly. On the other hand, it should be noted that the interest of the shareholders in profit is affected by this change. It is – as already stated above - admissible for example in Germany and Poland that premiums be used to cover losses and the reserves subsequently gradually rebuilt, with corresponding influence on the distribution of profit. If premiums were bound under the new item “equity capital”, this possibility would be lost. This applies all the more for France and Sweden where premiums are not protected and can be distributed. The introduction of a uniform "equity capital" would, in the states without full premium protection, therefore lead to a more strict block on distributions and ultimately to less capacity for distributing profits. No-par value shares In this model, it is proposed to introduce true no-par value shares representing a quota of the company’s equity. The share issue price should be fixed by the board according to its fair value, possibly by reference to the quotation of the share price on a stock exchange.141 Consequently, the shareholder no longer pays in the nominal value and the premium separately, but a single specified issue price for the share which is to be entered under the protected item “equity capital”. In this case a connection between the protected item “contributed capital” and the proceeds from the share issue remains, because both are to be entered completely as equity capital. Abolition of below-par issues The prohibition of below-par issues (non discount rule, Art. 8) would no longer arise because of the no-par value shares but rather the issue price would be specified by the general meeting or in the case of authorised capital by the board or management board and supervisory board according to the true value (relying on the stock exchange price, as the case may be). This has advantages in particular if a reconstruction is concerned. A company in need of restructuring, the stock exchange or market value of which is below-par (stock exchange price or market value is lower than the nominal value of the subscribed capital), must issue new shares at their nominal value if the prohibition on below-par issues applies. The financing and therefore the restructuring can in this case therefore be more difficult, because shares would have to be acquired for a price higher than their value. By the issue of the no-par value shares, this problem would be excluded from the outset. It is to be noted however, that there is a process to some extent in the Member States that the prohibition on below-par issues is counteracted by a capital reduction with subsequent capital increase being conducted. In Germany for example it is admissible that capital in this case (other cases are excluded) is reduced to zero in order then to be increased to a reasonable amount. 140 details regulated in German law by § 150 Stock Corporation Act. 141 Böckli in Festschrift Druey (2002), pp. 331, 347.


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Bonus shares It is also pointed out that with the abolition of the direct link between the number of shares and the subscribed capital, further capital measures which are linked to the division of the subscribed capital into shares could also disappear while participation in the company would be specified by the true value of the company. As an example, the issue of bonus shares as a price correction is quoted. Bonus shares are shares from a capital increase from company funds which – expressed briefly – can be described as a transfer in the books from reserves to equity capital. Shares from a capital increase out of company funds142 are issued to existing shareholders without the contribution of fresh capital so that the price of the shares is reduced because of the higher number of shares resulting from the capital increase. Such a bonus issue can be significant if the shares are traded at a high price. It is, however, seen in practice that a price correction can also be carried out by share splitting (division of one share into several shares). In case shares with an accountable par are used, no change to the par value is needed. Share splitting It is also argued that the no-par value shares could resolve the problem that a par value share issued at the minimum amount can no longer be split. This absence of splitting is seen as a disadvantage if the price of the par value share has risen so strongly that at least small shareholders refrain from purchasing such “heavy” shares.143 However, such minimum nominal amounts do not arise from the 2nd CLD but from national law – if this problem is at all today of practical relevance. In Germany, which has such a minimum nominal amount, this problem has been resolved with the introduction of the statutory minimum par value of one Euro. Simpler management It is also pointed out that in the case of true no-par value shares, the number of shares can be changed without changing the par value of each shareholder by a greater number of new shares (share splitting, cf. above) taking the place of a smaller number of shares (merger of shares). Technically, therefore, this provides a simplification of procedure because no change to the par value is needed. However, it should be pointed out that this advantage can be achieved even today with shares with an accountable par. Capital increases and reductions If new shares are issued, the replacement of subscribed capital by equity capital can remain in this model in the case of a capital increase (Art. 25), because the item “equity capital” is necessarily increased in a new issue of shares by the resulting proceeds. It could therefore be considered that conceptually, reference be made to an increase in the number of shares. No material change would, however, balance this because, in this model, with the issue of new shares and the inflow of the proceeds, equity capital must also be increased so that the terms “equity increase” or “equity capital increase” could remain. Furthermore, in this model, the pre-emption rights (Art. 29) and the capital reduction process (Art. 30) can remain because a protected equity capital exists which can be reduced. 142 with respect to the comparable problem of capital reductions cf. Münchener Kommentar-AktG/Heider, 8 marg. note 103. 143 Münchener Kommentar-AktG/Heider, 8 marg. note 34.


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Other provisions which refer to capital In the context of this model, the other provisions which are characterised by the reference to capital can, in principle, remain, because another protected item – contributed capital – would exist. This applies, for example, to the publication of equity capital, the minimum contribution, the contribution regulations, subsequent formation, the obligation to call a general meeting in the case of serious loss of capital, the acquisition by the company of its own shares, capital increases and reductions (see below) and distributions. The situation is different in the case of some regulations which refer to subscribed capital as reference for certain rights and obligations (e.g. dependent on a certain percentage of subscribed capital) both in relation to the provisions of the 2nd CLD (see below) and also under national law (see below). Subsequent adjustment due to change of the reference With the change of system dealt with, here from subscribed capital to equity capital, various consequent changes must be made. These changes refer to cases in which a certain proportion of subscribed capital or the subscribed capital as such is used as reference, because as already stated, equity capital would, after the change in system, be greater than the previous subscribed capital because of the addition of the former nominal values and premiums. In this respect, distinction is firstly to be made between the situations in which the 2nd CLD refers to a single percentage of subscribed capital and those in which it refers to subscribed capital as a whole and this leads to further consequences such as a barrier to distributions in the case of dividends. Reference to a certain proportion of the subscribed capital. If the 2nd CLD refers to a single percentage of subscribed capital, the question of whether an adjustment of this percentage to the new item of equity capital is necessary or instead the number of shares is to be relied on, arises, and, in this respect, distinction between European law and national law has to be made. Adjustment of the percentage in equity capital European Law Capital contribution In the case of capital contribution, it is questionable to what extent the existing provisions of the Directive according to which, in the case of cash contributions, 25% of the nominal value at the time of formation and the premium in full must be paid-up (Artt. 9, 26), needs to be amended. Because of the addition of the par value and premiums necessitated by the system change from subscribed capital to equity capital, payment of the total issue price will sometimes be required144. A compromise solution (e.g. 50% or 75% of the total amount) or retention of the existing amount could be considered. 144 This has been repeatedly suggested by the English Company Law Reform Steering Group cf. Modern Company Law – For a Competitive Economy – Company Formation and Capital Maintenance – A Consultation Document (URN 99/1145), October 1999, p. 31, 3.19.


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Subsequent formation In the case of subsequent formation (Art. 11), the extent to which the acquisition of an asset in return for 1/10th of the subscribed capital should be relied on for the application of the subsequent formation provision, is to be examined. In the case of a system change, the threshold would be higher than under the present law. Repurchase of shares In relation to the repurchase by the company of its own shares, the extent to which Art. 19 (1) c) of the 2nd CLD, according to which the par value or accountable part of the shares acquired may not be more than 10% of the subscribed amount, should be amended, has to be clarified (cf. Directive 2006/68/EC of 6 September 2006, which allows Member States to delete the current rule of the 2nd CLD that allows an acquisition of a company’s own shares only up to a proportion of 10% of the subscribed capital). Alarm function The 2nd CLD provides (Art. 17) that the EU Member States may not set the amount which is to be specified as a serious loss of subscribed capital at more than half. In the models examined, this provision could be retained. However, since the equity capital would include the entire proceeds (including premiums) and would therefore be greater than the capital subscribed so far, the question of adjusting this reference dimension arises. Maintaining the present dimension, would increase shareholder and creditor protection. Consequent amendments in national law In a change of system from “subscribed capital” to “equity capital”, the effects on national law and the associated consequent likely comprehensive amendments would also have to be considered. The various national laws rely at present in various areas on a specific proportion of subscribed capital. In Germany, this relates to the right to require that a general meeting be called or to have certain items placed on the agenda of a general meeting, the making of compensation claims of the company against members of the management and/or supervisory boards, the waiver of claims of the company against those and certain other persons, the rules of procedure for the general meeting, approval of amendments to the statutes and capital measures and inter-company agreements, the exclusion of pre-emption rights, the continuation of the company, terminations, various special resolutions and objections, integration, exclusion and transformation processes. Amendment of the percentage by calculation in number of shares As mentioned at the outset, there is also the possibility, instead of the reference figure which relies on a percentage amount of the protected proceeds from the share issue, to invoke the number of shares as reference.145

145 So Böckli in Festschrift Druey (2002), p. 331 (341, 343).


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Subscribed capital as barrier In this context, cases in which the entire subscribed capital item results in certain further consequences, in particular as a barrier to distributions, are also to be seen. Distributions The provisions of Art. 15 of the 2nd CLD, according to which distributions may only take place if the net assets exceed the subscribed capital plus the reserves, the distribution of which is forbidden by law or the statutes, are significant. As already shown a stronger barrier to distributions would be created in many Member States by the combination of subscribed capital and premiums, and this would lead to a reduction in dividends. The extent to which reliance on the equity capital as a barrier to distributions is justified, or whether it would lead to a considerable reduction in distributions, must be examined. Repurchase of shares, financial assistance The same questions arise in the case of the repurchase by the company of its own shares, in that under the existing provision of Art. 19, 1 of the 2nd CLD, the repurchase of shares may not lead to the net assets being impinged (cf. the amended provision of Directive 2006/68 EC of 6 September 2006, which also relies on the net assets). The combination of capital and premium could lead to less assets as hitherto under the 2nd CLD remaining for the repurchase of the company’s own shares. The same considerations apply to the new regulation of financial assistance in Directive 2006/68 EC of 6 September 2006, which relies, inter alia, on the financial assistance not impinging on the net assets. Editorial amendments The introduction of such a protected item "equity capital" would lead to changes in the 2nd CLD to the effect that the term "subscribed capital" would have to be replaced in various places by “equity capital”. The following provisions, in particular, would have to be so amended: in the recitals, “capital” would have to be replaced by “equity capital” (so that “equity

capital increase” would replace “capital increase”) and the “composition of the company’s capital” would become “the amount of equity capital”, in Art. 2 c), the amount of equity capital must replace the amount of subscribed

capital, in Art. 6 a minimum equity capital or an equity capital fixed by the statutes146 would

be necessary, in Art. 7 the contributed capital may consist only of assets the monetary value of

which is ascertainable, in Art. 15 ss. 1 as the central distribution provision, the uniform "contributed capital"

must replace "the amount of subscribed capital plus reserves"; the other sub-sections must also be reformulated accordingly, all other provisions dealing with „subscribed capital“ (cf. Arts.11, 17, 19, 20, 23, 25,

27 – 40 Capital Directive) must also be amended accordingly. 146 For a proposal to rather refer to the most recent financial statements, see Böckli in Festschrift Druey (2002), pp. 331, 347.


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Amendments to the 4th CLD would also be required in the case of the balance sheet items (Art. 19 of the 2nd CLD). The change of system to no-par value shares – as here investigated – would also involve the repeal of those provisions which reflect the par value system, i.e. by referring to a nominal capital value or a nominal share value. An example would be the new wording of Art. 3 of the 2nd CLD, which would then have to prescribe that the total number of shares and the contributed capital is to be disclosed and no longer the nominal amounts. Just as “capital” must be replaced by “contributed capital”, the „nominal value of the shares“ must be replaced by „share in the contributed capital“ or „contribution amount“, so that, for example, according to Art. 10 ss. 2 of the 2nd CLD, the report on contributions in kind must state whether the value actually corresponds to the contributed amount. In addition, Art. 8 of the 2nd CLD – as already described above – must be repealed and instead, the value (true value) at which the shares should be issued must be determined. Finally, the extent to which the consequent amendments described above, which result from the change to the reference dimension, should be implemented must be reviewed. They affect, in particular, Arts. 9, 11, 15, 17, 19 and 26 of the 2nd CLD. Consequences With the approach of introducing no-par value shares while retaining the capital system, in that all proceeds of the share issue are contributed to a protected capital amount, hardly any principle changes to the present system of the 2nd CLD arise. However, beyond the necessary abolition of the prohibition on below par issues many consequent amendments would be required because of the total binding of the proceeds from the share issues. This applies, in particular, to those provisions in which the 2nd CLD refers to subscribed capital items, or in which a special function is attributed to the subscribed capital (e.g. as a barrier to distributions). This would also continue into national law. The advantage in that system lies mainly in the disappearance of the prohibition on below par issues which can be of particular significance in connection with restructurings. As shown however, in practice – at least in certain EU Member States – methods of dealing otherwise with the related questions have emerged. In connection with the issue of bonus shares and share splitting or merger of shares also, certain advantages are referred to, which are, however, in practice hardly significant or which can also be achieved by pseudo no-par value shares. However, it should be noted that such a system change would, with regard to the binding of the total proceeds in an item "equity capital", in some EU Member States represent a considerably more onerous solution than the present one, which could affect the dividend interests of the shareholders. 6.3.2.2 Model 2: Variable capital The second possible model, in which the no-par value shares could be included, is characterised by the fact that the proceeds of the share issue are not completely contributed to a protected equity capital item – as is the subscribed capital – but to an only partially protected reserve.


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Reserve For this case, a model in which there is no item „subscribed capital“ and instead the proceeds of the share issue on the formation and capital increase are entered as a reserve which can be used only under certain conditions, such as making up losses or losses carried forward, could be considered. The proceeds of the share issue would, in that case, be only partially protected. Even if in this model, the catch-up principle - i.e. the rebuilding (possibly in stages) of these reserves after their reduction or loss - applied, the use of the reserve to make up losses would result in a reduction of the item (variable reserve). No-par value shares, below par issues The consequence of this model would be, in the case of the availability of no-par value shares, the dissolution of the connection between shares and entry values in which the proceeds of the issue are entered, if this item would be reduced when used to cover losses. The shares could continue unchanged, because their value would, according to the proportionate participation, be determined by the actual value of the company. In this model, the prohibition on below par issues would – as above described - disappear (for consequences see above). The above comments can also be referred to in connection with the issue of bonus shares, share splitting and the merger of shares. Capital increases In this model also, the reserves would increase by the proceeds of the issue of new no-par value shares. The concept of capital increase could therefore be maintained or the term "increase in reserves" used in that context (cf. the concept of increasing the number of shares above). Capital reduction A formal procedure of reduction of the reserve item in which the share proceeds are entered appears to be appropriate in this model, because the limited possibility of dissolving the reserves (suggested only to cover losses) permits situations in which the company would wish to reduce the reserves. The capital reduction provisions may be used as a precedent. Consequent amendments With regard to capital procurement, the same problem arises as in Model 1, because here the items subscribed capital and premium used on the 2nd CLD are combined in one item, namely the reserves. However, in this model, it also arises that the reserves, into which the contributions are to be paid, could be reduced to zero if used to cover losses, so that the items in the 2nd CLD, which have hitherto related to subscribed capital, would have to be reconsidered (cf. various considerations above). In the course of such a transition to reserves, which could even be reduced to zero, reference to that figure is completely excluded and there remains only the reference to the number of shares (which admittedly is only partially possible). In addition, in this model many consequent amendments in national law would be required (cf. above).


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Conclusions The reserves model has the same advantages as the Model 1 (in particular the avoidance of below par issues). The reduced protection for shareholders and creditors is characteristic of this model because the reserves for example in the case of an annual loss can be reduced to zero. The inviolable cushion of the subscribed capital of the 2nd CLD would not be available. In addition, this model would require many consequent amendments in European and national law. 6.3.2.3 Model 3: Mixed model No-par value shares could also be introduced in the context of a mixed model proposed by Jahr and Stützel as early as 1963 for German company law (“Saarbrücken Proposal”)147. This model provides for the retention of subscribed capital in spite of the introduction of no-par value shares. Subscribed capital –reserve According to this model, subscribed capital is formed on the establishment of the company, and the proceeds of the share issue are entered as such, until the minimum capital or a higher amount prescribed by the statutes is reached. Above that figure, the issue proceeds are no longer treated as subscribed capital but are entered as reserves. The reserves have a degree of protection because, according to the proposal, they can be used only to make up losses or losses carried forward or to increase the subscribed capital. In the event of later capital procurement measures, the proceeds can be added either to the subscribed capital or to the reserves and the proposal provides for various procedures in this respect – increasing capital or increasing the number of shares. Introduction of no-par value shares – no below par issues It is proposed in this model that true no-par value shares be introduced. Each no-par value share carries the same rights. The prohibition on below par issues no longer applies in this model (cf. above). The comments above can also be referred to in connection with bonus issues, share splitting and share mergers. Capital increases and reductions Two procedures have to be distinguished in this model in relation to the acquisition of new capital, depending on whether the proceeds of the share issue are intended to be attributed to the subscribed capital or to the reserves148. In both cases, a qualified general meeting resolution is required. If the proceeds are attributed to the reserves, the proposal refers to the issue of new shares. It also provides that a minimum amount below which the shares may not be issued, be fixed. If the proceeds are attributed to the subscribed capital, it is provided that the maximum increase in the subscribed capital is the total issue amount of the new shares. The protection of shareholders against dilution in the case of share issues without a capital increase is, in this model, intended to be provided by the amount of the issue having to be selected so that the reduction in the proportion of shares is balanced out by the increase in net assets.

147 Jahr and Stützel: no-par value shares (1963). 148 Cf. Overview in Weiß, Aktionärs- und Gläubigerschutz im System der echten nennwertlosen (Stück-)Aktie, Diss. 2007, pp. 196 et seq.


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The proposal also provides for a special procedure for capital reduction and the reduction in the number of shares (withdrawal of shares). Other provisions which refer to capital In this model, the other provisions which are characterised in that they refer to subscribed capital are retained by virtue of the continued existence of subscribed capital. Certain amendments are nevertheless required: Consequent amendments With the disappearance of the obligation to increase the subscribed capital with every capital procurement measure, the question of necessary amendments arises, because the subscribed capital no longer necessarily increases with the issue of new shares. The relevant comments made above and, in relation to editorial amendments, on the proposal of Jahr/Stützel are referred to149. Conclusion The Jahr/Stützel mixed model leads firstly to deviations from the existing par value system, with the removal of the prohibition on below par issues (cf. above). However, it should be noted that the necessity to have various procedures in place depending on whether the proceeds of the share issue are attributed to, or should be removed from, the subscribed capital or the reserves, leads to increased costs. It is also clear that the proposed model would lead to changes in the binding of the proceeds of the share issue. While it is already possible according to the 2nd CLD to attribute the proceeds of a share issue to the subscribed capital or the reserves, if the premium is resorted to, the difference that, under the 2nd CLD, a certain amount must be added to the subscribed capital remains. Accordingly, in this model, less of the proceeds could flow to the subscribed capital than under the 2nd CLD. This would then result in a certain reduction in protection. Under this model also, many consequent amendments in European and national law would become necessary. 6.3.2.4 Model 4: Solvency test A further model in which the introduction of no-par value shares can be integrated is a model in which legal capital as it exists at present is totally abolished. This model can invoke third states, for example New Zealand. This model would lead to considerable amendments to the 2nd CLD and would require the introduction of additional protection instruments such as solvency tests, which are not, however, linked to the introduction of no-par value shares as such. Removal of protection for share issue proceeds In this model, the proceeds from the issue of shares on formation and on capital increases are no longer protected against distribution (cf. the situation in New Zealand and Delaware).150 In

149 Jahr and Stützel: no-par value shares (1963). 150 See also the models existing in Canada and Australia where the proceeds from share issues cannot be distributed. Also these models use true no-par value shares.


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fact, the proceeds are to be entered as a constituent of equity capital (e.g. profit reserve) which can be distributed unless this is prevented by additional tests to be conducted (e.g. balance sheet test and solvency test). Introduction of no-par value shares Due to the abolition of subscribed capital and the possibility that share issue proceeds can, in principle, be distributed, no-par value shares must be introduced in this model. These no-par value shares would designate the value of shares purely by reference to the shareholder's proportionate share in the value of the company. By the introduction of no-par value shares, the shareholder would have to pay-in an equal amount per share as a specified issue price151. In addition, the prohibition of below par issues would also be removed by the introduction of no-par value shares (cf. above) and the results described above would arise on the merger or splitting of shares (on bonus shares see also above). Capital increases and reductions In later capital procurements, in this model the proceeds of the share issues are to be entered as equity capital in the same manner as the contributions received on formation. This process is sometimes described as an increase in the number of shares152 but sometimes the term capital increase continues to be used153. The requirements for the resolution and the pre-emption rights of shareholders, which can also be retained in this system, are to be seen independently thereof154 (cf. the California provisions according to which pre-emption rights are not retained per se but may be granted in the statutes). Capital reductions as such would no longer be necessary, because the receipts from the share issue can be distributed in any event155. Cancellation of other regulations which refer to capital In this model, the other regulations of the 2nd CLD which refer to capital, would have to be reviewed. Publication of equity capital would no longer be necessary because it can, in any event, be amended at any time. Apart from the capital reduction provisions, the obligation to call a general meeting in the case of serious loss of capital would no longer be necessary. At first sight, it can also be asked whether the provisions on capital procurement (in particular, the eligibility of services as a contribution and the valuation of contributions in kind by an auditor) make any sense in a no-par value system. As, however, they serve the precautionary purpose of ensuring measurable and valuable contributions, they are not, as such, contra-indicated in the no-par value system. Although it is intended in this model to apply solvency tests with respect to distributions, it should be pointed out that the change to the solvency system in regard to distributions and the repurchase of the company's own shares – and capital contribution - is not necessarily the result of the introduction of no-par value shares, because even with no-par value shares the existing distribution model of the 2nd CLD can be retained with certain amendments (cf. above).

151 Cf. the various proposals of the High Level Group and Rickford Group. 152 This is the case in New Zealand; cf. also the proposal of the Rickford Group. 153 This is the case in Delaware. 154 Cf. the proposals of the High Level Group and the Rickford Group. 155 Cf. however, the proposal of the Rickford Group.


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Conclusions This model would lead to a wide reaching system change, going far beyond the consequences linked to the introduction of no-par value shares, as such. As has been shown, the introduction of no-par value shares in this model is a necessary step due to the abolition of subscribed capital. The benefits of the introduction of no-par value shares as such would only have the advantages stated in respect of the Model 1. The question of whether and in what form regulations on distributions, the repurchase by the company of its own shares or proper contribution should be framed and what advantages can be thereby derived, does not depend on the question of the introduction of no-par value shares. The advantage to be gained from such regulations are described above. 6.3.2.5 Model 5: Solvency margin The Model 4 described above can be seen as the basis for the introduction of a solvency margin as for example under the law of California. In this model, the proceeds of a share issue are not per se protected – as is the case in the capital regime of the 2nd CLD – by being entered as a non-distributable item. There would, on the contrary, be a variable barrier. Legal capital, as provided in the 2nd CLD, would, in this model, be cancelled. The proceeds of a share issue would be entered as a constituent of equity capital. For a distribution according to the Californian model, it would firstly depend on whether profits were available. If not, two further tests must be passed. Firstly, the assets after the distribution, must be at least 125% of the liabilities (i.e. an equity ratio of 20% must be exceeded, for details see the legal annex California). Secondly, the short-term assets must cover the short-term liabilities. In this model, a variable barrier to distributions, which can lead, in the case of adequately high equity capital, to distribution of the proceeds of a share issue, is provided. Because of the abolition of the intrinsically protected equity capital item, this model – like the Model 4 – must be linked to no-par value shares. The same questions as arose with regard to the Model 4 also arise here and reference is therefore made to the comments above. It is also to be stated that the introduction of the solvency margin does not, as such, result from the introduction of no-par value shares. 6.3.2.6 Conclusion The introduction of true no-par value shares is possible within the framework of the 2nd CLD. Abandoning the par value concept by the introduction of true no-par value shares could be conducted in the context of various models. Distinction is made between those which rely as closely as possible on the current concept of the 2nd CLD (Models 1 to 3) and those based on other forms of capital regimes as can be found in the four non-EU countries (Models 4 and 5). In all of these models, the introduction of true no-par value shares would be linked to the abolition of below par issues. This can be helpful in company restructuring, although some EU Member States have already found solutions which cushion the prohibition on below par issues and which may be less burdensome than the introduction of no-par value shares for this purpose.


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Less significant, on the contrary, is the fact that no-par value shares provide the possibility of changing the number of shares so that without changing the nominal value of the shares of each shareholder, a smaller number of new shares (merger of shares) can take the place of a greater number of new shares (share splitting), because this advantage is diminished by the fact that even today under the 2nd CLD by means of pseudo no-par value shares, the same result can be substantially achieved (par value shares). Here also the advantage that, with no-par value shares, share splitting would no longer be prevented by a minimum par value is also reduced by the fact that the 2nd CLD does not specify any such minimum par value. Model 1 assumes an item similar to subscribed capital in which the entire proceeds of the share issue (subscribed capital and reserves) would be entered. Model 2 is characterised by the proceeds being entered in a less well protected reserve. Model 3 assumes a proportionate entry under subscribed capital and reserves, only the reserves being available for use after the subscribed capital has been achieved. Because of the different treatment of the proceeds from the shares, depending on the model, either enhanced or reduced protection of the proceeds from the shares compared to the present situation can result. Amendments would be required by the above models because of the amended entry of the proceeds from the share issues and because of the necessary abolition of the prohibition on below par issues. In addition, because of the differentiated protection of the proceeds against distributions, other necessary amendments to the 2nd CLD would be required. This applies, in particular, to those provisions in which the 2nd CLD refers to subscribed capital items, or in which a special function is attributed to the subscribed capital (e.g. as a barrier to distributions). This would also continue into national law. The other provisions which are characterised by their reference to the capital can, on the contrary, be retained in principle. That applies for example to the publication of the capital, the minimum contribution, the contribution regulations, subsequent formation, the obligation to call the general meeting in the case of serious loss of capital, the acquisition by the company of its own shares, capital increases and reductions and distributions. With the introduction of no-par value shares into a model which gives up legal capital (Models 4 and 5), also waiving the protection of the share issue proceeds provided in the 2nd CLD and relying instead on e.g. solvency tests or a solvency margin, the advantages of the introduction of such a type of share remain as above described. As, in this model, no-par value shares would be in a completely different environment, a comprehensive revision of the 2nd CLD would be necessary in practice, although this would not be due to the introduction of no-par value shares as such.


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To summarise, the following models could be envisaged to introduce true no-par value shares: True no-par value shares Model 1 "Protection of all proceeds from share issues" – This model maintains, as far as possible, the provisions of the 2nd CLD and places all proceeds from the issuance of shares under protection under a new balance sheet item “equity capital” similar to that applicable to subscribed capital. Amendments would be necessary apart from the abolition of the prohibition on below par issues in particular because of the total binding of the proceeds from the share issues. However, it should be noted that this solution would, in some EU Member States, represent a considerably more onerous solution than the present one. The reason is that it is admissible in certain EU Member States that premiums be used to cover losses. This possibility would be lost if premiums were bound under the item “equity capital”. Model 2 "Variable capital" - This model is characterised by the fact that the proceeds of the share issue are not completely contributed to a protected equity capital item but to an only partially protected reserve. In this model most of the provisions of the 2nd CLD could remain intact. Amendments apart from the abolition of the prohibition on below par issues would be necessary in particular because of the different binding of the proceeds from the share issues. Furthermore, it should be noted that the reserves can be – under certain circumstances - reduced to zero. Model 3 "Mixed model" - According to the mixed model, subscribed capital is formed on the foundation of the company, and the proceeds of the share issue are entered as such, until the minimum capital or a higher amount prescribed by the statutes is reached. Above that figure, the issue proceeds are no longer treated as subscribed capital but can be entered as reserves. This model leads to the necessity to have various procedures in place depending on whether the proceeds of the share issue are attributed to, or should be removed from, the subscribed capital or the reserves. Amendments to the 2nd CLD are – in addition to the introduction of the abovementioned different procedures and the abolition of the prohibition on below par issues – necessary as also this model leads to changes in the binding of the proceeds of the share issue. Furthermore, it should be noted that in this model less of the proceeds could flow to the subscribed capital than under the 2nd CLD. Models 4 and 5 "Total abolition of legal capital" – These two models protect the proceeds of the share issue not by the prevention of distributions but by admitting its distribution under certain conditions, namely a balance sheet and/or solvency test or solvency margins. As, in this model, no-par value shares would be in a completely different environment, a full revision of the 2nd CLD would be necessary in practice, although this would not be due to the introduction of no-par value shares as such.

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