Private equity (PE) firms are specialised investment firms that typically use leveraged buyouts (LBOs) when structuring their acquisitions. In an LBO, a company (the Target) is acquired using a combination of equity and external debt financing, the latter being the largest component. This technique is also called "bootstrap acquisition", considering the smaller amount of own equity invested in the Target, while the repayment of the external debt is typically serviced by the Target through its cash flows.
This financing technique is economically based on the tax shield gained by the Target, which assumes that it has sufficient debt capacity and that it generates cash flows in excess of its ongoing needs and so may increase its leverage1. Corporate tax law allows for the deduction of interest payment (subject to thin capitalisation rules) but not dividends, thus using maximum leverage in an acquisition in which the return on assets exceeds the interest expenses, leading to a higher return on equity.
The public have previously taken a dim view of this type of leveraged transaction, perceiving it as coming at the expense of employees who suffer job cuts and salary reductions. Nowadays, the benefits for the Target company, which enhances its performance through the use of the financial and corporate governance knowledge of PE firms, are largely accepted.
The favourable credit market coupled with attractive interest rates led to a comeback for leveraged loans following the financial crisis. In the light of this renewed lending activity, a substantive part of the work of our lawyers in the Banking & Finance team is related to this type of finance structure, mainly driven by PE firms or sometimes by strategic (non-financial) investors who seek to fund the acquisition of related industry companies with a portion of debt. In the transactions where our lawyers provided legal assistance, the Target companies had a strong market position, with consistent revenue growth and stable operations which generated predictable cash flows.
Romanian law places certain restrictions on this type of operation, which need to be carefully assessed when structuring the financing transaction.
Financial Assistance and LBOs
The Romanian Companies Law2 reflects the capital maintenance principles set forth in the Second Council Directive 77/91/EEC3, which bans joint stock companies from acquiring their own shares. The corollary of this restriction is that the financing or guarantees for the acquisition of own shares (operations known as "financial assistance") are also expressly prohibited.
Limiting the financial assistance granted by a company (i.e. the Target) in order to acquire its own shares by a third party is established by law in many European continental countries, following implementation of the Second Council Directive 77/91/EEC. This restrictive approach by European legislators in relation to the use of financial assistance led to a close to impossible implementation of financing schemes secured by the assets of the Target and was widely criticised for bringing unjustified restrictions to the M&A market and imposing a rigid approach with a standard protection level that was not always necessary.
Since 2006, and especially during 2012, the EU financing market was significantly restructured in order to address its dynamics. One of the pillars of the reform was Directive 2006/68/EC, reinforced through Directive 2012/30/EU of the European Parliament and of the Council4 which, among other measures, set forth a more permissive approach to financial assistance, subject to certain standards, thresholds and internal approvals known as "whitewash proceedings". Pursuant to these rules, transactions can take place under fair market conditions, under the responsibility of the management, which is required to prepare a written report, indicating among other things the risks to the liquidity and solvency of the company, and finally were to be subject to the prior approval of the general meeting of shareholders, under certain quorum and majority conditions. Moreover, companies must take into consideration that the aggregate financial assistance granted to third parties must at no time result in the reduction of net assets below the share capital.
Romania has not transposed the "whitewash proceedings" permitted by Directive 2006/68/EC and then by Directive 2012/30/EU, given that no such obligation was imposed on Member States. At a domestic level, Romanian company law expressly prohibits financial assistance granted by way of advancing funds or providing security interest rights. The penalties are very severe and directors, executive manager or legal representatives of companies that advance funds or loans for the company's shares are committing an offense punishable by prison. Furthermore, it is largely accepted in the doctrine5 that transactions which breach the financial assistance rules are null and void. This renders inapplicable the use of LBO structures which involve financial assistance for the Romanian joint stock Target companies.
However, there are a number of structures that have developed and that are used in practice in acquisition transactions.
Use of LBOs for Limited Liability Companies
Romanian company law regulates the financial assistance restrictions only with respect to joint stock companies, in Chapter IV – Joint Stock companies – Section 1 – About Shares. Limited liability companies have a separate regulation which reflects their status of "partnership" as they are owned by a limited number of shareholders (minimum one and maximum 50). Nevertheless, various doctrinal opinions have considered certain provisions related to joint stock companies as representing corporate law principles and therefore held that they should be extended also to limited liability companies. The question would then be if such financial assistance rules represented a corporate law principle, which naturally should apply also to limited liability companies. Our view is that this extension should not apply with respect to financial assistance rules, based on the following arguments:
1. There is no indication that legislators' intention was to regulate financial assistance as a corporate principle that should extend to all companies, including partnerships. On the contrary, these rules transpose the Second Council Directive, which expressly provides that its coordination measures apply in Romania only to joint stock companies, and not to other types of companies.
2. The regulation which transposes into a criminal sanction the breach of financial assistance expressly refers as being applicable with respect to "shares" (which in Romania are issued only by joint stock companies). A limited liability company may issue only "social parts", and therefore this sanction is not applicable to this type of company. The authors may only be individuals holding the position of director, executive manager or legal representative of a joint stock company6.
3. The High Court of Cassation and Justice has ruled that with limited liability companies, the rules provided for other types of companies may apply only if there is a specific reference norm, while "the absence of such reference norms, which are limited and of strict interpretation, to joint stock companies leads indubitably to the conclusion that the administration of a limited liability company is governed by different rules than those provided for joint stock companies" 7. As indicated, there is no reference norm to the financial assistance rules provided for joint stock companies; therefore these rules should not be applicable to limited liability companies.
Nevertheless, as the financial assistance rules have not been tested in Romanian courts as far as limited liability companies are concerned, and owing to the gravity of the sanctions, parties tend to be very cautious when structuring LBOs that include a financial assistance element.
Merger with Debt Push-Down
The financing structure of LBOs may include the immediate merger of the Target company into the acquisition vehicle (or, if suitable, and depending on the specifics of each transaction, sometimes it is the acquisition vehicle that is merged into the Target). This operation is also referred to as a debt push-down structure, because the acquisition financing (obtained at the level of the acquisition vehicle and generally financed by equity and not directly by the Target) is pushed down to the merged entity level. If a company does this, it could also be argued that any financial assistance issue no longer applies, as the prohibition only addresses the Target company, which ceases to exist after completion of the merger. In such a structure, the security for the acquisition finance is granted after the merger takes place.
Notwithstanding the above, the legality of a merger LBO involving a joint stock company as Target is uncertain given the obvious linkage between the merger and the financing structure. In such transactions, the merger would not be a separate, autonomous transaction but just the final part of the acquisition process. However, this risk does not apply to limited liability companies, which are not covered by the financial assistance rules.
Furthermore, the use of a merger with debt push-down needs to be carefully reviewed from a tax perspective to ensure it is done in a tax neutral manner. Under the Romanian Fiscal Code, a merger is a tax neutral event, from a corporate income tax perspective, if it meets certain requirements, in brief:
- It has economic substance and is not performed with the purpose of tax avoidance or tax evasion;
- The fiscal value of the shares received by the shareholders of the absorbed company in the absorbing entity is equal to the fiscal value of the shares held in the absorbed company prior to the merger;
- The fiscal value of any assets transferred in the merger process is preserved at the level of the absorbing company.
In other European jurisdictions (such as Switzerland and Italy) in the case of mergers with a debt push-down structure where the acquisition vehicle has been specifically incorporated for the purpose of acquiring the Target company, the deductibility of the interest has been questioned as potential tax avoidance. The key issue raised was that at the end of the acquisition process a significant debt was allocated to the Target and the interest generated by this debt was used to reduce the company's taxable income. However, in many cases, an acquisition followed by a merger of the acquisition vehicle with debt push-down is not tax-driven at all. The primary reason for the use of the acquisition vehicle is to separate the liability for this acquisition from other investments, a fairly standard practice for PE firms. After the acquisition is completed, there is no justification for having two separate entities (the acquisition vehicle and the Target) and through the merger the costs of maintaining the acquisition company can be saved, the corporate governance is simplified and the debt/equity ratio is optimised. Therefore, it can be successfully argued that the tax benefit is not the aim of the acquisition structure and that the interest deduction is just a consequence of the application of general rules given the lack of any specific provisions for merger LBOs.
Looking to a More Permissive Future?
Given the market dynamics, it is recommended that the Romanian legislation adopts a more flexible approach in terms of allowing financial assistance, subject to clear and predictable conditions, so as to encourage LBO transactions. This is because a very strict creditor protection regime may sometimes lead to undesirable consequences, such as establishing and enhancing protection for subjects that neither need nor desire it. Currently, the financial assistance prohibition applies to joint stock companies regardless of whether or not they have creditors, or whether, hypothetically, the creditors of a financially stable company approved a transaction involving financial assistance. On the contrary, financial assistance prohibition does not cover the acquisition of the company's assets, as it solely relates to the subscription or acquisition of its shares; such limitation is hard to justify from a practical perspective, as asset deals may be as detrimental to a company and its creditors as share deals. In order to prevent market players from engaging in various complex mechanisms to circumvent the financial assistance prohibition, and, implicitly, to stimulate the domestic economy in terms of time and cost efficiency, Romanian legislators should consider adopting a more permissive legal framework in respect of financial assistance, such as the one permitted by Directive 2006/68/EC. Moreover, by following the EU example establishing the responsibility of the management body for transactions involving financial assistance, the local regulations would also reduce moral hazard, simultaneously enhancing the corporate governance regime. Creditors and shareholders would benefit from clear debt information, which is an essential instrument for risk mitigation. In the long run, creditors' interest is that their debtors remain solvent on an ex post financial assistance basis, and, therefore, a creditor mutual agreement, together with a shareholder resolution passed with a high majority, would represent a viable solution for addressing the risks related to financial assistance and enhance the acquisition market.
1 This calculation is based on the Miller-Modigliani propositions, developed by the Nobel laureates Morton Miller and Franco Modigliani in their papers published in 1958 and 1961. Their "irrelevance propositions" asserted that under a restrictive set of conditions, neither a company's financing activity nor its dividend policy should be expected to affect its current market value.
2 Companies Law No. 31/1990, as further amended and restated.
3 Council Directive 77/91/EEC on the coordination of safeguards which, for the protection of the interests of members and others, are required by Member States of companies within the meaning of the second paragraph of Article 58 of the Treaty, in respect of the formation of public limited liability companies and the maintenance and alteration of their capital, with a view to making such safeguards equivalent (the Second Council Directive). The Second Council Directive was amended by Directive 2006/68/EC of the European Parliament and of the Council of 6 September 2006 amending Council Directive 77/91/EEC and then replaced by Directive 2012/30/EU of the European Parliament and of the Council. Competition Law and Data, 10 May 2016, http://www.autoritedelaconcurrence.fr/doc/reportcompetitionlawanddatafinal.pdf.
4 Directive 2012/30/EU of the European Parliament and of the Council of 25 October 2012 on the coordination of safeguards which, for the protection of the interests of members and others, are required by Member States of companies within the meaning of the second paragraph of Article 54 of the Treaty on the Functioning of the European Union, in respect of the formation of public limited liability companies and the maintenance and alteration of their capital, with a view to making such safeguards equivalent.
5 St.D. Cărpenaru, Gh. Piperea, S. David, Legea societăţilor, comentariu pe articole, 5th edition, Ed. C.H. Beck, Bucharest, 2014.
6 I. Schiau, T. Prescure, Legea societăţilor comerciale nr. 31/1990. Analize și comentarii pe articole, 2-nd edition, Ed. Hamangiu, 2009; C. Voicu, Al. Boroi et al. Dreptul penal al afacerilor, 4th edition, Ed. CH Beck, 2008.
7 High Court of Cassation and Justice, 2nd Civil Section, Decision No. 3679 from 31 October 2013.
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