The company that swallowed its own tail
27.10.2011
corporate
When acquiring shares it is important to examine whether either of the parties is a parent or subsidiary of the other. The existence of such ties may significantly restrict the acquirer’s share rights or even prevent effective acquisition of the shares.
A parent/subsidiary relationship between companies—control and dependence—is typically associated with the parent holding a majority of votes in the subsidiary.
But the Polish Commercial Companies Code provides a much broader definition of parent and subsidiary (Art. 4 §1(4)). The criterion of a majority of votes is indeed one of the most important factors, but not the only one resulting in a parent/subsidiary relationship.
One of the other factors, often overlooked in practice, is overlapping management (where members of the management board of the parent make up more than half of the membership of the management board of the subsidiary).
If this test is fulfilled at the same time in both directions between two companies, each company may be regarded as the parent of the other and also as a subsidiary of the other.
It is very important to reflect the existence of control or dependence in transactions, particularly transactions involving acquisition of share rights. In extreme instances, overlooking this aspect may invalidate the entire transaction. This primarily relates to the rule under which a subsidiary may not acquires shares in its parent (Commercial Companies Code Art. 200 §1 and Art. 362 §§ 1 and 4). In this case, acquisition of shares by the subsidiary is regarded as tantamount to the parent acquiring its own shares.
Violation of this prohibition is subject to different sanctions depending on whether it involves a limited-liability company or a joint-stock company.
In the event of acquisition of shares in a limited-liability company in violation of Art. 200 §1, the result is absolute invalidity of the acquisition. This means that despite conclusion of the share sale agreement, the seller continues to be the owner of the shares.
The code regulations governing joint-stock companies do not provide for such severe sanctions. Under Art. 364 §1, dispositive transactions in violation of the prohibition against a company’s acquiring its own shares are valid. The acquirer of the shares (the subsidiary) may not exercise any rights under the shares, however, except for the right to dispose of the shares or take steps intended to maintain the rights to the shares (Art. 364 §2). The acquirer’s rights are thus seriously restricted in this respect.
These situations may appear to be obvious. Transactional practice shows, however, that in some circumstances they may be very hard to discover, and the effects can be painful.
In the case of transactions involving acquisition of shares by foreign financial investors, the first step is often creation (or purchase) of a special-purpose vehicle (typically a Polish limited-liability company) to be used for the specific transaction. The SPV then acts as the direct acquirer of the shares that are the subject of the transaction. Typically, financial investors, unlike investors from the same industry, do not have professional management in place with experience in the specific industry. Until closing, the management board of the SPV are persons appointed temporarily by the investor, who will then be replaced by industry managers after the closing. Usually the new managers are persons from the acquired company, and in many instances they are also members of the management board of the acquired company. As a result, post-closing, the same persons may be serving on the management boards of both companies: professionals who came from the acquired company but represent the interests of the new owner going forward.
Under this setup, it is crucial to schedule carefully the actions related to closing of the transaction. First the shares that are the subject of the transaction should be acquired, and only after that should members of the management board of the acquired company be appointed to the management board of the SPV. Otherwise, the effectiveness of the transaction may be undermined. This is because appointment of members of the management board of the acquired company to the management board of the SPV creates a relationship of mutual control and dependence between the operating company and the SPV, due to the membership of the same persons in the management board of both companies, which meets the conditions for control under Art. 4 §1(4)(d) if members of the management board of the parent make up more than half of the membership of the management board of the subsidiary.
Existence of a mutual parent/subsidiary relationship generally prevents effective acquisition of the shares that are the subject of the transaction in the case of a limited-liability company, or in the case of a joint-stock company significantly limits the rights of the acquirer of the shares, who under Art. 364 §2 for the most part cannot exercise the rights to the shares.
The complications can be particularly severe if these connections only come to light some time after the transaction. Then it will turn out that the person acting as a shareholder during that period was not authorised to do so. This will in turn carry over to the effectiveness of resolutions adopted during that period, ultimately impacting the overall operations of the company.
If, however, the shares of the operating company are acquired by the SPV first, and then the management board of the SPV is changed, this specific risk does not arise, because at the time the shares change hands the acquirer will not both control the target and be a subsidiary of the target. Nor will this happen after the change in the management board of the SPV, because if there are several grounds justifying a parent or subsidiary relationship, the entity regarded as the parent will be the one on whose side more of the grounds for recognition of a dominant position arise. In the situation described above, there will be at least two grounds on the side of the acquirer: a majority of the shares (providing a majority of votes at the shareholder’s meeting) and overlapping membership of the management board.
This example demonstrates how important it is for the success of a transaction to examine the possibility that a parent/subsidiary relationship will arise, depending on the schedule of activities in the transaction.
It should also be borne in mind that in the event of ineffective acquisition of shares because of violation of the prohibition against a company’s acquiring its own shares, the acquirer will generally not be in a position to cure this defect later. Polish law does not recognise acquisition of shares by prescription. Even if the acquirer is entered in the share ledger or the commercial register, that does not in itself mean that it actually acquired the shares.
Dr Jarosław Grykiel, Mergers & Acquisitions practice, Wardyński & Partners