One of the most substantial changes to occur in the European M&A market during the last five years has been the appearance and multiplication of private investment funds as potential acquirers of companies. Apart from the proliferation of European funds, account should also be taken of the energy of the veteran US funds. The latter’s existence has been facilitated by the increase in 1998 of the maximum number of investors in a partnership from 99 to 500 and the entrance of the great pension funds as investors in venture capital companies attracted by the high returns obtained by such firms.
In addition to the entry of these great operators to the Spanish market, events such as the acquisition of Telecom Italia by Olivetti in 1999, have witnessed the unimaginable levels that may be reached by means of leveraged financing.
However, contrary to what has occurred in the last ten years in the UK and, to a lesser extent, in France, the Spanish market has entered late and shyly into the LBO transaction. There are several reasons for this timidity, one of which, in the opinion of venture capital funds, would be the traditional conservative attitude of Spanish banks. On the other hand, the features of Spanish legislation have also affected, to a certain extent, the growth of the LBO.
Spanish legislation is not the most accommodating for structuring an acquisition financed by the assets of the target company. Nevertheless, the same handicaps exist in other jurisdictions, such as Germany and, to a greater extent, the UK and yet they are flourishing markets. It is therefore important to demystify LBO operations, which are feared and rejected in practice by some lawyers in Spain. They have thus possibly hampered the entrance of more operators in the market. In this sense, it is understood that even if Spanish corporate legislation includes rules prohibiting the so-called “finance assistance”, it is possible to structure LBO operations without falling within the prohibition set out in articles 81 of the Joint Stock Companies Act (“LSA”) and 40.5 of the Limited Liability Companies Act (“LSRL”). This assertion is justified below.
The above-mentioned article 81 LSA, which is the Spanish transcription of article 23 of the Second Companies Directive (77/91/CEE) establishes that:
“A company can not anticipate funds, grant loans, give guarantees or facilitate any type of financial assistance for the acquisition of its own shares or the shares of its parent company by a third party”
Therefore, given that, by definition, an LBO implies repayment of the funding obtained to buy a company by the target company itself, once acquired, it is evident that the acquired company, at some point, seems to be rendering some kind of financial assistance to its acquirer.
Nevertheless, this rule, which could impede LBO’s of stock, does not have an equivalent rule in asset LBO’s. That is to say, acquisitions of assets and liabilities of a company may well be financed by a loan guaranteed by those same assets being acquired. Thus, solely stock LBO’s need to be analysed in the light of article 81.1 in order to assess their compatibility with Spanish legislation.
The typical structures of stock LBO’s would be as follows:
i) “Forward Merger LBO” and “Reverse Merger LBO”: The basic model would imply the incorporation of a new company (“newco”) destined to acquire the shares of the target company (“target”). Newco would offer the lenders the assets of target as a guarantee of the loan granted in order to acquire the target. Once the shares of target had been acquired, both companies would merge by either the target absorbing the newco (Reverse Merger LBO) or the newco absorbing the target (Forward Merger LBO).
As a result of either of the above mergers the surviving company would acquire both the assets of the target and the debts of the newco; thus concentrating both in the same company and allowing repayment of the loan through the resulting company’s cash flow and guaranteeing payment of the same by liens over the target’s former assets.
ii) LBO with no merger: In accordance with this model, much used in the US, the newco would obtain a non-secured loan with the proceeds of which it would acquire the shares of the target. Afterwards, the newco, as the target’s shareholder, would cause the target to obtain a new loan secured with the target’s own assets. The amount of such a loan should be sufficient to cover the principal and interests of the initial loan. The target would then hand over to the newco the amount of the new loan (via dividends, if this is possible or, normally, by means of a loan to the parent company). And the newco would use the funds to repay and cancel the initial loan with the amount of which the acquisition was carried out.
The different European modalities of the above structures are:
A) The newco would acquire the shares of the target with a non-secured loan. Immediately after the acquisition the newco would acquire all of the assets and liabilities of the target, paying for them their market price, which, obviously, should be similar, or even equal, to the price satisfied for 100 per cent of the target’s shares. The price of this last acquisition and normally, also the amount of the target’s reserves would be distributed by the target to the newco by the usual means (dividend, loan granted by the target to the newco, to its parent company, etc.). Subsequently, since the target would be an empty company the newco would adequate the book value of its 100 per cent holding in the target by the total amortisation of this amount. The dividends received from Target would be compensated against such loss. Once the newco owned the assets of the target the initial loan would be guaranteed with these assets.
B) Another variation of stock LBO’s would suppose the acquisition by the newco of the target’s shares (once again, with a loan not initially secured) and the subsequent dissolution and liquidation of the target, with the consequent granting of guarantees in favour of the lenders.
C) A third European variation, very similar to the former, would suppose the global assignment of the assets and liabilities of the target in favour of the newco, after the acquisition by the latter of 100 per cent of the shares of the target. This option is identical to B) with the advantage that the process of assignment of the assets, under article 117 LSRL, is simpler than a liquidation process, insofar as it is carried out in a single act, and its effects are similar to those of a universal succession.
In our opinion, most of the above-mentioned LBO structures fall within the prohibition set out in article 81.1 LSA except for two: the Forward Merger LBO and the LBO, which implies the dissolution of the target company (case B) above.
With regards to the Forward Merger LBO, the same may not be deemed as literally infringing article 81.1 LSA since this article supposes the existence of a casual relationship between the financial assistance and the acquisition of the shares. The “financial assistance” should be granted by the target; “for the acquisition of its own shares or the shares of its parent company”.
However, in a Forward Merger LBO there is no financial assistance by the target to the newco for the acquisition of its shares. Target’s shares are acquired and totally paid up by the newco with the loan obtained from third parties and this loan is later guaranteed by the assets of the newco itself (since as a consequence of the merger, the assets of the target shall be a part of the newco’s assets). The same conclusions are applicable when the LBO operation entails the dissolution and liquidation of the target.
Nevertheless, the legality of these operations must also be analysed in accordance with article 6.4 of our Civil Code. This code sets out that the acts carried out under the protection of the literal diction of a legal rule but with the intention of obtaining a result prohibited by law or not permitted thereby are considered to have been carried out in fraud of law and shall not impede the application of the rule they intended to elude.
Hence, it is important to examine the objectives pursued by article 81.1 LSA in order to assess the legality of LBO operations. The results, which article 81.1 LSA intends to prevent, would be, from our point of view, on the one hand, the dilution of the stock capital of the company as a consequence of acts which jeopardised the balance between its equity and its real net worth, thus endangering the interest of the creditors of the company. And, on the other hand, the prejudice caused to the minority shareholders in the case that the directors of the company and/or the majority shareholders would use the assets of the company to reinforce their position. Insofar as the LBO operations would not cause any of these effects, they would be perfectly compatible with Spanish legislation.
Forward Merger LBO’s would not affect the stock capital of the target since the same would be substituted by the stock capital of the merging company (newco). Consequently, the accounting basis of the target would disappear and its shares would be extinguished. The principles of integrity and consistency of the stock capital would not be harmed in such operation since, on the one hand, the shares of the target would be totally paid up and, on the other, because, after the merger, there would be no integrity to be defended. In brief, Forward Merger LBO operations do not affect the net worth of the target but that of the newco, which is indebted by the loan obtained to acquire the target’s shares.
As regards the interests of the target’s creditors, they would neither be damaged due to the fact that, according to article 243 LSA, creditors would be entitled to oppose the merger until their corresponding credits were guaranteed.
Finally, the LBO would normally entail the acquisition of 100 per cent of the target’s shares and thus there would not be minority shareholders whose interests should be protected. At any event, even if such minority shareholders existed, their interests would not be affected as they would obtain shares of the merging company in a proportion equivalent to the net worth of the target (intact) compared to the net worth of the newco (indebted). Hence, the guarantee for these minority shareholders would be achieved by an adequate ratio of exchange between the target’s shares and the newco’s shares.
The above-mentioned arguments would also be applicable (even more) in the case of the dissolution and subsequent liquidation of the target. In this case, the interests of creditors would remain absolutely unharmed and intact for all the debts would be paid up by means of a liquidation process specifically opened for such purpose.
Should the LBO suppose the global assignment of the assets and liabilities of the target in favour of the newco after the acquisition of Target’s shares, as explained in C), the legality of this operation would be more dubious inasmuch as it could be “concealing” a merger or it could entail the dissolution of the company without the corresponding liquidation. In effect, in case the purpose of such global assignment was to transfer the whole corporate net worth to the shareholders free from any debt, then this should be done by means of the dissolution and liquidation proceeding as established by Spanish corporate legislation, with the precautions therein foreseen. On the contrary, if the aim of the operation was a merger between the companies, the companies should comply with the requirements set out in Spanish corporate legislation for this kind of operations. In brief, the global assignment of assets and liabilities would only be possible if it were done in favour of a third party with the subsequent liquidation of the assignor company.
With regards to model A), that is, the sale of the target’s assets to the newco, it does not seem to be a practical model in Spain for the special problems attached to asset purchases. In this sense, account should be taken to the fact that the transfer of assets subject to registration, such as intellectual property, real estate assets and rights or charges related thereto, motor vehicles, ships and aircraft require specific formalities. On the other hand, most contracts and all rights of credit require the individual consent of the other party in order for the transfer to be effective. In any case, this model offers fewer guarantees for the creditors of the target. Nevertheless, should the price paid for the assets be a fair market price the target would be capable of fulfilling its compromises during its later corporate life. And in the case where the company would not be able to carry out its business with no asset of its own, creditor’s interests would be satisfied by the process of dissolution and liquidation of the company. Thus, in these cases it would not be problematic to defend the validity of the operation.
Notwithstanding the above considerations, according to the principal academic opinion the sole operations excluded from the prohibition set out in article 81.1 LSA would be the operations in which the management team or the employees of the company participate or those in which the initial loan with the proceeds of which the newco acquired the target’s shares is repaid by means of the dividends distributed by the target to the newco.
As regards to the first case, article 81.2 LSA establishes that the general rule prohibiting companies to grant financial assistance for the acquisition of its own shares shall not be applicable to the operations directed to facilitate such acquisition to the personnel of the company. However, pure management buyouts (MBO’s) are difficult to find in practise, being MBO’s most commonly found with the participation of a venture capital fund. In these cases, in our opinion, the exemption would only be applicable to the part of the stock capital financed by the personnel of the company since a different interpretation would suppose that even LBO’s in which the employees only acquired an insignificant participation would also be excluded from the general prohibition.
The second case raises no questions inasmuch as it seems evident that the initial loan may be repaid with the dividends distributed by the target insofar as the newco is simply using its own net worth to satisfy a debt.
Finally, it should be noted that the prohibition of financial assistance is even stricter in the case of Limited Liability Companies, for, by virtue of article 40.5 LSRL, it is extended to the operations regarding shares or participations of any other company belonging to the same group. In addition, the said article does not foresee the exemption in favour of the employees of the company, something which could be contrary to the declaration contained in article 129.2 of Spanish Constitution.