Pushing debt down

Author: | Published: 1 May 2008
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On its way to Europe, Turkey has a busy agenda to harmonise its legislation with EU directives. One of the items on the agenda is to pass the draft Commercial Code to replace the code issued in 1956. The current Turkish Commercial Code (TCC) is outdated and does not address most of the issues of the contemporary business world.

Recent acquisitions

As the pace of consolidation escalated in 2006 and 2007, new financing techniques became considerably important. In recent years, there have been a number of acquisitions in Turkey, either through privatisations of companies by the government or transfer of non-core businesses by private sector players. The appetite of foreign investors for big Turkish companies has increased tremendously in the past two years. Turkish firms are under the persistent scrutiny of foreign investors (mostly financial investors). Instead of applying old-fashioned financing methods, these bidders have tried to implement contemporary financing tools and acquisition financing, including the debt push-down mechanism, which is new to Turkish market.

In a nutshell, the structure may be described as a holding company, with substantial interest expense but little or no income. It incurs debt to acquire another company with substantial income, merging into the target on the closing of the acquisition.

Legal concerns

Although debt push-down is not expressly restricted in Turkish law, there are a number of hurdles that make such a tool unfeasible, if not illegal. Several Turkish law issues should be considered in connection with the structure.

Buy-back prohibitions

In the provisions of the TCC, a joint stock company is not allowed to acquire or create a pledge over its own shares. All agreements violating this rule are deemed null and void. Exceptions to the rule are determined in the TCC exhaustively in accordance with the numerus clausus principle. The cases in which a joint stock company is allowed to acquire its own shares are limited and cannot be changed or extended. In the following instances, the buy-back prohibition principle does not apply:

  • If shares are acquired pursuant to a resolution of the joint stock company for a reduction in share capital.
  • If shares are received in payment of debts due to the joint stock company.
  • If shares are transferred to the joint stock company as a result of an acquisition of a business or an enterprise together with all debts and receivables.
  • If acquisition of and pledge over the shares are transactions that fall within the scope of the joint stock company as specified in the Articles of Association.
  • If shares are deposited as a pledge with the joint stock company by the members of the board of directors, managers and officers as security for performance of their obligations.
  • If shares are acquired for no consideration.

If any of the exceptions arise, the joint stock company becomes its own shareholder. However, the rights attached to the shares acquired are suspended and the profit belonging to such shares is set aside as a reserve fund. Also, these shares do not have voting rights. If the joint stock company acquires its own shares following a process of capital decrease, the joint stock company must cancel and destroy them. In exceptions other than capital decrease, a joint stock company must sell the shares at the first available opportunity.

The buy-back prohibition is one of the barriers to the implementation of debt push-down method. A company's financing of its own shares' acquisition through the debt-push down mechanism may be regarded as a circumvention of the buy-back prohibition.

Technical bankruptcy

As with the merger rules applicable to public joint stock companies, as a result of merger the surviving entity will not fall within the scope of Article 324 of the TCC, which regulates technical bankruptcy.

According to Article 324, if a joint stock company's most recent statutory annual balance sheet shows that at least 50% of its share capital has been lost, then its board of directors must inform the shareholders in a general assembly. Under the same provision, if there are indications that a joint stock company is insolvent, then its board of directors must prepare an interim balance sheet reflecting the market value of its assets. If the value of the net assets of the joint stock company falls below the value of one-third of its share capital, the company must decrease its capital to an amount equal to one-third of its statutory capital – provided that the minimum capital requirement of the TCC, TL50,000 ($38,400) is satisfied – or the shareholders must inject additional capital to the company to replenish the share capital to its original level. Finally, according to the same provision, if the assets of a joint stock company are not enough to pay the creditors' receivables, the board of directors is required to notify the court. Failure to abide by this rule is a crime under the Execution and Bankruptcy Law. The court decides on the liquidation of the joint stock company. If the court, upon the request of the joint stock company's board of directors or any creditor, determines that it is possible to remedy the joint stock company's insolvent position, it may defer the liquidation decision.

So a holding company with substantial interest expense but little or no income can acquire a target company with substantial income, and a merger of the holding company into the target company with all its rights and liabilities can take place. This structure becomes unfeasible in most acquisitions, as on completion (that is, pushing the acquisition financing liabilities down to the target) the target company falls within the scope of Article 324. Under Turkish merger legislation the general succession principle is applied.

Mandatory tender offer

Generally speaking, shareholders owe no fiduciary duties to other shareholders in Turkish law. This principle has a prominent effect in capital markets, which leads to the fact that transfer of shares by shareholders without any restriction is one of the main principles of the Turkish capital markets legislation. However, as operations and therefore the prospective growth of a joint stock company mostly depend on the controlling shareholder, any transfer of shares shifting the control of a public joint stock company to a new party would affect the interests of non-controlling shareholders. Accordingly, protection of minority shareholders is regulated by the Capital Markets Board (the CMB) through mandatory offer rules entitling them to exit at the same terms. The rule stems from Article 16A of the Capital Markets Law, which states that to protect minority shareholders and enlighten the public, the CMB shall issue regulations on share transfers, tender offers, proxy solicitations, capital increase, mergers and acquisitions, aiming at gaining control of a public company.

Under the rules of the CMB, if any party or parties acting together acquire, directly or indirectly, 25% or more of the capital and voting rights or shares of a listed joint stock company granting management control, that party or parties must make an offer to the other shareholders to buy their shares as well. Furthermore, if a party or parties acting together and owning between 25% and 50% of the share capital and the voting rights of a listed joint stock company increase the ratio by 10% or more in any given 12-month period, such a party or parties acting together must offer to purchase the shares of the other shareholders. Within 15 days of the acquisition, the acquirer will apply to the CMB to make the offer to the other shareholders. The offer price must be paid in cash and the offer period must be at least 15 days. However, in the following circumstances, the CMB may exempt acquirers that would otherwise have to make mandatory offers. In a precedent set in 1998, the CMB ruled that the exemptions enumerated in the relevant communiqué are limited. They cannot be changed or expanded under the numerus clausus principle.

Exemptions may be issued in the following circumstances:

  1. If the acquisition of shares or voting rights is necessary to strengthen the target company's financial structure (the CMB may ask for a report prepared by an independent firm showing that such a capital increase is for the target company's financial needs).
  2. If the acquisition is approved by the general assembly of the target company with a meeting quorum corresponding to two-thirds of the total share capital.
  3. If the acquisition does not result in a change of management in the target company (upon the request of the parties, the CMB shall review the shareholding structure and decide whether the acquisition affects the management control).
  4. If the acquisition results from legal requirements. The CMB may ask the acquiring party to dispose of the excess portion within a period of time determined by the CMB.
  5. In connection with privatisation of public companies, the CMB may grant an exemption by taking the purpose of the privatisation into account.

It should be noted that the exemption is not automatically granted, as the CMB has discretionary power. Exemption requests shall be filed with the CMB within five days of reaching the legal thresholds. In most of the privatisations, on the request of the Privatisation Administration, the CMB grants an exemption. Even if there is an exemption, a merger to be implemented after the acquisition will be subject to a mandatory tender offer.

Mandatory tender offer rules and CMB practice may be another barrier to debt push-down structures. Along with the mandatory tender offer application by the acquirer (that is, the holding company) to the CMB, possible future reorganisations, including any planned mergers, must be disclosed to the CMB and the public. Minority shareholders may sell their shares if they think the possible merger of the holding into target would destroy their rights. This would affect the financing position of the holding company.

Merger of the holding company into the target company shall be subject to the prior approval of the CMB if the target is a public company, and other regulators if the target operates in a regulated sector. In its merger approval, the CMB may inform stakeholders that they have the right to be indemnified, as their rights would be affected or squeezed as a result of merger.

The Petrol Ofisi case

As per the disclosures made to the public, in 2000, a holding company was formed to acquire a 51% stake held by the government in Petrol Ofisi, a state-owned petroleum distribution company. The holding company financed the acquisition through a combination of equity and debt. The purchase price was not paid in full; instalments and shares transferred to the holding company were pledged to the Privatisation Administration as collateral. Following the acquisition, the holding company and the target decided to merge. Pre-merger, a voluntary tender offer was implemented to avoid jeopardising the merger process. Subsequently an application was filed with the CMB for pre-approval of the merger. The first rejection was from the Privatisation Administration, as the pledgee. It informed the CMB that the merger would not be approved until all the monies owed to the Privatisation Administration were paid in full. The CMB had approved the merger on the condition that any additional collateral to be requested by the Privatisation Administration would be provided. After the merger, the Privatisation Administration requested additional security in the form of bank letter of guarantee. When that additional security was not provided on time, it filed a lawsuit requesting the cancellation of the merger. Following negotiations between the Privatisation Administration and Petrol Ofisi, a new payment schedule and security package were agreed on.

Commentators have debated whether financing expenses pushing down the target should be deductible. In the Petrol Ofisi case, the tax authorities adopted the following approach. In 2006, tax inspectors had conducted a limited audit on Petrol Ofisi and the holding company and reported that the acquisition financing expenses (interest and currency exchange differences) of the holding company were non-deductible. As a result of the inspection, the Tax Office issued a fine. Petrol Ofisi challenged the fine before the tax courts. Finally the dispute was settled between the Tax Office and Petrol Ofisi.

Directors' duty of care

The TCC requires that directors should act like diligent company executives in performing their duties. A director shall act like a reasonably diligent business person (TCC Article 320). The duty of care owed by a director to the company is similar to the duty of care owed by an employee to its employer under an employment agreement. Directors are liable to the company; they do not represent shareholders.

Directors' failure to comply with the duty of care is a breach of contract between directors and the company; the directors will be held liable to the company, the shareholders and the creditors of the company under breach-of-contract principles. Accordingly, directors of the target company approving the merger of a parent company with substantial debt into a target are liable to all the relevant stakeholders. Under the Capital Markets Law, directors may personally be liable when they do not comply with their obligations. Under the Capital Markets Law a director may be subject to criminal penalties, including heavy monetary fines or imprisonment, for engaging in activities leading to loss or decrease of profit and assets.

Final words

With its clear intention to become a member of the EU and an effective player in the global markets, Turkey must take steps to adopt new rules to help Turkish companies overcome the blockages caused by out-dated principles. In the draft Commercial Code before the Turkish Parliament most of the issues are dealt with. The draft has been before the Parliament for a long time and is expected to be passed in 2008.

Author biography

Esin Taboglu

Taboglu & Demirhan

Esin Taboglu graduated from Istanbul University School of Law in 1986 and received her LLM degree from Harvard University in 1990. She was admitted to the Istanbul Bar Association in 1987. She is also a member of the Istanbul Bar Association, the Harvard Alumni Club (Istanbul), the Association of Fellows and Legal Scholars of the Center For International Legal Studies (honorary member) and the Turkish Women Entrepreneurs' Association (founding member).


Firm profile

Taboglu & Dermirhan

Taboglu & Demirhan is a full-service law firm, advising Turkish and overseas clients on matters ranging from corporate, commercial and financial deals to complex international transactions, including structured financing, government procurements and privatisations. The firm represents clients in public and private sectors including local and foreign investors. Its corporate practice involves establishment of companies, corporate governance issues, shareholders' rights and directors' liabilities and responsibilities. Its practice also covers business acquisitions, private equity, public takeovers, venture capital investments, mergers, de-mergers, spin-offs and reorganisations and joint ventures.

Taboglu & Demirhan have been actively involved in representing issuers and underwriters in the full range of securities offerings. These include initial public offerings, private placements of securities, global equity offerings for Turkish issuers, listings in major exchanges, convertible bonds, exchangeable bonds, high-yield bonds and asset-backed offerings. The firm represents borrowers and financial institutions in all types of financial products and transactions, which often involve multiple jurisdictions. It has an unparalleled experience in privatisation projects – of telecommunications, airlines, tobacco production, steel, fertiliser, petro-chemical and cement production companies, advising the state entity in charge of privatisation or the investors. Taboglu & Demirhan also advises in areas such as power, mining, transportation and other infrastructure sectors and represents project participants (sponsors, project companies, lenders and governmental organisations). It provides regulatory advice on all aspects of the telecommunications industry including all aspects of voice and data carriage, the mobile and value added services.

Taboglu & Demirhan is active in all categories of real estate practice, including financings, development, acquisitions and dispositions. It represents all of the various parties in real estate transactions. It advises clients on a broad spectrum of antitrust issues, such as structuring of joint ventures, mergers and acquisitions, creation and operation of distribution systems, negotiation and drafting of intellectual property licensing arrangements. Taboglu & Demirhan provides services to football players and technical directors with respect to their disagreements with their clubs and the Turkish Football Federation. The firm also has experience in employment contracts and consultancy agreements, dismissal issues and work permits. Members of the firm allocate a considerable amount of time to teaching.