Author: | Published: 4 Jan 2001
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For the last decade or so, Mexico has been one of the most popular destinations for foreign investment in various different shapes and forms, including private equity capital. Despite the ever-increasing popularity and growth of private equity financing in Mexico, the Mexican legal framework poses peculiar challenges to the private equity investor in four basic areas: corporate governance, capitalization and distributions and regulatory approvals.

Corporate governance

Perhaps the most significant legal issues and problems confronting private equity investors in Mexico relate to corporate governance matters, which partly derive from the outdated legal framework governing commercial companies.

One of the fundamental problems stems from the fact that Mexican corporate law, enacted in 1934, prohibits covenants whereby shareholders of a Mexican corporation (sociedad anónima) the most common form of corporation in Mexico, agree to vote, or refrain from voting until a future date. It is, arguably, the most important type of covenant found in a shareholders' agreement which effects certain understandings among the parties, such as protections regarding so-called 'major decisions' and registration rights.

In terms of major decisions, the issue is relatively easy to overcome by implementing supermajority protections, in the form of qualified voting quora, whereby the adoption of any 'major decision' requires the affirmative vote of the investor. However, where it is necessary for the investor, as a minority shareholder of the target company, to make the company undertake certain actions (not just refrain from taking actions), for example, executing agreements and registration statements, Mexican corporate law does not provide the investor with specific means to ensure compliance with voting agreements in shareholders' agreements.

Acknowledging the significance of this, lawyers have designed various solutions to create self-executing mechanisms whereby the investor is in a position to ensure compliance with otherwise unenforceable sections of a shareholders' agreement. In practice, the most widely accepted solution has been the creation of a voting trust (fideicomiso), through which the controlling shareholders deposit their shares, and specifically pre-instruct the trustee to vote in accordance with the instructions delivered by the investor.

Another key issue relating to corporate governance is the enforceability of certain restrictions and shareholders' rights in connection with transfers of shares, such as drag-along and tag-along rights. Once again the most popular means of ensuring compliance with drag-long provisions and other transfer restrictions is a trust.

Capitalization and distributions

As in the case of voting covenants, Mexican law does not have the ideal framework on which to structure sophisticated capitalization schemes. The obstacles are essentially threefold. 1) Mexican law does not allow for a shareholder to waive pre-emptive rights to subscribe capital increases in advance. 2) A company cannot agree to issue new stock and sell it without a resolution of the shareholders' meeting. 3) A company cannot repurchase its own stock, except through open-market transactions, where the company is publicly listed and subject to a number of limitations.

In light of these limitations, in certain cases it becomes very complicated to structure private equity investments, which typically call for adjustments in percentage equity interest held by the fund through the issuance of additional shares, or redemption of shares, upon the occurrence of certain events, or the failure of the target company to meet certain performance requirements.

The problems relating to the issuance of new shares are normally solved by issuing treasury shares at closing, and granting conditional subscription rights to the investor to subscribe and pay for the shares.

Unfortunately, if the terms of the investment require the repurchase of shares by the target company, the solution must generally centre around the controlling shareholders, or a third party acquiring the corresponding shares from the investor. This constitutes a direct liability on the part of the controlling shareholders and is not a self-executing mechanism.

Naturally, the problems relating to pre-emptive rights are more difficult to overcome if the target company is a listed company, in which case the public shareholders must be accorded a minimum 15-day term to subscribe the new shares, which inevitably delays the closing. One solution in the case of listed companies has been the issuance of convertible loan instruments to the investor, which may be issued without triggering any pre-emptive rights at the time of issuance, or conversion in favour of the target company's shareholders.

As far as distributions to shareholders are concerned, there are two fundamental principals under Mexican law that often create problems in structuring special rights on distributions. 1) A shareholder may not be excluded from the profits of a corporation and, 2) dividends may only be paid out of the target company's net profits and not from the profits generated exclusively by a division or an asset of the target company. As a result of these limitations, tracking stock schemes may not be implemented and so-called 'cash waterfalls', or special or senior rights of the shareholders in connection with distributions must be structured as preferred dividends and preferred liquidation premiums.

Regulatory approvals

Despite the fact that Mexico has been shifting from a heavily regulated to a more liberal laissez-faire economy, there remain a variety of pre-investment governmental consents required in order to consummate investment transactions.

In the case of private equity investments, the need to obtain regulatory consents frequently poses timing pressures which often test the expedited timetables under which such investments normally take place.

The nature of the governmental consents in Mexico depends on factors relating to the target company's industry - that is, whether the target company operates within a so-called 'regulated industry' such as telecommunications or banking, the size and form of the investment, and the size of the participants, namely the target company and the investor.

In the context of private equity transactions, the most common governmental consent required is the approval of the Federal Competition Commission. The need to obtain this consent is normally based on the total consideration or amount being invested, and/or the size of the investor or the target company, considering the corresponding exemption thresholds set out in the Federal Economic Competition Law.

From a timing perspective, the Competition Commission filing must be made before the execution of the transaction documents, which typically reflect the authorization of the Competition Commission as a condition to closing, or provide for an unwind mechanism whereby the investor would divest its investment if the Competition Commission denies or materially conditions the approval. In certain cases, where the target company has been hard-pressed for funds, companies have received capital in the form of convertible loans which generally do not require Competition Commission approval until the time of conversion.

In the context of regulated industries, the approval of industry regulators is generally required.

In certain circumstances, where the investor is a non-Mexican and the investment is particularly sizeable, the consent of the Foreign Investment Commission may be required.

Final Thoughts

Despite the challenges which result from having to structure cutting-edge deals within a regulated environment, and an outdated legal framework like Mexico's corporate law, practice shows that Mexican law has just enough flexibility and resources, like the fideicomiso, can be tailored to accommodate the needs and concerns of private equity investors relating to important matters such as timing of the investment, and corporate governance.

Creel, García-Cuéllar y Müggenburg

Bosque de Ciruelos 304 – 2o Piso
Bosque de las Lomas
11700 Mexico, D.F.

Tel: 52 5596 3309
Fax: 52 5596 1821