CAPITAL EROSION

During times of economic crisis, a large number of companies embark on restructuring drives to cut losses and to adjust their corporate structure to the new economic realities. Others seek alternative sources of financing to improve cash reserves. But while a company's management is considering its next move to stabilise corporate finance, the shareholders might be experiencing their own liquidity problems and could be seeking ways to liberate funds previously invested in the company's capital. This causes a conflict between the shareholders' interests and the management's duties to guarantee the company's solvency and creditors' interests.

Bulgarian legislation gives top priority to creditors' interests and protects them consistently through a collection of measures that create the capital maintenance system. It is important to know the main restrictions imposed by law concerning the capital of commercial enterprises, which operations do these restrictions impact, what are the potential tax implications and what are the penalties for failing to observe the regulations.

There are several fields in which Bulgarian legislation envisions special restrictions concerning operations with the capital of companies with multiple shareholders.

Dividend payment
The first area is the payment of dividend or other payments from the company to its shareholders. In this case, one must keep in mind the legislative provisions that guarantee that the payments cannot affect the capital and mandatory funds that the company must maintain at all times.

The first rule is that the so-called net worth of the property – defined in the Commerce Act as the difference between the company's assets and liabilities according to its balance sheet – after the distribution of dividend should not fall below the legal threshold for registered capital and other mandatory funds.

The second rule is that dividend pay-outs are limited to the size of the profit for the respective year, but also undistributed profits from previous years and excess funds from the previously mentioned funds, minus losses from previous years and the contributions to the mandatory funds. In other words, if the net worth of the property is created by the shareholder contributions and profits from the company's operation, only the latter is subject to payment as dividend.

Given that a company's profit, subject to dividend payment, is determined using the applicable accounting standards – the International Accounting Standards (IAS) and the national standards for financial reports for small and medium-sized enterprises – one must take into account some of the specifics that could result in manipulating the size of the profit and, respectively, the size of the dividend payout.

Thus, under IAS, some categories of assets – investment assets or some types of financial assets, to give just two examples – can be accounted for at their fair value, in which case every subsequent change of their fair value would have to be accounted for as a loss or a profit in the company's financial reports, without any sale having to be carried out. This creates the danger for the company's books to show so-called "unrealised" gains, meaning profits from the change in the value of assets owned by the company, which can then be paid out as dividend.

The question often pops up about the possibility to pay out as dividend a company's capital reserves. On one hand, the Commerce Act exhaustively lists the purposes for which a company can use that money – to cover losses from the current and previous years – and the surplus funds can be used to increase equity. On the other hand, the reading of the regulations on the requirements for paying out dividend leads to the conclusion that a distribution of the surplus in these mandatory funds would be legal as long as it meets the regulations concerning the relationship between the net worth of the property and the registered capital and mandatory funds, as well as the maximum amount of dividend payouts allowed.

Financial assistance
Special attention must be paid to the issue of financial assistance. This is key when structuring deals for the acquisition of other companies and essence of the issue is that the company being acquired is banned from giving loans or offering guarantees to the shareholders in the company making the acquisition. This provision is dealt with in brief detail in the Commerce Act, but failing to observe it can lead to the invalidation of the loan or guarantee.

Capital reduction
The reduction of equity capital is also regulated in such a way as to present guarantees to the company's creditors. Failing to meet the requirements for notifying creditors and meeting their demands can result in personal and solidary liability by the members of the company's managing body, in the amount that was denied to the creditors.

In principle, the money received by shareholders as a result of capital reduction is not taxable in Bulgaria. However, one must take into account that when a company's profit has not been paid out as dividend and was used to increase the company's registered capital, only for that registered capital (including the reinvested profit) to be reduced at a later date, for tax purposes it is being treated as a dividend payout.

Under certain circumstances – such as if the shareholder receiving the dividend is a person or a third-country company based outside the European Union or the European Economic Area – this dividend will be subject to taxation.

Own shares
Closely linked to the issue of maintaining the size of the company's capital are the acquisitions of its own shares. This can happen either as a buyback, including the case of callable preferred stock, the acquisition of own shares in order to reduce capital by cancelling the stock, or to exclude an existing shareholder, among other possibilities.

The acquisition can only happen using funds eligible for distribution, namely as dividend or interest on shares. The company cannot hold more shares than the equivalent of 10 per cent of its capital at any given time. If this provision is breached, the company must transfer them in a certain period of time, otherwise they are cancelled and its capital must be reduced. The company's managing body must disclose in the annual report certain facts about the amount of own shares owned by the company.

Some restructuring scenarios could lead to an outcome similar to that of a buyback, such as if company A, which owns shares in company B, transfers some of its own shares to company B. Then the shares being transferred would be considered own shares of company B, with all the resulting consequences spelled out by the law.

Stock buyback, however, must be carefully considered from an accounting and tax point of view. Depending on the exact circumstances, it can be treated as payment of dividend or liquidation stake, and some categories of callable preferred stock would be treated by the applicable accounting standards not as capital instruments, but as financial liabilities of the company, with all the consequent complications arising from that fact.

The law enforces the system for maintaining capital in a company by envisioning the possibility for forced liquidation of the company in the case when the net worth of the property falls below the registered capital amount and the general shareholders meeting does not take a decision to reduce capital, restructure or liquidate within a period of a year. In that case, a prosecutor can ask a court to launch liquidation procedures.

An overview of court practices shows that prosecutors have exercised that power in several cases. Of course, if the company is insolvent or heavily in debt, it faces the prospect of forced insolvency.

There are several legal ways to avoid the negative consequences of capital erosion. One of them is to carry out a simultaneous capital reduction and increase: the company's capital is reduced in order to reduce losses and equal the net worth of the property, but then is increased back to the same level or higher, often through an equity injection by a new investor. Restructuring, whether by merger or spinning off parts of the company, as outlined in the Commerce Act, also creates opportunities to optimise capital structure.