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Czech Republic: Securing parent company debt in light of a significant amendment to the Business Corporations Act

February 2021 – On 1 January 2021, a significant amendment to Act No. 90/2012, Coll., on Businesses and Cooperatives (the “Business Corporations Act”) entered into effect. Among other changes, the Act introduces a new Section 40 (5) prohibiting the performance of gratuitous services by business corporations to their shareholders as well as to their related persons (in Czech: osoba blízká) (with certain exceptions listed below).

What is a gratuitous service? Is the prohibition applicable to the provision of securities?

The term “gratuitous performance” includes the provision of any item or service of value by a company to its shareholder (or a person related thereto) without a consideration. In terms of debt financing, the amendment particularly affects the provision of securities by subsidiaries to service the debts of their shareholders (or other members of a group), whereby in order to mitigate the risks arising from a potential violation of this prohibition it becomes necessary to provide a certain consideration to subsidiaries for the establishment of such a security.

The relevant sections of the Business Corporations Act neither explicitly require for a consideration to be proportionate (or equal) to the value of the performance provided by the company, nor for the value of a consideration to be formally verified in any particular way (e.g. by an expert opinion); however, a disproportionate consideration could mean that a company’s statutory body is held to be liable for a breach of the general duty of due managerial care.

A consideration provided to a company may be of a financial nature. We generally hold that this consideration does not have to be monetary, and in specific situations, a consideration in another form may be sufficient, provided that its value can be quantifiably determined (i.e. it must be calculable in monetary terms). In order to avoid any potential breaches of the law, a consideration should not be of marginal or negligible value in relation to the performance provided by the subsidiary.

Personal scope of prohibition on gratuitous performance

The prohibition explicitly applies to the performance of gratuitous services to shareholders and any persons related thereto. The definition of a related person is provided in the Civil Code. If the shareholder is a natural person, the prohibition also applies to its relatives. If the shareholder is a legal entity, a literal definition would suggest that the prohibition will only apply to the shareholder. However, following practical application of the law, it is possible that a wider interpretation of the prohibition will also extend to the members of parent company bodies and other legal entities within the shareholder’s group. An argument in favour of such an extensive interpretation of the law could be the disproportion between the application of the prohibition to shareholders – namely, natural persons and legal entities.

Penalties for a breach

Presently, the prevailing professional opinion is that a breach of the prohibition will not impact the validity of any concluded agreements. This is supported, in particular, by the principle of the protection of third parties. Which is undoubtedly welcome news, especially for the creditors of parent companies, whose securities over the assets of subsidiaries will remain valid despite any potential failure to comply with the requirement to provide a consideration for establishment thereof. Nevertheless, invalidity could apply to any agreement deemed to involve the performance of a gratuitous service. Furthermore, a breach could result in (i) the invocation of a right by the subsidiary to claim an unjust enrichment by the shareholder (and thus the subsidiary’s entitlement to receive reimbursement) and, potentially, (ii) a company invoking a right to claim for any damages arising on the basis of a breach of due managerial care against its statutory body.

Exemptions

Four (4) exemptions are available from the application of the prohibition. These exemptions include situations where the company provides: (i) customary occasional gifts, (ii) donations of a reasonable amount for public benefit purposes, (iii) a performance for the purpose of fulfilling a moral obligation or consideration of decency, or (iv) an advantage permitted by law to the company in question.

From a practical point of view, we assume that the fourth exemption will be utilised frequently. This could incorporate, for example, the provision of financial assistance which is separately regulated under the Business Corporations Act.

Practical recommendations for financial transactions

In order to mitigate risk on the part of creditors (potential uncertainty concerning the validity of a security) and on the part of debtors and security providers (a risk of unjust enrichment or the liability of the statutory body), the prohibition must be considered within the overall context of debt financing. Group funding should be structured so that after factoring-in all the relevant circumstances, a reasonable conclusion can be drawn that the security provided by the subsidiary for the debts of its shareholder(s) or other related party (member of the group) has been provided for a consideration and thus no violation of Section 40 (5) of the Business Corporations Act has occurred.

We are of the opinion that, from a practical point of view, the use of the following instruments can be considered:

  • an agreement between a subsidiary and its shareholder (or other designated person in the group) on the provision of a security for the debts of the parent company (or other persons in the group) and the monetary remuneration for the establishment of such a security;
  • an agreement between a subsidiary and its shareholder (or other designated person in the group) on the provision of a security for the debts of the parent company (or other persons in the group) and a non-monetary consideration for the establishment of such a security;
  • a decision by the statutory body of the subsidiary on the provision of a security for the debts of the parent company (or other persons in the group), together with a statement that this security is provided in exchange for any benefits (a consideration) for the subsidiary resulting from its membership in the group.

The above instruments could be supplemented with expert opinions appraising the value of a given consideration in monetary terms and assessing its adequacy within the context of the provided security. The choice and content of the appropriate instrument will always depend on the particular aspects of the transaction.

Thus far, no prevailing market practice exists with regards to the issues outlined above. The conclusions presented above are based on our own interpretation of the relevant provisions, taking into account the views contained in current professional literature, and have not yet been confirmed by any binding judicial decisions or case law.

For more information, please contact Martina Březinová, Counsel, at

e-mail

Leo Javorek, Managing Associate, at , or Václav Kment, Associate, at .