The result of this is that the cashflow generated by the activity of the target company may be used, due to the confusion of the respective assets and liabilities resulting from the merger, for the repayment of the indebtedness incurred by the newco to perform the acquisition itself.
The legality of such a structure in the Italian legal framework has been strongly disputed by a number of authors and certain case law, based on the alleged violation of a rule stating the prohibition of so-called ‘financial assistance’. Moreover, in respect to cases where the merged company subsequently fell in bankruptcy, it has been also affirmed that the LBO may constitute an event of fraudulent bankruptcy, based on the fact that the liabilities of the target company, following the merger, are increased by the amount of the acquisition debt, to be considered under the bankruptcy law as not related to the activity of the target company, and therefore in prejudice of the rights of the target creditors.
The LBO has finally been recognised as legal in the Italian legal framework by article 2501 of the Italian Civil Code, as amended by the 2004 Reform of the Companies Law.
However, even according to the new rule, the legality of an acquisition based on an LBO structure is subject to certain conditions: the companies involved must provide to the Companies’ Register a ‘solvency assessment’, to be given by an expert to be appointed by the competent court, about the (expected and reasonably foreseeable) actual capacity of the company resulting from the merger to meet its financial obligations, including the acquisition debt. A further condition may be identified in that the transaction must be aimed to permit the newco, supposedly not already a controlling shareholder of target, to acquire a controlling holding in the latter.
The legality of the LBO has been admitted to the extent that the reason of the transaction may be identified in the actual need of a true acquiring party to finance a portion of the price for the acquisition, then permitting an acquiring party, through the merger, to support the repayment of the incurred debt through the cashflow generated by the target company; to the extent that this reason may be actually identified, the law considers as balanced, and suitable to be protected, both the interest of the purchaser to buy utilising both the financial means of the acquired company and the interest of the target’ creditors not to have jeopardised their rights against the target, even if, from a substantial point of view, it is clear that the increase of the liabilities of the target company of the amount of the acquisition debt results in a possible prejudice of the general protection of the target creditors’ rights.
But whenever the basic reason of the change of control cannot be identified, it should be considered as still prevailing the interest of the creditors of the target company to be protected against the substantial reduction of the net worth of the target company, which follows to the merger, due to the increase of the target’s liabilities of the amount of the acquisition debt.
In practice, however, so-called ‘re-cap’ transactions of companies which have been previously the target of an LBO are becoming more and more common. These transactions are commonly implemented through the incorporation of a further newco by the same shareholders owning the control of the company resulting from the previous LBO merger, where a ‘new’ newco becomes the purchaser, partially using the equity made available by its shareholders and partially incurring a new acquisition debt, of the above company, paying the price to the shareholders of the same, who then use these proceeds (partially) to subscribe the equity of the new incorporated newco, retaining however the portion of the price which is refinanced by the new acquisition debt.
From a practical point of view, the existing shareholders of the company (resulting from the merger in the framework of the past LBO) become the shareholders of the new acquiring company, without any substantial change of control in the same company, which, following a further merger, is simply charged by a new acquisition debt to be repaid.
In respect to the above described conditions to affirm the legality of the LBO under article 2501 of the Italian Civil Code, it is disputable if the requisite of the ‘change of control’ must be substantial or even simply formal (which happens whenever the further newco incorporated for the purpose of the re-cap transaction is finally owned by the same shareholders previously controlling the target).
A prudent approach should suggest that the acquisition of the controlling stake be ‘substantial’, particularly vis-a-vis the risk of a possible subsequent bankruptcy of the company resulting from the further merger, in which event it is doubtful that the protection granted by article 2501 may actually work against the risk of a requalification of the re-cap transaction as aimed simply to deprive the target of a portion of its assets, in prejudice of the creditors’ rights, and as put in place only to permit the shareholders of the target company to obtain a ‘cash-out’.
In summary, re-cap transactions are to be carefully considered as at risk, particularly in the event of a subsequent insolvency situation of the (new) merged company.
Maurizio Bernardi is managing partner of Agnoli Bernardi.
ItalyJune2008
