European Financial Restructurings Leave Several Avenues to Explore
By William Charnley (McDermott, Will & Emery, London), Konstantin Günther (McDermott, Will & Emery, Düsseldorf) and Rick Mitchell (McDermott, Will & Emery, London)
During the recent financial markets bubble, European businesses came to rely on a sometimes-toxic blend of senior bank debt, high-yield bonds and common equity listed in U.S. as well as European markets. This shift has wrought dramatic changes in the way financial restructurings of such businesses must be structured. Nevertheless, there are a variety of ways to accomplish such transactions.
Consensual Exchange vs. the London Approach
Under a traditional London approach in accordance with international principles applicable to bank restructurings, creditors cooperate closely to orchestrate an orderly standstill and exchange of information, with proportional provisions of new money and loss sharing. This is led by the bank with the largest exposure supported by a steering committee. In an exchange offer, the debtors make a carefully designed offer to all bondholders, the terms of which are calculated to encourage and reward participation and discourage
resistance. An exchange offer may permit a debtor to extend debt maturities, defer interest payments, subordinate existing debt, modify payment schedules or eliminate inconvenient or burdensome restrictive covenants.
Consensual exchange offers differ from the London approach to bank restructurings. Bondholders are usually less organized, more numerous and vastly more diverse in terms of their negotiating style and approach to the debtor, as well as in their investment objectives and time horizon, than the banks in a typical senior debt syndicate. Bonds tend to change hands more often and more quickly than bank debt. While the identities of the banks and bankers in a bank group are usually well known to the debtor, high-yield bonds are usually held anonymously in book-entry form through the Depository Trust Company (DTC), Euroclear and Clearstream. Where bonds are subject to the U.S. Trust Indenture Act, as most European high-yield bonds are, modification of the fundamental payment terms of the bonds is only possible with the express consent of each holder affected by the change, while modification of other terms often requires only majority consent.
Holdout and Exit Consents
Because of the unanimity requirement under the U.S. Trust Indenture Act, holdouts can be a significant problem. Bondholders refusing to exchange their bonds can potentially receive a windfall at the expense of participating bond-holders and others. The mere possibility of this occurring can cause bondholders and others to resist agreeing to a deal. To discourage holdouts, restructuring exchange offers are generally conditional on a high level of bondholder participation.
Another technique involves the solicitation of "exit consents," in which participating bondholders are asked to consent to waivers of or amendments to the terms of the existing debt. Quite significant terms of a typical European high-yield bond can be waived or amended with the consent of a specified percentage of bonds (often a simple majority), and the whole exchange can be conditioned on receipt of the requisite consents to permit such a waiver or amendment. By stripping away protective covenants in this way, a debtor can discourage holdouts from disrupting a deal that has widespread bondholder support.
Exit consents were the subject of fierce dispute and litigation in the United States during the early 1990s. While their legality is now fairly well settled under New York and Delaware law, under the laws applicable to European companies there is more uncertainty as a result of substantive corporate law as well as choice of law and conflicts issues.
Where the problem of holdouts cannot be resolved by these methods, another variation is to combine an exchange offer with solicitation of acceptances to a "pre-packaged" U.S. Chapter 11 plan involving the same commercial deal. If the requisite percentage of bonds is exchanged, the transaction closes on a consensual basis. If the requisite threshold is not achieved but the minimum percentage needed to approve the Chapter 11 plan is obtained, the debtor files under Chapter 11 and consummates the transaction—binding all bondholders under U.S. bankruptcy rules.
Communication with Bondholders and Others
The terms of a proposed exchange offer are typically contained in a circular or memorandum prepared by or on behalf of the debtor and circulated to the bondholders via the clearing agencies. The form and content of this circular is dictated by practical consideration as well as applicable law and regulations. For example, if the exchange is structured as a registered transaction under U.S. securities laws, the form and content of the document will be dictated by requirements under those laws. Even if the transaction is structured as an unregistered transaction, however, disclosure to bondholders will often closely resemble that of a registered deal.
Publicly traded companies must also be aware of their obligations under applicable securities laws, stock exchange regulations and other rules to keep their shareholders and the market at large informed of the impact of restructuring negotiations on their financial and operating position, the terms of a particular deal and the timing and implications of a potential transaction. This need to publicize important developments often gives rise to difficult questions as to when and how much information should be made public. While confidentiality may make negotiations easier, prompt public disclosure may be necessary in many cases.
Tender Offer, Takeover and Ownership Disclosure Rules
Restructuring exchange offers are subject to various (sometimes contradictory) rules applicable to tender and exchange offers and takeovers originating from various jurisdictions. Where the U.S. securities laws apply, the rules under Regulation 14e under the U.S. Securities Exchange Act of 1934 will dictate the timing and procedures to be followed. For example, Rule 14e-1 under the U.S. Exchange Act requires a tender offer to be held open for at least 20 business days and to be held open for at least 10 business days after the date of various changes in the terms of the offer, the consideration offered to be paid or the securities tendered returned promptly after termination or withdrawal of an offer and public notice to be given of any extension of an offer. Additional rules under U.S. securities laws will apply to tender offers involving equity securities.
Similar rules applicable in the home jurisdiction will also have to be considered. For example, in the UK the City Code on Takeovers and Mergers may apply where equity is exchanged for debt and a person or persons "acting in concert" acquire shares carrying 30 percent or more of the voting rights of a company or where significant shareholders increase their percentage voting power. Similar rules may apply under the newly established German Securities Acquisition and Takeover Act to companies which are publicly traded and have their "seat" in Germany. In certain cases, the City Code and the German Takeover Act may require a mandatory offer or a "whitewash" procedure. Ownership reporting rules in various jurisdictions may also apply to creditors who receive equity in an exchange transaction.
U.S. Securities Laws
Restructuring exchange offers involving non-U.S. companies whose shares are traded in the United States are subject to the U.S. Securities Act of 1933. As a result, exchange offers must either be registered under the U.S. Securities Act or an exemption must be found. Various approaches are available, each with advantages and disadvantages. A registered exchange offer provides exchanging bondholders with freely tradable securities, permits all bondholders to be included in the transaction, permits unlimited participation by financial advisers in soliciting participation by bondholders in the exchange and provides timely public disclosure of the timing, procedures and terms of the transaction. The disadvantages include potentially greater liability for the debtor and its senior management under the U.S. Securities Act, greater expenditures of time and money to document and complete the transaction and far greater public scrutiny of the commercial terms of the transaction.
William Charnley is head of McDermott, Will & Emery’s London Corporate Group. His practice covers the entire spectrum of corporate and corporate finance work. He is a corporate and company law specialist with vast experience of acting for both the issuer and the sponsor/underwriter in securities issues, takeovers, acquisitions and disposals, private equity transactions, joint ventures, demergers, reorganizations and restructurings. He can be reached at +44 20 7577 6910 or via e-mail at wcharnley mwe.com.
Konstantin Günther is a partner at McDermott, Will & Emery and head of the Corporate Department in the Düsseldorf office. His practice covers mergers and acquisitions, including public takeovers, private equity and capital markets as well as international and cross-border M&A transactions. He can be reached at +49 211 3003 221 or via e-mail at kguenther mwe.com.
Rick Mitchell is a partner in the Corporate Department of McDermott, Will & Emery’s London office, where he heads the U.S. Securities Group. He collaborates closely with our English and German Corporate and Finance Groups on European matters and advises U.S. and non-U.S. issuers and financial intermediaries extensively on the full range of corporate and securities activities. He can be reached at +44 20 7575 0379 or via e-mail at rmitchell mwe.com.
Market Powerhouses’ Pricing Strategies Come Under Fire
By Jonas Ewert and Thomas Hauss (McDermott, Will & Emery, Düsseldorf)
Section 20 of the German Act Against Restraints of Competition prohibits companies that have superior market power from selling goods or services below cost. In late 2002, the German Federal Court of Justice, essentially the highest federal court in Germany, held that the act prohibited U.S. discount store chain Wal-Mart from selling its goods in Germany below cost price under certain conditions. On August 4, 2003, the German Federal Cartel Office (FCO), the agency charged with administering the act, announced guidelines clarifying the act in light of the court’s interpretation. All companies doing business in Germany that possess significant market power should, therefore, ensure their pricing strategies comply with the recent interpretations of the act.
Under German law, a company with market share of more than 25 percent may have superior market power and with more than 50 percent is deemed to have superior market power. The FCO’s announcement makes clear that neither the existence of a predatory intent nor proof of an appreciable restraint of competition is necessary for liability to attach under the act.
The FCO guidelines also make clear that the act applies not only to the actual sale of goods and services, but it also applies to any offers to sell goods or services below cost.
Accordingly, if a company offers goods or services at a standing price, there may be liability if costs increase above that standing offer price. The FCO has provided exceptions to liability for isolated instances of below-cost offers resulting from unexpected price increases. The company bears the burden of proof for justifying any below-cost pricing under these exceptions.
New entrants to the German market are not likely to possess market power and, therefore, the below-cost pricing prohibitions of the act are unlikely to apply to companies resident in other countries that are first entering the German market. Companies that enter the German market may, however, face competition from dominant companies using below-cost pricing as a means to try to exclude the new entrant. In such instances, the new entrant may invoke the act to file for a preliminary injunction or complain to the FCO to intercede on its behalf to stop its competitors’ below-cost pricing. Established companies possessing market power in Germany should ensure that marketing strategies in Germany do not result in below-cost pricing.
Jonas Ewert is an associate in McDermott, Will & Emery’s Düsseldorf office. His practice covers intellectual property law, as well as competition law. He focuses on trademark law, unfair competition, copyrights, design rights and patents. He can be reached at +49 211 3003 212 or via e-mail at jewert mwe.com.
Thomas Hauss is a partner at McDermott, Will & Emery and head of the Intellectual Property and Competition Departments in the Düsseldorf office. His IP practice covers all aspects of European and German trademark law, unfair competition, copyrights, design rights and patents. He can be reached at +49 211 3003 211 or via e-mail at thauss mwe.com.
IP-Centric Courts Equal a Welcomed Change in Italy
By Margherita Bariè (McDermott, Will & Emery/ Carnelutti Studio Legale Associato, Milan)
After years of debate, the Italian government has finally approved a new act: the Legislative Decree No. 168 of June 27, 2003. The act was published in the Italian Gazzetta Ufficiale No. 159 of July 11, 2003, and creates specialized courts with exclusive jurisdiction regarding intellectual property issues. The creation of court divisions is important since it allows a venue for clearly identifying the competent court and assures a high level of knowledge among the latter’s relevant members. This will undoubtedly result in more consistent case law because of the inclusion of a small number of intellectual property-savvy judges who are appointed to preside over and work in the new divisions. This will help businesses that operate within the Italian borders to further protect their intellectual property from infringers.
History of Italian
Intellectual Property Ambiguity The creation of intellectual property-focused courts follows a range of legislative proposals that have occurred in Italy throughout the past decade. The need for specific divisions capable of dealing with this highly specialized field became an issue in Italy in the early 1990s. Many proposals were discussed by Italian Parliament members to establish a defined structure for hearing intellectual property disputes. This includes a bill drafted by the so-called Mirone Commission whose bill, art. n.11, provided the establishment of special sections in cities where the courts of appeal were located. These courts were dealing with, among other issues, IP-related disputes. Unfortunately, the above provision was never implemented.
It was only in 2002 that a solution was created for a specialized court section with IP expertise. This was through the adoption of Law No. 273 of December 12, 2002, which is considered the most important law focusing on the renewal of the Italian intellectual property judicial asset. The law delegated the Italian government to implement supplementary legislation on the necessary legal procedures for the handling of IP disputes. The Council of Ministers drafted the preliminary scheme for a new writ (i.e., a legislative decree) that establishes the specialized court divisions in order to deal with intellectual property issues. The context was discussed with the parliamentary commissions in order to evaluate whether the draft issued by the Italian government could be formally approved. The institution of specialized court divisions’ main concern was the relevant procedures to be applied. In this regard the Council of Ministers evaluated two different possibilities: whether to apply the commonly used civil procedure rules or to make reference to the earliest procedures set forth for commercial disputes. The draft of the legislative decree, as amended to include intellectual property specialized courts, was formally approved on June 27, 2003. It will go into force in January 2004.
Gazzetta Ufficiale Rule on Specialized IP Courts
These courts, which are special sections of the Italian Court of Appeal, will consist of a panel of judges who have specific intellectual property skills. The courts will be located in Bari, Bologna, Catania, Florence, Genoa, Milan, Naples, Palermo, Rome, Turin, Trieste and Venice. The relevant districts have been included in order to establish the territorial limit of each division’s jurisdiction, since the legislation did not establish specialized sections within all the cities where the courts of appeal are located.
The specialized court divisions have jurisdiction in connection with national, international and community trademarks; patents for inventions and new plants variety; utility models; designs and copyright; and unfair competition disputes relating to the protection of industrial and intellectual property. According to the provisions of the legislative decree, the presidents of the specialized divisions are granted the same rights and powers as those previously held by the presidents of the various district courts and courts of appeal. The specialized divisions consist of panels of judges with at least six members. Three judges handling the case together in full cooperation will make all of the decisions. The judges assigned to the specialized division are required either by the president of the district court or the president of the court of appeal to deal with subjects other than IP-related issues, provided this will not cause any delay in the handling of intellectual property cases. According to the provisions of the legislative decree in question, all proceedings pending at the time the decree came into force will continue progressing to the civil courts on the basis of the former procedure.
European Union’s Community Trade Mark Aspect
The specialized court divisions system recently established by the Gazzetta Ufficiale legislative decree still needs to be coordinated with the already existing Community Trade Mark based on the EU Office for Harmonization in the Internal Market (OHIM) of Alicante, Spain. In this respect, the OHIM has jurisdiction in connection with all procedures relating to the filing of community trademarks, designs and models, as well as with the oppositions potentially raised against the above applications. The jurisdiction concerning all the disputes relating to the nullity or avoidance of the Community Trade Mark, models and designs belongs to the European district court and the Court of Justice, both located in Luxemburg. It is important to note that Italian court divisions will have jurisdiction in connection with community trademarks, models and/or design infringement cases and/or subsequent actions aimed at obtaining the avoidance of the Community Trade Mark. This is provided the actions are submitted as counterclaims. In this latter respect, the Italian court will be entitled to postpone the trial requiring the OHIM to decide over the case, so the trial would continue before the community court.
It is important for businesspeople worldwide to protect their intellectual property, which is the heart of companies’ success. On the global stage, infringers abound. However, the introduction of specialized intellectual property courts in Italy, in conjunction with the EU Community Trade Mark, is another step in the right direction for providing companies a way to secure their business assets in the intellectual property arena.
Margherita Bariè is a partner at McDermott, Will & Emery/ Carnelutti Studio Legale Associato, resident in the Milan office. She acts as counsel in all forms of local arbitration and conducts and manages Italian and international litigation in various fields relating to commercial law and, in particular, intellectual property rights. She can be reached at +39 02 6558 5605 or via e-mail at m.barie mwe.com.
Single Pan-European Patent Protection Soon to Be a Reality
By Duncan Curley (McDermott, Will & Emery, London)
Many businesses familiar with the European patent system will be aware of the expense (relative to the United States and Japan) of obtaining patent protection in a number of European countries. Many will also be familiar with the fragmented nature of a European patent that, in reality, consists of a basket of national patents, each of which must be enforced separately in the European states that have been designated by the patentee for protection.
Following the success and popularity of the Community Trade Mark among businesses, it was announced in March 2003 that a single unitary patent, legally valid throughout the whole of the European Union, is to be created. This will be known as the Community Patent. After the European Union has expanded (to include a number of the former Eastern bloc countries, such as Poland) in May 2004 and the Community Patent has come into being, businesses will be able to obtain a patent that can be enforced on a pan-European basis in 25 countries.
The cost of obtaining a Community Patent is likely to be approximately euro 25,000. Although the cost will still be higher than in the United States and Japan, the Community Patent will offer potentially significant costs savings for those businesses interested in seeking pan-European patent protection under the umbrella of the Community Patent.
Businesses are expected to be able to apply for a Community Patent within five years. The European Patent Office in Munich, Germany, will administer the grant procedure. An application for a Community Patent must be prosecuted in one of the three official languages of the European Patent Office: English, German or French. At the time of grant, the applicant will have to file translations of the patent claims into the other two official languages. After a Community Patent has been granted, the patentee will have to file translations of the claims into all of the official languages of the European Union. This is likely to be a significant cost burden, although the European Commission is analyzing whether savings in the process can be made to keep the cost of a Community Patent competitive.
When it comes to enforcing rights under the Community Patent, this will be done through a new Community Patent Court (CPC), which is to be set up by 2010. This court will have exclusive jurisdiction in claims for infringement of Community Patents. It will be able to award pan-European injunctions and to award damages. The Community Patent Court will consist of three judges, all of whom will have experience in patent law. The court will also have technical experts to assist the judges.
Detractors of the Community Patent have said that businesses may not necessarily want to stake all on one unitary right, since if the validity of a Community Patent is successfully challenged in infringement proceedings, patent protection throughout the whole of Europe will be lost. However, the system as presently operated by the European Patent Office will continue to be available, if a patentee prefers instead to designate individual European member states for protection. It will also continue to be possible to file national patent applications in individual countries, on a country-by-country basis. Businesses will be able to select the type of patent protection that is most suited to their needs and to their budgets.
Duncan Curley is a partner in the Intellectual Property Department, resident in the London office. He regularly advises multinational clients on intellectual property matters, in particular pharmaceutical and biotech companies. He can be reached at +44 20 7575 0316 or via e-mail at dcurley mwe.com.
EU Council Regulations Bare Light on Patent Protection
By Jonas Ewert and Thomas Hauss (McDermott, Will & Emery, Düsseldorf)
An abstract of this article appears in the print and PDF versions of International News. The full-text version is available by clicking here.
Pitfalls to Avoid During Troubled Company Acquisition Transactions
By Robert Manger and Sandra Urban-Crell (McDermott, Will & Emery, Düsseldorf)
In 2003, the number of insolvent German companies reached one of its highest levels since the German economic crisis of the early 1930s. Thus, the acquisition of assets from troubled companies is becoming increasingly more important. In connection with acquisitions in the insolvency context, specific corporate and labor law issues must be considered by multinationals interested in the German market as well as for German-based businesses.
Corporate Law Issues
Acquisitions occurring after the opening of the insolvency proceedings pose different problems than acquisitions from a financially strained seller that take place before the opening of the insolvency proceedings. Due to the apparent bargain, potential purchasers are often tempted to acquire a business before the opening of the insolvency proceedings. However, such acquisitions come with a considerable business risk for the purchaser since there is a great likelihood that the acquired business has hidden shortcomings that resulted in the financial strain of the company. Additionally, the purchaser runs the legal risk that the insolvency administrator will attempt to avoid the sale during the course of the insolvency proceedings. Furthermore, the German Creditors’ Avoidance of Transfers Act (Anfechtungsgesetz) enables creditors to contest transfers under certain circumstances outside of the insolvency proceedings.
The acquisition of assets after the opening of the insolvency proceedings provides greater legal certainty for the purchaser since a purchase agreement concluded after the opening of the proceedings will not be subject to avoidance. (As a general rule, after the opening of the insolvency proceedings, only the insolvency administrator can represent the insolvent company and sign agreements on its behalf.) In addition, the insolvency administrator will generally attempt to sell the business of the debtor as a whole or, at least, in structurally independent divisions.
In contrast to acquisitions outside of the insolvency context, a purchaser of an insolvent seller’s business does not assume all of the seller’s liabilities and rights relating to the business. Rather, a purchaser will only assume those contractual liabilities that are directly and inextricably linked to the purchased assets, such as long-term supply, licensing or lease agreements.
Representations and warranties pose an additional problem in the insolvency context since insolvency administrators typically are unwilling to give any representations and warranties. In addition, purchasers in the insolvency context can generally satisfy their claims for a breach of a representation or warranty only from the insolvency assets. As a result, representations and warranties given by the insolvency administrator are of little economic value.
Purchasers in the insolvency context benefit from the exclusion of the applicability of Section 25 of the German Commercial Code (Handelsgesetzbuch). This code provides that a purchaser continuing an acquired business using the same or a similar corporate name is generally responsible for all of the seller’s liabilities attached to the business. In addition, as provided by Section 75(2) of the German Fiscal Code (Abgabenordnung), purchasers will not be liable for operating taxes.
Negotiations with the insolvency administrator generally turn out to be fairly difficult since insolvency administrators customarily assume a "take it or leave it" attitude towards a potential purchaser. In addition, such negotiations often take place under enormous time pressure since usually there are many potential purchasers interested in buying those parts of a troubled company offering the more interesting business opportunities.
In addition to negotiating a purchase agreement with the insolvency administrator, a potential purchaser must also be able to secure the creditor’s committee’s consent to the purchase agreement. As a rule, a creditor’s committee is elected by the creditor’s assembly in most insolvency
proceedings. The decisions of the creditor’s committee are generally based on pure economic interest. For example, the creditor’s committee will prefer the purchaser who offers the highest purchase price and is willing to pay the price at the earliest time possible. Secured creditors, who are generally decisive in the decision-making process of the creditor’s committee, often attach specific importance to the purchase price financing. Customarily, the purchase price is paid into an escrow account or secured by an unconditional bank guaranty enforceable against the bank on first demand.
Labor Law Issues
Section 613a of the German Civil Code (BGB) provides that all employment contracts pertaining to the business or part thereof being acquired are transferred to the purchaser by operation of law. It also states that the purchaser must assume all rights and obligations resulting from any employment relationships existing at the time of the transfer. Therefore, the seller and the purchaser cannot, by agreement, exclude employees from being transferred to the new owner without an employee’s consent. Except for certain exceptions, Section 613a BGB also applies to acquisitions concluded after the opening of insolvency proceedings.
The applicability of Section 613a I.1. BGB is limited to cases where an entire business or a part of a business that constitutes an organizational unit with its own business activity (such as a plant or a division) is sold, leased or transferred to another company. In the context of Section 613a BGB, German courts have defined "business" as a structurally independent part of a production facility (including all tangible assets, such as equipment, and all intangible assets of such part) that is continued by the purchaser as an independent, freestanding unit at a similar or higher level (a business unit). Thus, the transfer of a business unit must be distinguished from the acquisition of individual production equipment not constituting a business unit of the seller, on the one hand. On the other, it must be distinguished from the dissolution of an established operational business unit of the seller that will be incorporated into an already existing business unit of the purchaser.
Section 613a BGB applies neither to members of the managing board (Vorstand) of a stock corporation nor to the general managers (Geschäftsführer) of a limited liability company (GmbH) since such persons are not considered employees. The same holds true for retired and former employees who left the employment of the seller after their pension rights vested, but before they reached retirement age.
As a consequence of the transfer of a business unit or part thereof, all employment relationships attributable to the business unit being transferred, including all of the seller’s rights and obligations, are transferred to the purchaser as the new owner. If the transfer is restricted to a divisible part of a business, the transferor is only obligated to take over those employees working within this part.
The new owner of the business unit must assume all rights and obligations under the respective employment agreements of the transferred employees. Thus, such employees will have the same rights against the new employer as they had against the seller, including seniority and claims for unpaid salary. In addition, the terms of each individual employment agreement are binding on the new employer. As provided by the general principles of labor law, the consent of the transferred employee is required for any amendment of an employment agreement that would result in terms less favorable to a transferred employee. However, under certain limited circumstances, the new employer might be entitled to amend an employment agreement by means of an Änderungskündigung—an amendment of the employment agreement that, if not accepted by the employee, will be automatically converted into a termination notice.
After the opening of the insolvency proceedings, Section 613a BGB will not be applicable with respect to any liabilities existing at the time of the opening. Consequently, the new owner is not liable for any pension entitlements accrued by the transferred employees under the pension scheme of the seller. The transferred employees might, however, be entitled to participate in the pension scheme of the seller under certain circumstances.
The purchaser must assume the obligations provided for in Section 613a BGB beginning with the date of the transfer of the business unit or part thereof. Such transfer does not necessarily occur on the same date on which the title to the acquired assets is transferred pursuant to the purchase agreement between the parties. German courts have held that the date on which the purchaser is legally and practically in a position to conduct the acquired business as its own business will be deemed the date of transfer of the business unit.
Robert Manger is an associate in the Corporate Department of McDermott, Will & Emery, resident in the Firm’s Düsseldorf office. He focuses his practice on corporate law, capital markets, venture capital and mergers and acquisitions including public take-overs. He can be reached at +49 211 3003 232 or via e-mail at rmanger mwe.com.
Sandra Urban-Crell is an associate in the Labor and Employment Group of McDermott, Will & Emery’s Düsseldorf office. She focuses on restructuring, reduction of staff, outsourcing (including negotiations with the works council), co-determination of employees, as well as transaction- related labor law issues. She can be reached at +49 211 3003 242 or via e-mail at surban mwe.com.
Winds of Change Breeze into the Netherlands
By Stef van Weeghel (Stibbe, Amsterdam)
Until about two years ago, the Netherlands seemed to be a politically stable country and its economic policy and business climate were widely admired. The country appeared immune to problems that kept the rest of the world occupied. However, a number of events have somewhat reshaped the climate that will affect multinational corporations with interests in the Netherlands.
From 1994 to 2002, the country was governed by a coalition of the labor party and the liberal parties. Although the so-called poldermodel, in which government, employers and employee organizations ruled the country by consensus, appeared to work quite well, public discontent with this model and the growing political elite led to the rise of populist party LPF. This party was expected to win the elections in 2002, when just before the elections its leader, Pim Fortuyn, was murdered. The party nevertheless won the elections. But because of a complete lack of political experience on its side, the ensuing coalition with the Christian Democrats, who also claimed victory in the elections, came to an early end. New elections resulted in a conservative coalition of Christian Democrats and liberals. This coalition will have presented its first budget for 2004 by the time this article is published.
Because the Dutch economy has a negative growth forecast for the current year, the budget will likely contain reduced government spending and encourage labor organizations to exercise constraint in their negotiations with employers.
Relative to its size, the Netherlands is home to many large enterprises. Recently, these corporations came under public scrutiny as a result of executive compensation and global publicity from a major accounting scandal. Remuneration of executives, in particular large gains resulting from the exercise of stock options, prompted former Prime Minister Wim Kok to express "his disgust with exorbitant compensation" on Dutch television. Giant retailer Ahold became embroiled in the largest accounting scandal ever in the Netherlands and showed that such scandals do not only occur in the United States. Supervisory directors came under scrutiny as well. Where corporations in the United States have one board with inside and outside directors, large Dutch corporations generally have a two-tier board with managing and supervisory directors. These supervisory directors are entrusted to look after the interests of all stakeholders in the company, not just one group such as the management or the shareholders. Their independence is often questioned. This is because many supervisory directors are former managing directors of companies on whose boards they sit. They often comprise of significant numbers of supervisory board positions or supervise managing directors of other companies who in turn supervise them in the company on whose managing board they sit. These developments have prompted the appointment of a committee under the leadership of former Unilever-CEO Morris Tabaksblat. This committee recently issued its draft report with suggestions for corporate governance reform. The main thrust of this report is transparency, more control over management and more guarantees for supervisory directors’ independence. Although there has been significant criticism, it is expected that the report will be finalized towards year-end. It may then become part of Dutch corporate law.
One of the reasons why the Netherlands is home to many multinationals is its favorable tax climate. The ingredients are an exemption from dividends and capital gains to parent companies, a well-developed tax treaty network and a pro-taxpayer attitude of the tax authorities. This position is still very much the same, although the EU "code of conduct" regarding tax competition has caused the Netherlands to reform its ruling practice. While the Dutch ruling practice by and large was "tax-competition proof," the new ruling practice serves to ensure that it conforms to internationally accepted tax principles, such as the "arm’s length" standard.
The European Commission Court of Justice recently decided a case that could cost the Dutch government dearly: the Bosal case. As a result of the court ruling, Dutch holding companies will be entitled to deduct funding costs in respect of foreign subsidiaries. It is widely expected that immediately following this decision, the Dutch government will propose thin-capitalization rules that will apply to all corporations. Multinational corporations may want to reorganize their operations in Europe to optimize their Dutch tax position.
Euronext resulted from the merger of the Amsterdam, Brussels and Paris stock exchanges. This and other amalgamations in the markets have caused a decreased interest from fund managers in small- and medium-size Dutch listed companies. It can be expected that in the coming years a number of these companies will be delisted and acquired by venture capitalists or by larger multinationals.
Stef van Weeghel is a tax partner at Stibbe, Amsterdam, the Netherlands. He can be contacted at +31 20 5460382 or at stef.vanweeghel stibbe.com.
Republic of South Africa Introduces Black Empowerment Bill
By J. Michael Judin (Goldman Judin Maisels Inc., Johannesburg)
Soon to be introduced by the Republic of South Africa (RSA) Parliament is the broad-based Black Economic Empowerment (BEE) bill. The bill establishes an enabling framework for the promotion of BEE in South Africa. In particular, the legislation will allow the minister of trade and industry to issue guidelines and Codes of Good Practice on BEE. It also launches an advisory council, which will advise South African President Thabo Mvuyelwa Mbeki on the implementation of BEE and related matters. Other than the RSA constitution, the bill is probably one of the most important pieces of legislation introduced by the RSA government since 1994—the year in which the apartheid machinery was dismantled and South Africa became a member of the global community of nations.
It is generally accepted that South Africa needs a focused BEE strategy to achieve the broad-based economic empowerment of black persons: a generic term that means indigenous Africans and Indians in the Republic of South Africa. This will facilitate growth, development and stability in the RSA. The government defines the bill as a socio-economic process that brings about significant increases in the number of black people who manage, own and control the country’s economy. The BEE also aims to decrease income inequalities. This strategy is underpinned by four key principles, namely, that BEE is broad-based, it is an inclusive process, it is associated with good governance and it is part of the RSA’s growth strategy.
The policy instruments to achieve BEE will be the bill, various regulatory means to achieve its BEE objectives and the use of a "balanced scorecard" to measure progress by enterprises and sectors. It is important to note that the scorecard will measure three core elements of BEE: direct empowerment through ownership and control of enterprises and assets; human resource development and employment equity; and indirect empowerment through preferential procurement and enterprise development. The scorecard will be issued as a Code of Good Practice in terms of the legislation. In addition, there will be restructuring of state-owned enterprises, preferential procurement by government, institutional support and a BEE advisory council. Finally, of great interest is that the government will pursue its BEE objectives not only through the use of various government tools, but through the forging of partnerships with the private sector.
The introduction of a BEE partner will enable any company to make inroads into the burgeoning black marketplace. It will also enable a company to obtain government and provincial contracts and to supply the government and the provinces that would otherwise not be available to the previously white-owned company. If properly structured and if the labor force is a participant, then the introduction of a BEE partner invariably improves the labor relationship with the predominantly black labor force found in most companies in South Africa.
Although the legislation does not require it, many large, small and medium South African companies are, of their own volition, requiring that companies that supply them and to whom they outsource have a meaningful BEE. This is because white South Africans appreciate the crucial importance of BEE and the social benefits that follow, creating particularly a black middle-class economy that will prove vital for the long-term sustainability of the country. The Department of Trade and Industry has emphasized that the transfer of equity from established firms to black firms or individuals is not a necessity for local or non-South African companies. This applies except for government tenders or where companies themselves stipulate this as a requirement. A major Black Economic Empowerment challenge lies ahead for global companies that prefer to operate only through wholly-owned subsidiaries or branch companies. The answer to the challenge may lie in partly-owned subsidiaries and joint venture models, where good advice and carefully drafted agreements will be necessary in order to minimize risks, transaction costs and conflicts. The South African government is doing all it can to calm nerves among overseas investors who have been concerned about the country’s intentions regarding the ownership of non-South African subsidiaries and branches. Many issues still remain on the table for discussion.
Multinationals carrying on business in South Africa, which embrace and support BEE, will be treated equally to South African companies. This is because both entities will be required to comply with minimum BEE and balanced scorecard requirements. Minister of Trade and Industry Alex Erwin has described the legislation as innovation and the "final nail in the coffin of apartheid." He is also recorded as saying, "[E]quity and participation by all are the real drivers of growth and development."
The broad-based Black Economic Empowerment bill completed its passage through the RSA Parliment on September 23, 2003, when it was adopted in the National Council of Provinces—albeit with the objections of the Democratic Alliance (one of the opposition parties in the RSA). The bill is expected to become final and binding law shortly.
J. Michael Judin is a partner at Goldman Judin Maisels Inc., based in Johannesburg, South Africa. Michael can be reached at +0 83 300 5000 or via e-mail at michael elawnet.co.za.
Tax-Advising Accounting Firms Walk a Fine Line
By Peter Faber (McDermott, Will & Emery, New York)
The U.S. Sarbanes-Oxley Act of 2002 addressed a congressional concern that accounting firms were not acting as independent, objective auditors of their clients’ financial statements. The act came into force after the controversy surrounding energy giant Enron’s relationship with Arthur Andersen LLP. Andersen was viewed by many as acting in the best interests of the corporation’s management and not in the best interests of its multinational shareholders as well as the general public.
There has always been a conflict between the independent role of an outside accounting firm and the business reality that the company hires the firm. This often results in close personal and professional connections between members of the accounting firms responsible for a specific account and individuals in the company’s management. The U.S. Congress concluded that this inherent conflict of interest made it necessary to prohibit accounting firms from performing certain functions for their audit clients. Congress also concluded, however, that certain tax services, particularly the preparation of tax returns, were so linked to the work done traditionally by outside auditors that they should be permitted if approved by appropriate procedures. A number of the provisions relate to the extent to which different types of tax services should be allowed.
A U.S. Senate Committee on Banking, Housing and Urban Affairs report in connection with the act indicates that the purpose of the prohibitions is to bar activities that create a fundamental conflict of interest for the accounting firm. The prohibitions are based on three principles: an auditor cannot audit its own work, an auditor cannot perform management functions and an auditor cannot act as an advocate for its client. Congress and the U.S. Securities and Exchange Commission (SEC) view these functions as inconsistent with the auditor’s independent role.
Appraisal and Valuation Services
Appraisal and valuation services are expressly prohibited by the act. The SEC’s explanation of the proposed rules indicates that this applies to appraisals of intangible assets (such as goodwill and appraisals of tangible assets). The SEC explanation indicates that appraisals done for non-financial statement purposes, including transfer-pricing studies, will be permitted. Thus, an auditing firm could be engaged in connection with the determination of royalty rates for the licensing of intangible assets and with the provision of goods and services to affiliates.
It seems likely, although this is not clear, that an accounting firm may do transfer-pricing studies for an audit client. These will be allowed only in the context of establishing or monitoring a transfer-pricing arrangement. An accounting firm will probably not be allowed to do a transfer-pricing study in connection with litigation involving section 482 issues or state and local combined report issues.
Under current SEC rules, an auditor cannot provide legal services to a client. The new rules would expand this prohibition by referring to services that can be provided only by a lawyer. The SEC points out that a lawyer is under an ethical obligation to represent his or her client vigorously to the full extent permitted by the law, and one cannot do this and also objectively audit the client’s financial statements.
The SEC explanation states that in some countries only lawyers can perform certain tax services. The explanation indicates that in these cases accounting firms should be allowed to perform those tax services that would normally be permitted if performed in the United States, even though under the laws of the country in question they can be performed only by lawyers.
The SEC’s explanation of the final rules suggests that the principles underlying the act should be applied with respect to tax services in light of the historical role that accountants have played in the tax area. The provision of tax services, similarly to other permitted non-audit services, can be done only if they are pre-approved by the company’s audit committee. The explanation indicates that the audit committee should be mindful of the need to preserve independence when it considers particular services.
The explanation states that "accountants may continue to provide tax services such as tax compliance, tax planning and tax advice to audit clients." Accounting firms have often conducted "tax minimization" studies for audit and other clients in which they review a company’s tax profile and suggest strategies for reducing its tax burden. These strategies invariably purport to have a business purpose and economic substance, and the issues in litigation have revolved around whether they were what they purported to be. Making these determinations may be difficult for audit committees, and it is likely that many companies will conclude that they should use advisors other than their auditing firms for tax minimization projects.
Drawing the line will not always be easy. It is clear that a company should not do a transaction that it would not otherwise have done if the auditors brought it to their attention and suggested that it would save taxes. Although some such transactions and strategies may be non-controversial, the audit committee will have no way of evaluating this. Although the audit committee could look to the corporation’s tax staff or another outside firm for confirmation, it will always be at risk that the SEC could take a different view of the strategy.
It is easy to say that the company should not use its auditors to suggest to it tax-saving transactions that it would not otherwise do. It is harder to deal with tax planning with respect to transactions that the company was going to do anyway. This would seem to fit within accepted notions of tax planning that the SEC seems to be prepared to permit.
What if the auditing firm recommends a novel strategy for structuring a transaction that the company was planning to do in any event? The acquisition of Matthew Bender by Times-Mirror illustrates the problem. The transaction was initially planned as a cash purchase of Matthew Bender’s stock by Times-Mirror, which would have been fully taxable to the shareholders. An accounting firm developed a novel strategy that was intended to make the transaction tax-free. It involved an elaborate structure in which new entities were formed solely for tax purposes. The basic structure used a so-called mixing-bowl technique in which the Matthew Bender shareholders received an equity-like interest in an entity owning cash and Times-Mirror had control over, and the upside potential from, the business. This was a highly aggressive structure, recognized as such by all involved including the auditing firm, and it has been challenged by the Internal Revenue Service. Although this could be viewed as simply advising a client on how to structure an acquisition, the SEC might regard this as being so unusual that it would be hard for the accounting firm to review the financial statements of the corporate parties in an independent way. It would have a stake in the outcome that exceeds the normal interest of a professional advisor in having its advice upheld.
Accounting firms often approach audit and non-audit
clients with tax-saving strategies, even if they have not been engaged to do so. To be safe, the audit committee should approve any consideration of such a strategy in advance, and it should be made clear at the outset that, for the reasons indicated above, any fee paid to the firm will not be based on tax savings.
Many audit committees will conclude that there are so many uncertainties as to what their auditing firms can do that the safest course of action will be not to use them for any tax services other than the preparation or approval of tax returns and routine tax compliance. If the independence requirements are violated, the company will have to retain a new auditing firm, which can be time-consuming and expensive. Even where the nature of services is such that they can best be provided by an accounting firm, many companies will conclude that the uncertainties of using their auditing firm and the inconvenience of having the audit committee constantly making decisions as to what can and cannot be done are such that it is not worth the trouble. An accounting firm other than their auditing firm should be retained for tax services. Although the final rules indicate a softening of the SEC’s attitude, considerable uncertainty remains.
Peter Faber is a partner at McDermott, Will & Emery, resident in its New York office, where he heads the New York tax practice. He has advised corporations (both publicly held and privately held), partnerships and individuals on a wide variety of transactions, including mergers and acquisitions, restructurings, spin-offs and debt work-outs. He can be reached at + 212 547 5585 or via e-mail at pfaber mwe.com.
U.S.-Based Multinationals Benefit from Temporary Tax Deduction
By David Hardy (McDermott, Will & Emery, New York) and James Riedy (McDermott, Will & Emery, Washington, D.C.)
U.S.-based multinationals are strongly encouraged by U.S. tax and accounting rules to accumulate earnings in their non-U.S. subsidiaries. Such companies face substantial tax and earnings detriments if these earnings are distributed back to the U.S. parent company (repatriation). The build-up of non-U.S. earnings has caused many companies to devote considerable attention to strategies permitting repatriation on a tax-efficient basis.
The U.S. Congress has entered into this area as well. The Thomas Bill, introduced by Chairman Thomas of the U.S. Ways and Means Committee, is officially named the