- The Turkish Commercial Code (“TCC”) gives particular importance to the protection of capital in joint stock corporations and limited liability partnerships. The TCC determines mandatory measures to be adopted by these companies’ relevant bodies in the event of capital loss. Article 376 of the TCC governs over-indebtedness and technical bankruptcy. Article 376 distinguishes between three different levels of capital inadequacy and sets forth specific corporate remedies for each. It is crucial to take right the steps on time, because Technical Bankruptcy is one of the legal grounds for dissolution of companies. Companies’ board members and managers may be subject to legal and criminal liability, if they fail to fulfill their obligations under Article 376 as well as the Execution and Bankruptcy Law (“EBL”).
- Article 376 of the TCC governs over-indebtedness, Technical Bankruptcy and their consequences:
- Under Article 376/1 of the TCC, if the company’s board of directors sees from the previous year’s annual balance sheet that 1/2 of the company’s share capital and legal reserves have eroded, then the Board must call the general assembly of shareholders immediately for an extraordinary meeting and to prepare a proposal for strengthening the company’s financial status, to be submitted to the general assembly’s approval. The Board must report the financial situation of the Company to the general assembly by explaining its reasons and suggest remedies. The proposed remedies may vary from capital increase, cost reduction policy, suspension of investments to the sale of assets, depending on the circumstances.
- Under Article 376/2, if the Board sees that 2/3 of the company’s share capital and statutory reserves have eroded, the Board must immediately call for an extraordinary meeting of the general assembly and present a proposal for remedial measures, in order to improve the company’s share capital status. At this extraordinary meeting, the general assembly must resolve on either:
- completing the eroded portion of the share capital through a cash injection, in order to replenish the share capital to its original level; or
- proceeding with the amount equal to 1/3 of the share capital.
If the assembly fails to adopt any of the abovementioned resolutions at the general assembly meeting or if a meeting is not convened at all, the company would be deemed dissolved pursuant to the TCC and the EBL.
- In addition to the above, if there are significant signs that the company is over- indebted, the Board must prepare an “interim” balance sheet, where the value of the company’s current assets is recalculated at fair market value. If the interim balance sheet indicates that the company’s assets are not sufficient to cover its debts, the Board must notify the competent commercial court and file for bankruptcy (“Financial Insolvency”).
- In order to detect to what extent the loss of capital drained equity, the Board must compare (i) the shareholders’ equity in the Company with (ii) the sum of capital and legal reserves of the Company. If the ratio between the shareholders’ equity and capital+legal reserves is equal to or less than 1/2, the Company would not be deemed as under technical bankruptcy but would need to take necessary measures. However, if the ratio is equal to or falls below 1/3, the financial instability of the Company reaches the level of “technical bankruptcy”.
- It is important to distinguish between separate Technical Bankruptcy and Financial Insolvency, since their consequences are different. Insolvency can be defined as a debtor’s inability to cover its debts, while bankruptcy is a status to be determined by commercial courts, which announces the company’s inability to cover its debts by its assets. A company may be bankrupt under several circumstances. Insolvency is one of the grounds for bankruptcy.
- Recovery Methods
As explained above, capital companies can face Technical Bankruptcy or Financial Insolvency upon erosion of their share capital or if their statutory reserves reach the said thresholds. If the “shareholders’ equity/capital+legal reserves” ratio is between 1/2 and 1/3, the Board must immediately notify its shareholders and convene a general assembly meeting whereby the Board must report the financial situation of the Company to the general assembly by explaining its reasons and suggest remedies. The proposed remedies may vary from capital increase, cost reduction policy, suspension of investments to the sale of assets, depending on the circumstances.
- The most popular remedies are (i) injection of cash to the company as “loss remedy fund” or (ii) capital increase in order to resolve the insolvency problem. However, these methods also bring together certain financial and tax implications.
- Loss Remedy Fund: The shareholders/partners may inject cash to the company to replenish the company’s capital funds, through creating a special fund, called the “loss remedy fund”. The shareholder/partner can inject, via loss the remedy fund, in an amount that covers Technical Bankruptcy threshold. Moreover, if the amount injected by the shareholder/partner exceeds the sum of the accumulated losses plus 1/3 of the paid-in capital, tax authorities will deem the exceeding portion as an income of the company.
- Capital Increase: The TCC does not explicitly govern capital increase methods in the event of Financial Insolvency. That said, a capital increase may be conducted either through a cash contribution or conversion of the shareholder/partner loans into share capital.
- The main purpose of Article 376 of the TCC is to maintain the financial stability of companies and to ensure continuity of their operations. While incorporating a capital company, the initial share capital must be carefully determined, based on the profit and loss projections of the company. This will help avoid Technical Bankruptcy or a similar situation at the early stages of the company’s operations.