Contract ETD/2006/IM/F2/71

kpmg.com

Contract ETD/ 2006 / IM / F2 / 71

Feasibility study on an alternative to the capital maintenance

KPMG Feasibility Study on Capital Maintenance – Main Report

regime established by the Second Company Law Directive
77/91/EEC of 13 December 1976 and an examination of the
impact on profit distribution of the new EU-accounting regime

Main Report

Kontakt

KPMG Deutsche Treuhand-

Gesellschaft Aktiengesellschaft
Wirtschaftsprüfungsgesellschaft
Klingelhöferstraße 18
10785 Berlin
Germany

Georg Lanfermann
T +49 30 2068-1262
F +49 1802 11991-1262
glanfermann@kpmg.com

The information contained herein is of a general nature and is not intended to address the circumstances of 2008 KPMG Deutsche Treuhand-Gesellschaft
any particular individual or entity. Although we endeavor to provide accurate and timely information, there Aktiengesellschaft Wirtschaftsprüfungs-
can be no guarantee that such information is accurate as of the date it is received or that it will continue to gesellschaft, a member firm of the KPMG net-
be accurate in the future. No one should act on such information without appropriate professional advice work of independent member firms affiliated
after a thorough examination of the particular situation. with KPMG International, a Swiss Cooperative.
Printed in Germany. KPMG and the KPMG logo
are registered trademarks of KPMG International.
 Contract ETD/2006/IM/F2/71
kpmg.com

Contract ETD/ 2006 / IM / F2 / 71

Feasibility study on an alternative to the capital maintenance

KPMG Feasibility Study on Capital Maintenance – Main Report

regime established by the Second Company Law Directive
77/91/EEC of 13 December 1976 and an examination of the
impact on profit distribution of the new EU-accounting regime

Main Report

Contact

KPMG Deutsche Treuhand-

Gesellschaft Aktiengesellschaft
Wirtschaftsprüfungsgesellschaft
Klingelhöferstraße 18
10785 Berlin
Germany

Georg Lanfermann
T +49 30 2068-1262
F +49 1802 11991-1262
glanfermann@kpmg.com

The information contained herein is of a general nature and is not intended to address the circumstances of 2008 KPMG Deutsche Treuhand-Gesellschaft
any particular individual or entity. Although we endeavor to provide accurate and timely information, there Aktiengesellschaft Wirtschaftsprüfungs-
can be no guarantee that such information is accurate as of the date it is received or that it will continue to gesellschaft, a member firm of the KPMG net-
be accurate in the future. No one should act on such information without appropriate professional advice work of independent member firms affiliated
after a thorough examination of the particular situation. with KPMG International, a Swiss Cooperative.
Printed in Germany. KPMG and the KPMG logo
are registered trademarks of KPMG International.
 KPMG Feasibility Study on Capital Maintenance
– Main Report

Summary of contents
Main Report Pages

1 Executive summary 1

2 Introduction 13

3 Basic elements of capital regimes 17

4 Alternatives to the current regime of capital regime 25

4.1 Comparative analysis – situation in the European Union 25

4.1.1 France 25
4.1.2 Germany 50
4.1.3 Poland 76
4.1.4 Sweden 97
4.1.5 United Kingdom 117
4.1.6 Conclusions 143

4.2 Comparative analysis – situation in non-EU countries 155

4.2.1 USA – MBCA 155

4.2.2 USA – Delaware 161
4.2.3 USA California 183
4.2.4 Canada 201
4.2.5 Australia 217
4.2.6 New Zealand 236
4.2.7 Conclusions 256

4.3 Alternative regimes proposed by literature 269

4.3.1 High Level Group 269

4.3.2 Rickford Group 280
4.3.3 Lutter Group 294
4.3.4 Dutch Group 297
4.3.5 Conclusion 306

4.4 Conclusion on comparative analysis 311

5 Impacts of IFRS on profit distribution 315

6 Introduction of new regime 395

6.1 Introduction 395

6.2 Legal capital 396
6.3 True no-par value shares 410

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Annexes – Part 1 Pages

1 Sample methodology 1

2 Key questionnaires 5

2.1 CFO questionnaire 5

2.2 IFRS questionnaire 8

3 Legal annexes 45

3.1 EU legal annexes 45

3.2 Non-EU legal annexes 176

4 Private companies 310

Annexes – Part 2 Pages

1 Legal questionnaires 1

1.1 EU legal questionnaire 1

1.2 non-EU legal questionnaire 44

2 Cost questionnaires 85

2.1 EU countries 85
2.2 non-EU countries 194

Annexes Part 1 and Part 2 can be found in two separate binders.

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Table of contents
Summary of content I - II

Table of content III - IX

List of abbreviations X - XI

Table of figures XII - XV

1 Executive summary 1

2 Introduction 13

2.1 Area of EU company law under examination 13

2.2 Scope of the study 13

2.3 Methodological approach 14

3 Basics elements of capital regimes 17

3.1 Introduction 17

3.2 Statutory basis of the capital protection system 17

3.2.1 Provisions on the structure and acquisition of equity capital 17

3.2.2 Provisions in distributions 20
3.2.3 Provisions for the maintenance of contributed capital 21

3.3 Approach to the economic analysis 22

3.4 Considerations regarding the protection of shareholders and creditors 24

4 Alternatives to the current capital regime 25

4.1 Comparative analysis – situation in the European Union 25

4.1.1 France 25

4.1.1.1 Structure of capital and shares 25

4.1.1.2 Capital increase 29
4.1.1.3 Distribution 36
4.1.1.4 Capital maintenance 42
4.1.1.4.1 Acquisition by the company of its of own shares 42
4.1.1.4.2 Capital reduction 45
4.1.1.4.3 Withdrawal of shares 46
4.1.1.4.4 Financial assistance 47
4.1.1.4.5 Serious loss of half of the subscribed capital 47
4.1.1.4.6 Contractual self protection 48

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4.1.1.5 Insolvency 49

4.1.2 Germany 50

4.1.2.1 Structure of capital and shares 50

4.1.2.2 Capital increase 55
4.1.2.3 Distribution 62
4.1.2.4 Capital maintenance 68
4.2.1.4.1 Acquisition by the company of its of own shares 68
4.1.2.4.2 Capital reduction 71
4.1.2.4.3 Withdrawal of shares 72
4.1.2.4.4 Financial assistance 73
4.1.2.4.5 Serious loss of half of the subscribed capital 73
4.1.2.4.6 Contractual self protection 74
4.1.2.5 Insolvency 75

4.1.3 Poland 76

4.1.3.1 Structure of capital and shares 76

4.1.3.2 Capital increase 80
4.1.3.3 Distribution 85
4.1.3.4 Capital maintenance 90
4.1.3.4.1 Acquisition by the company of its own shares 90
4.1.3.4.2 Capital reduction 92
4.1.3.4.3 Withdrawal of shares 93
4.1.3.4.4 Financial assistance 94
4.1.3.4.5 Serious loss of half of the subscribed capital 94
4.1.3.4.6 Contractual self-protection 95
4.1.3.5 Insolvency 96

4.1.4 Sweden 97

4.1.4.1 Structure of capital and shares 97

4.1.4.2 Capital increase 101
4.1.4.3 Distribution 105
4.1.4.4 Capital maintenance 110
4.1.4.4.1 Acquisition by the company of its of own shares 111
4.1.4.4.2 Capital reduction 113
4.1.4.4.3 Withdrawal of shares 114
4.1.4.4.4 Financial assistance 114
4.1.4.4.5 Serious loss of half of the subscribed capital 114
4.1.4.4.6 Contractual self protection 115
4.1.4.5 Insolvency 116

4.1.5 United Kingdom 117

4.1.5.1 Structure of capital and shares 117

4.1.5.2 Capital increase 121
4.1.5.3 Distributions 126
4.1.5.4 Capital maintenance 134
4.1.5.4.1 Acquisition of own shares 135

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4.1.5.4.2 Capital reduction 138

4.1.5.4.3 Redeemable shares 139
4.1.5.4.4 Financial assistance 140
4.1.5.4.5 Serious loss of half of the subscribed capital 140
4.1.5.4.6 Contractual self protection 141
4.1.5.5 Insolvency 142

4.1.6 Conclusions for the five EU Member States 143

4.2 Comparative analysis – situation in non-EU countries 155

4.2.1 USA – MBCA 155

4.2.1.1 Introduction 155

4.2.1.2 Capital formation 156
4.2.1.3 Capital maintenance 157

4.2.2 USA – Delaware 161

4.2.2.1 Structure of capital and shares 161

4.2.2.2 Capital increase 164
4.2.2.3 Distribution 167
4.2.2.4 Capital maintenance 174
4.2.2.4.1 Acquisition by the company of its own shares 175
4.2.2.4.2 Capital reduction 178
4.2.2.4.3 Share redemption 178
4.2.2.4.4 Financial assistance 179
4.2.2.4.5 Serious loss of half of the subscribed capital 180
4.2.2.4.6 Contractual self protection 180
4.2.2.5 Insolvency 182

4.2.3 USA – California 183

4.2.3.1 Structure of capital and shares 183

4.2.3.2 Capital increase 184
4.2.3.3 Distribution 187
4.2.3.4 Capital maintenance 193
4.2.3.4.1 Acquisition of own shares 194
4.2.3.4.2 Capital decrease 196
4.2.3.4.3 Share redemption 196
4.2.3.4.4 Financial assistance 198
4.2.3.4.5 Serious loss of half of the subscribed capital 198
4.2.3.4.6 Contractual self protection 198
4.2.3.5 Insolvency 199

4.2.4 Canada 201

4.2.4.1 Structure of capital and shares 201

4.2.4.2 Capital increase 204
4.2.4.3 Distribution 206
4.2.4.4 Capital maintenance 211

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4.2.4.4.1 Acquisition of own shares 211

4.2.4.4.2 Capital decrease 212
4.2.4.4.3 Share redemption 213
4.2.4.4.4 Financial assistance 214
4.2.4.4.5 Serious loss of half of the subscribed capital 214
4.2.4.4.6 Contractual self protection 214
4.2.4.5 Insolvency 215

4.2.5 Australia 217

4.2.5.1 Structure of capital and shares 217

4.2.5.2 Capital increase 219
4.2.5.3 Distribution 222
4.2.5.4 Capital maintenance 228
4.2.5.4.1 Acquisition of own shares 228
4.2.5.4.2 Capital decrease 230
4.2.5.4.3 Share redemption 231
4.2.5.4.4 Financial assistance 232
4.2.5.4.5 Serious loss of half of the subscribed capital 233
4.2.5.4.6 Contractual self protection 233
4.2.5.5 Insolvency 234

4.2.6 New Zealand 236

4.2.6.1 Structure of capital and shares 236

4.2.6.2 Capital increase 238
4.2.6.3 Distribution 241
4.2.6.4 Capital maintenance 249
4.2.6.4.1 Acquisition by a company of its own shares 249
4.2.6.4.2 Capital reduction 251
4.2.6.4.3 Share redemption 251
4.2.6.4.4 Financial assistance 253
4.2.6.4.5 Serious loss of half of the subscribed capital 253
4.2.6.4.6 Contractual self protection 254
4.2.6.5 Insolvency 254

4.2.7 Conclusions for the four non-EU countries 256

4.3 Alternative regimes proposed by literature 269

4.3.1 High Level Group 269

4.3.1.1 The proposal 269

4.3.1.1.1 Outline 269
4.3.1.1.2 Necessary amendments to the 2nd CLD 269
4.3.1.1.3 Distributions 271
4.3.1.2 Economic analysis 275

4.3.2 Rickford Group 280

4.3.2.1 The Proposal 280

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4.3.2.1.1 Outline 280

4.3.2.1.2 Necessary amendments to the 2nd CLD 280
4.3.2.1.3 Distributions 282
4.3.2.2 Economic analysis 288

4.3.3 Lutter Group 294

4.3.3.1 The proposal 294

4.3.3.1.1 Outline 294
4.3.3.1.2 Necessary amendments to the 2nd CLD 294
4.3.3.1.3 Distributions 294
4.3.3.2 Economic analysis 295

4.3.4 Dutch Group 297

4.3.4.1 The proposal 297

4.3.4.1.1 Outline 297
4.3.4.1.2 Necessary amendments to the 2nd CLD 297
4.3.4.1.3 Distributions 299
4.3.4.2 Economic analysis 301

4.3.5 Conclusion on regimes proposed by literature 306

4.4 Conclusions on comparative analysis 311

5 Impacts of IFRS on profit distribution 315

5.1 Introduction 315

5.2 Overview on 27 EU Member States – part I 317

5.2.1 Introduction 317

5.2.2 Determination of distributable profits 318

5.2.2.1 Application of IFRS in the European Union 318

5.2.2.2 Determination of distributable profits based on IFRS 319
5.2.2.3 Deviations between national
accounting rules and IFRS 322

5.2.3 Specific areas of accounting 326

5.2.3.1 Investment property 326

5.2.3.2 Post-employment benefits 327
5.2.3.3 Financial instruments 330

5.2.4 Conclusion on overview of 27 EU Member States 332

5.3 Detailed country analysis - part II 335

5.3.1 France 335

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5.3.1.1 Introduction 335

5.3.1.2 Investment property 335
5.3.1.3 Employee benefits 335
5.3.1.4 Financial instruments - including hedging 336

5.3.2 Germany 341

5.3.2.1 Introduction 341

5.3.2.2 Investment property 341
5.3.2.3 Defined benefit plans (DBP) 344
5.3.2.4 Financial instruments 346

5.3.3 Poland 352

5.3.3.1 Introduction 352

5.3.3.2 Investment property 352
5.3.3.3 Defined benefit plans (DBP) 355
5.3.3.4 Financial instruments 357

5.3.4 Sweden 362

5.3.4.1 Introduction 362

5.3.4.2 Investment property 362
5.3.4.3 Defined benefit plans (DBP) 364
5.3.4.4 Financial instruments 367

5.3.5 United Kingdom 372

5.3.5.1 Overview of UK legal position on

distributable profits 372
5.3.5.2 Investment property 378
5.3.5.3 Defined benefit schemes 379
5.3.5.4 Financial instruments 383

5.3.6 Conclusions on detailed analysis for selected EU Member States 392

6 Introduction of a new regime 395

6.1 Introduction 395

6.2 Legal capital 396

6.2.1 Amendments to the 2nd CLD’s basic model of legal capital 396

6.2.1.1 Overview 396

6.2.1.2 Model 1A – “Company option” 397
6.2.1.3 Model 1B – “Regulator option” 399
6.2.1.4 Model 2 – “IFRS solvency add-on“ 400
6.2.1.5 Model 3 – “On equal terms“ 401
6.2.1.6 Model 4 – “Solvency test predominance“ 402

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6.2.2 Capital maintenance in groups of companies 404

6.2.2.1 Overview 404

6.2.2.2 Model 1 – “Do nothing” 405
6.2.2.3 Model 2 – “Add-on” 405
6.2.2.4 Model 3 – “Pure consolidated view” 405

6.2.3 Design of the solvency test 407

6.2.3.1 Overview 407

6.2.3.2 Model 1 – “Leave it to the companies” 408
6.2.3.3 Model 2 – “Current ratios” 409
6.2.3.4 Model 3 – “Short-term projection” 409
6.2.3.5 Model 4 – “Mid-term projection” 409

6.3 True no-par value shares 410

6.3.1 Introduction 410

6.3.2 Concepts for the introduction of true no-par value shares 411

6.3.2.1 Model 1: Protection of all

proceeds from share issues 411
6.3.2.2 Model 2: Variable capital 417
6.3.2.3 Model 3: Mixed Model 419
6.3.2.4 Model 4: Solvency test 420
6.3.2.5 Model 5: Solvency margin 422
6.3.2.6 Conclusion 422

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List of abbreviations
AASB = Australian Accounting Standards Board
ABL = Aktiebolagslagen (Swedish Companies Act)
AG = Advocate General
AGM = Annual General Meeting (of company shareholders)
AktG = Aktiengesetz (German Stock Corporation Act)
AMF = Autorités des Marchés Financiers
Art. = Article
ASIC = Australian Securities and Investments Commission
ASX = Australian Stock Exchange
B.C.C. = British Company Cases
BaFin = Bundesanstalt für Finanzdienstleistungsaufsicht
(German Federal Financial Supervisory Authority)
BALO = Bulletin des Annonces Légales Obligatoires
BIA = Bankruptcy and Insolvency Act (Canada)
BODACC = Bulletin Officiel des Annonces Civiles et Commerciales
CA (1) = Companies Act (United Kingdom)
CA (2) = Corporations Act 2001 (Australia)
CA (3) = Companies Act 1993 (New Zealand)
CAC = Cotation Assistée en Continu
CBCA = Canada Business Corporations Act
CCAA = Companies' Creditors Arrangement Act (Canada)
CCC (1) = Commercial Companies Code (Poland)
CCC (2) = California Corporations Code
CEO = Chief Executive Officer
CFO = Chief Financial Officer
CLD = Company Law Directive
DAX = Deutscher Aktienindex (German Stock Index)
EBIT = Earnings before Interest and Taxes
EBITDA = Earnings before Interest, Tax, Depreciation and Amortisation
ER = English Reports
EU = European Union
FRS = Financial Reporting Standard (United Kingdom)
FTSE = Financial Times Stock Exchange (United Kingdom)
FY = Financial year
GAAP = Generally Accepted Accounting Principles
GBP = United Kingdom Pound (currency)
GDP = Gross Domestic Product
HGB = Handelsgesetzbuch (German Commercial Code)
i.e. = id est (that is)
IAS = International Accounting Standard
IASB = International Accounting Standards Board
ICAEW = Institute of Chartered Accountants in England and Wales
ICAS = Institute of Chartered Accountants of Scotland
IFRS = International Financial Reporting Standards
IPO = Initial public offering
IRL = Polish Insolvency and Rehabilitation Act
J.C.P. = Journal of Consumer Policy
LBO = Leveraged buy-outs

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Ltd = Limited
M&A = Mergers and Acquisitions
MBCA = Model Business Corporation Act (United States)
MidCap = Middle capitalisation
NA = No answer
NZD = New Zealand Dollar
NZX = New Zealand Stock Exchange
PCG = Plan comptable général (General Accounting Plan)
PLC = Public Limited Company (United Kingdom)
PLN = Polish Zloty New (Polish currency)
S&P = Standard and Poor's
S.A. = Société Anonyme
SEC = Securities and Exchange Commission
SEK = Swedish Krona (Swedish currency)
SME = Small and medium-sized enterprises
TECH = Technical Release from the Business Law Committee of the ICAEW
TSX = Toronto Stock Exchange
UFTA = Uniform Fraudulent Transfer Act (California)
UK = United Kingdom
US = United States
WIG = Warszawski Indeks Giełdowy (Warsaw Stock Exchange Index)

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Table of figures

Number Title Page

2-1 KPMG methodological approach 15

4.1.1-1 Ratio of subscribed capital to market capitalisation (France) 26
4.1.1-2 CFO survey results: necessity of subscribed capital (France) 27
4.1.1-3 CFO survey results: level of subscribed capital (France) 28
4.1.1-4 Ratio of subscribed capital to total shareholder’s capital (France) 28
4.1.1-5 CFO survey results: attitudes towards increases of subscribed capital (France) 29
4.1.1-6 Process for ordinary capital increase (France) 33
4.1.1-7 Process for authorised capital increase (France) 34
4.1.1-8 Process for the injection of contributions (France) 35
4.1.1-9 Process of dividend distributions (France) 38
4.1.1-10 Determinants for the distribution of dividends in the holding company (France) 39
4.1.1-11 Important deterrents when considering the level of profit distribution (France) 39
4.1.1-12 Determinants for the distribution of dividends by the subsidiaries (France) 40
4.1.1-13 Process for the acquisition of own shares (France) 44
4.1.2-1 Ratio of subscribed capital to market capitalisation (Germany) 52
4.1.2-2 CFO survey results: necessity of subscribed capital (Germany) 52
4.1.2-3 CFO survey results: level of subscribed capital (Germany) 53
4.1.2-4 Ratio of subscribed capital to total shareholder’s equity (Germany) 54
CFO survey results: attitudes towards increases of subscribed capital
4.1.2-5 54
(Germany)
4.1.2-6 Process of an ordinary capital increase (Germany) 58
4.1.2-7 Process of the authorised capital increase 59
4.1.2-8 Process for the injection of contributions (Germany) 61
4.1.2-9 Due process for distributing profits (Germany) 64
Determinants for the distribution of dividends in the holding company
4.1.2-10 65
(Germany)
Important deterrents when considering the level of profit distribution
4.1.2-11 65
(Germany)
4.1.2-12 Determinants for the distribution of dividends by the subsidiaries (Germany) 66
4.1.2-13 Process for the acquisition of own shares (Germany) 69
4.1.3-1 Ratio of subscribed capital to market capitalisation (Poland) 77
4.1.3-2 CFO survey results: necessity of subscribed capital (Poland) 78
4.1.3-3 CFO survey results: level of subscribed capital (Poland) 78
4.1.3-4 Ratio of subscribed capital to total shareholder’s equity (Poland) 79
4.1.3-5 CFO survey results: attitudes towards increases of subscribed capital (Poland) 79
4.1.3-6 Process for ordinary capital increase (Poland) 83
4.1.3-7 Process for authorised capital increase (Poland) 84
4.1.3-8 Process for the injection of contributions (Poland) 84
4.1.3-9 Due process for distributing profits (Poland) 86
4.1.3-10 Determinants for the distribution of dividends in the holding company (Poland) 87
4.1.3-11 Important deterrents when considering the level of profit distribution (Poland) 88
4.1.3-12 Determinants for the distribution of dividends by the subsidiaries (Poland) 88
4.1.3-13 Process for the acquisition of own shares (Poland) 91
4.1.4-1 Common Stock – Market Capitalisation (Sweden) 99
4.1.4-2 CFO survey results: necessity of subscribed capital (Sweden) 99
4.1.4-3 CFO survey results: level of subscribed capital (Sweden) 100

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4.1.4-4 Ratio of common stock to total shareholder’s equity (Sweden) 100

4.1.4-5 CFO survey results: attitudes towards increases of subscribed capital (Sweden) 101
4.1.4-6 Due process for distributing profits (Sweden) 107
Determinants for the distribution of dividends in the holding company
4.1.4-7 108
(Sweden)
4.1.4-8 Important deterrents when considering the level of profit distribution (Sweden) 109
4.1.4-9 Determinants for the distribution of dividends by the subsidiaries (Sweden) 109
4.1.4-10 Process for the acquisition of own shares (Sweden) 112
4.1.5-1 Ratio of subscribed capital to market capitalisation (United Kingdom) 118
4.1.5-2 CFO survey results: necessity of subscribed capital (United Kingdom) 119
4.1.5-3 CFO survey results: level of subscribed capital (United Kingdom) 120
4.1.5-4 Ratio of subscribed capital to total shareholder’s equity (United Kingdom) 120
CFO survey results: attitudes towards increases of subscribed capital (United
4.1.5-5 121
Kingdom)
4.1.5-6 Process for ordinary capital increase (United Kingdom) 124
4.1.5-7 Process for the injection of contributions (United Kingdom) 126
4.1.5-8 Due process for distributing profits (United Kingdom) 130
4.1.5-9 Process of dividend distribution authorised by the directors (United Kingdom) 130
4.1.5-10 Process of dividend distribution declared by the shareholders (United Kingdom) 130
Determinants for the distribution of dividends in the holding company (United
4.1.5-11 131
Kingdom)
Important deterrents when considering the level of profit distribution (United
4.1.5-12 132
Kingdom)
Determinants for the distribution of dividends by the subsidiaries (United
4.1.5-13 132
Kingdom)
4.1.5-14 Process for the acquisition of own shares (United Kingdom) 136
4.1.6-1 Minimum subscribed capital in the five EU Member States 145
4.1.6-2 Importance of subscribed capital (EU comparison) 145
Ratio of subscribed capital to shareholders equity (average for 5 EU Member
4.1.6-3 146
States)
4.1.6-4 Permissibility to distribute premiums in the five EU Member States 146
4.1.6-5 Characteristics of balance sheet tests and solvency tests (EU comparison) 149
4.1.6-6 Deterrents to distributions (EU comparison) 149
4.1.6-7 Determinants of distribution for holding companies (EU comparison) 150
4.1.6-8 Determinants of distributions by subsidiaries (EU comparison) 151
4.1.6-9 Conditions for the repurchasing of own shares (5 EU Member States) 152
4.1.6-10 Incremental costs for the five EU Member States 153
4.2.2-1 Ratio of share capital to market capitalisation (USA) 163
4.2.2-2 Ratio of share capital to total shareholder’s equity (USA) 164
4.2.2-3 Process of capital increase (USA-Delaware) 166
4.2.2-4 Process of injection of contributions (USA-Delaware) 166
4.2.2-5 Due process for distributing profits (USA-Delaware) 169
4.2.2-6 Determinants for the distribution of dividends in the holding company (USA) 179
4.2.2-7 Important deterrents when considering the level of profit distribution (USA) 171
4.2.2-8 Determinants for the distribution of dividends by the subsidiaries (USA) 171
4.2.2-9 Process of acquisition of own shares (USA-Delaware) 176
4.2.3-1 Process for capital increase (USA-California) 186
4.2.3-2 Process for the injection of contribution (USA-California) 186
4.2.3-3 Due process for distributing profits (USA-California) 191
4.2.3-4 Process for the acquisition of own shares (USA-California) 195
4.2.4-1 Ratio of share capital to market capitalisation (Canada) 203

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4.2.4-2 Ratio of share capital to total shareholder’s equity (Canada) 204

4.2.4-3 Due process for distributing profits (Canada) 208
4.2.4-4 Determinants for the distribution of dividends in the holding company (Canada) 208
4.2.4-5 Important deterrents when considering the level of profit distribution (Canada) 209
4.2.4-6 Determinants for the distribution of dividends by the subsidiaries (Canada) 209
4.2.5-1 Ratio of share capital to market capitalisation (Australia) 218
4.2.5-2 Ratio of share capital to total shareholder’s equity (Australia) 219
4.2.5-3 Process for capital increase (Australia) 220
4.2.5-4 Process for the injection of contributions (Australia) 221
4.2.5-5 Due process for distributing profits (Australia) 225
Determinants for the distribution of dividends in the holding company
4.2.5-6 225
(Australia)
Important deterrents when considering the level of profit distribution
4.2.5-7 226
(Australia)
4.2.5-8 Determinants for the distribution of dividends by the subsidiaries (Australia) 226
4.2.6-1 Ratio of share capital to market capitalisation (New Zealand) 237
4.2.6-2 Ratio of share capital to total shareholder’s equity (New Zealand) 238
4.2.6-3 Process for the capital increase (New Zealand) 240
4.2.6-4 Process for the injection of contribution (New Zealand) 240
4.2.6-5 Due process for distributing profits (New Zealand) 244
Determinants for the distribution of dividends in the holding company (New
4.2.6-6 246
Zealand)
Important deterrents when considering the level of profit distribution (New
4.2.6-7 246
Zealand)
Determinants for the distribution of dividends by the subsidiaries (New
4.2.6-8 247
Zealand)
4.2.7-1 Overview on capital regimes in the four non-EU countries 257
4.2.7-2 Characteristics of balance sheet tests and solvency tests (non-EU countries) 261
CFO survey results: solvency tests and dividend determination (non-EU
4.2.7-3 263
countries)
CFO survey results: accounting standards and profit distribution (non-EU
4.2.7-4 264
countries)
4.2.7-5 Determinants of dividends for holding companies (non-EU countries) 264
4.2.7-6 Determinants of dividends for subsidiaries (non-EU countries) 265
4.2.7-7 Conditions for the repurchasing of own shares (5 non-EU jurisdictions) 265
4.2.7-8 Deterrent for profit distributions (non-EU countries) 267
4.2.7-9 Summary of incremental cost for the five non-EU jurisdictions 268
4.3.5-1 Estimated incremental burdens of theoretical models 310
4.4-1 Incremental costs in the five EU Member States 311
4.4-2 Incremental costs for the five non-EU jurisdictions 312
4.4-3 Comparison of the average EU and non-EU incremental costs 312
Comparison of the average EU incremental costs with estimated incremental
4.4-4 314
burdens of theoretical models
5.2-1 Mandatory and permitted application of IFRS 318
Survey on 27 EU Member States: profit distribution based on IFRS,
5.2-2 319
modification requirements
5.2-3 Survey on 27 Member States: average deviation of IFRS from national GAAP 323
5.2-4 Survey by IFRS standard: average deviation from national GAAP 324
5.2-5 Survey by IFRS standard: impact on equity 325
Survey for 27 EU Member States: accounting method under a post employment
5.2-6 328
benefit plan

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5.2-7 Relevance of parameters to calculate a post-employment benefit obligation 329

5.2-8 Method of recognition of actuarial gains or losses 330
5.2-9 Accounting treatment for non-derivative financial instruments 331
5.2-10 Recognition and measurement of derivative financial instruments 331
5.2-11 Forms of hedge accounting 332
5.3-1 Example deferred taxes (UK) 381
6.2-1 Five Approaches for amendments to the basic model of the 2nd CLD 397
6.2-2 CFO survey results: accounting framework and profit distribution 398
CFO survey results: determinants for dividend distributions by holding
6.2-3 404
companies
6.2-4 Three approaches concerning dividend distributions in groups of companies 405
6.2-5 CFO survey results: use of liquidity tests 407
6.2-6 Four approaches concerning the design of solvency tests 408

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1 Executive summary

The guiding objective of this study is to evaluate the feasibility of an alternative to the current
regime of legal capital established by the 2nd Company Law Directive (CLD) and to examine
the impacts of International Financial Reporting Standards (IFRS) on profit distribution. The
study is intended to help the European Commission to evaluate whether an alternative regime
would better support the efficiency and competitiveness of EU businesses. A particular
challenge for the capital regime as currently embedded in the 2nd CLD is the introduction of
IFRS in the European Union. Under the IAS Regulation (1606/2002), EU Member States may
permit or require companies to use IFRS for their individual financial statements. This
instantly raises the question whether IFRS as an accounting framework is adequate to be used
as the basis for profit distribution under the current capital regime of the 2nd CLD when IFRS
are not primarily designed for this purpose.

The decision on the introduction of an alternative to the current regime is a highly complex
task. Several disciplines on which alternative regimes may have an effect or influence, will
need due consideration. This primarily concerns the areas of company law and accountancy.
Furthermore, certain aspects of insolvency and securities legislation or taxation may also
come into play. For specific industries, such as the banking and insurance sector, certain
regulations e.g. Basel II or Solvency II may also affect the capital regimes of the companies
concerned. This study focuses on the core aspects of company law and accountancy as
relevant for any company falling under the 2nd CLD, not making specific considerations for a
particular industry. Taking into account the impact of IFRS on the current capital regime of
the 2nd CLD, the study examines the feasibility of an alternative system by way of measuring
the administrative burdens for EU businesses.

Overall, the cost analysis of the existing models adopted in the five EU Member States and
five non-EU jurisdictions has shown that the compliance costs related to the capital regimes in
all jurisdictions are generally not overly burdensome as by average they do not exceed
€30,000 for a specific process. Comparative synthesis tables can be found in section 4.4 of
this study report. A first conclusion of the study is that the reduction of compliance costs is
unlikely to be a motivation for the transition to an alternative, solvency-based system.

Concerning the accounting aspects, EU Member States may require or permit the use of IFRS
for individual accounts. As a consequence, IFRS individual accounts could also be used as a
basis for profit distribution subject to Member States’ legislation. This is currently the case in
17 of the 27 EU Member States. The practice on how IFRS are applied for distribution
purposes shows a mixed picture throughout these 17 EU Member States. In 7 of these 17
Member States, the IFRS accounting profits are modified for distribution purposes. The basic
modification consists in declaring certain “unrealised” profits resulting from IFRS individual
financial statements as non-distributable.

Comparative cost analysis of capital regimes in selected EU/non-EU jurisdictions and in

literature

Based on a legal analysis, the study conducts an economic analysis of the capital regimes of
five EU Member States (France, Germany, Poland, Sweden and the United Kingdom) and of
four non-EU countries (the USA, Canada, Australia and New Zealand) [for the legal analysis
see Annexes - part 1, section 3]. Furthermore, four models which can be found in the
literature (High Level Group, Rickford Group, Lutter Group and Dutch Group) are analysed.
The aim of this economic analysis is the identification of the administrative costs, i.e. the

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incremental burdens linked to company law provisions concerning the capital regimes in
existence and the proposed models in the literature. The comparison of the administrative
costs of different regimes may allow assessing whether a certain capital regime is more
advantageous than another for EU companies from a cost perspective. In order to obtain
comparable data throughout the various jurisdictions with different economic levels, we have
employed standardised cost rates of €100/€70 per hour for the main cost factor of the
provisions, the internal man hours spent on compliance. The basis for the economic analysis
formed in-depth interviews with high-ranking representatives of 35 companies of different
sizes in the five EU and the four non-EU countries. The interviews were complemented by the
results of a CFO questionnaire sent out to 3,578 companies in these countries; thereof 157
companies have responded to the questionnaire which represents 4.39 percent of the 3,578
companies [for the CFO questionnaire, see Annexes - part 1, section 2.1].

Administrative costs in five EU Member States

A main building block of the current capital regime of the European Union is the concept of a
subscribed capital which is protected from distributions. The concept of subscribed capital is
extended to the 2nd CLD’s approach to capital maintenance, which provides restrictions on
share repurchases, capital reductions, the withdrawal of shares and financial assistance.
Another building block is the use of balance sheet test to determine any distribution under the
2nd CLD. The balance sheet profit is the profit realised for the financial year after setting off
losses and profits brought forward as well as sums in mandatory and optional reserves. The
accounting framework from which the realised profits are derived is either national GAAP
harmonised to a certain degree by the 4th CLD or IFRS. A third building block of the current
regime of the 2nd CLD is the decision making authority of the general meeting concerning all
matters relating to an amendment of the subscribed capital or fundamental decisions
concerning transactions linked to capital maintenance issues.

The legal analysis of the company law regime adopted in five EU Member States showed that
all of them closely follow the 2nd CLD. However, in some EU Member States there are a few
significant additional protective measures in national legislation which partly concern profit
distribution. This is the case, for instance, for national provisions concerning the protection of
premiums and of certain reserves from distributions; the prohibition of transactions with
shareholders that are not conducted at “arm’s length”; the necessity of resolutions by the
general meeting to distribute profits; different quorums for general meetings and additional
rules regarding sanctions.

In implementing the 2nd CLD, the five EU Member States have set minimum subscribed
capital requirements which in all cases exceed the minimum of €25,000 required by the 2nd
CLD and extend up to €225,000 for French listed companies [see section 4.1.6]. In company
practice, the subscribed capital regularly exceeds the minimum amounts by far. However, the
interviews conducted with EU companies indicated that the practical relevance of the
subscribed capital for the assessment of the viability of a company is seen as low. The
companies as well as their peers like banks, rating agencies and analysts rather refer to other
equity figures such as “net equity” and “market capitalisation”. A comparison of the ratio of
subscribed capital to the total shareholders’ equity for the companies on the main stock
exchange indices of the five EU Member States showed that due to the low percentage of
subscribed capital, equity financing is not largely dependant on it and that there should be
sufficient equity base for adequate distributions. In this context, it must be noted that the
results of the CFO questionnaire underpin that the majority of the responding CFOs in all five
EU Member States do currently not particularly question the distribution restrictions implied

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by the concept of legal capital. The majority of the responding CFOs considered the
subscribed capital to be necessary for equity financing and, in their opinion the subscribed
capital does not constitute a barrier to the distribution of excess capital.

The general dividend policies of the companies interviewed differentiate from company to
company as they depend on their individual circumstances. The level of dividends as such is a
“political decision” of the parent company with a view to the share price. This includes
aspects like dividend continuity or sending certain signals to the capital market. The starting
point for the consideration of potential dividend levels is usually the consolidated financial
statements and the cash flow situation of the group. The results of the interviews in this
respect have been validated by the results of the CFO questionnaire. From an economic
perspective, the reference to the group situation shows that the legal profit distribution
concept which is based on the single legal entity, receives less consideration when discussing
the actual level of dividends.

In general, all five EU Member States follow the requirements of the 2nd CLD in restricting
profit distributions. The results of the CFO questionnaire showed that the responding CFOs
considered legal requirements concerning distributions as well as possible violations of
insolvency law as important deterrents regarding excessive levels of dividend payments; i.e.
payments which endanger the viability of a company. Other market-led solutions such as bank
covenants and rating agencies’ requirements play a less significant role.

To bring the parent company’s financial situation in line with the group perspective, a large
part of the companies interviewed steer the profit and cash flow situation of the parent
company. This is mostly done in a structured planning process over several years. This can
entail significant costs for companies. However, as this process is mainly undertaken to
achieve tax optimisation for intra-group distributions, we have disregarded the associated
costs as incremental burdens stemming from company law.

Altogether, we have tried to assemble the administrative costs associated with key processes
concerning compliance with the provisions of the implemented 2nd CLD. These processes
included capital increases and profit distributions as well as certain aspects of capital
maintenance such as the acquisition by the company of its own shares, capital reductions and
redemption/withdrawal of shares. We have mainly been able to retrieve meaningful data for
capital increases, profit distributions and acquisition by the company of its own shares as
companies are regularly using these processes. The average costs for each process do not
exceed €30,000. For capital reductions and the redemption/withdrawal of shares, there are no
meaningful data as the sampled companies have not made use of these processes. For
contractual self-protection such as covenants, we have found the use of such instruments but
have not received associated cost data. Furthermore, we have not found that compliance costs
vary according to the size of the company, in general.

In total, we conclude that the administrative costs concerning the 2nd CLD company law
requirements are generally low for companies interviewed throughout the five EU Member
States [for details please refer to section 4.1.6 of this study report]; more significant costs
arise outside the area of the core company law requirements, specifically with regard to
securities legislation (e.g. capital increases; acquisition by the company of its own shares).

In view of the most recent changes to the 2nd CLD in 2006, we have not been in a position to
verify the cost implications of these measures as they have not yet been applied by the EU
companies interviewed.

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In addition, we have analysed the situation of private companies in four of the five EU
Member States (Sweden has no separate legal form). In essence, the legal requirements
related to the capital regime of private companies are less restrictive than the regime for the
companies falling under the 2nd CLD [For an overview and further details, please refer to
Annexes – part 1, section 4]. Private companies maintain the capital as contributions can
usually not be distributed, although there is a trend at least to lower the amounts or de facto
abolish the minimum capital. Capital increases and decreases require a resolution by the
shareholder meeting. The basis for profit distributions are usually the net accounting profits as
shown in the annual financial statements; the UK deviates by referring to “realised profits”,
an approach also applied to UK companies falling under the 2nd CLD. The repurchase of own
shares is generally not restricted, except for the UK where basically the same rules as for
public companies apply.

Administrative costs in four non-EU countries

The four non-EU countries show different alternatives to the capital regime used in the EU.
We have examined two US state laws (Delaware and California), the Canadian federal
legislation as well as the company laws of Australia and New Zealand [for an overview see
section 4.2.7]. Furthermore, we have outlined the provisions of the US Model Business
Corporation Act (MBCA) which is a guideline for the company laws of a significant number
of US states [see section 4.2.1].

With the exception of Delaware, none of the non-EU jurisdictions prescribe a subscribed
capital or a minimum capital. In Delaware, the traditional capital system continues to be
applied although it does not play an important role in practice. Because Delaware
corporations usually issue shares with a very low par value (e.g. US$ 0.01 and less), capital is
negligibly low. As with EU companies, the equity figures “net equity” and “market
capitalisation” are much more important to the companies interviewed.

Instead, the emphasis has shifted to increased testing procedures for dividend payments and
other kinds of distributions such as the repurchase of the company’s own shares. This is
achieved through various solvency and balance sheet tests. In some of the jurisdictions
considered, the performance of the balance sheet test is based on audited consolidated
accounts for legal or practical considerations (e.g. for the United States US GAAP). The
results of the CFO questionnaire indicate that the responding CFOs of non-EU companies are
satisfied with the concept of a balance sheet test and that they consider their audited accounts
as a good starting point to determine the level of dividends. On the other hand, the majority of
the responding CFOs, with the exception of Australia, believes that a solvency test taking into
account future cash-flows better determines the ability to actually pay dividends than a
balance sheet test.

In the non-EU countries, the distribution decision lies with the board of directors which has
full discretion in this respect. The assessment by the company’s management about the
adequate level of dividend payments results, as in the EU Member States, is a “political”
decision driven by a share price objective. Aspects such as dividend continuity and other
signalling effects to the capital market play a role. Again, these companies regularly refer to
their consolidated accounts and cash flow position as a starting point for such considerations.
This is reconfirmed by the results of the CFO questionnaire. One interesting fact in this
context, however, is that the responding CFOs in the considered non-EU countries rank the
issue of the compliance with covenants much higher than their EU counterparts.

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One common feature of the non-EU capital regimes is that the increased responsibility of the
board in this regard translates into a fiduciary duty or personal liability. Particularly in the
United States, directors may also be subject to fraudulent transfer legislation.

As for EU Member States, we have tried to track the administrative costs associated with key
processes for the non-EU jurisdictions. These processes included capital increases and profit
distributions as well as certain aspects of capital maintenance such as the repurchase of
shares, capital reductions, redemption/withdrawal of shares. We have been able to retrieve
meaningful data only for capital increases, profit distributions and repurchase of shares as
companies regularly use such processes. The average cost for each operation does not exceed
€25,000. For capital reductions and the redemption/withdrawal of shares, there is no
meaningful data available as companies have not made use of these options. With respect to
contractual self-protection such as covenants, we found significant compliance costs
amounting on average up to €90,000. However, the costs relating to covenants mainly depend
on individual circumstances, especially how covenants are negotiated. Furthermore, we have
not found that compliance costs vary depending on the size of the company, in general.
However, it should be noted that the non-EU companies interviewed were all in good
financial health. The compliance effort may, in these models, significantly increase once a
company enters into a more difficult financial situation because the management assessment
to justify a dividend payment would become much more detailed.

In total, we conclude that the administrative costs are also generally low for companies
interviewed throughout the five non-EU jurisdictions [for details please refer to section 4.2.7
of this study report]; as market-led solutions, namely covenants, play a more prominent role,
additional costs may arise in this respect. More significant costs rather arise outside the area
of the core company law requirements, specifically with regard to securities legislation (e.g.
capital increases; repurchase of shares).

Administrative costs of four models in the literature

All four proposals in literature (High Level Group, Rickford Group, Lutter Group, Dutch
Group) consider possible changes to the current regime of profit distributions in the EU.
These proposals vary from partial to full scale reform of the 2nd CLD capital regime. All
systems differ as to how this affects the overall set-up of the capital regime.

The Lutter Group proposal [see section 4.3.3] to a large extent maintains the current system of
the 2nd CLD and only changes provisions on the distribution of profits to accommodate the
use of IFRS in the individual financial statements. To this end, the Lutter Group proposes a
solvency test, in addition to the balance sheet test already foreseen by the 2nd CLD.

The other three models (High Level Group, Rickford Group, Dutch Group) discuss a
fundamental change to the current capital regime by abolishing the concept of legal capital in
favour of distribution testing by means of additional solvency tests. The latter goes hand-in-
hand with the transition from a par value concept of shares to a true no-par value share
concept. The High Level Group [see section 4.3.1] and the Dutch Group [see section 4.3.4]
require the companies to meet both the balance sheet test as well as the solvency test. The
High Level Group additionally discusses the introduction of a solvency margin. The Rickford
Group [see section 4.3.2] ultimately only requires that a solvency test must be met to allow
for distributions.

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The solvency margin proposed by the High Level Group is an instrument which can only be
used in the context of a balance sheet test and may replace the concept of a fixed legal capital.
It ensures that the assets, after the distribution, exceed the liabilities by a certain margin. In
this respect, it is decisive to determine an appropriate margin level to avoid excessive
restrictions for companies to distribute dividends. In California, which is the only jurisdiction
under consideration which embeds a solvency margin in law, the margin only needs to be met
if a company does not have sufficient retained earnings for a distribution. We have not
encountered any practical case of a California incorporated company where such a margin test
has been actually performed.

The economic effects of these models are not fully clear, as they leave the most burdensome
administrative aspects of the 2nd CLD intact. This specifically concerns the preparation of the
general meeting in the case of capital increases, dividend distributions and the repurchase of
shares. This is the reason why we have used the EU average administrative cost as a starting
point for cost considerations. Presumably, this would also be true for capital reductions and
redemptions/withdrawals. However, as specified above, we have not been able to gather
reliable EU data in this regard.

All four models are, in differing degrees, incomplete in their suggestions on how to exactly
conduct changes to the 2nd CLD. One important example is the impact of different designs of
solvency tests. The existing gaps in these models partly allow for a wide interpretation and
can immensely influence the associated burdens for the companies concerned. For the High
Level Group, it seems relatively easy to comply as a reference to current balance sheet ratios
is proposed (current assets/current liabilities). For the Rickford and Lutter Group, cash-flow
projections are required. The Dutch Group leaves the design completely open. Except for the
reference to current ratios, we have not encountered a formalised detailed application of any
of these design approaches in the five non-EU jurisdictions. Therefore, we have not been in a
position to build on this experience and, thus, have not attempted to estimate the costs
associated with the different formats of the solvency tests [see section 4.3.5].

Result of the comparative cost analysis

Overall, the cost analysis of the existing models in the five EU Member States and four non-
EU countries has shown that the administrative costs of company law in this regard for the
companies in all jurisdictions are generally not overly burdensome as by average they do not
exceed €30,000 in a specific process. The comparative synthesis tables can be found in
section 4.4 of this study report. Thus, such considerations do not seem to play a decisive role
in determining whether the transition to an alternative system would actually benefit EU
businesses by lowering administrative burdens. However, administrative burdens can be of
significant relevance when considering the implementation of certain measures in a
jurisdiction. This is especially true for the design of solvency tests. Moreover, we have
considered qualitative aspects of shareholder and creditor protection within each model. Both
the EU and non-EU jurisdictions have certain shareholder and creditor protection instruments
in place. In particular, the EU jurisdictions generally require the involvement of the general
meeting concerning capital measures, whereas non-EU jurisdictions more often rely on the
board of directors to take decisions in this respect.

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Impacts of IFRS on profit distribution

The primary objective under which the IFRS are developed is the decision usefulness of the
information provided to the users of the financial statements. Accounting standards developed
under the IASB Conceptual Framework are not intended to serve as a basis for a distribution
policy which aims at warranting the future viability of a company. IFRS typically make use of
different measurement models, but rely in some areas to a large extent on fair value
measurements. As a consequence, re-measurements due to changes in relevant market prices
or equivalent measurement references result in recognition of (unrealised) profit/losses or
have a direct effect on equity. In this context there is a debate as to whether the 2nd CLD in its
current format is sufficiently prepared for this challenge.

Although the European Union has only introduced IFRS as a mandatory accounting
framework for the consolidated accounts of publicly traded companies, EU Member States
may require or permit the use of IFRS for individual accounts. As a consequence, IFRS
individual accounts may also be used as a basis for profit distribution subject to Member
States’ legislation.

This is currently the case already in at least 17 of the 27 EU Member States1. In 7 of these 17
Member States2, the net income presented under IFRS is modified for distribution purposes.
The main objective of suchc modifications is to eliminate “unrealised” profits/losses from
IFRS individual financial statements from the basis for distributions.

Concerning the impact of the transition from national accounting rules to IFRS, the analysis
shows that it cannot be generally assumed that the application of IFRS will result in a major
increase in profits or in equity. However, as specific circumstances at each company prevail,
situations may arise where the transition may show major impacts. In this context, it must be
kept in mind that when comparing different accounting frameworks, any difference impacting
accounting profits in one period will usually be reversed in a later period.

The analysis of the largest deviations of IFRS from national accounting rules for all 27 EU
Member States [see section 5.2] showed that the following standards are mainly concerned:
IAS 19 (Employee benefits), IAS 29 (Reporting in Hyperinflationary Economies), IAS 39
(Financial Instruments: Recognition and Measurement), IAS 40 (Investment Property), IFRS
2 (Share-based Payments), IFRS 3 (Business Combinations) and IFRS 5 (Non-current Assets
Held For Sale and Discontinued Operations). As a general rule, these are mainly accounting
standards which require or permit fair value measurements. Assessed by EU Member State,
the perceived deviation of IFRS standards from national accounting rules ranged between 1.6
and 3.8 on a scale between 1 (identical) and 5 (dissimilar).

For example, investment properties may be carried at fair value with an immediate impact on
profit or loss or immediately on equity. The accounting for defined benefit plans shows
differences in the methods of accounting and parameters utilised. Moreover, actuarial gains or
losses may not be recorded immediately. Accounting for financial instruments is a complex
task for derivative and non-derivative financial instruments. In several jurisdictions, the fair
value measurement of certain financial instruments is permitted or required.

1
Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, Greece, Ireland, Italy, Latvia, Lithuania, Malta,
Netherlands, Poland, Portugal, Slovakia, Slovenia and United Kingdom..
2
Denmark, Greece, Ireland, Italy, Malta, Netherlands and United Kingdom..

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In this context, however, it must be noted that the degree of deviation is, by essence,
determined by the national interpretation of the realisation principle as embedded in the 4th
CLD. The differing degrees of deviation reveal a lack of harmonisation of the interpretation of
basic accounting principles of the 4th CLD throughout the European Union. Under a national
accounting framework which is guided by the idea of decision usefulness the realisation
principle is differently interpreted than under an accounting framework which emphasises the
idea of prudence, e.g. German GAAP. This is one of the main reasons why there is no clear-
cut answer regarding the total effects of a transition to IFRS for the European Union as a
whole.

The last part of the IFRS analysis [see section 5.3] concerns a detailed comparison of national
accounting rules’ effects in the five EU Member States on distributable profits with IFRS in
distinct areas, namely investment properties, defined benefit pension plans and financial
instruments. These accounting areas showed a lack of European harmonisation as the national
accounting rules differ widely.

The analysis of the current legislative practices in the five EU Member States concerning the
interaction of national accounting frameworks under 4th CLD and the distribution model of
the 2nd CLD has revealed certain options for a single company to deal with excessive
distributions. A balancing element can be introduced at different levels. A first option is the
emphasis on prudence in the basic principles of an accounting framework, e.g. in Germany.
This option is, however, not relevant for IFRS. As a second option, a reassessment of what
profits are distributable or of what should be restricted, may also take place outside the core
financial accounting process. In particular, in the UK there is a differentiation between
accounting profits under UK GAAP and realised profits for distribution purposes; the UK
institutes ICAEW and ICAS have developed authoritative accounting guidance in this respect.
Certain accounting treatments are revised by means of an authoritative guidance of the
Institutes ICAEW/ICAS and determined as “realised” profits/losses. For further details on the
authoritative guidance, please refer to section 5.3.5 of this study report. Under such an
approach, certain accounting treatments of IFRS would need to be assessed as unduly
influencing the distribution capacity of the companies concerned. Companies are only
affected if they use these specific accounting treatments. Experience from the interviews with
UK companies shows a mixed picture: some UK companies were not at all affected and
others suffered from the administrative burdens associated with these provisions [see section
4.1.5].

In Sweden, the management has to observe a “prudence rule” in addition to the balance sheet
testing based on the 2nd CLD; Swedish company law obliges the management of Swedish
companies to specifically review the financial situation of the company and, in a group
situation, also of the group. This relates not only to the accounting results but also to the cash
flow situation. Interviews with Swedish companies pointed to a moderate compliance effort in
this regard. The “prudence rule” could also be applied to the determination of distributable
profits based on IFRS individual accounts.

Both the UK and Swedish approaches go beyond a simple consideration of accounting

frameworks and are rather embedded in company law.

Even though the direct use of IFRS for profit distribution purposes potentially allows for
excessive distributions, it must be acknowledged that IFRS as such may not necessarily cause
problems for companies in their capacity to distribute profits. For example, the experience
with the Polish companies interviewed did not point to major problems in the use of IFRS for

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distribution purposes. However, they were not subject to excessive fair value measurements
compared to a historical cost approach. They only reported issues concerning the transition to
IFRS with regard to the treatment of hyperinflationary effects [see section 4.1.3]. To this end,
potentially critical situations did not arise with the Polish companies interviewed.

Assuming that IFRS represents a uniform accounting framework throughout the European
Union, it could be argued that any solution concerning the flexibility for the use of IFRS
would need to be determined at EU level, also in view of warranting a comparable minimum
protection to creditors in all EU Member States. Another argument for an EU solution could
be that any further reaching reform which alters the current capital regime of the 2nd CLD
would at least require European consensus. On the other hand, it could be argued that
individual EU Member States may be best positioned to individually determine the necessary
changes to their national company law framework to achieve the flexibility in an effective and
efficient manner, especially when the capital regime as embedded in the 2nd CLD remains
untouched.

Finally, it must be noted that IFRS are still developing and it seems that the development
tends – although not finally decided - towards an increasing use of fair values as a
measurement basis. Such element should be kept in mind within the debate as to how IFRS
accounting profits should be relevant for profit distribution and whether modifications – such
as the introduction of non-distributable profits or reserves or additional solvency requirements
– ought to be permitted or required at EU or Member-State level.

Introduction of a new regime

As part of this study project, we have been specifically asked to explain the effects of the
introduction of a new regime. To this end, the study elaborates an array of options on how the
system of the 2nd CLD could be adjusted in order to introduce an alternative to the current
regime. This elaboration is based on capital regimes already existing in EU and non-EU
practice as well as the models in literature. The presentation of these options is designed to
find a competitive solution which will not overburden EU companies. However, this study is
not intended to recommend a single model to be implemented as an alternative. The
determination of such a model is the task of the institutions of the European Union in their
role as legislator. At the same time, such consideration will need to include shareholder and
creditor protection aspects.

To achieve flexibility regarding the implications of the use of IFRS for distribution purposes,
it is intended to present the different degrees of reform to the 2nd CLD structured into different
dimensions which provide basic lines of thinking. The dimensions discussed are possible
amendments to the basic model of legal capital of the 2nd CLD and the design of solvency
tests. Finally, there is a discussion concerning the introduction of true no-par value shares.

The potential amendments to the basic model of legal capital range from a limited change to
the distribution rules via the introduction of a specific fiduciary duty in company law up to a
full-scale reform of the 2nd CLD with the abolition of legal capital and the predominance of
solvency tests in determining dividend levels [see also section 6.2.1].

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Reform of the basic model of capital

Model 1a “Company option” – Based on a general fiduciary duty to be embedded in
company law, the board of directors could decide whether the balance sheet test prepared
under a certain accounting framework such as IFRS is adequate to present the basis for
distribution. If necessary, the board is entitled to make adjustments in view of a realised profit
for distribution purposes. The exercise of the fiduciary duty should also include a duty to
review whether the current or prospective cash flow situation allows for such distributions.
Such approaches can be found in the current practice of Delaware corporations and in
Sweden, where a separate “prudence rule” is introduced in company law. Such fiduciary duty
could be introduced at the EU or only Member State level.

Model 1b “Regulator option” – A central authority determines mandatory adjustments for

certain accounting treatments under a specific accounting framework such as IFRS as they are
considered as not adequate for distribution purposes. Such an approach can be currently found
in the United Kingdom where the Institutes ICAEW and ICAS have issued various pieces of
authoritative accounting guidance. Mandatory adjustments could be determined either at EU
or Member State level.

Model 2 “IFRS solvency add-on” – An additional mandatory solvency test is introduced for
all EU companies using IFRS for their individual financial statements. The remaining
elements of the 2nd CLD are kept intact. This approach is favoured by the Lutter Group. Such
an approach requires the introduction of a solvency test format at EU or only Member State
level.

Model 3 “On equal terms” – A full scale reform abolishes the legal capital of a company and
introduces a two-stage distribution test consisting of a balance sheet and solvency test which
have the same importance as they must both be met. This basic approach is suggested by the
High Level and the Dutch Group. An additional protective element could be a solvency
margin as discussed by the High Level Group. Concerning the balance sheet test, the buffer of
the legal capital of at least €25,000 would either fall away or be replaced by a solvency
margin. The solvency test is introduced as a balancing element.

Model 4 “Solvency test predominance” – Again, a full scale reform abolishes the concept of
legal capital. Within a two-stage distribution test, a solvency test must be met in any case. The
balance sheet test does not constitute any restriction on distributions as long as the solvency
test is met. In essence, this approach reflects the proposal of the Rickford Group. As a
consequence, distributions based on a negative balance sheet test would be permitted if the
cash situation allowed for this.

The design of solvency tests is for nearly all potential changes to the basic model of capital a
crucial feature of a reform of the 2nd CLD. It determines to a large extent the economic
burdens associated for companies. To this end, the options range from a fiduciary duty for
directors to adequately determine the format of a solvency test up to a prescribed mid-term
projection of future cash flows up to five years taking into account further future
commitments [see also section 6.2.3]. The responsibility of the directors for this solvency
assessment could be demonstrated to the general public via a solvency certificate. In this
context, it must be noted that we have not included as another option a solvency test based on
a long-term projection period. The reason for this is the fact that experience from the
interviews conducted in all nine EU and non-EU countries has shown that reliable forecasts
cannot usually be produced for time periods exceeding five years.

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Solvency test models

Model 1 “Leave it to the companies” – A general fiduciary duty could require the board of
directors of a company must justify a distribution from a cash flow perspective. As it is not
exactly prescribed how the solvency test will have to be performed, companies can flexibly
adapt the method to their financial situation. A company in good financial health with a
comfortable cash position will not need to perform detailed testing in this regard; a company
in financial distress may have to intensify its efforts in this regard. This approach has been
particularly found with Delaware corporations.

Model 2 “Current ratios” – A comparison of current assets to current liabilities based on

audited financial statements could be an easy way of fulfilling this requirement. This has been
suggested by the High Level Group. It does not take account of a prospective look into the
future where certain obligations may already be known.

Model 3 “Short-term projection” – A short term projection would cover at least the next
twelve months of a company’s life. Another important element is the inclusion of longer term
commitments. This is the basic approach of the Rickford and Lutter Group where the Lutter
Group would also see a two year period as appropriate for the detailed analysis.

Model 4 “Mid-term projection” – A mid term approach would cover the next three to five
years of a company’s life and would also include longer term commitments. The projection
period stretches to the boundaries of the current company’s practices and ability to project
cash flows in most cases.

Finally, possible ways are considered for the introduction of no-par value shares which do not
refer to a nominal or fractional value [see also section 6.3]. The 2nd CLD at present only
recognises par value shares and shares with an accountable par. The options discussed are
solutions which keep the current 2nd CLD mainly intact up to solutions which require a
fundamental reform as they allow that the proceeds contributed could be generally used for
distributions if specific tests like the solvency test or margin do not prevent this.

True no-par value shares

Model 1 "Protection of all proceeds from share issues" – This model maintains, as far as
possible, the provisions of the 2nd CLD and places all proceeds from the issuance of shares
under protection under a new balance sheet item “equity capital” similar to that applicable to
subscribed capital. Amendments would be necessary apart from the abolition of the
prohibition on below par issues in particular because of the total binding of the proceeds from
the share issues. However, it should be noted that this solution would, in some EU Member
States, represent a considerably more onerous solution than the present one. The reason is that
it is admissible in certain EU Member States that premiums be used to cover losses. This
possibility would be lost if premiums were bound under the item “equity capital”.

Model 2 "Variable capital" - This model is characterised by the fact that the proceeds of the
share issue are not completely contributed to a protected equity capital item but to an only
partially protected reserve. In this model most of the provisions of the 2nd CLD could remain
intact. Amendments apart from the abolition of the prohibition on below par issues would be
necessary in particular because of the different binding of the proceeds from the share issues.
Furthermore, it should be noted that the reserves can be – under certain circumstances -
reduced to zero.

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Model 3 "Mixed model" - According to the mixed model, subscribed capital is formed on the
foundation of the company, and the proceeds of the share issue are entered as such, until the
minimum capital or a higher amount prescribed by the statutes is reached. Above that figure,
the issue proceeds are no longer treated as subscribed capital but can be entered as reserves.
This model leads to the necessity to have various procedures in place depending on whether
the proceeds of the share issue are attributed to, or should be removed from, the subscribed
capital or the reserves. Amendments to the 2nd CLD are – in addition to the introduction of the
abovementioned different procedures and the abolition of the prohibition on below par issues
– necessary as also this model leads to changes in the binding of the proceeds of the share
issue. Furthermore, it should be noted that in this model less of the proceeds could flow to the
subscribed capital than under the 2nd CLD.

Models 4 and 5 "Total abolition of legal capital" – These two models protect the proceeds of
the share issue not by the prevention of distributions but by admitting its distribution under
certain conditions, namely a balance sheet and/or solvency test or solvency margins. As, in
this model, no-par value shares would be in a completely different environment, a full
revision of the 2nd CLD would be necessary in practice, although this would not be due to the
introduction of no-par value shares as such.

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2 Introduction

2.1 Area of EU company law under examination

The existing 2nd EU Company Law Directive (2nd CLD)3 imposes minimum capital
requirements on public limited liability companies and contains a range of detailed provisions
aimed at protecting shareholders and creditors. They apply inter alia to the formation stage,
profit distributions to shareholders, acquisitions of own shares as well as to increases and
reductions in capital. This Directive has currently been subject to a legislative process at EU
level (Directive 2006/68/EU dated 6 September 2006) in order to implement simplification
measures aiming at facilitating certain capital related measures. These simplification measures
were to a large extent triggered by the SLIM report of 1999.

Beyond this recently completed limited reform of the existing 2nd CLD, the Report of the
High Level Group of Company Law Experts of 2002 additionally called for the introduction
of an alternative regime which would not be based on the concept of legal capital but rather
on a solvency test. However, the High Level Group could at the time not establish whether the
current rules on capital formation and maintenance represent a disadvantage for EU public
companies. A study regarding the feasibility of such an alternative regime was embedded in
the European Commission’s Action Plan for Corporate Governance and Company Law of
2003 as a medium term measure.

The introduction of IFRS in the EU in 2002 (IAS regulation) created a new challenge for the
concept of the existing capital maintenance rules of the 2nd Company Law Directive. The
IASB framework does not relate to a specific concept of capital maintenance. Underlying
IFRS accounting concepts – especially the fair value based revaluations – cause doubts
whether distributable reserves and profits can be used for dividend payments.

A new development constitutes the inclusion of the 2nd CLD in the European Commission’s
simplification efforts of company law for small and medium-sized entities (SMEs). In the
general context of Better Regulation, the European Commission has decided to simplify the
regulatory environment for European businesses, in co-operation with the European
Parliament and the Member States. A Commission Communication (COM (2007) 394) dated
July 2007 postulates that “at least a review of that system should be considered in order to
give companies more flexibility in the field of distributions to their shareholders.” This study
report is supposed to provide additional information that should facilitate the Commission’s
assessment in this regard.

2.2 Scope of the study

KPMG Deutsche Treuhand-Gesellschaft Aktiengesellschaft Wirtschaftsprüfungsgesellschaft

(KPMG DTG) has been contracted by the European Commission to conduct a study project
whose overall objective is to evaluate the feasibility of an alternative to the current regime of
minimum capital established by the 2nd Company Law Directive (Contract
ETD/2006/IM/F2/71). This alternative regime could be established at the option of EU
Member States.

3
Second Council Directive 77/91/EEC of 13 December 1976.

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This study is intended to help the European Commission to evaluate whether an alternative
regime better supports the efficiency and competitiveness of EU businesses and whether
creditors´ and shareholders´ protection could be fully maintained.

To support the European Commission’s evaluation, the study assesses selected existing
capital regimes inside and outside the European Union. For the European Union, the current
legal capital regime in five EU Member States is subject to assessment, namely:

• France
• Germany
• Sweden
• Poland
• United Kingdom

After a thorough examination of the legal basis, the Member States’ regimes and practices are
examined under cost aspects. Specific focus of the study project was the degree of burdens of
the existing legal capital regimes for European stock corporations as well as the protection of
shareholders and creditors.

Furthermore, the study covers alternative approaches as in existence in other non-EU

countries as well as concepts in literature. This examination is not exclusively bound to
solvency based regimes. The examination of alternative regimes as in existence in other non-
EU countries comprises the following countries:

• USA – Delaware
• USA – California
• Canada
• Australia
• New Zealand

The concepts in literature concern the following four models:

• High-Level Group
• Rickford Group
• Lutter Group
• Dutch Group

A second part of the study deals with the impacts of the new IFRS accounting regime on the
current profit distribution scheme. In order to support the European Commission’s assessment
of the current situation, the study provides information on the financial statements to be used
in the determination of profits and the status of convergence of national GAAP to IFRS for all
27 EU Member States. Furthermore, the study gives specific information for the five EU
Member States with regard to the effect of national GAAP on distributable profits compared
with IFRS in three specific areas, namely financial instruments, defined benefit pension plans
and investment properties.

2.3 Methodological approach

The methodological approach chosen by KPMG DTG for conducting this study is specifically
tailored to address the objective of the study: evaluation of the feasibility of an alternative to
the current regime of minimum capital.

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The basis for any economic consideration of the issue of capital regime is a proper legal
analysis of the underlying legislation. A sound understanding of the legal framework in EU
and non-EU countries allows a comparison of the practices in companies concerned and gives
way to an analysis of the costs linked to practical processes existing in these companies.
Figure 2 – 1: KPMG methodological approach

local KPMG member

Preparatory legal firm
Phase 1 KPMG DTG
analysis or
external law firm

KPMG DTG
Phase 2 Economic analysis local companies
local KPMG member firm

Phase 3 Wrap-up

The study researches the relevant legal issues in the jurisdictions under consideration. For
Phase 1, two separate legal questionnaires were developed, one for the five EU Member
States (France, Germany, Sweden, Poland and the United Kingdom) and another one for the
four non-EU countries (USA (State laws of Delaware, California), Canada, Australia, New
Zealand). Both questionnaires have been submitted to the European Commission for
comment. Overall, the preparation of the legal questionnaires has proven to be very
demanding in order to achieve a satisfying level of conformity between EU and non-EU
countries. The EU legal questionnaire required a high level of describing elements in order to
present EU requirements in a way that they are easily accessible at local level and to also be
able to identify the local elements that may be overly burdensome to local stock corporations.
Overall, for the EU countries 525 pages of individually prepared documentation have been
received; for the non-EU countries 404 pages. Due to the complexity of the legal subject,
there was an intense iterative review and consultation process with the participating KPMG
member firms or external law firms in these countries. An aggregated description of the
individual capital regimes can be found in Annexes Part 1 of the study report.

In Annexes Part 1, the study also examines in which of the five EU Member States the
principles of the 2nd CLD are applied to private companies.

Subsequently, cost questionnaires were developed on the basis of the answers to the legal
questionnaires. The German cost questionnaire was subject to a „test run” with a German blue
chip company in April 2007. The individually prepared EU and non-EU cost questionnaires
amount can be found in Annexes Part 2 of the study report.

To finally assess the practical cost implications, companies of different sizes were selected for
in-depth interviews (for the detailed methodology for the selection of companies, please refer
to Annexes Part 1 of the study report). In the execution phase from July to September 2007,

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each of the 34 companies in nine countries was interviewed in-depth for 1 to ½ hours about
their practices concerning capital formation and maintenance and the related burdens. These
interviews were mainly conducted on-site in these countries with few exceptions where
interviews took place via telephone. The aggregated results of these interviews can be found
in the main body of the study report.

Furthermore, a “CFO questionnaire” was prepared to collect data on a wider statistical basis
(e.g. typical amount of subscribed capital or relation of subscribed capital to premium). This
questionnaire has been sent to 3,578 companies in the nine countries under consideration. The
questionnaire itself is very much focussed on a small number of questions to make it easy for
companies to respond to it and, thus, achieve a higher response rate. A copy of this
questionnaire can be found in Annexes Part 1 of the study report.

Concerning the impact of IFRS on distributable profits, the European Commission clarified in
October 2006 the required level of the analysis in this regard. In particular, the European
Commission asked to provide the following information in the course of the study:

− Complete list of Member States containing information on which financial

statements required or permitted to be used in the determination of distributable
profits.

− Complete list of Member States which are converging national GAAP to IFRS and
the progress on convergence, for the three areas listed below.

− Comparison of five Member States (DE, FR, PL, SW, UK) national GAAP effect on
distributable profits compared with IFRS in three specific areas:
ƒ investment properties;
ƒ defined benefit pension plans; and
ƒ financial instruments.

Based on these requirements, a 38-page IFRS questionnaire was developed and submitted to
local KPMG member firms in the 27 EU Member States. This IFRS questionnaire is divided
into two parts.

Part I is directed towards KPMG member firms in all 27 EU Member States. It analyses the
use of IFRS within Europe and provides an indication of the stage of convergence between
national GAAP and IFRS primarily based on three subjects. Part II of the analysis is only
directed to the core five EU countries of the study project (France, Germany, Poland, Sweden
and United Kingdom). The objective of this part of the analysis is to determine whether there
is a tendency towards increased equity/anticipated profits under IFRS compared with local
GAAP or vice versa.

Based on the results of the survey on burdens for companies and IFRS impacts on profit
distribution, the study identifies a range of approaches to capital regimes showing the
cost/benefit and timing effects of introducing alternatives to the current capital regime as
embedded in the 2nd CLD. These approaches encompass solvency-based and the current
capital-based systems. Regarding no-par-value shares, the study analyses from a legal point of
view the nature of no-par-value shares and examines the necessary changes to the current 2nd
CLD.

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3 Basics elements of capital regimes

3.1 Introduction

This study project looks at a variety of different capital regimes in altogether nine countries
and analyses alternative models currently only existing in literature. All these systems may
differ in their outset, however, there are certain common basic elements which all these
systems incorporate and which may show different formats in the various countries and
theoretical models under consideration. Below we try to define these elements which serve in
our analysis as a common denominator to show similarities or deviations of these systems and
to demonstrate their consequences.

Firstly, it must be stated that for all systems of public companies reviewed in the European
Union and non-EU countries, it is characteristic that the personal liability of shareholders for
the debts of the company is excluded. In fact only the company as a legal person is liable for
its debts and recourse in case of liability and the basis for credit are solely the assets of the
company which it has acquired initially on its formation and later through its economic
activity, for example in the course of capital increases4. It is therefore understood as self-
evident in all systems reviewed that the basis for the formation of set equity is the obligation
of the shareholders to pay-in their contributions. Only whoever pays-in a contribution can be
a shareholder. It is also inherent in all systems that the equity capital built up cannot be
returned to the shareholders without restriction, although the degree of protection differs
greatly as between the EU models and the non-EU models. Ultimately, there are regulations
which permit distribution to the shareholders, for example, in the form of dividends, only
under certain conditions everywhere. In all states, calculations are conducted to determine
whether assets may be distributed, differences, however, being evident in the methods of
calculation and the parameters on which they are based.

Apart from these fundamentals, which are responsible for the paying-in of contributions, the
maintenance of the contributions and the distribution of the company's assets, there are further
issues which must be referred to for the assessment of the efficiency of the systems employed.
A particular concern of the study is the ascertainment of the burdens for the public companies
affected, which have to apply these regulations. For these companies, the aspect of legal
certainty and the liability and other risks of sanctions associated with the regulations play a
special part, which ultimately determines their application in this respect. The company view
alone does not lead to efficiency from the shareholders' and creditors' point of view. Their
concerns or level of protection is intended to be illustrated separately.

3.2 Statutory basis of the capital protection system

3.2.1 Provisions on the structure and acquisition of equity capital

Regulations on the structure of equity capital are the first basic elements of the models
reviewed as it determines how the company may use the equity capital. The second basic
elements are regulations on the acquisition of equity capital. Distinction in that respect has to
be made between the formation and the capital increase, which are based, in the models
reviewed, on the same regulatory approach. In practice, the capital increase is far more
important, so that this aspect will constitute the emphasis regarding capital acquisition in the
later examination.

4
cf. Lutter, Kapital, p. 40.

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3.2.1.1 Structure of capital

All legal systems reviewed contain provisions on the question of how the company may use
equity capital acquired by contribution, in particular, whether it is regarded as a bound asset
not capable of distribution or not.

In the European model, public companies must be in a position to dispose over a stated
capital. The amount of the subscribed capital (minimum or higher amount) is characterised in
that it is subject to special regulations as to binding and therefore, in its function as a cushion
against losses, may not be distributed to the shareholders. In addition, there is the possibility
that the company acquires additional capital through the premium i.e. the obligation of the
shareholders to pay an amount above the nominal or accountable par value of their shares.
This is also bound, in the EU and non-EU countries reviewed, even if less strictly than the
subscribed capital. In addition, the assets of the company are also sometimes additionally
bound, for example, the distribution of assets of the company to the shareholders is admissible
only under a resolution on the distribution of profits. It is also characteristic for the European
Union system that the subscribed capital is divided into nominal value shares or non-genuine
no-par value shares.

It is also significant in this context that according to the European Union model, a connection
between the subscribed capital as reference amount and the number of shares exists. In the
case of no-par value shares, their total is the subscribed capital. In the case of non-genuine no-
par value shares, each share can, by division, be attributed an amount in the subscribed
capital.

In most of the third states, a subscribed capital is no longer prescribed. The funds paid-in by
the shareholders is recorded as a prescribed equity capital item e.g. referred to as "share
capital", "contributed capital" or simply "capital". These funds are not per se bound, but in
most of the countries reviewed, be reduced practically to zero, if adequate assets are present to
pay debts due. Usually, in these states, no-par value shares are used.

There are also non-EU countries in which the subscribed capital exists and is, in principle,
protected against distribution. Usually, in these countries the members of the board of
directors can freely determine the portion of the sale proceeds to be shown as subscribed
capital. In the cases in which nominal value shares are issued, this may not be less that the
total of the nominal value capital. The amount exceeding the nominal value, constitutes a
"surplus" which is available for distribution. If shares with a very low nominal value are
issued (e.g. $0.001), the resulting amount not eligible for distribution is negligibly small. In
the case of no-par value shares also permitted, it may even be zero

3.2.1.2 Formation

Formation concerns the attribution of a certain amount of capital to the company, and this
takes place by contributions. This element is found in all legal systems although with
differences in the determination of the contributions to be made and the binding of the
contributed assets.

Capital to be contributed

In all models reviewed, the founders may, in the course of the formation, determine the
amount of the capital which the company should have, in the statutes of the company. In the

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EU model, a certain minimum amount in the form a subscribed capital must be achieved. In
the non-EU countries, a minimum capital is not prescribed, although there are, in some cases,
principles according to which the company must be adequately capitalised for the scope of
business it is to conduct.

Ensuring the contribution of equity capital

A further basic element of all systems on the formation of equity capital is the obligation of
the shareholders to pay-in contributions to the company, in order to become shareholders in
that company and participate in it. There are also usually additional safeguards intended to
ensure that the capital of the company actually reaches the company. Among the most
important are:

Minimum amount

Provisions concerned with the amount of the contribution are found in all models. In the EU
model, a certain sum to be subscribed and undertaken is compulsory, the total of such sums
corresponds to the subscribed capital (prohibition on the issue of shares below par). The
subscribed capital is, for this purpose, divided into nominal value shares and non-genuine no-
par value shares. In view of the contribution of premia, there are provisions in the EU
Member States which assume full payment of contributions. In the models without nominal
value which exist in some of the third states, the amount determined by the founders must be
subscribed and undertaken. In these systems, division into nominal value is not provided for.

Objects capable of being contributed

A basic principle of all models is a provision as to what objects are capable of being
contributed. All models have in common that cash and in kind contributions may be made,
although in many non-EU models, the contribution of services is admissible, in others this is
not the case.

Protection against over-valuation

The models reviewed have provisions to protect against over-valuation of contributions. In

the EU model, as well as an internal audit of contributions in kind by the company's organs,
an audit by an expert is provided for. Individual states sometimes demand more, for example,
an audit by the register court. In the third states, it is a matter for the members of the board of
directors – in exercise of a certain duty of care – to determine the value of the contribution.
An examination by the third party is voluntary.

Sanctions

Finally, there are penalties in all EU Members States reviewed for improper contribution.

3.2.1.3 Capital increases

In a capital increase, equity capital is contributed at a later date. In the models reviewed, the
same basic provisions as in the case of formation are found, supplemented, however, by
provisions which take account of the special features of the capital increase.

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Contribution

A special element in comparison to the formation is firstly, that in the case of the acquisition
of capital by a capital increase, it is necessary in all models hat the amount of the capital or
the number of shares to be increased, is fixed and that either the shareholders directly or
through a prior authorisation, agree to the capital increase. In some third states models,
authorisations in the statutes, which can permit capital increases without mentioning a
minimum amount or a minimum period, are adequate.

Pre-emption rights

Another special element is the pre-emption right, which enables a shareholder to participate in
a capital increase in proportion to the number of shares he already holds. The details of the
pre-emption right vary. While in the EU Member States it is mandatorily prescribed for
capital increases in cash, it can, in the third states, be granted only on the basis of the statutes.
The amount of the pre-emption right and the possibility of its being excluded, differ as
between individual legal systems.

3.2.2 Provisions in distributions

In all systems reviewed, it is admissible to determine the amount of the company's assets and
to derive therefrom distributions to the shareholders and other entitled persons. The EU
provisions differ in detail from the third state provisions on the question of how the
distributable assets are to be calculated and determined. Based on statutory provisions, private
contractual protection covenants are found in varying degrees.

Provisions on the calculation of the distributable amount

A crucial basis element of any capital system is the provisions on the calculation of the
distributable amount. The EU and non-EU models differ considerably in this respect. The EU
model relies on the distribution of a profit on audited individual accounts, calculated
according to the accountancy regulations in the Accountancy Directive. Only the freely
available profit for the current accounting period and that accumulated from previous years
may be distributed.

The third states usually work with two or more test procedures to determine the distributable
amount. Two levels can be distinguished, in principle. The starting point is usually a method
of calculation relying on current profit and retained earnings. Sometimes distributions from
the surplus (excess of net assets over subscribed capital) are possible. In many legal systems,
distributions de lege lata are, in addition, even admissible if the company thereafter has
almost no or even negative capital.

These accountancy tests are partially applicable by law to balance sheets to be prepared
according to binding accountancy systems (e.g. US GAAP, New Zealand GAAP). In part, it is
also deemed to be admissible to deviate from accountancy on the basis of historical
acquisition and manufacturing costs and to use other accountancy methods, provided that
these are reasonable in the circumstances. Differences also arise on the questions of whether
and to what extent specific group situations are mandatorily to be taken into account.

On a second level, the determination of the distributable amount is to be conducted in the

non-EU countries reviewed by a solvency test, which is sometimes applied by law, and

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sometimes under judgements. It varies in detail. In principle, distributions are prohibited if the
company by the distribution would no longer be in a position to pay debts becoming due in
the normal course of its business.

Provisions on determining the distributable amount

The countries reviewed also provide regulations concerned with which organ proposes the
amount for distribution and whether and to what extent the consent of the shareholders is
required. There are differences precisely on the involvement of the general meeting.

Return of payments received without justification/liability

If payments are made in breach of the distribution procedure, the various legal systems have
provisions for their repayment and on liability of the organ members involved.

Contractual self-protection

Apart from the statutory protection mechanisms, creditors secure themselves also on a
contractual basis. In the third states, the model of contractual self protection, by which usually
major creditors secure themselves directly or indirectly against improper distribution of
assets, is especially developed.

3.2.3 Provisions for the maintenance of contributed capital

Also among the fundamentals of the models reviewed are provisions on the maintenance of
the contributed capital. Apart from the questions of whether the EU basic capital system is
applicable or not, the legal systems reviewed see certain – similar – transactions forms as
"dangerous" and therefore to be protected, although differences in detail remain. Apart from
the common features, some legal systems have other protection mechanisms.

Acquisition of the company's own shares

The acquisition by the company of its own shares, by which shareholders receive repayment
of their contributions, is regulated in all legal systems reviewed. Again the methods differ.
While in the European Union, the maintenance of net assets (assets less liabilities) and the
approval of the general meeting is relied on, in non-EU countries share repurchase is equated
mostly with other forms of distribution and subjected to the regulations. The countries
reviewed maintain provisions on redemption or cancellation of shares acquired.

Financial assistance

Financial assistance which prohibits public companies from granting loans or other support to
purchase their shares, is dealt with mainly in the EU Member States. In the non-EU countries,
such provisions are only occasionally found.

Capital reduction

Capital reduction plays a part only in the states which provide for stated capital. In the other
states, in particular the non-EU countries, the contribution paid for shares is reduced by other
methods, either by a reduction of the number of shares or by distributions although certain
restrictions on distributions have to be observed.

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Reduction in the number of shares

The reduction in the number of shares and the refund of capital associated therewith displays
a number of sub-groups, variously represented in the legal systems reviewed. Distinction has
to be made between the obligatory redemption of shares, redeemable shares, amortisation and
the cancellation of the company's own shares held by it.

Fraudulent transfers

Provisions on “fraudulent transfers” are regarded in the various third states as an important
element of protection of the company and its creditors. The provisions which apply during the
subsistence of the company or, above all, on the insolvency of the company, declare
transactions to be invalid for example, in which the debtor acts with the intention of
prejudicing creditors or which lead to only inadequate assets being left in the company.

3.3 Approach to the economic analysis

The determination of the burdens on the company constitutes a significant assessment

criterion of the efficiency of the existing provisions. Significant criteria which influence the
burdens are the legal certainly associated with the provisions and the associated liability and
penalty provisions.

The economic analysis always follows a prior legal analysis of the relevant capital protection
system. The prior legal analysis is intended to contribute to identifying the important
parameters for a company and rendering in particular the chronological order of legal
processes transparent (cf. Annex 2: Legal Questionnaire EU and non-EU).

Of their nature, the economic analyses constitute a comparison of burdens created by various
regulations for the relevant company. In the analyses of burdens, the "incremental cost" of a
regulation for the company is relied on. Only such costs are regarded as relevant which
usually arise for the company due to the specific regulation in company law. This includes
internal costs for personnel (highly qualified, lowly qualified), but also external advisory costs
and administrative charges. For the purposes of this study it is not usually adequate to restrict
oneself to the purely publication costs as the burden of capital protection regulations refers
mainly to internal processes. A restriction to publication costs would be therefore misleading.
The advantages of regulation arise ultimately from the comparison of a regulation with other
possible regulations for the same situation.

The information received for costs of high / low qualified personnel were generally collected
by man hours. To allow for comparability between jurisdictions with different levels of
welfare, we have applied standardised hourly rates (fully loaded) of €100 per hour for highly
qualified personnel and €70 per hour for low qualified personnel. The average internal hours
spent by companies on incremental burdens due to company law provisions is subsequently
multiplied by these hourly rates.

The information received for other costs were generally given in expenses per year. As these
regularly did not constitute the main incremental cost factor for companies concerned, these
amounts are only converted to Euro amounts with the exchange rates as of 09/15/2006.
Because of the relatively small total economic impact, we have not taken the effort to subject
them adaptations to reflect different levels of welfare in the various countries.

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The "incremental cost" is determined in interviews with selected companies. A few

companies which are intensively questioned, are concentrated on. The approx. 1 ½ hours
interviews are conducted with high-ranking company representatives (CEO, CFO or head of
the legal department, Treasury or Accounting). The exact costs of the compliance with the
legal processes that are subject to this study are not specifically recorded in the day-today
business of companies. Therefore, the information from the company itself relies to a large
extent to estimates on the basis of best knowledge (for more exact presentation of the
selection of companies or the questioning technique cf. Annexes 1 and 2 of the Study).

With regard to equity capital provision, the structure of the capital and the shares is
considered. It should be ascertained in each case whether the present structure causes special
burdens for the company. The significance of protected equity capital, in particular subscribed
capital play an important part in the financing of the company. On this, the question is asked
whether the subscribed capital is necessary for the financing of the company or whether the
bound amount is too high and could better be invested elsewhere. On the other hand, whether
the amount of subscribed capital could alone be adequate for financing the company or
whether there is usually other financing requirement, is also considered.

Finally, the structure of the shares is examined. The main question is whether the present
structure is relevant in assessing the viability of a company.

The efficiency of the company formation, as an historical event, is not specifically taken care
of in the economic analysis.

Particular emphasis in the economic analysis is placed on the distribution process, which
forms the central subject of all present reform efforts on capital protection. The internal
regulations on distribution amounts and their determinants from the company's point of view
are examined. An economic analysis encompasses the costs to comply with the statutory
restrictions on distributions. Finally, the other distribution process costs are ascertained. With
regard to possible changes in the system, the existence of certain conditions e.g. the practice
of budgeting of cash-flows are investigated. Here the attempt is also made to ascertain the use
of "covenants", i.e. contractual provisions with influence on the capacity of companies to
distribute and to estimate their burden for the company.

With regard to capital increases, the associated burdens for the company are intended to be
ascertained. The incremental expenses of the necessary company law steps will be considered.
In as far as possible the expense of company law requirements due to capital market law
requirements will also be looked at (e.g. for the preparation of prospectuses), in order to
clarify the significance of company law regulations in this context.

The subject matter of the analysis is regulations for maintenance of capital and the subjects of
"own shares" "financial assistance", "capital reduction/ withdrawal of shares". With regard to
"own shares", the expense of the regulations for the company will be examined. Here also
comparisons can, as far as possible, be made with the costs of the capital market regulation of
"own shares", in order to assess their significance. Financial assistance will usually be more
difficult to investigate because the liberalisation of EU legislative provisions in this respect
took place only in 2006. "Capital reduction/ withdrawal of shares" will first be examined as to
its use and the costs, as far as existing, estimated. In addition, the relevance of continuous
monitoring of information obligations on the loss of stated capital and the continuous
relevance of the insolvency provisions will be considered.

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3.4 Considerations regarding the protection of shareholders and creditors

The various models examined also display provisions characterised by more or less protection
of shareholders and creditors. They are also to be considered because more regulation with
higher expense can also result in higher protection of shareholders and creditors. Examples
for such regulations are the auditing obligations of contributions in kind by an expert third
party, the obligation to obtain shareholder approval for a capital increase and to acquire the
company's own shares, the granting of pre-emption rights, publication obligations, auditing
obligations of annual accounts, distributions and the implementation of the principle of
equality between shareholders.

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4 Alternatives to the current capital regime

4.1 Comparative analysis - situation in the European Union

4.1.1 France

4.1.1.1 Structure of capital and shares

4.1.1.1.1 Legal framework

With respect to the means of equity financing by shareholders French law is based on the
subscribed capital and on share premiums. With respect to the structure of shares French law
differentiates between shares with a nominal value and shares with an accountable par.

Structure of capital

Subscribed capital

Under French law the share capital must be at least €225,000 in listed public companies and
at least €37,000 in other public companies. Above this minimum amount, the shareholders are
entitled to freely fix the share capital. The share capital must be higher than €225,000 or may
be lower than €37,000 in the case of some regulated activities, such as insurance or press
publishing. In the stage of formation the French Commercial Code does not use the possibility
of fixing authorised capital. This possibility only exists in case of an increase in share capital.

Premiums

Under French law it is possible to use share premiums at the stage of formation but this
possibility is hardly used in practice. The premiums must be accounted on the liabilities side
under the section: subscribed capital (“capital social”), account 104 (Article 441/10 PCG).
However, the premiums can be distributed to the shareholders or be used in any other manner
(Cass. Com. 09.07.1952, J.C.P. 1953, II, 7742).

Premium distribution may be decided by shareholders’ resolution in general meetings. In the

event of the liquidation of the company, no individual has a right to premiums paid by him;
the premiums remain in the liquidation surplus and can be thus distributed to any shareholder
without distinction.

Protection of the public company`s assets

The share capital may not be returned to shareholders except for cases in which the capital is
decreased (see. under 4.1.2.3.2). Premiums may be returned to the shareholders under the
conditions mentioned above. Furthermore French law limits to transactions can follow from
the company's corporate objects ("objet social") or from the prohibition on misuse of the
company's funds ("abus de biens sociaux").

Structure of shares

According to the provisions of the 2nd CLD the French Commercial Code French law offers
shares with a nominal value (par value shares) or, alternatively, shares with an accountable
par. Under French law, shares with a nominal value must represent a certain numeric amount

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which is the amount of the contribution which has been/must be paid on the subscribed
capital. On the contrary shares with an accountable par do not dispose of such a numeric
amount. These shares represent the same fraction of the subscribed capital as all shares with
an accountable par participate in the subscribed capital with the same amount. As these shares
are linked to the subscribed capital, they are in fact notional no-par value shares.

4.1.1.1.2 Economic analysis

Practical relevance of subscribed capital and structure of shares for an assessment of the
viability of a company

The responses from the French companies interviewed showed a mixed reaction to the
concept of minimum legal capital and par value.

The concept of minimum legal capital was considered to be more important for SMEs and for
start-ups. In this context, it can be seen as a sign of seriousness concerning the foundation of
the company. Two companies interviewed explicitly stated that for listed companies it was
not perceived to be important due its minimal amounts. Instead the net equity figures were of
much higher relevance.

To verify the statement for listed companies, we have additionally performed an analysis of
certain ratios concerning subscribed capital for the main French stock exchange index CAC
40:

Figure 4.1.1-1: Ratio of subscribed capital to market capitalisation (France)

France: Subscribed Capital to Market

Capitalisation

6%

8%
< 5%
14% 5%- 10%
47% 10%- 20 %
20%- 30%
> 30%
25%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of September 2006

For 47 percent of the CAC 40 companies the subscribed represents less than 5 percent of their
market capitalisation. Thus, the overall importance of subscribed capital figure seems to be
marginal for listed companies.

Concerning the concept of par value, the picture was mixed. Three companies considered the
“par value” to be relevant as it was part of the legal set-up which guarantees the minimum
capital of companies. Two other companies stated that the “par value” concept was of little
use to their companies.

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One company specifically stated that the legal framework should rather allow for measures
that the share price would not become “too high”. This particular statement alluded to
measures that possibly lower the stock price, e.g. stock splits which are easier to be
contemplated under a “no-par value regime”.

The respective attitudes were not linked to the size of the companies and were rather
motivated by personal opinions of the persons interviewed.

Restriction for distribution

The results from the CFO questionnaire sent to 287 French public companies showed that
there is no uniform assessment by French companies concerning the distribution restrictions
implied by the concept of legal capital.

Figure 4.1.1-2: CFO survey results: necessity of subscribed capital (France)

"In general, w e do not consider

stated/subscribed capital to be necessary; it
unnecessarily reduces our com pany's
flexibility to distribute excess capital."

38%
True
False
63%

Source: CFO questionnaire, September 2007

The responses to the CFO questionnaire did not deliver a clear statement in faour or against
legal capital. While 63 percent of the respondents considered the existence of subscribed
capital to be necessary, this view was opposed by 38 percent of the respondents.

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However, according to the respondents to the CFO questionnaire there does not seem to be
any interest in excessive restrictions to distributions:

Figure 4.1.1-3:CFO survey results: level of subscribed capital (France)

"The com pany's m anagem ent considers it

advantageous to increase the level of
stated/subscribed capital to the highest
possible extent because it should not serve
for distributions."

13%

True
False

88%

Source: CFO questionnaire, September 2007

A clear majority of 88 percent of the respondents rejected the idea to increase the level of
subscribed capital to the highest extent possible to avoid distributions.

Role of the subscribed capital in equity financing

For CAC 40 companies, the ratio of subscribed capital to total shareholder’s equity shows that
for 64 percent of the CAC 40 companies the subscribed equity portion stays under 20 percent
of total shareholder’s equity.

Figure 4.1.1-4: Ratio of subscribed capital to total shareholder`s capital (France)

France: Subscribed Capital to Total

Shareholder's Capital

22% 25%
< 5%
5%- 10%
10%- 20 %
14% 20%- 30%
> 30%
25%
14%

Source: One source: Subscribed capital for the FY 2005, shareholder’s equity (consolidated) for the FY 2005

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This underpins that the equity financing is not largely dependant on the subscribed capital and
that there is a sufficient equity base in the CAC 40 companies and their subsidiaries to allow
for adequate distributions. The existence of a subscribed capital does seem to be a stumble
block for the CAC 40 companies in their approach to equity financing and distribution policy
from a group perspective.

The following answers to the CFO questionnaire concerned the attitude of companies
regarding capital increases:

Figure 4.1.1-5: CFO survey results: Attitudes towards increases of subscribed capital (France)

"Our com pany intends to keep its m axim um

flexibility and w ill try to m inim ise the portion
allocated to stated/subscribed capital to the
am ount strictly necessary for legal or other
reasons."

38%
True
False
63%

Source: CFO Questionnaire, September 2007

63 percent of the respondents stated that they usually try to keep the level of subscribed
capital to the minimum amount necessary. 38 percent of the respondents opposed this view.

These responses show that companies are generally not interested in a dominant role of
subscribed capital in equity financing.

Subsequent formations

We have not received any information on subsequent formations as these provisions are not
relevant to the French companies interviewed.

4.1.1.2 Capital increase

4.1.1.2.1 Legal framework

In accordance with the 2nd CLD French law differentiates between different forms of capital
increase and mechanisms which ensure that the subscribed capital is contributed to the
company.

Increase in capital

Under French law one can distinguish between ordinary capital increases and increases by
authorised capital and also special forms of capital increase.

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Ordinary capital increase

For an ordinary capital increase an extraordinary general meeting may decide an immediate or
possible capital increase, on the basis of a report from the board of directors or the
management board. However, it is general practice to convene, when needed, such an
extraordinary general meeting at the same venue and date as the annual general meeting. The
extraordinary general meeting has a quorum when first convened only if the shareholders
present or represented hold at least one quarter of the voting shares and, if reconvened, one
fifth of the voting shares. Failing this, the second meeting may be postponed to a date not
later than two months after the date originally scheduled. In non-listed public companies, the
memorandum and statutes may require higher quorums. The resolution on the capital increase
must be passed by a majority of two thirds of the votes held by the shareholders present or
represented.

After completion of tax registration formalities, the decision to increase the share capital shall
be published as follows: legal announcement in a gazette; filing with the Registry of
Commerce and Companies of the following documents within one month from the date of the
said general meeting:

• two copies duly signed and certified by the legal representative, of the general meeting’s
minutes deciding or authorising the increase in share capital;
• where applicable, two copies of the minutes of the board of directors’ or management
board’s decision to implement the capital increase,
• two copies of the depository’s certificate,
• two copies duly signed and certified by the legal representative, of the general meeting’s
minutes deciding on the necessary amendment to the statutes,
• two copies of the amended statutes and notice of the amendment to the Companies and
Commercial Registry, publication in BODACC.

Authorised capital

Under French law, the extraordinary general meeting may delegate its competence to decide
on a capital increase to the board of directors or the management board. In order to do so, the
extraordinary general meeting sets the period during which that authorisation may be used, up
to a maximum of twenty-six months, and the overall maximum amount for that increase. The
board of directors or the management board must use the authorisation within the twenty-six-
month period and implement the increase in share capital within five years from the date on
which the authorising resolution was passed.

Other forms of capital increase

Furthermore French law provides for the following special kinds of increases in capital.
Firstly, the capital can be increased by capitalisation of reserves.

Alternatively, the share capital may also be increased for example by means of the exercise of
stock options as an effect of a successful takeover bid or of a demerger, by way of exercising
a right attached to transferable securities giving access to the capital, including, if applicable,
payment of the corresponding sums.

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Contributions of premiums

In accordance with the 2nd CLD, French law allows to use share premiums in the context of
the increase in capital. The share premium must be fully paid-up on subscription. The share
premium amount is decided either by the extraordinary general meeting or the management
board/supervisory board if the extraordinary general meeting has delegated its competence to
decide on the terms of the increase in capital.

Mechanisms to ensure the contribution of capital

Subscription of shares

The French Commercial Code is based on the principle that the share capital must be
subscribed in full. If the subscribed capital is less than the share capital, the company may be
annulled. Newly issued shares must be fully paid up within 5 years. Public Companies are
prohibited to subscribe their own shares, either directly or through a person acting in his own
name but on the company’s behalf. In accordance with the 2nd CLD, the French Commercial
Code prescribes that shares may not be issued at a price lower than their nominal value or
accountable par. If the capital is increased, it is necessary to amend the statutes as well, the
contribution (i.e. date of the decision to increase the share capital and the amount of the
increase in share capital), as well as the share capital (i.e. new amount of the capital and new
total number of shares).

Contributable assets / paying in

Under French law, capital increases can be performed by contributions in cash and in kind.
Any immoveable or moveable asset (whether tangible or intangible) whose monetary value
can be assessed and whose ownership or possession is transferable can become a contribution
in kind. Only commercially exploitable assets can be contributed to commercial companies. A
contribution can be made in ownership, possession or usufruct.

In the case of cash contributions at least one-fourth of the nominal value of any shares
subscribed in cash must be paid-up upon subscription and, where applicable, the entire
amount of any issue premium. The balance must be paid-up, in one or several instalments,
within the 5 years following the day on which the capital increase becomes final.

Protection against over-valuation

In the event of a contribution in kind or of the granting of special advantages, one or several
Contribution Appraisers (“commissaires aux apports”) must be appointed by court order. The
Contribution Appraiser’s report must be kept available to the shareholders at the registered
office, for at least 8 days before the date of the extraordinary general meeting. If the general
meeting approves the valuation of the contributions and the granting of special advantages, it
then formally acknowledges the completion of the capital increase. If, on the other hand, the
general meeting reduces the valuation of the contributions or the benefit of any special
advantages granted, then these modifications must be expressly approved by the contributors,
the beneficiaries or their duly authorised representatives, failing which the capital increase
cannot be implemented. Also with respect to mergers, French law requires the appointment of
an Expert Appraiser (a “commissaire à la fusion” and a “commissaire aux apports,” who may
be the same person but who nonetheless has two separate assignments and must draw up two
separate reports).

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Sanctions

Shareholders are not bound by the valuation determined by the expert appraiser. However if
the valuation is not based on serious arguments, shareholders of a limited liability company
(such as société anonyme, société à responsabilité limitée and société par actions simplifiée)
could be sued for a fraudulent increase in the contribution (Article L.241-3-1 of the French
Commercial Code). Furthermore, the managers and shareholders of limited liability
companies who subscribed for the capital increase can be jointly liable for 5 years, if the
amount retained is different from the valuation made by the expert appraiser (Article L.223-
33 paragraph 2 of the French Commercial Code).

Pre-emption rights

French law provides a preferential right to shareholders to subscribe capital increases based
on contributions in cash in proportion to the value of their shares. Such a pre-emption right
does not exist if the capital increase results from a contribution in kind. This pre-emption right
does not exist if the capital increase results from a contribution in kind. To enable
shareholders to exercise their rights, the company must also comply with certain publication
formalities, which may vary depending on whether the company makes a public offering or
not: for non-listed public companies: registered letter with acknowledgement of receipt sent to
the shareholders 14 days before the planned date for the close of the subscription; for listed
public companies or in case the shares are not all registered: publication in the BALO 14 days
before the planned date for the close of the subscription. Pre-emption rights are attached to
either ordinary or preference shares.

The general meeting which decides or authorises a capital increase may remove the
preferential subscription right for the total capital increase or one or more tranches thereof. To
do so, the general meeting must be informed by a report from the board of directors or the
management board and a special report from the statutory auditor.

The exclusion of the pre-emption right is only valid for an 18-month period; thus the issue of
new shares must be implemented in this period of time.

If the general meeting has merely approved the capital increase, and authorised the board of
directors or the management board to implement it, the authorisation also covers the exclusion
of the pre-emption right under the same voting and majority conditions. In addition, a
complementary report, which includes the aforementioned information, must be issued by the
board of directors to the general meeting. A second report from the statutory auditor will be
handed over to the board of directors or the management board at the time of the
implementation of the increase.

4.1.1.2.2 Economic analysis

The practice of handling capital increases in the French companies interviewed was again
quite surprising. The different ways for increasing their capital showed the pattern that these
French companies nearly all preferred authorised capital over an ordinary share capital
increase with one exception where a company increased its capital during its initial public
offering (IPO).

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Ordinary capital increase

The first “traditional” way of increasing capital is the ordinary capital increase where the
company’s management proposes a shareholder resolution with an immediate capital
increase.

Practical steps

Under French stock corporation law, the following chronological order of practical steps
would be necessary for such an ordinary capital increase:

Figure 4.1.1-6: Process for ordinary capital increase (France)

Ordinary capital increase

Proposal of the board on how the company should be financed (amount of
Step 1
subscribed capital, amount of premiums)
Step 2 Invitation to shareholders meeting
Resolution by shareholders on capital increase and alteration of statutes /
Step 3
Resolution by shareholders on pre-emption rights in case of cash consideration
Subscription by shareholders to the increase in share capital: deposit of the
Step 4
amount to the company’s bank account
Step 5 Amending statutes to raise the amount of subscribed capital
Step 6 Tax registration
Step 7 Legal announcement in a legal gazette
Step 8 Filing with the Clerk of the Commercial Court of legal documentation
Step 9 Modifying publication to the Companies and Commercial Registry
Publication in BODACC (Bulletin Officiel des Annonces Civiles et
Step 10
Commerciales)
Step 11 Up-dating of the corporate registries

Analysis

None of the French companies interviewed have recently conducted an ordinary capital
increase. One exception was mentioned by a company that had conducted its initial public
offering (IPO) several years ago. However, we were not able to obtain specific data on this
“ordinary” capital increase.

Authorised capital

A much more common way of increasing the capital of the French companies interviewed is a
way by which an extraordinary general meeting may delegate its competence to decide on a
capital increase to the board of directors or the managing board within the period twenty-six
months. This possibility is used by all French companies interviewed and is in most of the
French companies interviewed a longer standing tradition.

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Practical steps

To fix authorised capital, the following chronological order of legal steps has to be adhered
to:

Figure 4.1.1-7: Process for authorised capital increase (France)

Authorised capital increase

Proposal of the board on how the company should be financed (amount of
Step 1
subscribed capital, amount of premiums)
Decision by shareholders’ meeting on the principle of the increase in capital, and
delegate powers to the board the decide or not the realisation of the increase in
Step 2
capital;
Resolution by shareholders on pre-emption rights in case of cash consideration
Step 3 Decision of the board to use the delegation and to increase the capital
Step 4 Amending statutes to raise the amount of subscribed capital
Step 5 Tax registration
Step 6 Filing with the Clerk of the Commercial Court of legal documentation
Step 7 Modifying publication to the Companies and Commercial Registry
Publication in BODACC (Bulletin Officiel des Annonces Civiles et
Step 8
Commerciales)
Step 9 Up-dating of the corporate registries

Analysis

In practice, all French companies interviewed have used the opportunity to create an
authorised capital. Three of the companies interviewed have actually used this possibility. The
proposal for the shareholder assembly, to introduce or prolong the authorised capital. As it
mainly a repetitive shareholder resolution every five years, the company reuses and updates
the documentation used in the previous authorisation process. According to the estimates
received the use of internal resources amounts from 3 to 24 hours depending on the individual
circumstances as well as culture and organisation of the company. The effort required does
not seem to be linked to the size (market capitalisation) of the company. Mostly, the legal
aspects are dealt with on an in-house basis. Outside legal advice was widely used but only to
reconfirm the correctness of the inhouse work performed. The external legal costs associated
with the proposal are partly covered by general service agreements with the law firms and if
there were separately charged ranged in the area of several thousand euros. Again, this seems
to be very much linked to the individual circumstances of the company.

We specifically asked in what format the extraordinary shareholder assembly was convened.
We were reassured that the extraordinary shareholder assembly would regularly follow an
ordinary shareholder meeting and, thus, the fact of an extraordinary meeting would not
constitute an additional burden for the companies concerned.

The board’s decision to use the authorisation may require very different levels of preparation
which again are not linked to the size of the company and rather have to do with individual
circumstances and culture of the company. The effort described varied from 1 hour to 20
hours of highly qualified personnel. The same is true for the amendment of the statutes of the
company ranging in between 0.1 to 5 hours of highly qualified personnel.

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Steps 5 to 9 (publication) are partly handled in-house and partly by outside service providers,
notably so called “formalistes” who professionally take care of filing matters with public
institutions or partly also banks concerning the update of corporate registries. Internal efforts
amount to about 10 hours of which 5 hours may be of lower qualification. The costs for the
external handling of filing matters are estimated around €1,000. The banking fee amounts to
several thousand euros.

In the French environment, companies did not volunteer information concerning the effort
required for compliance with the securities market legislation (costs for prospectuses etc.).

Incremental Costs
HighQ LowQ Other Costs
Hours spent 9.1 to 54 5 -
Hourly rate €100 €70 -
€910 to €5,400 €350 €11,000
Total costs €12,260 to €16,750

Mechanisms to ensure the contribution of capital - contributions-in-kind

Practical steps

Regarding contributions in cash or in kind which can be injected during a capital increase the
following steps have to be taken under French law in a chronological order:

Figure 4.1.1-8: Process for the injection of contributions (France)

Injection of contributions
Step 1 Monitoring if assets to be contributed are capable of economic assessment
Step 2 Monitoring if the designated amount is paid in the foreseen time frame
Step 3 Performance of valuation process with respect to contributions in kind
Appointment of an expert “contribution appraiser” in charge of appraising the
value of the assets to be contributed. The appointment is made by the President of
Step 4
the Commercial Court located in the same district as the registered offices of the
company increasing its share capital.
Drafting and signing of a contribution agreement, which is to set out the terms
Step 5
and conditions, the valuation and the remuneration of the contribution of assets.
Publication of report: the contribution appraiser’s report must be kept available to
the shareholders at the registered office for at least 8 days before the scheduled date
Step 6 of the Shareholder’s Meeting. Within the same 8-day period, it must also be filed
with the Clerk of the Commercial Court located in the same district as the
registered office of the Company.
Holding of a Shareholders’ Meeting which will:
- approve the valuation and remuneration of the contribution in kind
Step 7
- approve the terms of the contribution agreement
- decide on the capital increase and the modification of the statutes.
Step 8 Modification of the statutes

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Analysis

In the course of our interviews, we have only encountered two cases in which a company had
made use of contributions-in-kind when acquiring another company in return for stocks.
However, these companies were not in a position to provide us with detailed data on the
burdens associated with these acquisitions. We were explained that the preparation of these
acquisitions required significant effort including the necessary documentation and
publications. Several formal requirements were handled by “formalistes”, the professional
care-takers for filing purposes. Another important aspect was the cost for the valuation of the
contribution-in-kind by an external expert. However, we did not receive specific data on the
associated internal and external cost for this exercise. We only received general comments
that the cost depended on the complexity of the assets to be contributed. Contributions-in-cash
are much easier to handle.

4.1.1.2.3 Protection of shareholders and creditors

Regarding the provisions on capital increase one can draw the following conclusions under
the aspect of shareholder and creditor protection. Firstly, it should be noted that the
requirement that the shareholders have to agree to the ordinary capital increase has clearly a
shareholder protective character. Furthermore, the provisions on authorised capital contain
elements which are shareholder protective as the authorisation must be given by the
extraordinary general meeting. Also the fact that the authorisation period is limited to twenty-
sixth months and the amount which can be covered by the authorisation are shareholder
protective.

In this respect French law contains further protective provisions, as it prescribes the
registration of the shareholders’ resolution to increase the capital, the registration and
publication of the increase in capital and the registration and publication of the amendment of
the statutes. To ensure that an equal treatment in contributions takes place French law
prescribes the drawing up of a report by an independent expert in case of contributions in kind
to protect shareholders before over-evaluations and its consequences. Under the aspect of
shareholder protection the mandatory pre-emption rights are furthermore of importance as
they prevent from dilution. Insofar it should be noted that under French law, these provisions
protect the shareholders only in the case of contributions in cash.

4.1.1.3 Distribution

4.1.1.3.1 Legal framework

French provisions on distributions differentiate between provisions dealing with the

calculation of the distributable amount, the determination of the amount to be distributed and
the consequences of incorrect distributions.

Calculation of the distributable amount

Under French law, the provisions of Article 15-1 of the 2nd CLD are implemented in the
French Commercial Code. Accordingly, the distributable amount is the net after-tax profit;
minus any negative retained earnings or allocations to legal or statutory reserves; plus any
positive retained earnings; plus distributable reserves if the general meeting so decides
(distributable profits are first taken from the profit; if some distributable profits are taken from

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the distributable reserves, the decision of the general meeting shall expressly mention from
which distributable reserves these amounts are taken).

Except in case of a reduction in share capital, no distribution can be made to shareholders

when the net equity is or would be, after the distribution, less than the amount of the share
capital plus legal or statutory reserves that are not distributable. The French Commercial Code
aquires that every year five percent of the financial year’s earnings less any losses brought
forward have to be allocated to a reserve fund referred to as “the legal reserve” until the legal
reserve reaches ten percent of the subscribed capital or a higher percentage if so provided by
the company’s statutes. However, the share premium is not part of the legal reserve and
therefore can be distributed.

Connection to accounting rules

The balance sheet profit is determined with reference to the annual accounts which must be
drawn up in accordance with national GAAP. The annual accounts must be audited except
where the public company is considered to be small.

Determination of the distributable amount – responsibilies

In France, a dividend distribution falls within the exclusive competence of the annual general
meeting which approves the annual accounts, upon proposal of the company’s governing
body (i.e. board of directors, president). The general meeting can only decide on the dividend
distribution after having approved the annual accounts of the relevant financial year and
having acknowledged the amount the distributable profits. The majority required is that for
the ordinary general meeting (majority of the votes). Minutes of the general meeting
approving the annual accounts and allocating the result (i.e. dividend distribution) shall be
filed with the competent Commercial Court as well as the annual accounts. These documents
are then publicly available at the Commercial Court.

Sanctions

French law provides for different instruments for the case that the distribution was not in line
with the aforementioned provisions. First of all shareholders can challenge improper decisions
of general meetings before the competent Commercial Court. It is often the case that majority
shareholders systematically vote that the profit made by the company not be distributed but
rather allocated to reserves. In such cases, minority shareholders may petition the relevant
court in order for such a decision to be considered as an abuse of majority. Nevertheless, case
law requires proof of such an abuse of majority: for this purpose, it has to be proved that such
a decision to allocate profit to reserves is contrary to the company’s general interest and only
in the majority shareholders’ interest. But in some cases, the court has sanctioned penalised
such decisions, which were considered as an abuse of majority.

Any dividend distribution/interim dividend distribution din breach of the rules provided in
Article L.232-11/L.232-12 of the French Commercial Code constitutes a “false dividend
distribution” which is subject to specific penalties i.e., a five-year imprisonment and a fine of
€375,000 and to civil damages.

Shareholders are obliged if the distribution took place in violation of the before mentioned
rules to return to the company any payment received if the recipients knew about the irregular
nature of the distribution. Furthermore the managers, the directors or the presidents are liable

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in criminal law in case of distribution of “dividend fictifs” (five year imprisonment and a fine
up to €375,000). Furthermore, they, as well as the statutory auditors, may have to pay civil
damages if they were aware of the irregular distribution and if they had not revealed it to the
general meeting.

4.1.1.3.2 Economic analysis

Overall, French companies considered the French legislation concerning dividend distribution
as easy to comply with. The reference to the accounting profit derived from the annual
accounts provides a high degree of legal certainty which gives the French companies
interviewed comfort.

Practical steps

The distribution of the balance sheet profits requires the following practical steps which are of
importance for the cost analysis.

By chronological order, the series of practical steps comprises:

Figure 4.1.1-9: Process of dividend distributions (France)

Process for dividend distributions

Step 1 Closing of the FY / Use of company’s annual accounts
Monitoring of distributions made / monitoring of the provisions determining the
Step 2
distributable amount
Step 3 Calling of a board of directors’ meeting
Board of directors’ meeting (that notably calculate the distributable profit
Step 4
according to the legal constraints mentioned above)
Certification of the annual accounts by th1e statutory auditor and issuance of its
Step 5
general report
Step 6 Calling of the annual shareholders’ meeting
Annual shareholders’ meeting (and filing of the corresponding Minutes and of
Step 7
the annual accounts to the Clerk of the Commercial Court)
Payment of the dividend within a maximum period of nine months after the
Step 8
closing of the FY

Analysis

Calculation of the distributable amount

From an economic point of view, the establishment of the dividend proposal typically
involves the CFO and CEO and other selected high ranking company representatives
preceded by preparations in the company’s administration (treasury, tax and/or accounting
departments). The level of dividends is also a political decision concerning the attractiveness
of the shares to investors. The dividend proposal is subsequently subject to a discussion in the
company’s management board before it is handed over to the supervisory board. The
intensiveness of the discussion in the management and supervisory board depends on the
specific importance of dividend levels for the performance of the shares of the company.

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The point of reference for the determination of the distributable amount is the consolidated
financial statements of the company. The individual financial statements which are the legally
decisive set of accounts are also considered but more with a view concerning possible
constraints for envisaged distributions. Other aspects like dividend continuity and certain
signals to the capital market via the level of dividends are also important aspects for the
French companies interviewed.

The results of a CFO questionnaire sent to French companies listed on main indices reconfirm
this:

Figure 4.1.1-10: Determinants for the distribution of dividends in the holding company (France)

"What are the determ inants for the distribution of dividends by your holding
com pany?"

5
4,25
3,64
Importance

4
4,22 2,96 3,06
France
3
3,50 2,15 2,12
2,71
EU Average
2
2,14 2,00 1,86
1
Fin. performance Financial Dividend Signalling device Credit rating Tax rules
(group accounts) performance continuity considerations
(individual
accounts of the
parent company)

Determ inants

Source: CFO Questionnaire, September 2007

However, concerning the importance of the current legal restrictions on profit distribution, the
CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market
led solutions like rating agencies’ requirements or bank covenants.

Figure 4.1.1-11: Important deterrents when considering the level of profit distribution (France)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"

3,44
4
Importance

2,43 2,65 France

3
2,16 EU Average
3,14
2 2,43
2,25
1,71
1
Distribut ion/ Legal capital Rating agencies' Cont ract ual agreements Possible violations of
requirement s requirements with creditors (covenants) insolvency law

Deterrents

Source: CFO Questionnaire, September 2007

Depending on the structure of the company, it may be necessary to bring the consolidated
view in line with the disposable profits / cash at parent company level. This requires a certain
planning effort regarding necessary distributions from subsidiary levels. In this context, tax
considerations may also play a certain role in generating profits and cash at parent level. We
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were not able to obtain specific data on the exact effort required for this. However, as this
planning effort may be largely based on tax optimisation any effort in this respect could also
be considered non-incremental.

Again, the results of a CFO questionnaire sent to French companies listed on main indices
show the importance of tax considerations:

Figure 4.1.1-12: Determinants for the distribution of dividends by the subsidiaries (France)

"What are the determ inants for the distribution of dividends by your
subsidiaries?"

5
4,13
4
Importance

4,07 3,14 3,29

France
3
EU Average
2,71 2,74
2

1
Demands from the ultimate parent Tax rules Own investment decisions

Determ inants

Source: CFO Questionnaire, September 2007

Connection to accounting rules

Due to the immediate link to the audited financial statements under French GAAP, the French
companies interviewed considered it easy to verify the distributable amount from a legal
compliance point of view. There is no specific effort needed in this regard.

Determination of the distributable amount

The total time spent on this process does amount by average between 10 and 20 hours of
highly qualified personnel of the company. Thereof the largest bulk is spent on the
establishment of an adequate dividend proposal. The time effort for the distribution proposal
by management varies depending on the culture and organisation of the individual company
and is typically not linked to certain size criteria.

From a legal compliance perspective, the French companies interviewed spent by average
regardless of the size of the company about 3 hours of highly qualified personnel to comply
with the relevant French restrictions in connection with the distribution proposal. One
company with exceptional circumstances (distribution from additionally paid-in capital) had
an increased time effort and external legal advice. However, this extraordinary situation did
not represent an exceptional increase in cost - even in a borderline situation. In this situation,
the time effort tripled and there was a marginal amount of money necessary to receive legal
advice on the situation (several thousand euros).

The legal compliance effort concerns the preparation of the board of director’s meeting as
well as the shareholders’ meeting ranges between 1 and 2 hours of highly qualified personnel.
A considerable effort constitutes the actual payment of dividends which is mainly arranged
via banks for certain fees. The time effort for highly qualified personnel is rather limited

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(about 5 hours). The handling cost for banks for the registration of shareholders and the
transfer of dividends largely depend on the number of shareholders to the company and can
range from several thousand euros to more than €100,000. However, it should be kept in mind
for the purpose of this study that the costs for the actual payment of dividends are the result of
a negotiation between the bank and the company. It is an effort that would arise under any
legal distribution scheme and it cannot be particularly influenced by company law.

The companies interviewed do typically not engage external legal advisors in this process and
rather use in-house solutions. We have encountered one exception with a company that
distributed from its additionally paid in capital; however, costs amounted only to several
thousand euros.

The remaining other steps were considered to be non-incremental as they were from the
companies’ perspective not originating from the compliance with distribution provisions such
as the preparation of the accounts, the annual audit and the general preparations for holding
the annual general meeting.

Regarding the establishment of alternative cash-flow projections to be used in the distribution

process all companies interviewed had a very detailed cash flow planning for at least one
year. However, this planning is based on internal rules on how to prepare such projections and
is clearly linked to the business needs of these companies. The maximum projection period
which allowed for serious estimations was considered between three to five years depending
on the nature of the business of the company.

One specific feature of the French environment that was mentioned to us by one company is a
requirement for the company to issue a statement about its future solvency to the worker’s
council. A 1984 law imposes on French companies to inform the worker’s council twice a
year on the results of a check whether the company is able to meet its liability during the next
year.

Sanctions

Concerning the efforts to comply with provisions concerning incorrect dividend distributions,
the French companies interviewed generally considered the risk of liability for company’s
management to be low. The reason for this is mainly the very clear cut legal provisions on
profit distributions which due to their simplicity provide a high level of legal certainty.

However, in one instance mentioned above (profit distribution from additionally paid-in
capital) the workload has been labelled as “high”. However, from a wider perspective the
compliance can still be considered as minor (17 hours of highly qualified personnel, several
thousand euros in legal costs).

Related parties

In general, there were also no significant issues concerning the question of the monitoring of
the relationships with related parties and potential other refluxes of funds to shareholders.

In two cases, there was increased attention to this aspect due to the shareholder structure of
the company. One company has introduced a special board committee to monitor the
relationship with its major shareholder. Another company has a policy that contractual
relationships with shareholders owning more than 10 percent of the company’s shares need

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prior board approval. The work effort resulting from this internal requirement amounts to two
days (16 hours) of highly qualified personnel.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 16 to 27 - -
Hourly rate €100 €70 -
€1,600 to €2,700 - -
Total costs €1,600 to €2,700

4.1.1.3.3 Protection of shareholders / creditors

Under the aspect of shareholder and creditor protection one can draw the following key
conclusions from the before mentioned provisions on distributions. Firstly, it should be noted
that the clearly formulated legal distribution limitations including in particular the subscribed
capital and the legal or statutory reserves as well as the immediate link to the audited financial
statements lead to a legal certainty and to a little risk with respect to the liability of board
members. Furthermore, these rules can be characterised as creditor protective as they limit the
distributable amount by the profits and preserve a certain amount of the equity for the
creditors. The obligation that the general meeting has to decide on the allocation of the
dividend distributions, which stems from the national legislation, leads to shareholder
protection. Also the principle of equal treatment in distributions protects shareholders. In this
respect French law contains further protective provisions, as it allows shareholders to
challenge resolutions that may lead to incorrect distributions. Also the national provisions
prescribing the liability of members of the management board and the supervisory board for
losses caused by unlawful distributions are shareholder protective.

4.1.1.4 Capital maintenance

French law provides for different instruments dealing with the capital maintenance. Among
these are the provisions on the limitation of the acquisition of own shares and the prohibition
of financial assistance as well as the provisions on capital decreases, the withdrawal of shares
and the serious loss of the subscribed capital and the principles on the prohibition of the
misuse of the company’s funds. Furthermore the question arises in how far the contractual
self protection is of importance.

4.1.1.4.1 Acquisition by the company of its of own shares

4.1.1.4.1.1 Legal framework

French law generally prohibits companies from purchasing or subscribing their own shares,
except in the limited cases provided for by law. These exceptional cases cover purchases like
in the framework of a capital reduction that is not the result of losses. The repurchased shares
must in this case be cancelled immediately; in order to grant shares to the company’s
employees, for example, under a profit-sharing plan, a stock option plan or a plan to grant free
shares. Furthermore, French law provides for a general authorisation of the acquisition by the
company of its own shares. According to this provision, the general meeting of a listed public
company can authorise the board of directors to acquire 10% of the company’s capital. The
general meeting has to resolve on the purpose, the terms and conditions of the acquisition.
The authorisation can be given for a maximum period of 18 months. This authorisation can be
used, for example, to improve the financial management of the shareholders’ equity. The

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relevant information must be notified to the market (general regulations of the Autorités des
Marchés Financiers ( i.e., the French securities exchange commission, hereinafter the “AMF”
and AMF instructions). The details of the redemption program must be published in one or
several newspapers, made available at the issuer’s registered office, and posted on the issuer’s
website. A company’s acquisition of its own shares is, moreover, subject to the following
conditions:

- the purchase must not be made by a person acting on the company’s behalf,
- a 10% limit; i.e. the company may not acquire more than 10% of the total number of its
shares,
- the shareholders’ equity must be maintained: the company’s purchase of its own shares
must not have the effect of reducing its shareholders’ equity to an amount that is lower
than the combined amount of its capital and non-distributable reserves.

Furthermore, the company’s purchase of its own shares must be authorised by the ordinary
general meeting. In France, the shares purchased by the company must be registered shares
and be paid-up in full.

The acquisition by the company of its own shares has the consequence that the voting rights
of treasury shares are cancelled. The same applies to the right to dividends and pre-emption
rights. Furthermore, it must be noted in this context that the amount of the company’s
reserves, not including its legal reserve, must be at least equal to the value of all the shares it
holds.

In accordance with the 2nd CLD, the French Commercial Code prescribes that any shares held
by the company in contravention of the legal provisions must be sold within one year of their
acquisition, failing which they must be cancelled. Any corporate officers or executives who,
on behalf of the company, have purchased shares issued by it without satisfying the related
conditions of purchase, or who have held on to them beyond the deadline for disposing of
them, are subject to a €9,000 fine.

Under French law it is prohibited for the company from taking a pledge of its own shares,
either directly or through persons acting in their own name but on the company’s behalf.

Regarding the resale of the company’s own shares French law does not provide specific
regulations.

Regarding a prospective implementation of the amendments of the 2nd CLD it should be noted
that they have not yet been implemented into national law.

4.1.1.4.1.2 Economic analysis

In France, the amendments to the 2nd CLD in the year 2006 have not yet been enacted in
French legislation (dropping of the 10 percent limit, prolongation of the authorisation by
another five years). Thus, the interview results still refer to the current French arrangements
for the acquisition of own shares.

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Practical steps

To acquire own shares a company has to follow this process:

Figure 4.1.1-13: Process for the acquisition of own shares (France)

Acquisition of own shares

Step 1 Proposal of board to acquire own shares
Step 2 Calling a shareholders’ meeting
Step 3 Ordinary shareholders’ meeting authorising the acquisitions of own shares
Step 4 Monitoring of provisions (amount of nominal value, net assets, fully paid in etc)
Step 5 Information in the annual accounts and in the annual management report.

Analysis

All of the French companies interviewed (5 companies) dispose of an authorisation by the

shareholders’ assembly to the company’s management to acquire own shares. Four of these
companies make use of their authorisation and actually acquire own shares. Authorisations
are normally renewed at least every two years within the legally permitted timeframe of 18
months. The relaxation of the revised 2nd CLD will prolong these periods to five years and,
thus, will help to lift the burden for companies by less frequent renewals of authorisations.

The French companies interviewed buy back shares for mainly two reasons: either for share
option programmes or in connection with liquidity programmes to support the trading of the
share at the stock exchange. Potential acquisitions may be another reason.

Within the legal process, there are several steps that require preparations mainly by the
company’s departments responsible for legal matters and for treasury.

The first step is the proposal by the management board which takes between 3 and 24 hours
of preparation of highly qualified personnel depending on the complexity of the issue. This
proposal is regularly an update of pre-existing documents which have been elaborated at the
time of the initial introduction. This proposal is regularly prepared in-house and is in some
cases checked by an external lawyer. This can be part of a general service agreement with a
law firm and is not an extensive effort. The initial elaboration of the documentation and other
documents is a costly exercise which may amount to several ten thousand euros of external
legal advice.

The actual buyback is the most burdensome exercise in the acquisition of own shares. It is
mostly done via trading houses/banks for charges amounting to several ten thousand euros.
The monitoring of these activities takes by average about 20 hours of highly qualified
personnel. The documentation of the buybacks for the securities regulator can amount to 8
hours of highly qualified personnel per month (106 hours per year). However, it is clear that
these burdens stem rather from securities regulation than company law.

Another step is the preparation of the notes to the accounts to inform about the acquisition of
own shares. Depending on the complexity of the buyback activity, the average time effort is
10 hours of highly qualified personnel.

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In general, we have not noticed significant deviations in the work load between different sizes
of companies. It rather depends on the level of activity of the company regarding stock
buyback programmes.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 33 to 54 - -
Hourly rate €100 €70 -
€3,300 to €5,400 - €50,000
Total costs €53,300 to €55,400

4.1.1.4.1.3 Protection of shareholders and creditors

Under the aspect of shareholder and creditor protection one can draw the following key
conclusions from the before mentioned provisions on the acquisition of own shares. Firstly, it
should be noted that with respect to the most important case of acquisitions of own shares -
the acquisition of own shares on the basis of an authorisation of the general meeting – the
shareholders have to authorise the acquisition of own shares by a resolution which can be
done for a maximum period of 18 months, what is shareholder and creditor protective.
Furthermore, the provisions which limit the amount of own shares which can e acquired (the
10% threshold) and the provision which prescribe that own shares may not be acquired with
the subscribed capital and not distributable reserves aim at protecting shareholders and
creditors.

In the case shares have been purchased different shareholder and creditor protection rules are
applicable. Of importance are for example the provisions which prescribe that all rights
attached to the acquired shares are suspended. Also of importance is the provision that, when
acquired shares are included on the assets’ side of the balance sheet, a reserve of the same
amount not available for distribution must be set up and specific information about the
acquisition and the reselling of shares must be made.

4.1.1.4.2 Capital reduction

4.1.1.4.2.1 Legal framework

The French Commercial Code provides for two kinds of capital reductions: the simplified
capital reduction (which is due to losses) and the ordinary capital reduction (which is not due
to losses). The reduction in share capital may be implemented either by the reduction of the
number of shares or by reduction of their nominal value. The extraordinary general meeting is
exclusively competent to decide or authorise the capital reduction. However, the meeting can
delegate to the board of directors all its powers to implement the capital reduction. The
extraordinary general meeting has a quorum when first convened only if the shareholders
present or represented hold at least one quarter of the voting shares and, if reconvened, one
fifth of the voting shares. Failing this, the second meeting may be postponed to a date not
later than two months after the date originally scheduled. In non-listed public companies, the
statutes may require higher quorums. The extraordinary general meeting resolves on the
capital reduction with a majority of two thirds of the votes held by the shareholders present or
represented.

Under French law it is possible to reduce the share capital to €225,000 for a listed public
company and €37,000 for a non-listed public company (S.A.).

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Regarding the ordinary capital reduction, the creditors of the company may notify to the
company their objection to the reduction within 20 days after the filing with the Commercial
Court of the minutes of the general meeting deciding on the reduction. If the judge of original
jurisdiction grants the objection, the capital reduction procedure is immediately halted until
sufficient guarantees are provided or until the debts are repaid. If he rejects it, the reduction
procedure may recommence and the distribution or repayment of their shares to the
shareholders can be made.

The simplified capital reductions can only be used to offset losses; the regime is slightly
different.

The amendments of the 2nd CLD with respect to the burden of proof have not yet been
implemented into national law.

4.1.1.4.2.2 Economic analysis

Within our sample none of the French companies has neither reduced its capital nor
considered to do so.

4.1.1.4.2.3 Protection of shareholders and creditors

Regarding the shareholder and creditor protection existing with respect to capital decreases,
firstly the requirement that the shareholders have to agree to the capital decrease with a
majority of two thirds of the votes held by the shareholders present or represented is of
importance. Furthermore the safeguards to the creditors which have under certain
circumstances the right to obtain security are creditor protective.

4.1.1.4.3 Withdrawal of shares

4.1.1.4.3.1 Legal framework

Regarding the withdrawal of shares French law allows the compulsory withdrawal of shares.
Furthermore French law provides for the withdrawal of own shares. Not possible is the
issuance of redeemable shares.

In accordance with the 2nd CLD, the compulsory withdrawal of shares is only permissible if it
is prescribed or authorised by the statutes before the shares to be withdrawn are subscribed for
or with the unanimous approval of the shareholders.

The statutes must expressly provide the conditions (grounds, competent body, procedure to be
followed). These conditions must be objectively determined, and that the value shall be
determined, in case of dispute, by an expert. In case the compulsory withdrawal leads to a
capital reduction, the capital reduction shall be implemented in accordance with the
provisions stated by French law regarding ordinary capital reduction.

Shares which have been acquired by the company can be cancelled by means of a reduction in
capital. The acquisition, assignment or transfer of the said shares may be effected by any
means.

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4.1.1.4.3.2 Economic analysis

Within our sample of French companies, we have only encountered one case in which capital
decrease provisions have been used to lower the number of shares. It concerned the
redemption of own shares. We have not received specific data concerning the redemption of
the shares but were reassured that it would be a simple procedure which is normally
authorised by the same shareholder’s meeting dealing with the share buyback programme.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.1.1.4.3.3 Shareholder and creditor protection

Regarding the withdrawal of shares it is with respect to shareholder and creditor protection
firstly of importance that it is only permissible if it the statutes allow it before the shares to be
withdrawn are subscribed for or if the shareholders concerned approve the withdrawal if it is
made possible by the statutes after the shares have been subscribed. Furthermore in case the
compulsory withdrawal leads to capital reduction, the safeguards to creditors are of
importance, which correspond to the ones which apply in the case of ordinary capital
decreases.

4.1.1.4.4 Financial assistance

4.1.1.4.4.1 Legal framework

Under French law a company cannot grant any loans or securities for the purpose of allowing
a third party to subscribe or purchase its own shares. This prohibition applies not only to
subscriptions or purchases by persons unrelated to the company but also to transactions made
by the shareholders themselves.

4.1.1.4.4.2 Economic analysis

As the changes to 2nd CLD have not been implemented, there could not have been any
practical cases in the course of the interviews with French companies.

4.1.1.4.5. Serious loss of half of the subscribed capital

4.1.1.4.5.1 Legal framework

In France, in the event that, because of losses of the company, the net equity becomes lower
than one half of the share capital, an extraordinary general meeting must be held in order to
decide on whether or not the company should be dissolved. If the shareholders decide not to
dissolve the company, it is mandatory that the company bring its net equity to an amount that
is at least equal to one half of the share capital before the end of the second financial year
following that during which the shareholders’ meeting was held. The decision (whether to
dissolve or not) is published in a legal gazette and filed with the Commercial Court.

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4.1.1.4.5.2 Economic analysis

The French companies interviewed spent very little time on the monitoring of this provision
on the serious loss of subscribed capital. In general, they would see a significant increase in
monitoring activity if the financial position of the company showed indications that such a
situation could actually occur. The management of the companies interviewed normally use
their normal internal reporting and risk management systems to monitor the financial position
of the company/group. This would give them sufficient lead time to recognise critical
situations.

4.1.1.4.5.3 Shareholder and creditor protection

The provisions dealing with the serious loss of the subscribed capital have a shareholder and
also creditor protective character as the shareholders meeting gets the possibility to decide on
dissolving the company or not.

4.1.1.4.6 Contractual self protection

4.1.1.4.6.1 Legal framework

In France there are no specific legal provisions concerned with contractual self protection of
creditors which can guarantee the payment to the creditors, except the texts regarding
warrantees (pledge, security, etc.). The contractual provisions usually provide that the
reimbursement of the loan shall prevail against any other repayment. Other provisions can
provide that no security can be taken over the assets of the company at least without the prior
approval of the bank. Those kinds of protections can also be provided for in shareholders’
agreements.

4.1.1.4.6.2 Economic analysis

Three of the five French companies interviewed have covenant in the format of financial
ratios in loan agreements. These covenants do regularly not foresee direct restrictions on
profit distributions but refer to certain ratios (e.g. EBIT / financial charges or Equity / net
debt). These may indirectly result into restrictions to profit distributions. The existence of
such covenants is a matter of negotiation with the respective banks. We did not receive
specific data concerning the administrative burden for the companies but we were reassured
that the covenant by nature do not present a severe burden.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.1.1.4.6.3 Shareholder and creditor protection

Regarding the aspect of creditor protection it should be noted, that covenants are based on
private law contracts and that only individual creditors are protected by them.

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4.1.1.5. Insolvency

4.1.1.5.1 Legal framework

In France, an insolvency test is required to ascertain if the company is in “cessation des

paiements”, that means not able to meet its financial obligations and to pay its current
liabilities with its liquid assets.

The board must apply this test when the company encounters difficulties in meeting its
financial obligations or when the statutory auditors trigger the alert procedure. However, the
board can trigger other procedures (“Mandat ad hoc” and “procédure de sauvegarde”) to
prevent insolvency before the “cessation des paiements”. The purpose of the "mandat ad hoc"
is to obtain an agreement with the company’s main creditors with the help of a person
appointed by the court. The “procédure de sauvegarde”, which is the principle reformation of
the French reform, is an insolvency procedure available only when the company is not in
“cessation des paiements”; it can be initiated only at the debtor’s request

The board can be caused to apply the insolvency test after a procedure of alert (“Procedure
d’alerte”). This procedure can be triggered either by the statutory auditors, the works council,
the minority shareholders or the president of the Commercial Court.

The main procedure of alert is that exercised by the statutory auditors. They must alert the
board on facts which, according to them, can compromise the continuity of the activity of the
company. This alert is given by registered letter addressed to the board and asking for
explanations of the situation.

If the statutory auditors think that the explanations given or the decisions taken are not
sufficient, they draft a special report for the attention of the shareholders convened for the
occasion by the board. The statutory auditors shall also inform the president of the
Commercial Court of their intentions with regard to the decisions taken by the shareholders.
The president of the Commercial Court can decide, if he is of the opinion that the situation
(such as information given by the statutory auditors or request of a creditor) threatens the
survival of the company, to convene the directors to question them about the situation of the
company.

4.1.1.5.2 Economic analysis

Like for the provision on the serious loss of subscribed capital the French companies
interviewed spent very little time on the monitoring of insolvency triggers. Again, they would
generally see a significant increase in monitoring activity if the financial position of the
company showed indications that such a situation could actually occur. The management of
the companies interviewed normally use their normal internal reporting and risk management
systems to monitor the financial position of the company/group. This would give them
sufficient lead time to recognise critical situations.

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4.1.2 Germany

4.1.2.1. Structure of capital and shares

4.1.2.1.1 Legal framework

With respect to the means of equity financing by shareholders, German law is based on the
subscribed capital and on share premiums. Furthermore, additional equity contributions in the
form of bonds or by contractual obligation are possible. With respect to the design of shares,
German law differentiates between shares with a nominal value and so called notional “no par
value shares”.

Structure of capital

Subscribed capital

Under German law, public companies are required to have subscribed capital which has to be
entered under equity in the balance sheet and cannot be distributed to shareholders. German
law prescribes a minimum subscribed capital of €50,000. Above this minimum amount the
founders are entitled to freely fix a higher capital amount which is protected in the same way.
Furthermore, the German Stock Corporation Act uses the possibility of fixing authorised
capital at the stage of formation. The board of directors can be authorised for a maximum
period of five years, starting with the incorporation of the company, to increase the subscribed
capital by up to half of the subscribed capital that existed at the time the authorised capital
was fixed in the statutes. The subscribed capital can be – in line with the 2nd CLD – increased
by an ordinary increase in capital, by an increase in capital which is based on authorised
capital or special forms of capital increase, like for instance the nominal increase in capital or
the conditional increase in capital.

Premiums

As mentioned, the other form of equity financing is the use of share premiums which is very
common in practice in the context of capital increases but which is already allowed at the
stage of formation. Under German law, the term “share premiums” is generally understood as
the amount the subscriber of new shares has to pay in excess of the nominal value to the
shares. According to the German Commercial Code, share premiums are to be placed in the
capital reserve (“Kapitalrücklage”). The capital reserve and the statutory reserve (“gesetzliche
Rücklage”) form a “legal reserve fund” so that, in each financial year, five percent of the
financial year’s earnings less any losses brought forward have to be placed in the statutory
reserve until the statutory reserve and the capital reserves reach ten percent of the subscribed
capital or a higher percentage if so prescribed by the company’s statutes. The “legal reserve
fund” – and thus the share premium – must not be distributed. It serves in the first place to
offset losses which otherwise reduce the subscribed capital. If the combined sum of the
capital reserve and the statutory reserve exceeds ten percent of the subscribed capital or the
higher percentage prescribed by the company’s statutes, it may also be used for an increase in
capital.

Protection of the public company’s assets

Apart from the principle that subscribed capital cannot be distributed and premiums can only
be used under certain circumstances, there is general consensus that the German Stock

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Corporation Act must be understood to the effect that it prohibits any payment to a
shareholder out of the corporation’s funds if it is made not in the context of a distribution of
the balance sheet profits and is not allowed because of a special statutory regulation.
Therefore, the prohibition applies if the payment is made out of the subscribed capital, the
statutory reserve or the optional reserve if an effective shareholders’ resolution on the
distribution does not exist. Furthermore, it should be noted that the prohibition covers not
only patent but also hidden transactions such as dealings with shareholders not at arm’s
length.

Structure of shares

According to the provisions of the 2nd CLD, the German Stock Corporation Act offers shares
with a nominal value (par value shares) or, alternatively, so called “notional” no-par value
shares. Under German law, shares with a nominal value must describe the amount of the
contribution which has been/ must be paid to the subscribed capital. For the German notional
no-par value shares, it is characteristic that every no-par value share represents the same
fraction of the subscribed capital as that in which all no par value shares participate in the
subscribed capital. They are still linked to the subscribed capital.

4.1.2.1.2 Economic Analysis

Practical relevance of subscribed capital and structure of shares for an assessment of the
viability of a company

In general, the German companies interviewed did not see a high degree of practical relevance
of the legally imposed subscribed capital concerning the assessment of their viability by
outsiders. This also includes the question how the subscribed capital is structured, i.e. whether
a legal capital is based on an accountable par. The subscribed capital is not, in their opinion,
specifically relevant in the assessment by banks, analysts or rating agencies. For these
institutions, other indicators are more relevant for assessing the financial position of the
company.

According to the results of the interviews conducted, these companies rather look at the
figures “net equity” and “market capitalisation” as relevant to determine their equity position
and their assessment of their chances to preserve their business or to attract additional capital.
It was therefore neither feasible nor useful to extract data on the initial foundation of these
companies.

To verify this statement, we have additionally performed an analysis of certain ratios

concerning subscribed capital for the main German stock exchange index DAX 30:

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Figure 4.1.2-1: Ratio of subscribed capital to market capitalisation (Germany)

Germ any: Subscribed Capital to Market

Capitalisation

10%

13%
< 5%
5%- 10%

57% 10%- 20%

20%- 30%
20%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of september 2006

Compared to the market capitalisation, the subscribed capital shows even a lower portion. For
57 percent of the DAX companies the subscribed represents less than 5 percent of their
market capitalisation. Thus, the overall importance of subscribed capital figure seems to be
marginal.

Restriction for distribution

However, the German companies interviewed did not particularly question the distribution
restrictions implied by the concept of legal capital.

The latter was also reconfirmed by results from the CFO questionnaire sent to 354 German
public companies.

Figure 4.1.2-2: CFO survey results: necessity of subscribed capital (Germany)

"In general, w e do not consider

stated/subscribed capital to be necessary; it
unnecessarily reduces our com pany's
flexibility to distribute excess capital."

15%
True
37%
False
NA
48%

Source: CFO questionnaire, September 2007

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48 percent of the respondents considered the existence of subscribed capital to be necessary.

This view was opposed by 37 percent of the respondents.

However, according to the respondents to the CFO questionnaire there is no interest in

excessive restrictions to distributions:

Figure 4.1.2-3: CFO survey results: level of subscribed capital (Germany)

"The com pany's m anagem ent considers it

advantageous to increase the level of
stated/subscribed capital to the highest
possible extent because it should not serve
for distributions."

7% 15%
True
False
NA
78%

Source: CFO questionnaire, September 2007

A clear majority of 78 percent of the respondents rejected the idea to increase the level of
subscribed capital to the highest extent possible to avoid distributions.

Role of the subscribed capital in equity financing

The subscribed capital figure as part of the wider equity of the company is necessary for the
financing of the company. According to the companies interviewed, the subscribed capital is
not sufficient for the equity financing of the operations of the company.

For DAX 30 companies, the ratio of subscribed capital to total shareholder’s equity shows
that for 87 percent of the DAX 30 companies the subscribed equity portion stays under 20
percent of total shareholder’s equity.

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Figure 4.1.2-4: Ratio of subscribed capital to total shareholder`s equity (Germany)

Germ any: Subscribed Capital to Total

Shareholder's Equity

3%
10%
23%
< 5%
5%- 10%
10%- 20%
34% 20%- 30%
> 30 %
30%

Source: One source: Subscribed capital for the FY 2005, shareholder’s equity (consolidated) for the FY 2005

This underpins that the equity financing is not largely dependant on the subscribed capital and
that there is a sufficient equity base in the DAX companies and their subsidiaries to allow for
adequate distributions. The existence of a subscribed capital does seem to be a stumble block
for the DAX companies in their approach to equity financing and distribution policy from a
group perspective.

The following answers to the CFO questionnaire concerned the attitude of companies
regarding capital increases:
Figure 4.1.2-5: CFO survey results: Attitudes towards increases of subscribed capital (Germany)

"Our com pany intends to keep its m axim um

flexibility and w ill try to m inim ise the
portion allocated to stated/subscribed
capital to the am ount strictly necessary for
legal or other reasons."

15%
True
False
26% 59%
NA

Source: CFO Questionnaire, September 2007

59 percent of the respondents stated that they usually try to keep the level of subscribed
capital to the minimum amount necessary. Only 26 percent of the respondents opposed this
view.

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These responses show that companies are generally not interested in a dominant role of
subscribed capital in equity financing.

Subsequent formations

Concerning subsequent formations, some of the interviewees had recent experiences with the
provisions at subsidiary level. These provisions are perceived to be burdensome, as they may
require the review of all the contracts with shareholders in order to avoid the applicability of
the provisions on subsequent formations. It is felt that there is inadequate attention to the
materiality of such transactions in the legal assessment.

4.1.2.2 Capital increase

4.1.2.2.1 Legal framework

In accordance with the 2nd CLD, German law differentiates between different forms of capital
increase and mechanisms which ensure that the subscribed capital is contributed to the
company.

Increase in capital

Under German law, one can distinguish between ordinary capital increases, increases by using
authorised capital, nominal capital increases and, for instance, conditional capital increases.

Ordinary capital increase

For an ordinary capital increase, by which the subscribed capital is increased, a shareholders’
resolution is required. German law provides that a double majority is required for this
resolution: a simple majority of the votes submitted and a majority of ¾ths of the votes
attached to the subscribed capital represented in the general meeting (capital majority). The
statutes may determine that the capital majority must be lower or greater than ¾ths of the
votes attached to the subscribed capital represented. For this purpose, the shareholders must
be invited to a general meeting in which the resolution can be passed. This is possible at the
annual general meeting. The German Stock Corporation Act requires the publication of both
the shareholders’ resolution to increase the capital and the increase in subscribed capital. The
board of directors and the chairman of the supervisory board are firstly required to register the
shareholders’ resolution and the increase in capital at the register court. The same applies to
the amendment of the statutes. The registration of the increase in capital and the amendment
of the statutes are then to be published.

Authorised capital

Under German law, the statutes can contain an authorisation, for a maximum period of five
years, to the management board to increase the capital. If the statutes do not contain a
sufficient basis for authorised capital, the statutes may be amended to insert such a possibility
by shareholders’ resolution passed by a simple majority and a qualified capital majority (see
above). Authorised capital is restricted to ½ of the subscribed capital which exists at the time
the authorisation to increase the capital is given. To use the authorised capital, the
management board has to decide on the capital increase within a maximum period of five
years. The management board’s decision to issue new shares is subject to the consent of the
supervisory board. The German Stock Corporation Act requires that the increase in capital be

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published. Before the increase in capital is published, it must be registered at the register
court.

Other forms of capital increase

The German Stock Corporation Act also provides for a nominal increase in capital which
refers to a process whereby the capital reserve and the profit reserve are converted into
subscribed capital, and a conditional increase in capital which refers to a process whereby the
capital is increased only to the extent that use of conversion rights or subscription rights
which the company grants in respect to new shares, is made. In accordance with the 2nd CLD,
the German Stock Corporation Act extends the rules applicable to ordinary increases in
capital to the issue of convertible bonds and profit-sharing bonds.

Contributions of premiums

In accordance with the 2nd CLD, German law allows the use of share premiums in the context
of the increase in capital. Share premiums must be placed in the capital reserve and are not,
therefore, available for distribution.

Mechanisms to ensure the contribution of capital

Subscription of shares

Under German law, the principle that all shares must be subscribed before the increase in
capital is registered, applies. The public company is prohibited from subscribing its own
shares and so is any subsidiary and third person acting in his own name but on behalf of the
issuing company. In accordance with the 2nd CLD, the German Stock Corporation Act
prescribes that shares may not be issued at a price lower than their nominal value or
accountable par. The minimum nominal value/ accountable par is – going beyond the
provisions of the 2nd CLD – provided for but is relatively low: one Euro. If the capital is
increased, the amount of the subscribed capital stated in the statutes must be amended as well
as, if applicable, the nominal values of shares, the number of shares of each nominal value or,
where there are no-par value shares, their number, the classes of shares and the number of
shares of each class of shares.

Contributable assets/ paying in

Under German law, in the context of capital increases, capital may be contributed in cash or
in kind. Cash contributions may be made by legal currency, namely banknotes and coins, or
via credit to a company’s or director’s bank account. In cases in which the capital is
contributed other than in cash, the consideration must constitute assets capable of economic
assessment. Where the capital is increased by consideration in cash, at least 25 percent of the
nominal value/ accountable par of the shares must be paid-up , and where shares are issued at
a premium, the full premium must be paid in as well. The sum paid in must also be
irrevocably at the management’s board free disposal. The management must ensure that the
sum has not been returned to shareholders. In cases in which the capital is increased by a
consideration other than in cash, the consideration is to be transferred to the company within
five years of the time the capital increase is registered, unless – going beyond the provisions
of the 2nd CLD - the consideration constitutes rights of use and enjoyment which must have
been transferred to the company by the time the capital increase is registered.

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Protection against over-valuation

Where the capital is increased by consideration other than in cash, the German Stock
Corporation Act requires – in line with the provisions of the 2nd CLD – that the consideration
must be valued and a report must be drawn up by independent experts. Where the report
reveals that the value of the consideration other than in cash does not correspond to the
nominal value/accountable par of shares issued for it, the register court is required to reject
the company’s application to register the capital increase.

Sanctions

According to German law, the register court is required to reject the company’s application to
register the increase in capital if it is of the opinion that the value of the consideration is not
immaterially lower than the nominal value/accountable par of the shares issued for it.

Regarding the liability of the management board and supervisory board, the Stock
Corporation Act provides, on the one hand, for criminal sanctions where a member of either
board gives incorrect information about the subscription of shares, payment on contributions
or contributions in kind. On the other hand, members of either board are also liable in civil
law to compensate the company for any damage caused due to incorrect statements about the
capital increase.

Pre-emption rights

The German Stock Corporation Act provides for pre-emption rights in the context of capital
increases. German law prescribes that pre-emption rights are not only to be granted on the
condition that the capital is increased by consideration in cash but also - beyond the
provisions of the 2nd CLD - if the capital is increased by consideration other than in cash.
However, in practice capital increases in kind are in general linked with an exclusion of the
pre-emption rights.

Under German Stock Corporation Law, pre-emption rights may only be excluded by a
shareholders’ resolution, in fact the decision may only be made in the resolution to increase
the subscribed capital. The resolution requires a simple majority of the votes submitted and a
majority of ¾ of the votes attached to the subscribed capital represented in the general
meeting. The management board is required to present to the general meeting a report
indicating the reasons for the exclusion and justifying the proposed issue price. Because of the
heaviness of the intervention and the position of the shareholders protected under
constitutional law the Federal Supreme Court held that any restriction of pre-emption rights
must be justified by facts.

Apart from that German law also provides for the possibility that the pre-emption rights may
be excluded in the general meetings’ resolution authorising the board to increase the capital.
Furthermore, the statutes and the general meeting may delegate the power to restrict or
withdraw pre-emption rights to the management board empowered to decide on the capital
increase within the limit of the authorised capital. In all these cases the substantive
requirements developed by the Federal Supreme Court do not apply to the full extent: It must
only be stated that the exclusion serves a purpose which is in the company’s interest.

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4.1.2.2.2 Economic analysis

The practice of handling capital increases in the German companies interviewed was quite
surprising. The different ways used for increasing their capital showed the pattern that these
German companies all preferred the authorised capital over an ordinary share capital increase.
Conditional capital increases are used for the issue of convertible bonds or in connection with
stock option programmes but with a different degree of use between companies.

Ordinary capital increase

The ordinary increase of capital was not used be the interviewed companies because of the
possibility to use more flexible forms of capital increase.

Practical steps

Under the German Stock Corporation Act, the following chronological order of practical steps
would be necessary for such an ordinary capital increase:

Figure 4.1.2-6: Process of an ordinary capital increase (Germany)

Ordinary capital increase

Proposal of the board on how the company should be financed (amount of
Step 1
subscribed capital, amount of premiums).
Step 2 Calling of a general meeting
Resolution by shareholders on capital increase, if applicable, separate vote of
shareholders of each class of shares and amendment of the statutes. Notarial
Step 3
recording of the resolution to amend the statutes, filing with the registrar (§ 130
AktG).
Resolution by shareholders on pre-emption rights in case of contributions of
cash and in kind –or possible resolution of shareholders that shares are issued to
Step 4
banks or financial institutes with the obligation that they be offered to shareholders
of the company (§ 186 (5) AktG).
Registration of the shareholders’ resolution to increase the capital (§ 184 AktG),
Step 5 registration and publication of the increase in capital (§§ 188, 190 AktG) and
registration and publication of the amendment of the statutes (§ 181 AktG).

Analysis

None of the German companies interviewed have recently conducted an ordinary capital
increase. The provisions were considered too inflexible as this procedure requires the
immediate involvement of the general meeting and, thus, also not considered as a very
desirable way of increasing capital. One interviewee also responded that in Germany so called
“professional shareholder activists” would see this as a welcome opportunity to bring legal
action on doubtful grounds against the annual meeting resolution and, thereby, block the
capital increase process with a potential severance payment from the company in mind to
drop the proceeding.

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Authorised capital

A much more popular way of increasing the capital among the companies interviewed is the
possibility of fixing authorised capital in the statutes. This possibility is used by all German
companies interviewed and is, in most of the German companies interviewed, a longer
standing tradition. Considerable efforts have to be made in connection with the elaboration of
the proposal for authorisation. However, the proposal usually only requires an update of
already existing documentation as this is usually a repetitive action. Most costs actually stem
from securities regulation which is not relevant in terms of incremental costs of compliance
with company law provisions.

Practical steps

To fix authorised capital, the following chronological order of legal steps has to be adhered
to:

Figure 4.1.2-7: Process of the authorised capital increase (Germany)

Authorised capital increase

Proposal of the founders/board on how the company should be financed (amount
Step 1
of subscribed capital, amount of premiums).
Fixing authorised capital in the statutes during the stage of formation.
If authorisation to increase the capital is not already laid down in the statutes:
shareholders’ resolution on the increase in capital, if applicable, separate vote of
Step 2
shareholders of each class of shares, and amendment of the statutes, notarial
recording of the resolution, filing with the registrar (§ 130 AktG), registration of
the amendment of the statutes (§ 181 (1) AktG) and publication (§ 181 (2) AktG).
Decision of the board to increase the capital up to a specific amount with due
Step 3 regard to the restrictions laid down in the statutes/by the shareholders’ resolution,
consent of the supervisory board.
Resolution by shareholders on pre-emption rights in case of cash consideration
or consideration in kind (if not excluded) or possible resolution of shareholders that
Step 4
shares are issued to banks or financial institutes with the obligation to offer them to
shareholders of the company (§§ 203 (1), 186 (5) AktG).
Determination of the content of the rights attached to the new shares and the
conditions of the issue of new shares by the management board if the statutes
Step 5
do not provide otherwise (§ 204 (1) AktG). Consent of the supervisory board (§
204 (1) s. 2 AktG).
Registration and publication of the increase in capital (§§ 203 (1) s. 1, 188 (1),
Step 6
190 AktG).

Analysis

In practice, most German companies interviewed have used the opportunity to create
authorised capital. However, only two of the companies interviewed have actually used this
possibility.

The introduction of authorised capital happens for various reasons linked to the individual
strategy of a company’s management. It is also considered as a way of raising additional
interest in the potential shareholder community to buy or hold the stock.

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Bearing this in mind, we had the opportunity to gather most data for the first important step,
the proposal for the general meeting to introduce or prolong the authorised capital. As it is
mainly a repetitive shareholder resolution every five years, the company reuses and updates
the documentation used in the previous authorisation process. According to the estimates
received, the use of internal resources amounts to between 5 to 40 hours depending on the
individual circumstances as well as the culture and organisation of the company. This also
includes the subject of pre-emption rights. The effort required is not linked to the size (market
capitalisation) of the company. Outside legal advice was only used in a minority of cases.
Mostly, the legal aspects are dealt with on an in-house basis. The legal costs associated with
the proposal are partly minimal (3 hours for outside lawyers) up to €30,000 for external
advice. Again, this is very much linked to the individual circumstances of the company.

Significantly, more work and cost is incurred once it is decided to execute the authorised
capital and to actually increase the capital. This requires about 80 hours of highly qualified
personnel over a time period of several months and, if a prospectus is required, legal and other
costs amount to approximately €1,000,000. However, it has to be noted that this burden
results from capital market regulation and does not, in essence, stem from company law (2nd
CLD or national company law). Again, the workload and costs can vary from company to
company depending on the individual circumstances.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 85 to 120 - -
Hourly rate €100 €70 -
€8,500 to €12,000 - up to €30,000
Total costs €8,500 to €42,000

Conditional capital increase

With respect to the conditional increase in capital in the course of the interviews, we have
encountered in four cases (more than 50 percent) the use of conditional capital increases.
These are mainly used for the issuance of convertible bonds, partly also for stock option
programmes for employee participation.

In a few cases, we have received data estimates from the companies interviewed for the
workload and costs associated with the issuance of convertible bonds, which seem to be
significant. The preparation of the decision for the issuance of convertible bonds takes
approximately 50 hours of highly qualified personnel and another 27 hours of highly qualified
personnel for the negotiation of the terms with the banks. Legal advice in this regard costs
about €200,000. However, it should be noted that these burdens for the company are not
linked to the provisions of the 2nd CLD. Overall, these burdens may vary from company to
company depending on individual circumstances.

Mechanisms to ensure the contribution of capital – contributions-in-kind

None of the interviewed companies had practical experience with contributions in kind.
However, the economic aspects were discussed on the basis of the practical steps in a general
way.

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Practical steps

The following steps have to be taken under German law to increase capital by contributions in
kind:

Figure 4.1.2 -8:Process for the injection of contributions (Germany)

Injection of contributions
Where shares are to be issued for a consideration other than in cash, fixing the
terms of the resolution to be voted on by shareholders in the general meeting,
namely the nominal value of shares or, where there are no-par value shares, the
Step 1
number of shares issued for a consideration other than in cash together with the
nature of the consideration and the name of the person providing the consideration
(§ 183 (1) s. 1 AktG). Monitoring that the terms of the resolution are laid down in
the agenda of the general meeting and are duly published (§ 183 (1) s. 2 AktG).
Where shares are issued for a consideration other than in cash, monitoring if assets
Step 2
that serve as consideration are capable of economic assessment.
Monitoring if contributions in cash have been paid up to an extent of at least 25
percent of the lowest advanced amount and, where shares are issued at a
premium, also the premium at the time the capital increase in registered (§§ 188
(2) s. 1, 36a (1) AktG). Monitoring that the sum paid in is irrevocably at the
Step 3
management board’s free disposal (§§ 188 (2) s. 1, 36a (1) AktG). Monitoring if
considerations other than in cash (namely rights of use and enjoyment) have been
transferred to the company by the time the capital increase is registered (§§ 188
(2) s. 1, 36a (2) AktG).
Performance of valuation process with respect to contributions in kind
(valuation of the consideration other than in cash, appointment of independent
Step 4
experts by the local court, drawing up the expert report on consideration other than
in cash).
Publication of report: Submitting the expert report on the consideration other
Step 5
than in cash to the management board and to the register court.
Amendment of the statutes (Stating the subscribed capital in the statutes; if
applicable, the nominal values of par value shares and the number of shares of
Step 6 each nominal value or, where there are no-par value shares their number, where
there are several classes of shares, the classes of shares and the number of shares
of each class).
Registration of the shareholders’ resolution to increase the capital (§ 184 AktG),
registration and publication of the increase in capital including the fixing of
Step 7
contributions in kind (§§ 188, 190 AktG) and registration and publication of the
amendment of the statutes (§ 181 AktG).

Analysis

Unfortunately, we have not encountered any practical cases of contributions-in-kind during

our interviews with German companies. However, a general opinion was that the most
burdensome aspect is the valuation process of the contribution by external experts. This
requires, on the one hand, enormous effort to collect relevant data for the valuation and the
cost for the outside expert may also be considerable. The actual burden for such kind of
valuations largely depends on the complexity of the subject to valuation. This may be a single
asset or a highly complex company.

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Protection of shareholders and creditors

Regarding the provisions on capital increase, one can draw the following conclusions under
the aspect of shareholder and creditor protection. Firstly, it should be noted that the
requirement that the shareholders have to agree to the ordinary capital increase as well as to
the conditional or nominal capital increase with a qualified majority, clearly has a shareholder
protective character. Furthermore, the provisions on authorised capital contain elements
which are shareholder protective as the authorisation must be stated in the statutes or, if this is
not the case, an amendment of the statutes with qualified majority is necessary. Also the fact
that the authorisation period is limited to five years and the amount which can be covered by
the authorisation - half of the subscribed capital – are shareholder protective. In this respect,
German law contains further protective provisions, as it prescribes the registration of the
shareholders’ resolution to increase the capital, the registration and publication of the increase
in capital and the registration and publication of the amendment of the statutes. To ensure that
equal treatment in contributions takes place, German law prescribes the drawing up of a
report by an independent expert in case of contributions in kind to protect shareholders
against over-evaluations and their consequences. To prevent circumventions of the provisions,
German law prohibits hidden contributions in kind. Under the aspect of shareholder
protection, the mandatory pre-emption rights are furthermore of importance as they prevent
dilution. It should be noted that under German law, these provisions protect the shareholders
not only in the case of contributions in cash but also in the case of contributions in kind.

4.1.2.3 Distribution

4.1.2.3.1 Legal framework

German provisions on distributions differentiate between provisions dealing with the

calculation of the distributable amount, the determination of the amount to be distributed and
the consequences of incorrect distributions.

Calculation of the distributable amount

In accordance with the provisions of the 2nd CLD under German law only the balance sheet
profit may be distributed to the shareholders. The balance sheet profit is the profit for the
financial year as shown in the profit and loss account after setting off losses and profits
brought forward as well as sums placed into mandatory and optional reserves. The disclosed
reserves comprise the capital reserve in which any premiums paid must be placed and the
profit reserves. The profit reserves comprise the legal reserve, the reserve for own shares held
by the company, statutory reserves and “other profit reserves”. The capital reserve and the
statutory reserve form a “legal reserve fund” which is not available for distribution and may
not, therefore, be dissolved to this end. Hence, any premiums and a certain part of the
financial years’ profit placed into the statutory reserve, may not, in addition to the subscribed
capital and the reserve for own shares held, be paid back to shareholders. The statutory
reserves and “other profit reserves” are by contrast distributable. However, an amount equal
to these reserves is bound in the company as long as these reserves are not dissolved by the
management board and the general meeting has not decided on the distribution.

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Connection to accounting rules

The balance sheet profit is determined with reference to the annual accounts which must be
drawn up in accordance with German accounting rules. The annual accounts must be audited
except where the company is considered to be small.

Determination of the distributable amount – responsibilities

In Germany, the management board is required to submit a proposal on the allocation of the
balance sheet profit to the supervisory board. The proposal must comprise the amount to be
distributed to shareholders, the amounts to be allocated to profit reserves, the profit brought
forward and the balance sheet profit. The supervisory board examines the proposal together
with the annual accounts and draws up a report on the examination. The report is then
submitted to the management board which is required to call a general meeting and display
the report on the examination and the proposal on the balance sheet profit in the company’s
premises for inspection by shareholders. The shareholders decide on the allocation of the
balance sheet profit by resolution for which a simple majority is required. The shareholders
are not bound by the management board’s proposal. However, allocations to profit reserves
and carrying profits forward to new accounts is restricted if such measures are not financially
necessary. In this case, the amount to be distributed may not fall short of 4 percent of the
subscribed capital. The German Stock Corporation Act requires that the shareholders’
resolution on the allocation of the balance sheet profit must fix the amount to be distributed to
shareholders, the allocation to profit reserves, the profit brought forward, the balance sheet
profit and additional expenses arising from the resolution. The shareholders’ resolution and
the management board’s proposal on the allocation of the balance sheet profit must be filed
with the registrar and published in the Joint Electronic Register Portal of the Federal States.
Regarding the dividend the shareholders receive, the principle of equal treatment is
applicable; the shareholders must be paid pro rata.

Sanctions

German law provides for different instruments for the case that the distribution was not in line
with the aforementioned provisions. Firstly, the German Stock Corporation Act allows
shareholders to challenge resolutions that may lead to incorrect distributions by bringing an
action to set aside the resolution. Furthermore, shareholders are obliged, if distributions took
place in violation of the before mentioned rules, to return to the company any payment
received contrary to the Stock Corporation Act. Where the payments received constitute
dividends, the payments must be returned only if the company proves that those e
shareholders knew of the irregularity of the payment or could not, in view of the
circumstances, have been unaware of it. The German Stock Corporation Act provides that
members of the management board and the supervisory board are liable to compensate the
company for losses caused by unlawful distributions.

4.1.2.3.2 Economic Analysis

Overall, German companies considered the German legislation on this issue to be very light
and easy to comply with. The reference to the accounting profit derived from the annual
accounts provides a high degree of legal certainty which is a very desirable feature for
German companies interviewed. The companies are more concerned about the elaboration of
the dividend proposal by the board. The actual payment may also present a major effort.

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However, the costs are linked to capital market requirements and depend on the number of
shareholders.

Practical steps

Based on the legal analysis, the distribution of the balance sheet profits requires the following
practical steps which are the basis for the economic analysis.

Figure 4.1.2-9: Due process for distributing profits (Germany)

Due process for distributing profits

Step 1 Drawing up the company’s annual accounts in accordance with national GAAP.
Placing sums in mandatory reserves (capital reserve, legal reserve, statutory
Step 2
reserves).
The management board determines the balance sheet profit with reference to
Step 3
the annual accounts (§ 170 AktG).
The management board submits the annual accounts and the proposal on the
Step 4
allocation of the balance sheet profit to the supervisory board (§ 170 (2) AktG).
Audit of annual accounts (§ 316 (1) HGB). The supervisory board examines the
Step 5 accounts and the management board’s proposal on the allocation of the balance
sheet profit (§ 171 AktG).
The supervisory board draws up a report on the examination of the accounts
Step 6
and the proposal (§ 171 AktG).
The supervisory board submits the report on the examination to the management
Step 7
board (§ 171 (3) AktG).
Adoption of accounts (normally) by the supervisory board and the management
Step 8
board (§ 172 AktG).
Calling a general meeting; displaying the report on the examination and the
Step 9 management board’s proposal on the allocation of the balance sheet profit in the
premises of the company for inspection by shareholders (§ 175 AktG).
Shareholders’ resolution on the allocation of the balance sheet profit (§§119 (1)
Step 10
no. 2, 174 AktG).
Filing of the management board’s proposal on the allocation of the balance sheet
Step 11 profit and the shareholders’ resolution with the registrar, publishing them in the
Joint Electronic Register Portal of the Federal States (§ 325 (1) HGB).

Analysis

Calculation of the distributable amount

From an economic point of view, the establishment of the dividend proposal typically
involves the CFO and CEO and other selected high ranking company representatives
preceded by preparations in the company’s administration (treasury, tax and/or accounting
departments). As the level of dividends is also a political decision concerning the
attractiveness of the shares to investors, investor relation experts may also play a significant
role in the elaboration of the dividend proposal. The dividend proposal is subsequently subject
to a discussion in the company’s management board before it is handed over to the
supervisory board. The intensiveness of the discussion in the management and supervisory
board depends on the specific importance of dividend levels for the performance of the shares
of the company.

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The clear point of reference for the determination of the distributable amount is the
consolidated financial statements of the company, not the individual financial statements
which are the legally decisive set of accounts. This first assessment is complemented by
considerations concerning dividend continuity and return on investment considerations for
shareholders.

The results of a CFO questionnaire sent to German companies listed on main indices
reconfirm this:

Figure 4.1.2-10: Determinants for the distribution of dividends in the holding company (Germany)

"What are the determ inants for the distribution of dividends by your holding
com pany?"

5
4,33
Importance

3,65 3,64
4
4,22 Germany
3,06
3 3,37 2,41 2,35
2,96 EU Average
2,72
2
2,15 2,12
1
Fin. performance Financial Dividend Signalling device Credit rating Tax rules
(group performance continuity considerations
accounts) (individual
accounts of the
parent company)

Determ inants

Source: CFO Questionnaire, September 2007

However, concerning the importance of the current legal restrictions on profit distribution, the
CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market
led solutions like rating agencies’ requirements or bank covenants.

Figure 4.1.2-11: Important deterrents when considering the level of profit distribution (Germany)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"

3,48
4
Importance

2,37 2,37 2,65 Germany

3
3,44 EU Average
2
2,16 2,63
2,25

1
Distribution/Legal capital Rating agencies' Contractual agreements Possible violations of
requirements requirements with creditors (covenants) insolvency law

Deterrents

Source: CFO Questionnaire, September 2007

Depending on the structure of the company, it may be necessary to bring the consolidated
view in line with the disposable profits / cash at parent company level. This requires a certain
planning effort regarding necessary distributions from subsidiary levels. In this context, tax
considerations may also play a certain role in generating profits and cash at parent level. We
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were not able to obtain specific data on the exact effort required for this. However, as this
planning effort may be largely based on tax optimisation, any effort in this respect could also
be considered non-incremental.

Again, the results of a CFO questionnaire sent to German companies listed on main indices
show the importance of tax considerations:

Figure 4.1.2-12: Determinants for the distribution of dividends by the subsidiaries (Germany)

"What are the determ inants for the distribution of dividends by your
subsidiaries?"

5
4,30

4
Importance

4,07 3,22
2,74 Germany
3
3,14 EU Average
2,74
2

1
Demands from the ultimate parent Tax rules Own investment decisions

Determ inants

Source: CFO Questionnaire, September 2007

Connection to accounting rules

Due to the immediate link to the audited financial statements, the German companies
interviewed considered it simple to verify the distributable amount from a legal compliance
point of view. There is no specific effort needed in this regard as the preparation and the audit
of the annual accounts is not considered as an incremental cost.

Determination of the distributable amount

From an incremental cost perspective, all German companies interviewed considered step 3,
i.e. the proposal on the allocation of balance sheet profits, to be the most time-consuming
effort in this legal process. The total time spent on this process amounts to between 10 and 50
hours of highly qualified personnel of the company. Thereof, more than 90 percent is spent on
the establishment of an adequate dividend proposal. This time effort for the distribution
proposal by management varies depending on the culture and organisation of the individual
company and is typically not linked to certain size criteria.

The pure legal compliance effort is by average less than 2 hours of highly qualified personnel
and, thus, can be considered as negligible. This concerns the specific time needed for the
report on the distribution proposal by the supervisory board as well as for the preparation for
the general meeting and for the publication in the Joint Electronic Register Portal of the
Federal States. The monetary amount to be spent on the publication is also considered
minimal and remains below €10,000. The companies interviewed do not generally engage
external legal advisors in this process and rather use in-house solutions. We have encountered
one exception with a company with very low market capitalisation where this is part of a
common external routine check on legal documents.

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The remaining steps were considered to be non-incremental as they did not, from the
companies’ perspective, originate from the compliance with distribution provisions such as
the preparation of the accounts, the annual audit and the holding of the annual general
meeting.

Regarding the establishment of alternative cash-flow projections to be used in the distribution

process, all companies interviewed had a very detailed cash flow planning for at least one
year. However, this planning is based on internal rules on how to prepare such projections and
is clearly linked to the business needs of these companies. The maximum projection period
which allowed for serious estimations was considered between three to five years, depending
on the nature of the business of the company. There was general scepticism concerning the
establishment of distinctive rules concerning the elaboration of cash flow projections. The
same is true for any outside attestation service by third parties (experts, accountants etc.).

Sanctions

Concerning the efforts to comply with provisions concerning incorrect dividend distributions,
the companies interviewed considered the risk of liability for the company’s management to
be low. The reason for this is mainly the very clear cut legal provisions on profit distributions
which, due to their simplicity, provide a high level of legal certainty.

Related parties

There were also no significant issues concerning the question of the monitoring of the
relationships with related parties and potential other reflows of funds to shareholders. One
respondent also referred to the existence of a specific report on the dependence of
shareholders as a protective instrument (“Abhängigkeitsbericht”, § 312 AktG).

Incremental Costs
HighQ LowQ Other Costs
Hours spent 10 to 50 - -
Hourly rate €100 €70 -
€1,000 to €5,000 - < €10,000
Total costs €1,000 to €15,000

4.1.2.3.3 Protection of shareholders / creditors

Under the aspect of shareholder and creditor protection, one can draw the following key
conclusions from the above mentioned provisions on distributions. Firstly, it should be noted
that the clearly formulated legal distribution limitations, including, in particular, the
subscribed capital and the premiums as well as the immediate link to the audited financial
statements, lead to a high legal certainty and to little risk with respect to the liability of board
members. Furthermore, these rules can be characterised as creditor protective as they limit the
distributable amount by the profits and preserve a certain amount of the equity for the
creditors. The obligation that the general meeting has to decide on the allocation of the
balance sheet profit, which stems from German national legislation, leads to shareholder
protection. The principle of equal treatment in distributions also protects shareholders. In this
respect, German law contains further protective provisions, as it prescribes that the
shareholders’ resolution and the management board’s proposal on the allocation of the
balance sheet profit must be published in the Joint Electronic Register Portal of the Federal
States and that the shareholders have the possibility to challenge resolutions that may lead to

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incorrect distributions. The national provisions prescribing the liability of members of the
management board and the supervisory board for losses caused by unlawful distributions are
also shareholder protective even though this rule is of minor practical importance. Regarding
creditor protection, the obligation of the shareholders to return to the company any payment
received contrary to the Stock Corporation Act is of importance.

4.1.2.4 Capital maintenance

German law provides for different instruments dealing with capital maintenance. Among
these, are the provisions on the limitation of the acquisition by the company of its own shares
and the prohibition of financial assistance as well as the provisions on capital reductions, the
withdrawal of shares, the serious loss of the subscribed capital and hidden distributions.
Furthermore, the question arises in how far contractual self protection is of importance.

4.2.1.4.1 Acquisition by the company of its of own shares

4.1.2.4.1.1 Legal framework

In Germany, public companies are allowed – based on the provisions of the 2nd CLD - to
acquire their own shares provided that certain conditions are observed.

The first case allows the acquisition by the company of its own shares on the basis of an
authorisation of the general meeting. In Germany, the acquisition by the company of its of
own shares is subject to several conditions. The German Stock Corporation Act requires a
resolution by shareholders which shall determine the duration of the period for which
authorisation is given to the management board to the acquisition by the company of its own
shares and which may not exceed 18 months, the maximum and minimum consideration for
the shares as well as the nominal value of shares to be acquired which may not exceed 10% of
the subscribed capital. Furthermore, the German Stock Corporation Act prescribes that the
nominal value or the accountable par of acquired shares held by the company, including
shares previously acquired by the company and held by it, and shares acquired by a third
person acting in his own name but on behalf of the company, may not exceed 10% of the
subscribed capital. Also under German law, only fully paid up shares may be acquired and the
acquisition may not affect the subscribed capital and the reserves not available for
distributions. Furthermore, German law provides for additional informational and procedural
requirements. For instance, the management board is required to give notice of the
shareholders’ authorisation to the company to acquire its own shares to the Federal Financial
Supervisory Authority. The management board is also required to inform the next general
meeting after the acquisition has been carried out, of the reasons for and the purpose of the
acquisition.

The German legislator used the possibilities of the 2nd CLD to provide for exemptions to the
strict requirements on share repurchase where the acquisition serves specific purposes, e.g. in
cases in which the acquisition is necessary to prevent serious and imminent harm to the
company and in cases in which the acquired shares are to be distributed to the company’s
current or former employees or the current or former employees of an associated company. In
accordance with the 2nd CLD, the German Stock Corporation Act prescribes that shares
repurchased in contravention of the legal provisions must be disposed of and, where this is not
carried out during a period of one year, cancelled. Beyond the provisions of the 2nd CLD,
under German law, not only the voting rights attaching to the shares but all rights are
suspended if the company acquires its own shares.

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When shares are included on the asset side of the balance sheet, a reserve of the same amount
not available for distribution must be set up and specific information about the acquisition and
the reselling of shares must be laid down in the notes to the accounts.

In respect to the reselling of own shares, the principle that shareholders who are in the same
position must be treated equally, applies. Furthermore, the German legislator did not make
use of the option under the 2nd CLD to provide for certain exceptions where a subsidiary of
the company acquires its shares. In such case, under German law, the acquisition or holding
of shares in a company by its subsidiary is regarded as having been effected by the company
itself.

The amendments of the 2nd CLD have not yet been implemented into national law.

4.1.2.4.1.2 Economic analysis

In Germany, the amendments to the 2nd CLD in the year 2006 have not yet been enacted into
German legislation (dropping of the 10 percent limit, prolongation of the authorisation by
another five years). Thus, the interview results still refer to the current German arrangements
for the acquisition of a company’s own shares. From a company law perspective, most efforts
go into the proposal for the authorisation to purchase the company’s own shares. However,
the actual buyback of shares may entail much higher costs. Unfortunately, we have not
received detailed data on this from the German companies interviewed, but have similar
experiences in other EU countries. Nevertheless, only incremental costs invoked by company
law are relevant to this analysis. Thus, these costs resulting from securities legislation are
remarkable - but not from an incremental cost perspective.

Practical steps

To acquire its own shares a company has to follow this process:

Figure 4.1.2-13: Process for the acquisition of own shares (Germany)

Acquisition of own shares – authorisation by the general meeting

Step 1 Proposal of the management board to acquire the company’s own shares.
Calling a general meeting, publishing the agenda of the general meeting in the
Step 2
company gazette.
Calling a general meeting, resolution by shareholders on acquisitions of the
Step 3 company’s own shares, notarial recording of the resolution, filing with the registrar
(§ 130 AktG).
Monitoring inter alia that shareholders’ authorisation is not given for a period
which exceeds 18 months, that the maximum and minimum consideration for the
Step 4
shares is stated and that the nominal value or accountable par of shares to be
acquired does not exceed 10% of the subscribed capital.
Giving notice of the shareholders’ authorisation to acquire the company’s own
Step 5
shares to the Federal Financial Supervisory Authority.
Step 6 Acquisition of the company’s own shares.
Monitoring that only fully paid up shares are acquired, that a reserve on the
liabilities’ side of the balance sheet is set up without reducing the subscribed capital
Step 7
and undistributable reserves, that, for example, the nominal value or accountable
par of the shares acquired do not exceed 10% of the subscribed capital or the lower

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amount stated in the shareholders’ resolution and that the consideration paid for
shares is within the scope of the minimum and maximum consideration stated in
the shareholders’ resolution.
Setting down in the notes to the accounts specific information about the acquisition
Step 8
of own shares.
Informing the next general meeting of the reason for and the purpose of the
acquisition, the number and nominal value or accountable par of shares acquired,
Step 9
the proportion of the subscribed capital they represent and the consideration for
these shares.

Analysis

Two-thirds of the companies interviewed (5 companies), have authorisation by the

shareholders’ assembly to the company’s management to acquire the company’s own shares.
One third of these authorisations (2 companies) are making use of their authorisation and
actually acquire the company’s own shares. Authorisations are normally renewed at least
every two years within the legally permitted timeframe of 18 months. The relaxation of the
revised 2nd CLD will prolong these periods to five years and, thus, will help to lift the burden
for companies by less frequent renewals of authorisations.

Within the legal process, there are several steps that require preparations mainly by the
company’s departments responsible for legal matters and for treasury.

The first step is the proposal by the management board which takes between 2 to 3 hours of
preparation of highly qualified personnel. This proposal is regularly an update of pre-existing
documents which have been elaborated at the time of the initial introduction. This proposal is
in some cases checked by an external lawyer as part of a routine check of legal documents.
The initial elaboration of the documentation and other documents is a costly exercise which
may incur fees for external legal advice of tens of thousands Euro.

The written notice of the share buyback authorisation to the German securities regulator
BAFIN is not very demanding, as it is simply a repetition of the shareholder resolution. The
time effort does not exceed 0.1 to 0.5 hours for highly qualified personnel.

The actual buyback is handled differently from company to company. It is normally

commissioned to one or several banks and depends on the company how closely it is involved
in the buyback process. We have not received detailed data on the costs of the banks in this
regard. However, in general, we were reassured that the companies would pay “normal” or
“low” fees for their engagement which nevertheless can be very high in comparison to other
burdens associated with the process of buying back shares. This is shown by the experience in
other EU countries.

Another step is the preparation of the notes to the accounts to inform about the acquisition of
the company’s own shares. Depending on the complexity of the buyback activity, the average
time effort will be between 1 and 2 hours of highly qualified personnel. The required
information to shareholders requires on average between 2 to 3 hours of highly qualified
personnel.

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In general, we have not noticed significant deviations in the workload between different sizes
of companies. It rather depends on the level of activity of the company regarding stock
buyback programmes and the way the company reacquires its own shares.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 3 to 5 - -
Hourly rate €100 €70 -
€300 to €500 - €50,000
Total costs €50,300 to €50,500

4.1.2.4.1.3 Protection of shareholders and creditors

Under the aspect of shareholder and creditor protection, one can draw the following key
conclusions from the above mentioned provisions on the acquisition by a company of its own
shares. Firstly, it should be noted that, with respect to the most important case of acquisitions
of a company’s own shares - the acquisition of shares on the basis of an authorisation of the
general meeting – the shareholders have to authorise the acquisition of the shares by a
resolution which can be valid for a maximum period of 18 months, which is shareholder
protective. Furthermore, the provisions which limit the amount of the shares which can be
acquired (the 10% threshold) and the provision which prescribes that the shares may not be
acquired with the subscribed capital and not distributable reserves, aim at protecting
shareholders and creditors. Furthermore, the obligation of the management board to give
notice of the shareholders’ authorisation to acquire the company’s own shares to the Federal
Financial Supervisory Authority is creditor and shareholder protective.

If shares have been purchased, different shareholder and creditor protection rules are
applicable. Of importance are, for example, the provisions which prescribe that all rights
attached to the acquired shares are suspended. Also of importance is the provision that, when
acquired shares are included on the asset side of the balance sheet, a reserve of the same
amount not available for distribution must be set up and specific information about the
acquisition and the reselling of shares must be laid down in the notes to the accounts. With
respect to the reselling of the company’s own shares, under German law, the principle that
shareholders who are in the same position must be treated equally, applies and this must be
characterised as shareholder protective.

4.1.2.4.2 Capital reduction

4.1.2.4.2.1 Legal framework

The German Stock Corporation Act provides for two kinds of capital reductions: the ordinary
capital reduction and the simplified capital reduction. The ordinary capital reduction is subject
to a shareholders’ resolution which must be passed by a majority of the votes and at least ¾ths
of the subscribed capital represented in the general meeting. In line with the 2nd CLD, German
law requires that the shareholders’ resolution specifies the purpose of the capital reduction
and the way in which the reduction is carried out. The reduction may only be carried out by
way of consolidating the shares if otherwise the nominal value of shares falls below the
minimum amount of €1. With regard to safeguards to creditors, the German provisions
correspond to the provisions of the 2nd CLD. Accordingly, every creditor whose claims
antedate the publication of the shareholders’ resolution, which have not fallen due and which
have been notified within a certain period of time, have a right to obtain security. Unless

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creditors have obtained security or have been satisfied, no payment may be made to
shareholders. The right to obtain security may not be set aside. In Germany, the simplified
capital reduction may serve either to offset losses or to include sums of money in the capital
reserve. In effect, the simplified capital reduction is only permissible where it is necessary to
establish sound conditions. The amounts deriving from the capital reduction and from
dissolving the capital and profit reserves may not be used for making payments or
distributions to shareholders or to discharge shareholders from their obligation to make their
capital contributions. Beyond this, further restrictions on profit distributions apply. The
amendments of the 2nd CLD with respect to the burden of proof have not yet been
implemented into national law.

4.1.2.4.2.2 Economic analysis

Within our sample of German companies, we have not encountered any capital decreases.

4.1.2.4.2.3 Protection of shareholders and creditors

Regarding the shareholder and creditor protection existing with respect to capital reductions,
firstly the requirement that the shareholders have to agree to the capital reduction with a
qualified majority, is of importance. Furthermore, the safeguards to creditors, which have,
under certain circumstances, the right to obtain security, are creditor protective.

4.1.2.4.3 Withdrawal of shares

4.1.2.4.3.1 Legal framework

German law allows the compulsory withdrawal of shares. Furthermore, German law provides
for the withdrawal of the company’s own shares. Not possible are redemption of the
subscribed capital without reduction of the latter and the issuance of redeemable shares.

In accordance with the 2nd CLD, the compulsory withdrawal of shares is only permissible if it
is prescribed or authorised by the statutes before the shares to be withdrawn are subscribed.
Where the compulsory withdrawal of shares is merely authorised by the statutes, German law
requires – in line with the 2nd CLD – a resolution by shareholders. In this respect, a majority
of at least ¾ths of the votes attaching to the subscribed capital represented in the general
meeting, is required. Only where the compulsory withdrawal follows the simplified
procedure, for instance in cases in which fully-paid up shares which are made available to the
company free of charge are withdrawn and in cases in which the shares are to be withdrawn
using funds available for distributions, a simple majority is sufficient. Also under German
law, in the context of a compulsory withdrawal of shares, the rules on creditor protection
apply which are also applicable in the context of an ordinary decrease in capital. Only in cases
in which fully-paid up shares which are made available to the company free of charge are
withdrawn and in cases in which the shares are to be withdrawn using funds available for
distributions, do the rules on creditor protection not - in line with the 2nd CLD – apply.

In respect to the reduction of the subscribed capital by redemption of shares acquired by the
company, the same rules apply. In this connection, it should be noted that - different from the
provisions of the 2nd CLD - shares acquired by a subsidiary or third person in his own name
but on behalf of the company, may not be redeemed.

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4.1.2.4.3.2 Economic analysis

Within our sample of German companies, we have only encountered one case in which
capital decrease provisions have been used to lower the number of shares. It concerned the
redemption of the company’s own shares. The company concerned described the time effort
for the capital reduction to amount to 5 to 10 hours of highly qualified personnel. A very
complicated procedure was the split of the global certification of the company’s shares with
the clearing house which administers the shares.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 5 to 10 - -
Hourly rate €100 €70 -
€500 to €1,000 - -
Total costs €500 to €1,000

4.1.2.4.3.3 Shareholder and creditor protection

Regarding the withdrawal of shares, it is, with respect to shareholder and creditor protection,
firstly of importance that it is only permissible if the statutes allow it before the shares to be
withdrawn are subscribed or if the shareholders concerned approve the withdrawal if it is
made possible by the statutes after the shares have been subscribed. Furthermore, the
safeguards to creditors which correspond to those which apply in the case of capital decreases
are of importance. The same principles apply with respect to the reduction of the subscribed
capital by redemption of shares acquired by the company.

4.1.2.4.4 Financial assistance

4.1.2.4.4.1 Legal framework

Under the German Stock Corporation Act, public companies are still prohibited to provide
financial assistance with a view to the acquisition of its shares by a third party. The
amendments of the 2nd CLD by Directive 2006/68/EC have not yet been implemented into
national law.

4.1.2.4.4.1 Economic analysis

As the changes to 2nd CLD have not been implemented, there could not have been any
practical cases in the course of the interviews with German companies.

4.1.2.4.5. Serious loss of half of the subscribed capital

4.1.2.4.5.1 Legal framework

In Germany, the management board is - in line with the provisions of the 2nd CLD - required
to call a general meeting in the case of a loss of half of the subscribed capital. The
management board must notify the general meeting of the loss and the notification must be
already announced in the agenda of the general meeting which is to be published in the
company’s gazette when the general meeting is called. In the general meeting, the
shareholders may then vote on resolutions on measures to be taken. Suitable measures are
particularly resolutions on corporate action or the resolution to wind-up the company.

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4.1.2.4.5.2 Economic analysis

The German companies interviewed spent very little time on the monitoring of this provision
on the serious loss of subscribed capital. In general, they would see a significant increase in
monitoring activity, if the financial position of the company showed indications that such a
situation could actually occur. The management of the companies interviewed normally use
their normal internal reporting and risk management systems to monitor the financial position
of the company/group. This would give them sufficient lead time to recognise critical
situations.

4.1.2.4.5.3 Shareholder and creditor protection

The provisions dealing with the serious loss of the subscribed capital have a shareholder and
also creditor protective character, as the general meeting gets the possibility to decide on
safeguarding measures.

4.1.2.4.6 Contractual self protection

4.1.2.4.6.1 Legal framework

In Germany, there are no specific legal provisions concerned with contractual self protection
of creditors. Surveys showed that, in Germany, it is not possible that creditors negotiate
contracts with a public company to limit the distributable amount. Such contracts are rather a
side issue. However, credit institutions will usually demand security for lending, such as a
guarantee from third persons.

4.1.2.4.6.2 Economic analysis

More than half of the German companies interviewed have covenants in the form of financial
ratios in loan agreements which are mainly contracted with continental European banks.
These covenants do not usually provide direct restrictions on profit distributions as there are
restrictions resulting from the competencies of the general meeting. Instead, they refer to
certain debt/income, debt/equity ratios that reflect the business of the company. These may,
under certain conditions, indirectly result into restrictions on profit distributions.

The existence of such covenants is a matter of negotiation with the banks. Some companies
interviewed did not have such covenants in loan contracts. Others had several different
covenants.

Specifically the question whether such ratios can be met is decisive for the effectiveness for
the company on the one hand; on the other hand badly negotiated covenants can also result in
considerable payments to banks for breaches of such covenants. In one case, a company
regularly has to pay several tens of thousands of Euro for a waiver of each breach of a
covenant.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

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4.1.2.4.6.3 Shareholder and creditor protection

Regarding the aspect of creditor protection it should be noted, that covenants are based on
private law contracts which do not, in Germany, seem to be extensively used. Furthermore,
only individual creditors are, under German law, protected by them.

4.1.2.5. Insolvency

4.1.2.5.1 Legal framework

In Germany, three factors trigger insolvency: the inability to pay one’s debts, the impending
inability to pay one’s debts and over-indebtedness. A company is unable to pay its debts if it
is not able to pay its payment obligations due which shall be assessed on the basis of a
balance sheet showing liquidity. A company is on the verge of insolvency if it is expected to
be unable to pay its payment obligations that fall due at a specific point in time which shall be
assessed on the basis of a cash budget. A company is over-indebted if its assets do not cover
its liabilities. Whether this is the case shall be judged on the basis of a statement of assets and
liabilities for which the annual accounts are not suitable. Under German law, there is no
formal duty of the management board to apply the above mentioned tests; the point in time
when the tests are to be applied is, hence, not stipulated, either. A duty of the management
board to apply these tests may, at the best, be inferred from the general duty of the board to
take due care and will arguably be triggered when the company is in financial distress.
Pursuant to the German Stock Corporation Act, the management board is required to file for
insolvency when the company is unable to pay its debts or is over-indebted.

4.1.2.5.1 Economic analysis

As with the provision on the serious loss of subscribed capital, the German companies
interviewed spent very little time on the monitoring of insolvency triggers. Again, they would
generally see a significant increase in monitoring activity if the financial position of the
company showed indications that such a situation could actually occur. The management of
the companies interviewed normally use their normal internal reporting and risk management
systems to monitor the financial position of the company/group. This would give them
sufficient lead time to recognise critical situations.

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4.1.3 Poland

4.1.3.1 Structure of capital and shares

4.1.3.1.1 Legal framework

Polish law on equity financing by shareholders is based on the subscribed capital and share
premiums. Polish law differentiates between shares with a nominal value and notional “no par
value shares”.

Structure of capital

Subscribed capital

Under Polish law, public companies are required to have a minimum subscribed capital of
PLN500,000 (approx. €131,000 according to the exchange rate on 6 December 2006). Above
this minimum amount there are no statutory limits as to the maximum amount of the share
capital. Under the Polish Commercial Companies Code, the statutes may provide for a
minimum or/and maximum share capital to be subscribed by the initial shareholders. The
incorporation of the company is effected with the subscription of the shares up to the
minimum share capital. The subsequent subscription of shares of a company which was
already incorporated in this way has the effect of an increase in the company’s share capital.

Furthermore, the Commercial Companies Code also provides the possibility of creating
authorised capital in the statutes. The legal institution of authorised capital is provided more
as a means of increasing the share capital in a company that has already been registered. It is
the right and the power of the management board to decide on the increase of the share capital
within the thresholds provided for in the statutes, and, upon specific authorisation provided
for therein, granted for a period not exceeding three years.

Premiums

Under the Polish Commercial Companies Code, premiums may be fixed at the stage of
formation and if so, must be paid in full before the company is registered.

Premiums are regarded as being associated with the contribution to the share capital, in
particular with respect to the rule that they may not be returned to shareholders. Premiums
must be allocated to the compulsory reserve. Compulsory and voluntary reserves may be used
under a resolution of the general meeting. Reserves up to an amount of 1/3 of the registered
share capital may be used only to cover the losses shown in the annual financial statements.

Protection of the company’s assets

The share capital and the premiums may not be returned to shareholders.

Structure of shares

The Polish Commercial Companies Code only offers shares with a nominal value.

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4.1.3.1.2 Economic analysis

Practical relevance of subscribed capital and structure of shares for an assessment of the
viability of a company

The Polish companies interviewed saw no particular advantage of the subscribed capital for
the viability of their company. It is rather considered as a statistical figure. In general, the
interviewees are interested in their net equity figures and the market capitalisation of their
company. In this sense, one interviewee made the remark that the share premium is an
“expression of the market situation and Polish GDP”.

To verify this statement, we have additionally performed an analysis of certain ratios

concerning subscribed capital for the main Polish stock exchange index WIG 20:

Figure 4.1.3-1: Ratio of subscribed capital to market capitalisation (Poland)

Poland: Subscribed Capital to Market

Capitalisation

16%

< 5%
5%- 10%

84%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of September 2006

For 84 percent of the WIG 20 companies, the subscribed capital represents less than 5 percent
of their market capitalisation. Thus, the overall importance of the subscribed capital figure
seems to be marginal.

Restriction for distribution

The results from the CFO questionnaire sent to 133 Polish public companies show a
diversified picture of attitudes concerning distribution restrictions. However, it has to be noted
that there was only a very low number of Polish responses.

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Figure 4.1.3-2: CFO survey results: necessity of subscribed capital (Poland)

"In general, w e do not consider

stated/subscribed capital to be necessary; it
unnecessarily reduces our com pany's
flexibility to distribute excess capital."

33% 33% True

False
NA
33%

Source: CFO questionnaire, September 2007

The responses received pointed to a support for the existence of subscribed capital.
However, there does not seem to be an appetite for excessive restrictions to distributions:

Figure 4.1.3-3: CFO survey results: level of subscribed capital (Poland)

"The com pany's m anagem ent considers it

adantageous to increase the level of
stated/subscribed capital to the highest
possible extent because it should not serve
for distributions."

0%

True
False

100%

Source: CFO questionnaire, September 2007

The responses received unanimously rejected the idea of increasing the level of subscribed
capital to the highest extent possible to avoid distributions.

Role of the subscribed capital

The subscribed capital as such is not by far, in their opinion, sufficient to finance the
operation of the company.

Because it is so low, neither does the subscribed capital constitute a restriction on the ability
to distribute excess capital.

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For WIG 20 companies, the ratio of subscribed capital to total shareholders’ equity shows that
for 68 percent of the WIG 20 companies, the subscribed equity portion remains under 20
percent of total shareholders’ equity.

Figure 4.1.3-4: Ratio of subscribed capital to total shareholder`s equity (Poland)

Poland: Subscribed Capital to Total

Shareholder's Equity

16%
31% < 5%
5%- 10%
16% 10%- 20%
20%- 30 %
> 30%
21% 16%

Source: One source: Subscribed capital for the FY 2005, shareholders’ equity (consolidated) for the FY 2005

This illustrates that equity financing is not largely dependant on subscribed capital and that
there is a sufficient equity base in the WIG 20 companies and their subsidiaries to allow for
adequate distributions. The existence of subscribed capital does seem to be a stumbling block
for the WIG 20 companies in their approach to equity financing and distribution policy from a
group perspective.

The following answers to the CFO questionnaire concerned the attitude of companies to
capital increases:

Figure 4.1.3-5: CFO survey results: Attitudes towards increases of subscribed capital (Poland)

"Our com pany intends to keep its m axim um

flexibility and w ill try to m inim ise the
portion allocated to stated/subscribed
capital to the am ount strictly necessary for
legal or other reasons."

0%

True
False

100%

Source: CFO Questionnaire, September 2007

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All of the responses received stated that they usually try to keep the level of subscribed capital
to the minimum amount necessary.

These responses show that companies are generally not interested in a dominant role of
subscribed capital in equity financing.

Subsequent formations

We have not received any information on subsequent formations as these provisions are not
relevant to the Polish companies interviewed.

4.1.3.2 Capital increase

4.1.3.2.1 Legal framework

In accordance with the 2nd CLD, Polish law differentiates between different forms of capital
increase and mechanisms which ensure that the subscribed capital is contributed to the
company.

Increase of capital

Under Polish law, one can distinguish between ordinary capital increases, increases by
authorised capital and special forms of capital increases such as increases by capitalisation of
the reserves and the “conditional increase of capital”.

Ordinary capital increase

For an ordinary capital increase, an amendment to the statutes and, in consequence, a

resolution by the shareholders is required. The increase in capital may be performed by either
issuing new shares or raising the nominal value of the existing shares. In the case of issuing
new shares, a “subscription contract” is required. Because of the abovementioned requirement
of amending the statutes, a qualified majority of at least ¾ths of the votes is needed.

Since the ordinary capital increase requires an amendment to the statutes, it also requires
registration in the court and subsequent publication in the Official Journal.

Authorised capital

Under Polish law, the statutes can contain an authorisation to the management board to
increase the capital up to a set amount for a maximum period of three years. Within the set
amount, this may be performed in several increases. The shareholders` resolution amending
the statutes in order to authorise the management board requires a ¾ths majority of the votes
with at least half of the capital present. If the company is listed, this resolution requires only
1/3rd of the capital present. The management board may not issue privileged shares. The
maximum amount of the capital increase may not exceed ¾ths of the company’s subscribed
capital on the day of the authorisation. The management board is empowered to decide on the
authorised capital increase.

The resolution amending the statutes as well as the increase in capital performed by the
management board is required to be published in the Official Journal. The shareholders’

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resolution on the amendment of the statutes is subject to notarial recording and must be
registered at the register court and then be published.

Other forms of capital increase

Furthermore, the Polish Commercial Companies Code provides for an increase in capital by
capitalisation of the reserves from the company’s reserve fund or other funds created from
profits if these may be utilised in this way. The shareholders` resolution on capitalisation of
the reserves is an amendment to the statutes and requires a qualified majority of ¾ths of the
votes, registration at the register court before publication in the Official Journal.

Another special kind of increase in capital is the “conditional increase of capital”. The
shareholders meeting may adopt a resolution on the increase of capital on the condition that
the person granted the right to subscribe the new shares will exercise that right in the manner
indicated in the resolution. The nominal value of the conditional increase in capital may not
exceed twice the value of the company’s capital at the moment of adopting the resolution. The
shareholders` resolution requires a qualified majority of ¾ths of the votes, registration at the
register court and publication in the Official Journal.

Contributions of premiums

The capital obtained from shares paid in at a premium price must be transferred to the reserve
capital account and is not available for distribution.

Mechanisms to ensure the contribution of capital

Subscription of shares

Under Polish law, the subscription of the shares must be finalised within two weeks from the
deadline set. Public companies are prohibited to subscribe their own shares. The prohibition
also applies to subsidiaries and dependant cooperatives. The Polish Commercial Companies
Code provides that, in case of an increase in capital, the newly issued shares may not be
issued below their nominal value which has to be a minimum of 1 grosz (1/100 of PLN).

The resolution amending the statutes must include the amount of the increase in the capital.

Contributable assets / paying-in

Under Polish law, in the context of capital increases, capital may be contributed in cash or in
kind. Besides the requirement that the asset must be capable of economic assessment as set
out in the 2nd CLD, the Polish Commercial Companies Code provides that the contribution to
the capital of the company may only be an asset that is transferable. Services and work may
not be considered as contributions.

The Commercial Companies Code provides that ¼th of the nominal value of shares
subscribed for cash must be paid-up before registration.

Shares subscribed for in kind contributions should be paid-up in full (the contributions should
be transferred to the company) not later than 1 year after the company was registered.

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If shares are subscribed for in kind contributions or mixed in kind and cash contributions, at
least in ¼th of the value of the prescribed registered share capital of PLN500,000 must be
paid-up before registration of the company.

Protection against over-valuations

Contributions in kind are subject to a valuation by the company's founders, who must deliver
a report in this respect. The report should include in particular: a description of the assets, the
number and types of the shares and other title to participate in the profits or in the company’s
assets after its liquidation, the individuals that make the in-kind contributions and the adopted
method of valuation. In the case of a contribution of an enterprise (business), its financial
statements for the last 2 years must be attached to the report.

Sanctions

If a contribution in kind was properly subjected to the above mentioned evaluation procedure
but the value the shareholder contributed is nevertheless less than the value intended, the
statutes may not release the shareholder from his responsibility for the remainder of that
contribution. He is obliged to indemnify the company for the damage caused. If the
shareholder pays less than the value required, the company may redeem the uncovered shares.

Pre-emption rights

The Polish Commercial Companies Code grants current shareholders pre-emption rights in
proportion to the number of shares held. Pre-emption rights apply to shares to be subscribed
for cash as well as for contributions in kind. The general meeting may, in the interests of the
company, exclude the shareholders` pre-emption rights, in part or in whole, by a resolution
adopted by a majority of 4/5ths of the votes. A written opinion stating the grounds for the
exclusion of the pre-emption rights and a proposed issuing price of the shares or the manner
of fixing the price must be presented by the board.

Under Polish law, the general meeting may not delegate the power to restrict or exclude pre-
emption rights to the management board empowered to decide on the capital increase.

4.1.3.2.2 Economic analysis

The Polish companies interviewed showed a preference for ordinary capital increases.
Authorised capital was not used by the Polish companies interviewed. However, one company
stated that the notarial costs may be cheaper in the case of a capital increase via authorised
capital. Only one of the Polish companies interviewed used authorised capital in the past but
let this authorised capital lapse last year due to lack of justification (i.e. no capital increase
was implemented).

Ordinary capital increase

The first traditional way of increasing capital is the ordinary capital increase, where the
company’s management proposes a shareholders’ resolution with an immediate capital
increase.

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Practical steps

Under Polish company law, the practical steps necessary for such an ordinary capital increase
in chronological order are:

Figure 4.1.3-6: Process for ordinary capital increase (Poland)

Ordinary capital increase

Proposal of the board on how the company should be financed (amount of
Step 1
subscribed capital, amount of premiums)
Step 2 Invitation to shareholders’ meeting
Step 3 Resolution by shareholders on capital increase and alteration of statutes
Resolution by shareholders on pre-emption rights in case of cash consideration or
Step 4
possible resolution that bank should offer shares
Step 5 Amending statutes to raise the amount of subscribed capital
Step 6 Publication of the decision
Step 7 Subscription of the shares
Step 8 Registration of the increase in capital and amendment of the statutes
Step 9 Issue of the shares

Analysis

Two of the Polish companies interviewed conducted an ordinary capital increase in the past.
In this process, the requirements stemming from company law play a minor role in
comparison to those from securities legislation. The most burdensome aspect is the
preparation of prospectuses which requires a high documentation effort. Due to the
complexity of the undertaking, companies were only able to provide overall figures, not
clearly differentiating between company law and securities law provisions. The process
requires about 500 hours of highly qualified personnel and 5,000 hours of lower qualified
personnel over a time period of several months. The legal costs amount to at least
PLN500,000 and administrative costs amount to PLN100,000. In addition, the registration of
the increase in capital and amendment to the statutes cause administrative costs as high as
PLN20,000. Thus, the average total costs of an ordinary capital increase amount to a
minimum of PLN620,000 (= €165,000).

Incremental Costs
HighQ LowQ Other Costs
Hours spent 50 500 -
Hourly rate €100 €70 -
€5,000 €35,000 €15,634
Total costs €55,634

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Authorised capital

Practical steps

To issue authorised capital, the following legal steps in chronological order are required:

Figure 4.1.3-7: Process for authorised capital increase (Poland)

Authorised capital increase

Proposal of the founders/board on how the company should be financed (amount of
Step 1
subscribed capital, amount of premiums)
Step 2 Laying down in the statutes/ decision by shareholders’ meeting
Step 3 Decision of the board
Resolution by shareholders (or by board being so entitled by statute) on pre-
Step 4 emption rights in case of cash consideration or possible resolution that bank should
offer shares
Step 5 Amendment to statutes to raise the amount of subscribed capital
Step 6 Publication of the decision
Step 7 Subscription of the shares
Step 8 Registration of the increase in capital
Step 9 Issue of the shares

Analysis

In practice, most Polish companies interviewed have not used the opportunity to create
authorised capital. Only one Polish company interviewed had done this in the past but has not
actually used it. It expired due to lack of reason for keeping the authorised capital.

Mechanisms to ensure the contribution of capital - contributions in kind

Practical steps

To inject capital into the company, the following steps for cash contributions and
contributions in kind have to be taken in chronological order:

Figure 4.1.3-8: Process for the injection of contributions (Poland)

Injection of contributions
Step 1
Monitoring whether assets to be contributed are capable of economic assessment
Step 2 Monitoring whether the designated amount is paid-up in the intended timeframe
Step 3 Performance of valuation process with respect to contributions in kind
Step 4 Publication of report
Step 5 Amendment of the statutes

Analysis

Unfortunately, we have not encountered any practical cases of contributions in kind during
our interviews with Polish companies. However, a general opinion was that the most

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burdensome aspect is the valuation process of the contribution. This requires, on the one
hand, enormous effort to collect relevant data for the valuation and the cost for the outside
expert may also be considerable. The actual burden for such valuations largely depends on the
complexity of the subject to be valued. This may be a single asset or a highly complex
company, thus the costs were estimated to range from a few PLN1,000 to PLN100.000.

4.1.3.2.3 Protection of shareholders and creditors

One can draw the following conclusions under the aspect of shareholder and creditor
protection in case of capital increases. Firstly, it should be noted that the requirement that the
shareholders have to agree to the ordinary capital increase as well as to the conditional capital
increase with a qualified majority has clearly a shareholder protective character. Furthermore,
the provisions on authorised capital contain elements which are shareholder protective as the
authorisation must be stated in the statutes or, if this is not the case, an amendment of the
statutes with a qualified majority is necessary. The fact that the authorisation period is limited
to three years and the amount which can be covered by the authorisation - half of the capital
present – are also shareholder protective. In this respect, Polish law contains further protective
provisions, as it prescribes the registration of the shareholders’ resolution to increase the
capital, the registration and publication of the increase in capital and the registration and
publication of the amendment of the statutes. To ensure that equal treatment in contributions
takes place, Polish law prescribes the drawing-up of a report by an independent expert in case
of contributions in kind to protect shareholders from overvaluations and their consequences.
Under the aspect of shareholder protection, the mandatory pre-emption rights are furthermore
of importance as they prevent dilution. It should be noted that, under Polish law, these
provisions protect the shareholders not only in the case of contributions in cash but also in the
case of contributions in kind.

4.1.3.3. Distribution

4.1.3.3.1 Legal framework

Polish provisions on distributions differentiate between provisions dealing with the

calculation of the distributable amount, the determination of the amount to be distributed and
the consequences of incorrect distributions.

Calculation of the distributable amount

In accordance with the provisions of the 2nd CLD, under Polish law shareholders are entitled
to participate in the profit shown in the audited financial statements and appropriated by the
general meeting to be paid to shareholders. Distributions may not be paid out before the
compulsory reserve and other reserves – to be accumulated out of the net profit – reach the
level provided in the company’s statutes. In any event, contributions paid in return for shares
can never be refunded to shareholders.

Connection to accounting rules

The balance sheet profit is determined with reference to the annual accounts which must be
drawn up in accordance with the Act on Accounting and in conformity with IFRS. The annual
accounts must be audited.

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Determination of the distributable amount – responsibilities

In Poland, distributions have to be proposed by the management board. The proposals are
subject to the opinion of the supervisory board. The general meeting is, in any event,
competent to decide on the distribution of profit and is not obliged to accept the management
board’s proposals and may resolve solely at its own discretion. The resolution must state the
amounts required to cover losses, the amounts allocated to particular reserves and the amounts
to be distributed. The resolution on the dividend requires a simple majority of the votes cast.
No specific quorum is required. Annual resolutions on distribution of profit have to be
submitted to the court within 15 days from the approval of the financial statements.

Sanctions

Shareholders who have received any benefits (including any form of distributions) from the
company, in violation of provisions of the law or the company’s statutes, are obliged to return
the same. The exception to this general rule is a case where the shareholder receives a share of
profit in good faith. Good faith of the shareholder does not change the liability of board
members. The liability of board members responsible for the unlawful benefit is not based on
fault.

4.1.3.3.2 Economic analysis

Overall, the Polish companies interviewed considered the Polish company law provisions on
profit distribution as easy to comply with. The reference to the accounting profit derived from
the annual accounts prepared under IFRS, provides a high degree of legal certainty. The
reference to IFRS does not cause difficulties for the Polish companies interviewed which may
also be caused by the fact that the use of fair value measurements was very limited. There
have been issues in the application of IAS 29 (“inflation accounting”) due to hyperinflation in
Poland in the mid-1990s.

From an incremental cost perspective, all Polish companies interviewed considered step 1, i.e.
the proposal of the management board using the annual accounts / monitoring of provisions
determining the distributable amount, to be the most time-consuming effort concerning the
compliance with company law provisions. Further, major expenses are associated with the
actual payment of dividends. However, the actual requirements are closely linked to securities
legislation and depend significantly on the number of shareholders in the company.

Practical steps

In chronological order, the series of practical steps comprises:

Figure 4.1.3-9: Due process for distributing profits (Poland)

Due process for distributing profits

Proposal of the management board using the annual accounts / monitoring of
Step 1
provisions determining the distributable amount
Step 2 Opinion of supervisory board in respect of the proposal
Resolution of the annual general meeting of shareholders on allocation of net
Step 3 profit/resolution of management board on payment of advance towards the
dividend.
Step 4 Publication / payment of dividend

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Analysis

Calculation of the distributable amount

The preparation of the dividend proposal typically involves the CFO and CEO and other
selected high ranking company representatives preceded by preparations in the company’s
administration (treasury, tax and/or accounting departments). As the level of dividends is also
a political decision concerning the attractiveness of the shares to investors, investor relation
experts may also play a significant role in the elaboration of the dividend proposal. The
dividend proposal is subsequently subject to a discussion in the company’s management
board before it is handed over to the supervisory board. The intensiveness of the discussion in
the management and supervisory boards depends on the specific importance of dividend
levels for the performance of the shares of the company.

An important point of reference for the determination of the distributable amount is the IFRS
consolidated accounts. The results of a CFO questionnaire sent to Polish companies listed on
main indices reconfirm this:

Figure 4.1.3-10: Determinants for the distribution of dividends in the holding company (Poland)

"What are the determ inants for the distribution of dividends by your holding
com pany?"

5,00
5
4,00
Importance

4 3,67
4,22 3,06 Poland
3 3,64
2,15 2,12 EU Average
2,96
2
2,33 2,00 1,67
1
Fin. performance Financial Dividend Signalling device Credit rating Tax rules
(group performance cont inuity considerations
accounts) (individual
accounts of the
parent company)

Determ inants

Source: CFO Questionnaire, September 2007

IFRS are also regularly applied to the individual accounts which are the basis for calculating
profit distribution restrictions. Nonwithstanding the application of IFRS, the results of the
CFO questionnaire show that the responding CFOs rank legal restrictions higher than market
led solutions like rating agencies’ requirements or bank covenants, even under an IFRS
accounting framework.

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Figure 4.1.3-11: Important deterrents when considering the level of profit distribution (Poland)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"

5
4,33

3,50
4
Importance

2,50 Poland
3
3,44 2,25 EU Average
2,65
2
2,16 2,00
1
Distribution/Legal capital Rating agencies' Contractual agreements Possible violations of
requirements requirements with creditors (covenants) insolvency law

Deterrents

Source: CFO Questionnaire, September 2007

One common feature with other EU Member States under consideration concerns the fact that
the Polish companies interviewed have to ensure that there is sufficient profit and cash at
parent level to allow for distributions, based on considerations from the group’s perspective.
Again, the results of a CFO questionnaire sent to Polish companies listed on main indices
show the relevance of tax considerations in this regard:

Figure 4.1.3-12: Determinants for the distribution of dividends by the subsidiaries (Poland)

"What are the determ inants for the distribution of dividends by your
subsidiaries?"

5
4,33
4
Importance

4,07 3,33
3,50 Poland
3
3,14 EU Average
2,74
2

1
Demands from the ultimat e parent Tax rules Own invest ment decisions

Determ inants

Source: CFO Questionnaire, September 2007

Connection to accounting rules

Due to the direct link to the audited financial statements under IFRS, the Polish companies
interviewed considered it relatively easy to determine the distributable amount. There is no
specific effort needed in this regard.

Concerning the use of IFRS, there were no relevant implementation and application issues
except for the accounting for hyperinflation under IAS 29 and, in one case, concerning the
accounting for stock options under IFRS 2. Accounting for hyperinflation has been a general
theme with Polish companies in the changeover to IFRS, due to Polish hyperinflation in the
mid-1990s. There was only a very limited use of fair value measurements with the companies
interviewed.
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Determination of the distributable amount

The total time spent on the distribution proposal is rather minimal and varies between 0.1 and
4 hours of highly qualified personnel of the company. However, the time requirement for the
distribution proposal by management varies depending on the culture and organisation of the
individual company and is typically not linked to certain size criteria.

Another 2 hours of highly qualified personnel time concerns the specific time needed for the
supervisory board’s opinion on the distribution proposal and the preparation for the general
meeting. The monetary amount to be spent on the publication is also considered minimal and
remains under PLN20,000.

The companies interviewed do not generally engage external legal advisors in this process
and rather use in-house solutions.

The remaining steps were considered to be non-incremental as, from the companies’
perspective, they did not result from compliance with distribution provisions such as the
preparation of the accounts, the annual audit and the holding of the annual general meeting.

Sanctions

The companies interviewed considered the risk of liability for the company’s management
due to non-compliance with the provisions concerning incorrect dividend distributions, to be
low. The reason for this is mainly the very clear-cut legal provisions on profit distributions
which, due to their simplicity, provide a high level of legal certainty.

Related parties

There were no significant issues concerning the question of the monitoring of the
relationships with related parties and other potential return of funds to shareholders. This
monitoring is mainly performed for transparency (accounting) or tax purposes, not primarily
for compliance reasons stemming from company law.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 2.1 – 4 - -
Hourly rate €100 €70 -
€210 – €400 - < €5,043
Total costs €210 to €5,443

4.1.3.3.3 Protection of shareholders / creditors

Under the aspect of shareholder and creditor protection, one can draw the following key
conclusions from the abovementioned provisions on distributions. Firstly, under Polish law,
clearly formulated legal distribution provisions exist. The reference to IFRS does not cause
problems to the Polish companies interviewed. However, the use of fair value measurements
under IFRS could lead to more distribution decisions which are not based on the principle of
prudence and this could potentially undermine the protection of creditors. The obligation that
the general meeting has to decide on the allocation of the balance sheet profit, which stems
from the national legislation, provides shareholder protection. The principle of equal
treatment in distributions also protects shareholders. In this respect, Polish law contains

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further protective provisions, as it allows shareholders to challenge resolutions that may lead
to incorrect distributions. The national provisions prescribing the liability of members of the
management board and the supervisory board for losses caused by unlawful distributions are
also shareholder protective. Regarding creditor protection, the obligation of the shareholders
to return to the company any payment received contrary to the Company Commercial Code,
is of importance.

4.1.3.4 Capital maintenance

Polish law provides for different instruments dealing with capital maintenance. Among these
are the provisions on the limitation of the acquisition by the company of its own shares and
the prohibition of financial assistance as well as the provisions on capital reductions, the
withdrawal of shares, the serious loss of the subscribed capital and hidden distributions.

4.1.3.4.1 Acquisition by the company of its own shares

4.1.3.4.1.1 Legal framework

In Poland, a public company may not, in principle, acquire its own shares. The prohibition on
the company acquiring its own shares also applies to the acquisition of a dominant company's
shares by its dependent companies or cooperatives. The prohibition also applies to persons
acting for the account of a dependent company or cooperative.
The Polish CCC provides several exceptions for cases in which public companies acquire
shares in order to comply with obligations resulting from warrants convertible into shares;
acquisitions of shares by universal succession; cases in which a financial institution which, for
a consideration, acquires fully paid-up shares for another's account for re-sale; acquisitions of
shares to be redeemed; acquisitions of fully paid-up shares by execution, to satisfy such
claims of the company which cannot be otherwise satisfied from the shareholder's estate;
gratuitous acquisitions of fully paid-up shares; acquisitions of shares in other circumstances
provided for in the Act; acquisitions of shares with the object of preventing major damage
with which the company is directly threatened; acquisitions of shares to be offered to
employees or persons who were employed in the company or its related companies for no less
than three years; cases in which a financial institution acquires shares for its own account with
the object of reselling them within the limits of an authorisation granted by the general
meeting for a period no longer than one year; however, the financial institution may not hold
shares so acquired the total nominal value of which exceeds 5 % of the initial capital.

Regarding the last three cases, there are further limitations, namely, shares may be acquired
only if the shares to be acquired are fully paid-up, the total nominal value does not exceed
10% of the registered capital, the total purchase price and purchase costs are not higher than
capital distributable as dividends.

Shares acquired against the law should be resold within 1 year. Shares acquired lawfully but
in excess of the 10% of the registered capital should be resold within 2 years. If not, the
management board should redeem the shares.

If the company holds its own shares, it is not allowed to exercise the participation and voting
rights attached to those shares, except for the power to transfer the same or to perform acts
conducive to preserving such rights. Furthermore, it is necessary in this case that the shares
are shown in the balance sheet as a separate liability. At the same time, the reserve capital
must be reduced and the supplementary capital increased correspondingly.

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The provisions covering the acquisition of the company’s own shares are also applicable to
pledges of shares. However, this does not apply with respect to financial institutions, if the
creation of the pledge over the shares is in connection with the financial institution’s normal
business.

The recent amendments to the second directive have not been implemented into national law.
At the present time, no legislative proposals to implement the said amendments are known.

4.1.3.4.1.2 Economic analysis

Practical steps

To acquire its own shares, a company has to follow this process:

Figure 4.1.3-13: Process for the aquisition of own shares (Poland)

Acquisition by the company of its own shares

Step 1 Proposal of board to acquire the company’s own shares
Notify the next general meeting of the reasons for or purpose of acquisition of the
Step 2
shares
Step 3 Facultative resolution by shareholders on acquisitions of the company’s own shares
Step 4 Monitoring of provisions (amount of nominal value, net assets, fully paid in etc)
Step 5 Board’s report on acquisition
Step 6 Appropriate entries into the balance sheet

Analysis

Two of the three companies have set up programs to buy back their own shares. The process
of setting up a proposal for the buy-back of a company’s own shares depends on the
complexity of the buy-back program. We have encountered in the one case a work
commitment of 4 hours of highly qualified personnel and 8 hours of lower qualified personnel
and in the other case around 80 hours (around 5-6 working days for 2-3 persons such as CEO,
CFO, legal or administrative staff) of highly qualified personnel. In both cases, a second
opinion is usually obtained from a law firm to secure the right approach.

Moreover, there are extensive transparency and information duties with regard to the Warsaw
stock exchange supervisory institution for the buying of shares. Thus, the main activity is
compliance and monitoring for stock exchange purposes (which takes 60 hours of lower
qualified personnel and costs around PLN10,000). The actual buying of the shares usually
takes place via a brokerage house. Negotiation of terms of buy-back with brokerage house (no
set share price; long buy-back period not to disturb share price) needs intensive work by the
legal department (3 working days). The stock exchange requires continuous reporting on
share buy-backs (which is done weekly by a brokerage house).

In general, we have not noticed significant deviations in the work load between different sizes
of companies. It rather depends on the level of activity of the company regarding stock buy-
back programmes and the way the company re-acquires its own shares.

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Incremental Costs
HighQ LowQ Other Costs
Hours spent 28 -104 0-8 -
Hourly rate €100 €70 -
€2,800 to €10,400 up to €560 -
Total costs €2,800 to €10,960

4.1.3.4.1.3 Protection of shareholders and creditors

Under the aspect of shareholder and creditor protection, one can draw the following key
conclusions from the before mentioned provisions on the acquisition by a company of its own
shares.

The provisions which limit the amount of shares which can be acquired (the 10% threshold)
and the provision which prescribes that the shares may not be acquired with the subscribed
capital and not distributable reserves, aim at protecting shareholders and creditors.

If shares have been purchased different shareholder and creditor protection rules are
applicable. Of importance are, for example, the provisions that all rights attached to the
acquired shares are suspended. Also of importance is the provision that the acquired shares
are shown in the balance sheet as a separate liability.

4.1.3.4.2. Capital reduction

4.1.3.4.2.1 Legal framework

The Polish Commercial Companies Code provides for the possibility of an ordinary reduction
in capital. The minimum required for the resolution is a ¾ths majority of the votes. If
different classes of shares exist within the company, any resolution on a reduction in capital
that may infringe rights of holders of certain classes of shares must be adopted by resolutions
of the different classes of shareholders.

The management board has to announce the intended capital reduction, requesting the
creditors of the company to raise their objections within three months from the date of the
announcement in the event that they should be against the reduction. Creditors of the
company that raise their objections within the prescribed time must be satisfied (if the claims
are due), or secured. The creditors who fail to raise their objections are deemed to have agreed
to the intended capital reduction. Shareholder’s claims raised during the procedure of the
reduction in capital shall be satisfied after 6 months from the announcement of registering the
capital reduction in the national register. A reduction to an amount less than that prescribed in
the Polish Commercial Companies Code is not possible. The Polish Commercial Companies
Code provides that the maximum reduction of capital is limited by the minimum capital of the
company as prescribed (PLN500,000).

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The Polish Commercial Companies Code provides for some exceptions to the above
mentioned procedure, such as:

a) although the capital is reduced, shareholders’ contributions for shares are not returned to
shareholders, and shareholders are not released from the duty to make contributions to
the initial capital and at the same time the capital is increased at least to its initial value,
or
b) the capital reduction is effected with the object of covering losses suffered or
transferring certain amounts of capital to the reserve capital, or
c) the capital reduction is effected in the case of a redemption of shares which were
acquired by the company and not sold within the timeframe provided by the Polish CCC
(2 years).

The amendments of the 2nd CLD with respect to the burden of proof have not yet been
implemented into national law.

4.1.3.4.2.2 Economic analysis

Within our sample of Polish companies, we have not encountered any capital decreases.

4.1.3.4.2.3 Protection of shareholders and creditors

Regarding the shareholder and creditor protection existing with respect to capital reductions,
firstly the requirement that the shareholders have to agree to the capital reduction with a
qualified majority (3/4ths majority of the votes) is of importance. Furthermore, the safeguards
to creditors which have, under certain circumstances, the right to obtain security are creditor
protective.

4.1.3.4.3 Withdrawal of shares

4.1.3.4.3.1 Legal framework

Polish law allows the compulsory withdrawal of shares. Furthermore, Polish law provides for
the withdrawal of a company’s own shares. Not possible are redemption of the subscribed
capital without reduction of the latter and the issuance of redeemable shares.

A compulsory withdrawal in this way is only permissible if the company's statutes so provide,
as well as for the grounds and the procedure thereof. The redemption of the shares requires a
resolution of the general meeting. The resolution has to state, in particular, the legal grounds
for the redemption, the compensation and the manner of reducing the initial capital. A
compulsory redemption is subject to compensation.

The resolution on the redemption of the shares must be adopted by a majority of 3/4ths of the
votes. Where at least half of the capital is represented at the general meeting, a simple
majority of votes is sufficient. The company's statutes may set more rigorous requirements.
The resolution shall follow the terms and manner previously fixed in the statutes. The
resolution on the redemption must be published.

The Commercial Companies Code stipulates that the company's shares acquired by the
company itself and not sold within the timeframe provided in the Commercial Companies
Code are subject to redemption by the authority of the management board without the need of

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a resolution of the general meeting. This method of redemption does not need to be provided
for in the statutes.

4.1.3.4.3.2 Economic analysis

Two of three companies have made use of the redemption of their own shares acquired in a
buy-back programme, but this has seldom happened. One of the companies mentioned that it
has twice annulled its own shares in the last ten years.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.1.3.4.3.3 Shareholder and creditor protection

Regarding the withdrawal of shares, it is, with respect to shareholder and creditor protection,
of importance that it is only permissible if the statutes allow it before the shares to be
withdrawn are subscribed for.

4.1.3.4.4 Financial assistance

4.1.3.4.4.1 Legal framework

The Polish Commercial Companies Code provides that companies may not make loans,
provide security, advance payments or in any other manner, directly or indirectly finance the
acquisition or taking-up of their own shares. This does not, however, apply to transactions in
the ordinary course of business of financial institutions or share issues to employees of the
company or of an associated company provided that a reserve capital was previously created
for this purpose.

The amendments of the 2nd CLD by Directive 2006/68/EC have not yet been implemented
into national law.

4.1.3.4.4.2 Economic analysis

As the changes to the 2nd CLD have not yet been enacted into Polish law, there could not have
been any practical cases in the course of the interviews conducted with Polish companies.

4.1.3.4.5 Serious loss of half of the subscribed capital

4.1.3.4.5.1 Legal framework

In Poland, if the balance sheet prepared by the management board shows a loss in excess of
the total of the compulsory and voluntary reserves, and one third of the registered capital, the
management board is required to call a general meeting with the object of adopting a
resolution on the continuation of the existence of the company. A separate notification of the
loss does not have to be published. The calling of the general meeting should include its
agenda i.e. that a resolution on the continuation of the existence of the company is required by
the law due to the amount of losses incurred by the company.

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The general meeting must adopt a resolution in respect of the continuation of the company or
a resolution winding-up the company. Failure to call the general meeting can lead to civil
liability and/or penal liability of the management board and may give grounds for dismissal of
the board.

4.1.3.4.5.2 Economic analysis

The Polish companies interviewed spent very little time on the explicit monitoring of this
provision on the serious loss of subscribed capital. The management of the companies
interviewed normally use their normal internal reporting and risk management systems to
monitor the financial position of the company/group. This is typically a monthly report with
key figures concerning the company/group. This would give management sufficient lead time
to recognise critical situations. In general, they would see a significant increase in monitoring
activity once the financial position of the company showed indications that such a situation
could actually occur.

4.1.3.4.5.3 Shareholder and creditor protection

The provisions dealing with the serious loss of the subscribed capital have a shareholder and
also creditor protective character as the general meeting gets the possibility to decide on
safeguarding measures such as winding-up the company.

4.1.3.4.6 Contractual self-protection

4.1.3.4.6.1 Legal framework

In Poland there are no specific legal provisions concerned with contractual self protection of
creditors.

As the board represents the company vis-à-vis the creditors, and the general meeting decides
upon the dividend, any of such contractual obligations (limitations) would have to be made by
the board as the competent body.

There are no obstacles to a shareholders’ agreement suspending payment of the dividend. In

case of such contracts, especially in the case of public companies, it must be considered
whether the legitimate rights of minority shareholders are not violated, so that their consent
would be required.

4.1.3.4.6.2 Economic analysis

Only one of the three Polish companies interviewed had covenants in a loan contract with
Polish banks. These concerned restrictions on the disposal of main assets as well as the
maintenance of certain liquidity ratios. There are no direct restrictions on the distribution of
profits.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

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4.1.3.4.6.3 Shareholder and creditor protection

Regarding the aspect of creditor protection it should be noted that covenants are based on
private law contracts which do not, in Poland, seem to be extensively used. Furthermore, only
individual creditors are, under Polish law, protected by them.

4.1.3.5 Insolvency

4.1.3.5.1 Legal framework

According to the Polish Insolvency and Rehabilitation Act (IRL), bankruptcy proceedings are
initiated in respect of a debtor (including a legal entity) that has become insolvent, i.e. that is
not able to fulfill its current and due liabilities. This is particularly the case when liabilities of
the company exceed its assets, or while the debtor has reasonable assets, due to inadequate
cash flow cannot pay its current debts.

A presumption exists that if the liabilities of a company exceed the value of its property, the
company is deemed to be insolvent. In the case of minor or temporary difficulties in meeting
liabilities or non-material indebtedness (i.e. when the period for which the company is late in
payment of debts does not exceed 3 months and the amount of due liabilities does not exceed
10% of net assets), the court may refuse to declare bankruptcy.

There are two kinds of proceedings in the case of insolvency: liquidation (when the company
is liquidated) or arrangement (when its operation is supervised by the court and creditors and
special arrangement with creditors must to be made). The latter may be taken into
consideration when the probability of satisfying the creditors is higher than in the case of
liquidation.

The reasons for insolvency are of an objective nature and must be evaluated by the person
obliged to file a proper petition to the court (the company management) or a person entitled to
do so (creditor). The circumstances are examined by the court.

The petition may be filed by the debtor or its creditors. When the company becomes
insolvent, the duty of each and every member of the management board is to file the petition.
The petition for a declaration of bankruptcy must be filed within two weeks from the moment
the company became insolvent.

4.1.3.5.2 Economic analysis

As for the provision on the serious loss of subscribed capital, the Polish companies
interviewed spent very little time on the monitoring of insolvency triggers. The management
of the companies interviewed normally use their internal reporting and risk management
systems to monitor the financial position of the company/group. This would give them
sufficient lead time to recognise critical situations. Again, they would generally see a
significant increase in monitoring activity if the financial position of the company showed
indications that such a situation could actually occur.

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4.1.4 Sweden

4.1.4.1. Structure of capital and shares

4.1.4.1.1 Legal framework

Structure of capital

Subscribed capital

Also under the new Swedish Companies Act (“Aktiebolagslagen”= ABL) which came into
force on 1 January 2006, public companies must have a minimum subscribed capital of SEK
500,000 what goes beyond the minimum set by the 2nd CLD (SEK 500,000 equal about
€50,000). Above this minimum amount the founders are entitled, as it is provided for in the
2nd CLD, to freely fix a higher capital amount.

Private Companies are required to have a minimum subscribed capital of SEK 100,000
(which equals about €10,000). The founders are also entitled to freely fix a higher capital
amount.

Swedish law prescribes that share capital must be determined in the statutes.

Premiums and other forms of equity contribution

Under Swedish Law it is permissible to fix premiums in the stage of formation. The New
Swedish Companies Act provides that the payment for a share may not be less than the share's
quotient value. For example, if the founders have decided that the company's share capital
shall be SEK 100,000 and there are 1,000 shares in the company, payment for each share
must thus be not less than SEK 100. On the other hand, there is nothing to prevent the shares
being issued at a premium, i.e. in exchange for payment which exceeds the shares' quotient
value. In such case, the part of the payment for the shares which corresponds to the quotient
value will constitute the company's share capital while the premium will be reported as
unrestricted equity under the heading Share Premium Reserve.

Under Swedish Law the payment for the subscribed shares must take place in cash or through
non-cash consideration. Set-off is not permitted in conjunction with formation of a company.

Protection of the public company’s assets

In the new Swedish Companies Act, rules concerning the way and extent to which assets can
be transferred from the company to shareholders or other parties have been assembled under
the term "value transfers". Value transfers are prohibited for sums so large as to leave the
restricted equity without full coverage after the transfer (“monetary barrier”). When the scope
for a value transfer is decided, an examination must also be made of whether the planned
value transfer is justifiable bearing in mind the amount of equity required by the type and size
of the business and the risks involved (“the prudence rule”).

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The concept of value transfer refers to:

- dividends
- acquisition of own shares
- reduction of the share capital or statutory reserve fund for repayment to shareholders,
and
- other business transactions of a non-commercial nature that entail a reduction in the
company’s assets.

Structure of shares

Every share represents the same fraction of the subscribed capital (“quotient value”). The
concept of nominal value was abolished in the new Swedish Companies Act. Accordingly, the
subscribed capital may be broken down according to the number of shares which requires
shares of the same amount. All Swedish companies had to amend their statutes in this respect.

4.1.4.1.2 Economic analysis

Practical relevance of subscribed capital and structure of shares for an assessment of the
viability of a company

In general, the Swedish companies interviewed did not see a high degree of practical
relevance of the legally imposed subscribed capital concerning the assessment of their
viability by outsiders. There was no significant difference seen between par value and no-par
value shares. No-par value shares are considered to be a bit less burdensome to administrate.

The companies interviewed are rather looking at the figures “net equity” and “market
capitalisation” as relevant to determine their equity position and their assessment of their
chances to preserve their business or to attract additional capital. One company gave a
specific example by referring to a self-created trademark which cannot be capitalised in the
balance sheet, but generates significant cash flows for the company. This trademark is not
reflected in the balance sheet but in the market capitalisation of the company.

To verify the statement, we have additionally performed an analysis of certain ratios

concerning subscribed capital fort the main Swedish stock exchange index Attract 40.

For nearly all (98 percent) of the Attract 40 companies the subscribed capital represents less
than 5 percent of their market capitalisation. Thus, the overall importance of the subscribed
capital figure seems to be marginal.

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Figure 4.1.4-1: Common Stock – Market Capitalisation (Sweden)

Sw eden: Com m on Stock / Market

Capitalisation

2%

< 5%
5%- 10%

98%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of September 2006

Restriction for distribution

The results from the CFO questionnaire sent to 245 Swedish public companies showed
support for the concept of subscribed capital.

62 percent of the respondents considered the existence of subscribed capital to be necessary.

This view was opposed for more than a third of the respondents (38 percent).

Figure 4.1.4-2: CFO survey results: necessity of subscribed capital (Sweden)

"In general, w e do not consider

stated/subscribed capital to be necessary; it
unnecessarily reduces our com pany's
flexibility to distribute excess capital."

38% True

62% False

Source: CFO questionnaire, September 2007

However, according to the respondents to the CFO questionnaire there is no interest in

excessive restrictions to distribution.

A clear majority of 95 percent of the respondents rejected the idea to increase the level of
subscribed capital to the highest extent possible to avoid distributions.

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Figure 4.1.4-3: CFO survey results: level of subscribed capital (Sweden)

"The com pany's m anagem ent considers it

advantageous to increase the level of
stated/subscribed capital to the highest
possible extent because it should not serve
for distributions."

0%
5%
True
False
NA
95%

Source: CFO questionnaire, September 2007

Role of the subscribed capital in equity financing

For Attract 40 companies, the ratio of subscribed capital to total shareholder’s equity shows
that for 81 percent of the Attract 40 companies the subscribed equity portion stays under 20
percent of total shareholder’s equity.

This underpins that the equity financing is not largely dependant on the subscribed capital and
that there is a sufficient equity base in the Attract 40 companies and their subsidiaries to allow
for adequate distributions. The existence of a subscribed capital does not seem to be a stumble
block for the Attract 40 companies in their approach to equity financing and distribution
policy from a group perspective.

Figure 4.1.4-4: Ratio of common stock to total shareholders`s equity (Sweden)

Sw eden: Com m on Stock / Total

Shareholder's Equity

11%
8% < 5%
41% 5%- 10%
15% 10%- 20%
20%- 30 %
> 30%

25%

Source: One source: Subscribed capital for the FY 2005, shareholder’s equity (consolidated) for the FY 2005

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The following answers to the CFO questionnaire concerned the attitude of companies
regarding capital increases:

86 percent of the respondents stated that they usually try to keep the level of subscribed
capital to the minimum amount necessary. Only 10 percent of the respondents opposed this
view.

These responses show that companies are generally not interested in a dominant role of
subscribed capital in equity financing.

Figure 4.1.4-5: CFO survey results: Attitudes towards increases of subscribed capital (Sweden)

"Our com pany intends to keep its m axim um

flexibility and w ill try to m inim ise the portion
allocated to stated/subscribed capital to the
am ount strictly necessary for legal or other
reasons."
5%

10% True
False
NA
86%

Source: CFO questionnaire, September 2007

Subsequent formations

We have not received any information on subsequent formations as these provisions are not
relevant to the Swedish companies interviewed.

4.1.4.2. Capital increase

4.1.4.2.1 Legal framework

In the new Swedish Companies Act, rules concerning increase in share capital have been
restructured and given a different legal design. Still, in substance the rules are similar to what
applied before.

A Swedish limited company can increase its share capital through bonus issues and new
issues.

With respect to both types of increase in share capital, the share capital may not be increased
in a way which violates the statutes. Thus, the Companies Act prescribes that the statutes
must be altered before a resolution is adopted regarding an issue, if the resolution is not
compatible with the statutes. If the share capital in the statutes is stated as a fixed amount, a
resolution to increase the share capital cannot be adopted unless the statutes are altered at the
same time. This is also the case if the statutes state a minimum and a maximum share capital

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and the increase results in the maximum capital being exceeded. If there is more than one
class of shares in the company, an issue resolution may not result in the maximum number, or
the maximum portion, of shares of a particular class as prescribed in the statutes being
exceeded.

Ordinary capital increase

As a main rule, under Swedish Law a resolution regarding a new issue is adopted by the
general meeting. Where the shareholders have pre-emption rights to subscribe for new shares,
a simple majority is normally sufficient to adopt a resolution regarding a new issue. Thus, the
resolution must be supported by shareholders with more than half of the votes cast. If the
issue resolution requires an alteration of the statutes, the qualified majority requirements
applicable to a resolution regarding such alterations must be observed (two thirds of the votes
cast and shares represented at the meeting). This is also the case if the general meeting
decides to derogate from the shareholders' pre-emption rights and carry out a private
placement; in that case too the resolution must be supported by shareholders representing two
thirds of the votes cast and shares represented at the meeting.

In the event of a new issue against payment in cash or by set-off, the shareholders have pre-
emption rights to new shares pro rata to the number of shares held previously. Thus, the
shareholders are entitled to subscribe for, and be allotted, shares in the issue pro rata to their
previous shareholdings.

The Swedish legislator has not made use of the option laid down in Art. 41 (1) of the 2nd CLD
which allows member states to depart from the requirement of a shareholders’ resolution to
increase the capital to the extent that it is necessary for the adoption or application of
provisions designed to encourage the participation of employees in the capital of
undertakings.

In accordance with the 2nd CLD, the Swedish Companies Act requires the publication of the
shareholders’ resolution to increase the capital. All documents shall be available for the
shareholders and presented to the general meeting. The resolution shall be published within
six month after the resolution for registration in the Companies Register.

Authorised capital

The Swedish Companies Act uses the possibility of fixing authorised capital. If the statutes
state a minimum and maximum share capital, the board of directors can decide on a new issue
based on advance authorisation provided by the general meeting. Such authorisation, which is
often granted at the annual general meeting, may not extend for a period of time beyond the
next annual general meeting.

Other forms of capital increase

Another form of capital increases concern the capitalisation bonuses. A bonus issue means
that the share capital is increased through the contribution of an amount which is taken from
the statutory reserve, the revaluation reserve or unrestricted equity in accordance with the
most recently adopted balance sheet or through the value of a fixed asset being written-up.
The share capital increases without an external contribution of capital.

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A bonus issue may take place with or without new shares being issued. In the former case, the
new shares are allotted between the existing shareholders. In the latter case, the increase gives
rise only to an increase in the shares' quotient value.

In the event of a bonus issue in which new shares are to be issued, the shareholders have an
unconditional right to such shares pro rata to the number of shares previously held.

A resolution regarding a bonus issue must always be adopted by the general meeting. The
resolution is adopted by simple majority of the votes cast.

Contributions of premiums

Under Swedish Law it is permissible to fix premiums in capital increases. The only provision
of the new Swedish Companies Act is that the payment for shares may not be less than the
share’s quotient value. Quotient value means that each share represents an equally large
portion of the of the share capital. Shares may not be issued for a sum below the quotient
value. If shares are issued for a sum exceeding the quotient value, the premium must be set
aside in a special fund, the share premium reserve. This share premium reserve constitutes
non-restricted equity of the company, i.e. funds allocated to the premium reserve can be
distributed to shareholders in the same way as profits.

Mechanisms to ensure the contribution of capital

Subscription of shares

The Swedish Law is based on the principle that all shares need to be subscribed before the
capital increase may be registered. The subscription for new shares takes place on a
subscription list which contains the issue resolution. The documents presented to the general
meeting and a copy of the statutes must be attached to the subscription list. If all shares are
subscribed for by the persons entitled to subscribe at the time when the general meeting
decides on the new issue, subscription can take place through a simplified procedure, referred
to as simultaneous subscription. This means that share subscription takes place directly in the
minutes of the meeting.

A Swedish company may not subscribe to its own shares. Where the shares have been
subscribed for by a person on behalf of the company, the subscriber shall be deemed to have
subscribed for the shares on his or her own behalf.

Contributable assets/ paying in

Under Swedish law capital increases can be performed by contributions in cash and
contributions in kind. In the event of non-cash consideration, payment shall take place
through the property being separated and included in the company's property. An auditor must
issue a written, signed statement with respect to the payment verifying that non-cash
consideration has been provided to the company, that it is or may be assumed to be of benefit
for the company's operations and that it has not been reported at a higher value than the actual
value for the company. The statement should be registered with the Companies Register.

Within six months of the new issue resolution, the board must notify the resolution for
registration in the Companies Register, unless the resolution is ineffective due to insufficient
subscription. As a general rule, registration is conditional, among other things, on full

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payment having been made for all subscribed and allotted shares. In this respect, the Act does
not differentiate between payment in cash or contributions in kind.

Protection against over-valuation

Where shares are issued for a consideration other than in cash, Swedish law requires that a
report on the consideration other than in cash needs to be drawn up by an independent expert
before the company is incorporated.

Swedish Law determines that an auditor shall provide a written, signed statement in respect of
the payment. An auditor shall be any authorised public accountant or approved public
accountant or a registered accounting firm.

The Swedish Companies Act does not prescribe which methods of valuation are allowed.
However, the auditor shall describe the non-cash consideration and state the method of
valuation and also any special difficulties associated with the estimation of the value of the
property. Non-cash consideration may not be set higher than the actual value to the company.

Sanctions

As a consequence of incorrect financing, the company will not be registered and the
formation of the company lapses. The amounts paid for subscribed shares as well as accrued
income thereon, less costs incurred as a consequence of measures take, shall be repaid
immediately. This shall also apply to non-cash consideration.

The founders and the members of the board of directors shall be jointly and severally liable
for such repayment.

Pre-emption rights

The Swedish Companies Act provides for pre-emption rights against payment in cash or by
set-off in the context of capital increase. A pre-emption right confers the right to have new
shares pro rata to the number of shares held previously. Thus, the shareholders are entitled to
subscribe for, and be allotted, shares in the issue pro rata to their previous shareholdings.

Furthermore, the rule regarding pre-emption rights does not apply if the statutes contain
different provisions regarding pre-emption rights. If the company has shares which carry
different rights to the company's assets or profits or which carry different voting rights, the
issue of pre-emption rights in the event of a cash issue of new shares must be specifically
regulated in the statutes.

It is also possible to prescribe derogation from the main rule in the actual issue resolution – to
decide on a "private placement", for example to an external investor with full coffers.

The Swedish legislator provides for the possibility that the board of directors can decide on
the exclusion or reduction of pre-emption rights, if this decision is authorised or subsequently
ratified by the general meeting.

The general meeting’s resolution regarding the authorisation shall be notified immediately for
registration in the Company’s Register. Furthermore, an auditor’s review takes place and shall
apply with respect to the content of the board’s resolution.

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4.1.4.2.2 Economic analysis

None of the companies interviewed had recently performed a capital increase or disposes of
an authorised share capital. One company serviced its employee stock option programmes via
share buy backs.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.1.4.2.3 Protection of shareholders and creditors

The basic element of shareholder protection is the fact that the shareholders have to agree to
the ordinary capital increase or an authorisation to the board of directors to increase capital.
To ensure that equal treatment in contributions takes place, Swedish law prescribes the
drawing up of a report by an independent expert in case of contributions in kind to protect
shareholders against over-valuations and their consequences.

4.1.4.3 Distribution

4.1.4.3.1 Legal framework

Swedish distribution requirements can be categorised in provisions concerning the calculation

of the distribution, the procedural determination of the distributable amount and the
consequences of incorrect distributions.

Calculation of the distributable amount

The distributable amount is determined based on the concept of a value transfer. A value
transfer may not take place where, after the transfer, there is insufficient coverage for the
company’s restricted equity (“monetary barrier”). The calculation shall be based on the most
recent balance sheet taking into consideration changes in the restricted shareholders equity
which have occurred subsequent to the balance sheet date.

Notwithstanding this, under the “prudence rule” the company may effect a value transfer to
shareholders or another party only provided such appears to be justified taking into
consideration

- The demands with respect to size of shareholders equity which are imposed by the nature,
scope and risks associated with the operations and
- The companies need to strengthen its balance sheet, liquidity and financial position in
general.

Both circumstances are subject to a written statement from the board confirming compliance
to be presented to the general meeting when deciding upon distribution.

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Connection to accounting rules

The amount that can be distributed consists of two parts. Firstly, the reported net profit for the
financial year less obligatory reserves. Secondly, the non-restricted reserves or retained profits
which can serve for distributions. For a group of companies, the distributable amount for
dividend payment is determined as the lesser of distributable amounts available at the parent
company’s level or the distributable amount according to the group accounts.

In this context, the above mentioned “prudence rule” also plays a decisive factor in
determining the actual distribution. This requires specific considerations concerning the
company’s/group’s financial position, especially in view of cash flows.

Determination of the distributable amount – responsibilities

The board proposes a resolution to the general meeting. If the distribution is to be decided on
by the annual meeting the proposal is included in the annual report. The general meeting may
resolve upon the distribution of a larger amount than proposed or approved by the board only
where such an obligation exists in accordance with the statutes or where the distribution was
resolved upon at the request of a minority of shareholders.

If the decision of the shareholders is to be taken at a meeting other then the annual general
meeting (extraordinary general meeting), additional information is to be prepared/distributed.
The decision is nevertheless to be based on available capital according to the most recent
adopted balance sheet. The auditor of the company provides a statement to be presented to the
general meeting

The resolution by the general meeting must be taken with a simple majority at the annual
general meeting. The basis for this resolution is the profit and loss account, the balance sheet
and allocation of profits or losses as adopted by the general meeting. If taken at an general
meeting, the resolution on proposal comes from the board.

If the resolution has been adopted at the general meeting, the annual report shall be sent to the
Companies Register including an attestation on the resolution regarding profit or loss. If the
resolution has been adopted at an extraordinary general meeting, the resolution shall be
notified to the Companies Register.

Sanctions

Swedish law provides for different ways of challenging the distribution resolution. If the
challenge to the distribution resolution refers to an error that can be adopted with unanimous
consent of all shareholders, the challenge must be commenced within three months from the
date of resolution. If the challenge refers to an error that can not be adopted this way, there is
no time limitation.

4.1.4.3.2 Economic analysis

Due to the application of the “prudence rule”, Swedish law offers a universal approach for
value transfers to shareholders and other stakeholders. It obliges the management to assess
whether a dividend appears to be justified taking into consideration the demands with respect
to size of shareholders equity which are imposed by the nature, scope and risks associated
with the operations and the company’s need to strengthen its balance sheet, liquidity and

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financial position in general. Nevertheless, the overall administrative effort still seems not
overly burdensome and was at least partly seen as rather positive for the Swedish companies
concerned.

The actual payment of dividends may also present a major effort. However, the costs are
linked to capital market requirements and are depending on the number of shareholders.

Practical steps

Based on the legal analysis, the distribution of profits requires the following practical steps
which are the basis for the economic analysis.

Figure 4.1.4-6: Due process for distributing profits (Sweden)

Due process for distributing profits

Monitoring either preparation of annual accounts (annual meeting) and/or capital
Step 1
available for distribution (extraordinary shareholders meeting)
Monitoring proposal to be presented by the board (chapter 18, section 1). The
shareholders meeting may resolve upon the distribution of a larger amount than
Step 2 proposed or approved by the board only where
a) such an obligation exists in accordance with the statutes
b) the distribution was resolved upon at the request of a minority
The board establish a proposal for decision to be presented to the shareholders
meeting (chapter 18, sections 2-4), if the distribution is to be decided on by the
annual meeting the proposal is included in the annual report.
If the decision of the shareholders is to be taken at a meeting other then the annual
Step 3
meeting (extraordinary shareholders meeting), additional information is to be
prepared/distributed (chapter 18, section 5). The decision is nevertheless to be
based on available capital according to the most recent adopted balance sheet
(chapter 17, sec. 3)
The auditor of the company provides a statement to be presented to the
Step 4 shareholders meeting (chapter 9, section 32 (annual meeting) or chapter 18, section
6 (extraordinary shareholders meeting))
Invitation to attend shareholders meeting (chapter 7, section 18 and chapter 18,
Step 5
section 8)
Step 6 Proposal to be made available for the shareholders (chapter 18, section 7)
Resolution by the shareholders meeting (chapter 18, section 9)
- Annual meeting; the profit and loss account, balance sheet and allocation of
Step 7
profit or loss is to be adopted by the shareholders meeting (chapter 7, section 11)
- Extraordinary meeting; resolution on proposal from the board
If the resolution is has been adopted at the annual meeting, the annual report shall
be sent to the Companies Register including an attestation on the resolution
Step 8 regarding profit or loss (Annual Reports Act, chapter 8, section 3)
If the resolution has been adopted at an extraordinary shareholders meeting, the
resolution shall be notified to the Companies Register (chapter 18, section 10)

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Analysis

Calculation of the distributable amount

From an economic point of view, the establishment of the dividend proposal typically
involves the CFO and CEO and other selected high ranking company representatives
preceded by preparations in the company’s administration (treasury, tax and/or accounting
departments). The companies interviewed have defined dividend policies by distributing
certain percentages of their consolidated profits. Also the aspect of dividend continuity plays
a certain role.

The clear point of reference for the determination of the distributable amount is the
consolidated financial statements of the company, not the individual financial statements.

Depending on the structure of the company, it may be necessary to bring the consolidated
view in line with the disposable profits / cash at parent company level. For the companies
interviewed, this was of lesser importance as the main business lied with the parent company.
However, it was indicated to us that tax advantages in other jurisdictions may give incentives
not to transfer profit immediately to the parent company.

The results of a CFO questionnaire sent to Swedish companies listed on main indices
reconfirm this:

Figure 4.1.4-7: Determinants for the distribution of dividends in the holding company (Sweden)

"What are the determ inants for the distribution of dividends by your holding
com pany?"

5
4,22
Importance

3,64
4
4,10 3,26
2,96
3,57
Sw eden
3
3,06 2,16 2,21 EU Average
2 2,42 2,15 2,12
1
Fin. performance Financial Dividend Signalling device Credit rat ing Tax rules
(group performance continuity considerations
accounts) (individual
accounts of the
parent company)

Determ inants

Source: CFO Questionnaire, September 2007

However, concerning the importance of the current legal restrictions on profit distribution, the
CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market
led solutions like rating agencies’ requirements or bank covenants.

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Figure 4.1.4-8: Important deterrents when considering the level of profit distribution (Sweden)

"Which of the following deterrents are important for you when you
consider the level of profit distributions?"

3,44
4
Importance

3,00 Sw eden
3
3,29 2,29 2,25 EU Average
2,65
2
2,16 2,19

1
Distribution/Legal capital Rating agencies' Contractual agreements Possible violations of
requirements requirements with creditors (covenants) insolvency law

Deterrents

Source: CFO Questionnaire, September 2007

Concerning the determinants of distributions by subsidiaries, the results of a CFO

questionnaire show the importance of tax considerations:

Figure 4.1.4-9: Determinants for the distribution of dividends by the subsidiaries (Sweden)

"What are the determ inants for the distribution of dividends by your
subsidiaries?"

4,07
4
Importance

3,25
3,68 Sw eden
2,74
3
3,14 EU Average
2,74
2

1
Demands from t he ultimate parent Tax rules Own investment decisions

Determ inants

Source: CFO Questionnaire, September 2007

Connection to accounting rules

Due to the immediate link to the audited financial statements, the Swedish companies
interviewed considered it simple to determine the distributable amount. However, for
compliance reasons, both, the individual and consolidated accounts situation, needs to be
taken into account. The “prudence rule” also asks for the assessment of cash flows at
company and group level.

Furthermore, the compliance with the “prudence rule” requires a more detailed assessment of
the financial position of the company / group, especially from a cash flow perspective.

Determination of the distributable amount

The proposal for dividend distribution is part of a wider assessment by the board of directors
of the companies interviewed as already described in the previous section. The overall
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compliance effort amounts between 30 to 40 hours of highly qualified personnel. This figure
also includes time needed for the actual dividend proposal. However, these number are
individually determined for the companies interviewed and could easily change depending the
financial position and the complexity of the business of an individual company / group.

Other steps were considered to be non-incremental as they did not, from the companies’
perspective, originate from the compliance with distribution provisions such as the
preparation of the accounts, the annual audit and the holding of the annual general meeting.

Regarding cash-flow projections, the companies interviewed have a very detailed cash flow
planning for at least one year. However, this planning is based on internal rules on how to
prepare such projections and is clearly linked to the business needs of these companies. The
maximum projection period which allowed for serious estimations was considered between
three to five years, depending on the nature of the business of the company.

Sanctions

Concerning the efforts to comply with provisions concerning incorrect dividend distributions,
the companies interviewed considered the risk of liability for the company’s management as
rather low.

Related parties

Transactions with related parties may also be caught by the prudence rule as they may
constitute value transfers. This would require including such transactions in the assessments
to be made in this regard by the board of directors.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 30 – 40 - -
Hourly rate €100 €70 -
€3,000 – €4,000 - -
Total costs €3,000 – €4,000

4.1.4.3.3 Protection of shareholders / creditors

Both shareholders and creditors benefit from the introduction of the concept of value transfer.
The board of directors needs to give assertion via a statement that such transactions do harm
the financial position of the company. The obligation that the general meeting has to decide
on the allocation of the profit also leads to a high degree of shareholder protection.

4.1.4.4 Capital maintenance

Swedish law provides for different instruments dealing with capital maintenance. Among
these, are the provisions on the limitation of the acquisition by the company of its own shares
and the prohibition of financial assistance as well as the provisions on capital reductions, the
withdrawal of shares and the serious loss of the subscribed capital. The analysis also contains
the contractual self protection of creditors via covenants. It has to be noted that since the
enactment of the new Swedish Companies Act in 2006 transfers to shareholders and other
stakeholders generally fall under the prudence rule assessment by the board of directors. This
specifically includes the acquisition of own shares, reductions of the share capital or statutory

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reserve fund for repayment to shareholders and other business transactions of a non-
commercial nature that entail a reduction in the company’s assets.

4.1.4.4.1 Acquisition by the company of its of own shares

4.1.4.4.1.1 Legal framework

Even though as a general rule the acquisition of own shares is not allowed under Swedish law,
there are exceptions and permissions, mainly for Swedish public companies.

In general, the Swedish law provides that a company may not subscribe its own shares. This
shall also apply with respect to a subsidiaries’ subscription. Where a company has subscribed
for its own shares the management board shall be jointly and severally liable for payment.
Shares which have not been withdrawn through a reduction shall be disposed of as soon as
they may occur without loss, however not later than three years from the date of the
acquisition. Shares which have not been disposed of within this time frame shall be declared
void by the company.

General exceptions to acquire own shares are:

- shares for which is it not obliged to pay;
- included in business operations which are acquired by the company, where the shares
represent a small portion of the company’s share capital;
- redeem own shares in accordance with Ch. 25 Sec. 22 ABL;
- purchase at auction its own shares if the auction is held in the course of the execution in
respect of the company’s claims.

For Swedish public companies, a separate regime applies. A public company listed on a
Swedish or foreign exchange, authorised market or any other regulated market may acquire its
own shares in addition to the provisions above if the acquisition takes place on an exchange
and the company does not acquire more than one tenth of all shares in the company which is
in line with the provisions of the 2nd CLD.

In such case, a resolution regarding the acquisition shall be adopted by 2/3rds of both the
votes cast and the shares represented at the general meeting. In this respect a proposal is
necessary which states the period of time within which the resolution must be executed, the
number of shares, the consideration to be given for the shares and other conditions and terms.
As the acquisition of own shares constitutes a “value transfer”, the board of directors needs to
observe the “prudence rule”, i.e. an examination whether the planned value transfer is
justifiable bearing in mind the amount of equity required by the type and size of the business
and the risks it involves.

The Swedish Companies Act requires a resolution by 2/3 of the shareholders either to perform
an acquisition or to delegate to the board of directors to perform the acquisition.

As provided for by the 2nd CLD – Swedish Law determines the maximum and minimum
consideration for the shares as well as the value of shares to be acquired which may not
exceed 10% of the subscribed capital. After the acquisition there must be full coverage for the
company’s restricted equity. Shares acquired in breach of these provisions shall be disposed
of within six months from the date of the acquisition.

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4.1.4.4.1.2 Economic analysis

From a company law perspective, most efforts go into the proposal for the authorisation to
purchase the company’s own shares. However, the actual buyback of shares may entail much
higher costs. Unfortunately, we have not received detailed data on this from the Swedish
companies interviewed, but have similar experiences in other EU countries. Nevertheless,
only incremental costs invoked by company law are relevant to this analysis. Thus, these costs
resulting from securities legislation are remarkable - but not from an incremental cost
perspective.

Practical steps

To acquire its own shares a company has to follow this process:

Figure 4.1.4-10: Process for the acquisition of own shares (Sweden)

Acquisition of own shares

Step 1 Monitoring amount available for value transfers (chapter 19, section 22)
The board establish a proposal for decision to be presented to the shareholders
meeting (chapter 19, section 19). The proposal includes, but is not limited to, the
manner in which the shares shall be acquired, the numbers of shares/classes of
shares to which the offer shall relate, consideration to be given and other terms and
conditions for the acquisition (chapter 19, sections 20-21).
Step 2 If the decision of the shareholders is to be taken at a meeting other then the annual
meeting, additional information is to be prepared/distributed (chapter 19, section
23).
- It is possible for the shareholders meeting to authorise the board to adopt a
resolution regarding acquisition/selling of own shares (chapter 19, sections 17 and
33)
Step 3 Notice to attend shareholders meeting (chapter 19, section 26)
Step 4 Make proposal available to the shareholders (chapter 19, section 25)
Resolution by the shareholders meeting (chapter 19, sections 27 and 28
Step 5
(authorisation))
Monitoring acquire/selling of own shares (chapter 19, sections 13- 15 (acquire)
Step 6
and sections 31-32 (selling)

Analysis

In order to propose a share buy back, the management of the company needs to assess the
“value transfer” linked to the share buy back. In doing this, the board of directors needs to
observe the “prudence rule”, i.e. an examination whether the planned value transfer is
justifiable bearing in mind the amount of equity required by the type and size of the business
and the risks it involves. In the course of the interviews, it was stated that the compliance with
the prudence principle a detailed assessment of the company’s financial position both from a
net assets as well as a cash perspective within the individual legal entity and the group.
However, as the authorisation is usually given in the same shareholder assembly which also
decides on the dividend distribution, both value transfers, i.e. the buyback and the dividend,
are assessed at the same time. One company assessed this effort as very positive for the
company as it helps the management of the company to take conscious decisions in this

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regard. The combined effort amounts to about 32 hours of high qualified work. This also
includes the proposal to the shareholder which is regularly an update of pre-existing
documents and, thus, requires an insignificant effort

The holding of the shareholders’ annual meeting is considered a non-incremental effort as this
also serves other purposes.

The actual buyback may be handled differently from company to company. It is normally
commissioned to banks and it depends on the company how closely it is involved in the
buyback process. We have not received detailed data on the costs of the banks in this regard.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.1.4.4.1.3 Protection of shareholders and creditors

Concerning shareholder protection, it must be noted that the shareholders have to authorise
the acquisition of the shares by a resolution. If shares have been purchased, different
shareholder and creditor protection rules are applicable. Of importance are, for example, the
provisions which prescribe that all rights attached to the acquired shares are suspended.

4.1.4.4.2 Capital reduction

4.1.4.4.2.1 Legal framework

The Swedish Companies Act provides for the possibility of a decrease in capital. In
accordance with the 2nd CLD, a decrease in capital is subject to a shareholders’ resolution. A
general meeting must therefore be called. A proposal to reduce the capital must be set down
in the agenda for the general meeting. The resolution must be passed with a majority of at
least 2/3 of the votes cast and shares represented at the general meeting – the same majority
requirement applies within classes of shares.

In accordance with the 2nd CLD the resolution must specify the purpose of the reduction in
capital, particularly whether it serves to return capital to shareholders or to cover losses where
unrestricted shareholders’ equity equal to the loss is not available or for transfer to a fund to
be used pursuant to a resolution adopted by the general meeting and, furthermore, the way in
which the capital reduction is to be effected – with or without withdrawal of shares.

The capital reduction is also subject to the “prudence rule”, whereby the board of directors
has to examine whether the planned value transfer is justifiable bearing in mind the amount of
equity required by the type and size of the company.

In line with the 2nd CLD the Swedish Companies Act requires the board to register the
resolution with the Companies House within 4 months.

4.1.4.4.2.2 Economic analysis

Within our sample of Swedish companies, we have not encountered any capital decreases.

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4.1.4.4.2.3 Protection of shareholders and creditors

Regarding the shareholder and creditor protection existing with respect to capital reductions,
it is of utmost importance that the shareholders have to agree to the capital reduction with a
qualified majority.

4.1.4.4.3 Withdrawal of shares

4.1.4.4.3.1 Legal framework

In Sweden, there is no general regulation on compulsory withdrawal, but the statutes may
provide a redemption clause. However, a court may order the company to buy-out the shares
of a shareholder. This is a remedy available to the court following fraud on minority
shareholders.

4.4.4.3.2 Economic analysis

In the course of the interviews conducted, we have not been made aware of cases of
compulsory withdrawals.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.1.4.4.3.3 Shareholder and creditor protection

Minority shareholder may be protected via the statutes or a court decision.

4.1.4.4.4 Financial assistance

4.1.4.4.4.1 Legal framework

In Sweden, the amendments of the 2nd CLD Directive 2006/68/EC have not been
implemented into national law. However, a parent company may provide financial assistance
to a third party buying shares in a subsidiary (Ch. 21 Sec. 5 ABL).

4.1.4.4.4.2 Economic analysis

As the changes to 2nd CLD have not taken effect, we have not been able to identify such cases
with the Swedish companies interviewed.

4.1.4.4.5 Serious loss of half of the subscribed capital

4.1.4.4.5.1 Legal framework

If there is reason to believe that more than 50% of the capital has been lost, the board must
prepare a special balance sheet for liquidation purposes. If the balance sheet shows that there

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is less than 50% of the share capital remaining, the board has 8 months to restore the
shareholders capital.

4.1.4.4.5.2 Economic analysis

The Swedish companies interviewed spent very little time on the monitoring of this provision
on the serious loss of subscribed capital. In general, they would see a significant increase in
monitoring activity, if the financial position of the company showed indications that such a
situation could actually occur. The management of the companies interviewed normally use
their normal internal reporting and risk management systems to monitor the financial position
of the company/group. This would give them sufficient lead time to recognise critical
situations.

4.1.4.4.5.2 Shareholder and creditor protection

The provisions dealing with the serious loss of the subscribed capital have a shareholder and
also creditor protective character, as it sets conscious time limits to the companies’ directors
to take action on the worsening financial position of the company.

4.1.4.4.6 Contractual self protection

4.1.4.4.6.1 Legal framework

There is no regulation in Sweden concerning self protection of creditors respectively

covenants.

4.1.4.4.6.2 Economic analysis

The Swedish companies interviewed are exposed to covenants in connection with bank loans.
These covenants do not directly limit distributions. They rather aim at limitations concerning
the disposal of assets as well as cash-flow related ratios and change of control clauses. The
strictness of the covenants depends on the credit rating of the company. The companies
interviewed considered them easy to comply with as they could be determined in a simple
manner by referring to annual account figures.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.1.4.4.6.3 Shareholder and creditor protection

Covenants result from negotiations of major creditors with the companies willing to take
loans. These protections are not primarily designed for smaller creditors and shareholders.
However, they may benefit from them.

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4.1.4.5. Insolvency

4.1.4.5.1 Legal framework

The issue of insolvency is not regulated in the Swedish Companies Act, but in the Insolvency
Act. In general terms, a Swedish company is insolvent when it is not in a position to pay it
debts when due and when this incapacity is not temporary.

4.1.4.5.2 Economic analysis

The Swedish companies interviewed spent very little time on the monitoring of this provision
on the serious loss of subscribed capital. In general, they would see a significant increase in
monitoring activity, if the financial position of the company showed indications that such a
situation could actually occur. The management of the companies interviewed normally use
their normal internal reporting and risk management systems to monitor the financial position
of the company/group. This would give them sufficient lead time to recognise critical
situations.

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4.1.5 United Kingdom

4.1.5.1. Structure of capital and shares

4.1.5.1.1 Legal framework

As regards equity financing by shareholders, the UK Companies Act 2006 (CA 2006) is based
on the subscribed capital and on share premiums. According to s 542(1) CA 2006, shares
must each have a fixed nominal value. An allotment of a share that does not have a fixed
nominal value (no-par value share) is void.

Structure of capital

Subscribed capital

Under the UK Companies Acts, a public company is required to have an authorised minimum
share capital of £50,000. The authorised share capital, to which this minimum applies, is an
upper limit, set out in the statutes, as to the aggregate nominal value of shares which the
company may have. It need not allot all of this capital at incorporation (formation). The
founders are entitled to freely fix a higher capital amount. The called-up share capital is not
available for distributions to shareholders.

Under the Companies Act 1985, founders of a public limited company are required to state in
the memorandum of association the amount of the share capital with which the company
proposes to be registered and the nominal amount of each of its shares. This is known in the
UK as the "authorised share capital" and acts as a ceiling on the amount of capital which can
be issued - although the limit may be subsequently raised by members’ ordinary resolution.
Under the Companies Act 2006 the requirement for a company to have an authorised share
capital is abolished. However, the founders of the company are free to limit the maximum
share capital in the statutes.

Premiums

The British UK Companies Acts do not require the possibility of fixing premiums, yet such
possibility is implicit in national law. Hence, the terms of a company’s statutes could require
that its shares be allotted only at a specified premium. The amount of the premium is the real
value (i.e., not accounting values) of the assets’ contributed in excess of the nominal value of
the shares (Shearer v Bercain Ltd [1980] 3 All ER 295).

If the company decides to issue shares at a premium, the premium must be added to the “share
premium account”. Exceptions are for share-for-share transactions and subscription of non-
cash assets intra-group (provided the subscriber and the issuer are within a wholly owned
(portion of the) group). The share premium account is treated in virtually all respects as if it
were subscribed capital. Thus, the share premium account is not available for distributions); if
however it is dissolved in accordance with the rules on a formal reduction in capital, then the
amount may be used to offset a deficit of distributable reserves or, unless the court specifies
otherwise in the course of the reduction process, to create a surplus available for distribution;
this latter is currently a matter of legal analysis but is expected to be codified in secondary
legislation under powers set out in the 2006 Act. Moreover, UK law requires that premiums
on formation must be in cash.

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Protection of the public company’s assets

There is no statutory facility to return funds to shareholders other than by way of one of the
2nd CLD exceptions or by way of distribution.

Structure of shares

Under UK law shares must have a nominal value. The possibility of the 2nd CLD to allow the
issuance of shares with an accountable par has not, therefore, been included in national law.

4.1.5.1.2 Economic analysis

Practical relevance of subscribed capital and structure of shares for an assessment of the
viability of a company

The UK companies interviewed did not see any specific benefit of the legally imposed
minimum subscribed capital of £50,000 for different reasons. Creditors would rather rely on
other instruments such as covenants to secure their outstanding balances. Some companies
remarked that this low number should rather be increased for listed companies. One
respondent believed that the minimum capital requirement would rather drive his group to
transform its UK subsidiaries into Ltds to be able to abandon the legal capital regime for
PLCs. Another respondent remarked that it may be a theoretical sign of solidity and substance
but in practice had no merit.

Concerning the par value of shares, most of the UK companies interviewed generally did not
see a specific merit. The companies are able to live with the concept but missed the practical
relevance. One argument was that there is no fundamental difference between subscribed
capital and share premiums as neither can generally be distributed.

To verify the relevance of the subscribed capital figure for equity financing, we have
additionally performed an analysis of certain ratios concerning subscribed capital for the main
UK index FTSE 100:

Figure 4.1.5-1: Ratio of subscribed capital to market capitalisation (United Kingdom)

UK: Subscribed Capital to Market

Capitalisation
4%

3%

10% < 5%
5%- 10%
10%- 20%
24% 59% 20%- 30 %
> 30%

Source: One source: Subscribed capital for the FY 2005, market capitalisation as of September 2006

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Compared to the market capitalisation, the subscribed capital shows even a lower portion. For
59 percent of the FTSE 100 companies the subscribed capital represents less than 5 percent of
their market capitalisation. Thus, the overall importance of subscribed capital figure seems to
be marginal.

Restriction for distribution

However, the UK companies interviewed did not particularly question the distribution
restrictions implied by the concept of legal capital.

The latter was also reconfirmed by results from the CFO questionnaire sent to UK public
companies.

Figure 4.1.5-2: CFO survey results: necessity of subscribed capital (United Kingdom)

"In general, w e do not consider

stated/subscribed capital to be necessary; it
unnecessarily reduces our com pany's
flexibility to distribute excess capital."

10%
True
41%
False
48% NA

Source: CFO questionnaire, September 2007

48 percent of the respondents considered the existence of subscribed capital to be necessary.

This view was opposed by 41 percent of the respondents

However, according to the respondents to the CFO questionnaire there is no interest in

excessive restrictions on distributions:

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Figure 4.1.5-3: CFO survey results: level of subscribed capital (United Kingdom)

"The com pany's m anagem ent considers it

advantageous to increase the level of
stated/subscribed capital to the highest
possible extent because it should not serve
for distributions."

3%
10% True
False
NA
86%

Source: CFO questionnaire, September 2007

A clear majority of 86 percent of the respondents rejected the idea of increasing the level of
subscribed capital to the highest extent possible to avoid distributions.

Role of the subscribed capital in equity financing

The subscribed capital figure as part of the wider equity of the company is necessary for the
financing of the company. According to the companies interviewed, the subscribed capital is
not sufficient for the equity financing of the operations of the company.

For FTSE 100 companies, the ratio of subscribed capital to total shareholders’ equity shows
that for 84 percent of the FTSE 100 companies the subscribed equity portion stays under 20
percent of total shareholders’ equity.
Figure 4.1.5-4: Ratio of subscribed capital to total shareholders’ equity (United Kingdom)

UK: Subscribed Capital to Total

Shareholder's Equity

10%

6% < 5%
36%
5%- 10%
20% 10%- 20%
20%- 30 %
> 30%

28%

Source: One source: Subscribed capital for the FY 2005, shareholders’ equity (consolidated) for the FY 2005

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This underpins that the equity financing is not largely dependant on the subscribed capital and
that there is a sufficient equity base in the FTSE companies and their subsidiaries to allow for
adequate distributions. The existence of a subscribed capital does seem to be a stumbling
block for the FTSE companies in their approach to equity financing and distribution policy
from a group perspective.

The following answers to the CFO questionnaire concerned the attitude of companies to
capital increases:

Figure 4.1.5-5: CFO survey results: Attitudes towards increases of subscribed capital (United Kingdom)

"Our com pany intends to keep its m axim um

flexibility and w ill try to m inim ise the portion
allocated to stated/subscribed capital to the
am ount strictly necessary for legal or other
reasons."

10%
True
21%
False
69% NA

Source: CFO Questionnaire, September 2007

69 percent of the respondents stated that they usually try to keep the level of subscribed
capital to the minimum amount necessary. Only 21 percent of the respondents opposed this
view.

These responses show that companies are generally not interested in a dominant role of
subscribed capital in equity financing.

Subsequent formations

The UK companies interviewed are already in existence for a longer period. Therefore, it was
neither feasible nor useful to extract data on the initial foundation of these companies. This is
also true for the application of rules concerning subsequent formations.

4.1.5.2 Capital increase

4.1.5.2.1 Legal framework

According to the 2nd CLD, UK law differentiates between different forms of capital increase
and mechanisms which ensure that the subscribed capital is contributed to the company.

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Increase in capital

1985 Act

Under the 1985 Act the initial authorised share capital is established in the memorandum of
association required on the formation of the company. The memorandum must state the
amount of share capital with which the company purposes to be registered and the different
classes of the share capital into shares of fixed amounts (i.e. the nominal amount of each class
of each share). This authorised share capital is a limit upon the capacity of the company itself.
This is different from the question as to the authorisation of the directors to allot of such of its
authorised share capital that is not yet allotted; this authorisation corresponds with that set out
in Article 25 of 2nd CLD. Under the 2006 Act, there is no authorised share capital. Under the
1985 Act following the initial establishment of the authorised share capital, a company can
increase its authorised share capital by passing an ordinary resolution (unless its statutes
require a special resolution) in a general meeting of its members. A copy of the resolution and
a notice of the increase must be filed on the public registry. There is no maximum amount of
share capital established by UK law nor is there any period for which the increase occurs –
the increase is (except in the case of reduction) permanent. There are however time limits on
the actual allotment of share capital as discussed below. Under the 1985 Act, even though a
company will have authorised share capital, the directors of the company do not have
complete power to issue additional shares up the amount of the authorised share capital. The
Act requires that in order for the directors to have such powers they need either consent of the
shareholders (by the passing of an ordinary resolution by its general meeting – at which the
different classes of shares have such voting rights as are set out in the statutes) or be so
authorised within the statutes of the company. These powers granted are limited as the
resolution is required to contain the maximum of shares that can be issued under that
resolution and that the period of authority cannot exceed five years from the date of the
resolution.

2006 Act

Under the 2006 Act, the directors of the company do not have complete power to issue
additional shares. The Act requires that in order for the directors to have such powers they
need either consent of the shareholders (by the passing of an ordinary resolution by its general
meeting – at which the different classes of shares have such voting rights as are set out in the
statutes) or being so authorised by the statutes of the company. The powers granted under the
2006 Act are limited as the resolution is required to contain the maximum of shares that can
be issued under that resolution and that the period of authority cannot exceed five years from
the date of the resolution. When shares are actually allotted notification must be filed on the
public registry within a month of the allotment.

Other forms of capital increase

Under the 2006 Act the company may allot bonus shares to its existing shareholders applying
amounts previously credited to the share premium account, the capital redemption reserve, a
revaluation reserve or, subject to the statutes, out of its unrealised or realised profits. The
allotment is in essence a form of distribution.

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Contribution of premiums

UK law allows the use of share premiums in the context of an increase in capital. The share
premium account is treated in virtually all respects as if it were subscribed share capital.

Mechanisms to ensure the contribution of capital

Subscription of shares

The 2006 Act prohibits shares being allotted by a public company pursuant to an offer for
subscription unless all shares issued are subscribed for or the terms of the offer state
otherwise. If the shares are not fully subscribed, the company has to return the monies
received to the applicants. Furthermore, the 2006 Act prohibits a company from acquiring its
own shares via subscription and extends this prohibition to its subsidiaries. In accordance with
the 2nd CLD, UK law prescribes that they are issued at a discount off their nominal amount.

A subscription of new shares does not require any change to the statutes unless, under the
1985 Act, it is necessary to increase the authorised share capital (statement of the total
maximum capital and the classes and numbers of shares into which it is divided) to facilitate
the subscription. Under the 2006 Act there is no concept of authorised share capital. Under
both Acts it is, however, necessary to furnish a return of allotment to the registrar of
companies, detailing the number and nominal value of shares allotted, the allotees and the
consideration paid or payable.

Contributable assets / paying in

UK law requires that shares which are allotted by a company may be paid up in money or
money’s worth (including goodwill and know-how). Only a quarter of the nominal value,
along with the full amount of any premium, must be paid-up on allottment.

Protection against over-valuations

If shares are to be paid for other than in cash (as required by the 2nd CLD), a valuation report
is generally required before the shares are allotted. The report must state the nominal value of
the shares to be wholly or partly paid for by the consideration in question, the amount of any
premium payable on the shares, the description of the consideration, the method used to value
it, the date of valuation and whether the value covers the nominal value of the shares and any
premium proposed to be treated as paid up by the consideration.

Sanctions

If a share is allotted at a discount to nominal value, the allottee is liable to pay up the discount
in cash with interest at the appropriate rate. In the same way the allottee of a share allotted for
less then one quarter paid-up or less then the full amount of any premium, must pay the
shortfall in cash with interest. If the valuation report requirements (for non-cash
consideration) are not complied with, the allottee is liable to pay the subscription price in
cash. The company and any officer in default in incorrect financing are liable to a fine.

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Pre-emption rights

UK law on pre-emption rights in the context of capital increases. The rights relate only to the
allotment for cash of equity shares (shares carrying unrestricted rights both as to income and
capital) or of securities that are convertible into such shares or that carry the right to subscribe
for such shares. In addition the Act provides that the pre-emption rights may be excluded. The
law governing such exclusion provides that when the directors are being authorised to issue
the shares they may seek authority from the shareholders to exclude the pre-emption rights. In
order to be granted such powers, the shareholders of the company are required to pass a
special resolution (75% majority) at a general meeting. Alternatively the statutes may provide
that pre-emption rights are automatically excluded where an allotment authority is granted.
Furthermore, UK law contains the requirement that any permission can be given with a
limited life (it cannot be longer than the outstanding period of the Section 80/ 551 authority –
itself limited to five years) and hence the permission will cease if revoked or if it expires
(without being renewed).

4.1.5.2.2 Economic analysis

Capital increases can be very complex and require – especially in view of securities
regulations – a high level of internal efforts and external costs. Lighter procedures come into
play in connection with employee stock option programmes which are, from a compliance
perspective, very easy to handle and involve few burdens. There are regularly shareholder
pre-approvals for such increases.

The increase in capital was used by the interviewed companies for major capital increases or
acquisitions.

Practical steps

The following chronological order of practical steps would be necessary for such an ordinary
capital increase:

Figure 4.1.5-6: Process for ordinary capital increase (United Kingdom)

Ordinary capital increase

Proposal of the board on how the company should be financed (amount of
Step 1
capital to be issued and allotted, amount of premiums)
Invitation to general meeting to approve increase in authorised share capital (only
Step 2 required in cases in which the authorised capital does not suffice), to give directors
authority to allot shares and on pre-emption rights
Ordinary resolution[s] by shareholders on increase in authorised share capital, if
Step 3
needed, and authority to allot shares
Special resolution by shareholders on pre-emption rights in case of cash
Step 4
consideration
Filing of resolution approved by shareholders’ meeting and appropriate form with
Step 5
the Registrar of Companies
Step 6 Issuing of shares and filing requirements

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Analysis

UK companies interviewed have not volunteered detailed information on such capital

increases. We have received some total cost numbers which range between £6,000,000 to
£9,000,000. Internal preparation can consume around 5,400 hours of highly qualified
personnel. However, it should be kept in mind that these figures relate to very specific
circumstances. The high costs are, to a large extent, also necessary to comply with securities
market regulation.

In practice, four UK companies interviewed regularly consult the general meeting for an
approval of capital increases, mainly for employee stock option programmes. Of these
companies, one has not made use of the authorisation.

From a procedural point of view, it is mainly a repetitive shareholder resolution which the
company reuses when it comes to the renewal. According to the estimates received the use of
internal resources amounts to from 1 to 10 hours, partly highly and less qualified personnel,
depending on the individual circumstances as well as the culture and organisation of the
company. In one case, we received information concerning the engagement of external legal
advisors charging around £5,000 to £10,000. The effort required is not linked to the size
(market capitalisation) of the company.

Due to the specific nature of the capital increases for stock options, the actual increase of
shares is not overly burdensome. It requires between 1 and 80 hours of usually highly
qualified personnel. Again, the workload and costs can vary from company to company
depending on the individual circumstances.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 2 to 90 - -
Hourly rate €100 €70 -
€200 to €9,000 - €7,403 to €14,806
Total costs €7,603 to €23,806

Mechanisms to ensure the contribution of capital - contributions-in-kind

None of the interviewed companies provided us with information on practical experiences

with contributions in kind because it was irrelevant for them in recent years.

Practical steps

With respect to contributions in kind effected during a capital increase the following steps
have to be taken under UK law:

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Figure 4.1.5-7 Process for the injection of contributions (United Kingdom)

Injection of contributions
Step 1 Decision by the company as to number of shares to be issued and allotted
Step 2 Determination of issue price (nominal price is fixed, the premium is variable)
Monitoring if assets to be contributed are those the company may accept as
Step 3
consideration for the shares allotted
Step 4 Performance of valuation process with respect to contributions in kind
Step 5 Filing of report
Monitoring of subscription and allotment (no subscription by the company, in
Step 6 cases in which the offer for subscription does not state otherwise, no allotment of
shares unless all shares offered have been subscribed for)
Step 7 Monitoring that shares are not issued under the nominal value
Step 8 Filing of documents with registrar

Analysis

Unfortunately, we were not able to retrieve any specific recent cost information on practical
cases of contributions in kind during our interviews with UK companies.

4.1.5.2.3 Protection of shareholders and creditors

Regarding the provisions on capital increase, one can draw the following conclusions under
the aspect of shareholder and creditor protection. Firstly, it should be noted that the
requirement that the shareholders according to the 2006 Act have to agree to the capital
increase has a shareholder protective character. Furthermore, the provisions on the
authorisation of the board contain elements which are shareholder protective as the
authorisation must be stated in the statutes. The fact that the authorisation period is limited to
five years and that the general meeting has to fix the maximum amount of shares that can be
issued are shareholder protective. In this respect, UK law contains further protective
provisions, as it is necessary to furnish a return of allotment to the registrar of companies,
detailing the number and nominal value of shares allotted, the allottees and the consideration
paid or payable. The 2006 Act also requires a statement of capital to be furnished to the
registrar, detailing the post-allotment share capital of the company (number, nominal value,
amounts paid-up including premium and share rights). To ensure that equal treatment in
contributions takes place, UK law prescribes the drawing up of a report by an independent
expert in case of contributions in kind to protect shareholders against over-valuations and
their consequences. Under the aspect of shareholder protection, the mandatory pre-emption
rights for contributions in cash are furthermore of importance as they prevent dilution.

4.1.5.3 Distributions

4.1.5.3.1 Legal framework

UK provisions on distributions differentiate between provisions dealing with the calculation

of the distributable amount, the determination of the amount to be distributed and the
consequences of incorrect distributions.

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Calculation of the distributable amount

Under UK law, a public company may not make a distribution if, at the time of the
distribution or to the extent that immediately after the distribution, its net assets are less than
the aggregate of its called-up share capital and (defined) undistributable reserves. A
company’s undistributable reserves are i) the share premium account (i.e. that pursuant to
Article 26, ii) the capital redemption reserve (i.e. that pursuant to Article 39(e)), iii) the excess
amount of unrealised profits over unrealised losses, iv) any other reserve which is prohibited
from being distributed by another enactment or by its statutes. The redenomination reserve
(which exists only under the 2006 Act) is also undistributable. Net assets mean a company’s
total assets (not including uncalled share capital) less its total liabilities (including provisions)
as shown in usually the last annual accounts under the 4th CLD.

Furthermore, it should be noted that, under UK law, a public company can only make
distributions out of its accumulated, realised profits, so far as not previously distributed or
capitalised, less accumulated, realised losses, so far as not previously written off in a
reduction or reorganisation of capital. The maximum amount that can be distributed under this
principle (and under (aa)) is determined by reference to the profits, losses, assets, liabilities
and share capital and reserves as stated in (usually) the company’s annual accounts, under the
4th CLD, laid before members in general meeting.

A profit is a realised profit if it is generally accepted as so for accounting purposes. Pursuant

to that section there are various pieces of authoritative accounting guidance in relation to
determining what profits are realised, issued by the Institute of Chartered Accountants in
England and Wales (ICAEW) jointly with Institute of Chartered Accountants of Scotland
(ICAS). These are listed in the general information section of this document.5 Put simply,
whilst the starting point for determining realised profits is the accounts profits, this is far from
the end of the matter. First of all not all accounts profits may be realised. Second, some
accounting losses may not be losses for the purposes of company law (e.g., accrual of capital
repayment, on liability classified preference shares, presented as an interest charge on a
liability). Third, some items are profits as a matter of law but not for accounting purposes
(e.g., contribution of capital otherwise than for share capital). Thus the accounting profits
must first be adjusted to add in some items and take out others; and then what is left must be
further narrowed down to leave only the realised items. Put briefly, and subject to the
question of fair value accounting, something is realised if is in the form of cash, an asset
readily convertible to cash, a debtor meeting certain conditions or elimination of a liability
(collectively, called Qualifying Consideration). In relation to fair value accounting, the key is
whether the asset or liability that is so accounted is itself readily convertible into cash. This
requires that an asset can be immediately cashed-in, e.g. by being able to close out the
position; that observable market data for this are available; and that the company can actually
dispose of/ close out the position, e.g. without needing to curtail its business or accept adverse
terms.

Taking the net assets and earned surplus tests together, the effects of accounting under IAS 32
(and its UK equivalent – FRS 25 – applied in annual accounts of companies that do not adopt
IFRS) are complex and a source of difficulty in application. The ICAEW guidance in this area
(TECH 2/07) devotes considerable material to this topic. The effect of IAS 32 is in some
cases to recognise a liability in relation to a share (typically a preference share) or in relation
to a written option to acquire the company’s own shares in the future. The first complicates
5
Cf. s275 (1985), s841 (2006) for guidance on realised profits and losses for revalued fixed assets. Cf. s268
(1985); s843 (2006) for guidance on realised profits for insurance companies with long term business.

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the operation of the net assets test but does not necessarily change its result: since share
capital and net assets are to be determined according to the accounts, both are reduced
equally. On the other hand, the latter case restricts distributions. This is because when the
liability to purchase the share is recognised, net assets are reduced and a debit is taken directly
to reserves. The debit does not fall to be included (as a deduction from) share capital and
undistributable reserves and thus distributions are restricted (net assets are reduced but share
capital etc. is not). This is so notwithstanding that the debit is not, as a matter of law, a loss
and thus cannot be a realised loss. (It is not a loss because, as a matter of law, the amount is
the advance recognition of a future capital repayment or distribution.) Thus not only are the
rules difficult to comprehend and apply in the context of modern accounting practice, but they
have an adverse effect on companies’ distributable reserves.

Modern accounting practice is also having the effect of including ever more fair values in the
accounts. This has the effect of straining or creating a disconnect between accounting profits
and distributable profits on the realised earned surpluses test. As a result, there is a strong
climate of opinion in the UK (e.g., it is the position of the ICAEW that the usefulness and
operability of a distribution test based upon accounting measures (including pursuant to IAS
32) calls for a fundamental re-appraisal of the distribution regime with the aim of breaking
that link.

Connection to accounting rules

The balance sheet profit is determined with reference to the annual accounts which must be
drawn up in accordance with national UK GAAP or IFRS. The annual accounts must be
audited except where the company is considered to be small.

As under UK law, a public company can only make distributions out of its accumulated,
realised profits, the question whether a profit is considered as “realised” is of the utmost
importance. An accounting profit under UK GAAP is not immediately considered as
“realised”. There are various pieces of authoritative accounting guidance in relation to
determining what profits are realised, issued by the Institute of Chartered Accountants in
England and Wales (ICAEW) jointly with Institute of Chartered Accountants of Scotland
(ICAS).

Determination of the distributable amount – responsibilities

Under the standard Table A statutes (the default statutes of a company under the CA 1985
unless it adopts something different), a distribution can be decided on by the directors or be
declared by the members in general meeting by a simple majority. In the latter case the
amount must not exceed that recommended by the directors.

As regards the content of the resolution, there is no specific national provision. The resolution
will be documented in the minutes of the board or general meeting (as appropriate). In the
case of a dividend to be approved by shareholders, typically the amount of the proposed
dividend per share, the date on which the dividend will be paid and the date on which the
shareholder must be included on the company’s register of shareholders to be entitled to the
dividend, will be given.

The distribution would be considered unlawful unless it is supported by the accounts. There is
no specific procedural requirement to check the accounts, but sanctions apply if the
distribution is unlawful. But note that if the accounts relied upon are the annual accounts (4th

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CLD), they must first be laid before the general meeting; if they are interim accounts, they
must be filed on the public registry.

Sanctions

UK law provides for different instruments for the case that the distribution was not in line
with the aforementioned provisions. Firstly, if an illegal distribution has been made this
would give rise to a claim by the company against the recipients of the dividend who knew or
have reasonable grounds for believing that the distributions are unlawful. There is also the
possibility under case law for recovery to be sought from the directors, cf. recovery for an
illegal distribution to be sought from the directors - Bairstow vs Queens Moat Houses Plc
[2001] 2 BCLC 531. Where a member receives an unlawful distribution and at the time of the
distribution, he knew or had reasonable grounds to know that the distribution had been
unlawfully made, he is liable to repay it. See s277(1985); s847 (2006).

4.1.5.3.2 Economic analysis

The actual UK practice of profit distributions pointed to some particularities which we did not
encounter in other EU jurisdictions. One particularity of the UK system is the fact that the
differentiation between accounting profits and realised profits causes the companies to make
adjustments to their accounting figures under UK GAAP. With one exception, IFRS are not
used by the UK companies interviewed for specific reasons. This reconciliation requirement
may be difficult to comply with depending on the extent that the companies use fair value
measurements in their accounts.

Severe practical problems and burdens for the companies seem to be linked to the necessity to
channel sufficient profits and cash up to the parent company. Every few years, some of the
interviewed companies spend enormous amounts of time and external costs to secure
sufficient profit and cash levels at the parent company in order to distribute dividends.
However, it is debatable if these efforts are actually linked to company law requirements or
whether they are rather driven by tax optimisation efforts. We have encountered similar
practical needs in other EU Member States but were not pointed to severe burdens in this
respect.

The most efforts of the company concern the preparation of the dividend proposal for the
board. The actual payment also may present a major effort. However, the costs are linked to
capital market requirements and depend on the number of shareholders.

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Practical steps

The series of practical steps comprises:

Figure 4.1.5-8: Due process for distributing profits (United Kingdom)

Due process for distributing profits

Step 1 Directors establish the value of the distribution they wish to make
Directors consult the relevant accounts of the company and authoritative
Step 2
accounting guidance to see if sufficient distributable reserves exist.
Directors consider whether circumstances have arisen subsequent to the date of the
Step 3 relevant accounts which have reduced the distributable reserves calculated in step
2.
If required following Step 3, the directors revise the value of the distribution they
Step 4
wish to make.
Where insufficient distributable reserves exist to cover the amount to be
Step 5 distributed, but profits have subsequently been earned and assets have built up
accordingly, directors draw up properly prepared interim accounts.
Step 6 The interim accounts are filed with the registrar
Dividend is either approved by the Board (ALTERNATIVE A) or declared by
Step 7
shareholders in general meeting (ALTERNATIVE B)

ALTERNATIVE A: Dividend authorised by the directors

Figure 4.1.5-9: Process of dividend distribution authorised by the directors (United Kingdom)
Step 8 Board meeting of the Directors held
Step 9 Board resolves to pay the dividend
Step 10 Resolution is documented in board minutes
Update of Step 3 (Consideration of whether profits have been lost since last annual
Step 11
accounts) before payment of dividend
Step 12 Dividend is paid.

ALTERNATIVE B: Dividend declared by the shareholders

Figure 4.1.5-10: Process of dividend distribution declared by the shareholders (United Kingdom)
Update of Step 3 (Consideration of whether profits have been lost since last annual
Step 8
accounts)
Step 9 General meeting of the shareholders is held
Step 10 Shareholders vote on the proposed distribution
Shareholders pass an ordinary resolution declaring the dividend and dividend
Step 11
becomes a liability of the company
Step 12 Declaration is documented in minutes of general meeting
Step 13 Dividend is paid.
TOTAL

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Analysis

Calculation of the distributable amount

From an economic point of view, the establishment of the dividend proposal typically
involves the CFO and CEO and other selected high ranking company representatives
preceded by preparations in the company’s administration (treasury, tax and/or accounting
departments). As the level of dividends is also a political decision concerning the
attractiveness of the shares to investors, investor relation experts may also play a significant
role in the elaboration of the dividend proposal. The dividend proposal is subsequently subject
to a discussion in the company’s board. The intensiveness of the discussion in the board
depends on the specific importance of dividend levels for the performance of the shares of the
company.

In determining the distributable amount, all companies referred to the consolidated financial
statements of the company, not the individual financial statements which are the legally
decisive set of accounts. Partly, the companies have published explicit dividend policies
which base their distribution on certain percentages of their net earnings based on the
consolidated financial statements. Furthermore, companies interviewed considered other
relevant aspects like dividend continuity and return on investment. Finally, companies
interviewed assessed the effects of certain dividend levels on the future cash flow situation of
the company / group.

The results of a CFO questionnaire sent to UK companies listed on main indices reconfirm
this:

Figure 4.1.5-11:Determinants for the distribution of dividends in the holding company (United Kingdom)

"What are the determ inants for the distribution of dividends by your holding
com pany?"

5 4,22
3,97
Importance

4
4,14 3,39
2,96 3,64
3 UK
2,82 3,06 2,15 2,12
2 EU Average
1,97 1,96
1
Fin. performance Financial Dividend Signalling device Credit rating Tax rules
(group performance continuity considerations
accounts) (individual
accounts of t he
parent company)

Determ inants

Source: CFO Questionnaire, September 2007

However, the CFO questionnaire shows that the responding CFOs rank legal restrictions on
profit distribution higher than market led solutions like rating agencies’ requirements or bank
covenants.

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Figure 4.1.5-12: Important deterrents when considering the level of profit distribution (United Kingdom)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"

3,48
4
Importance

2,65 UK
3
3,44 2,16 2,25 EU Average
2
2,14 2,39
1,97
1
Distribut ion/ Legal capital Rating agencies' Cont ract ual agreements Possible violations of
requirement s requirements with creditors (covenants) insolvency law

Deterrents

Source: CFO Questionnaire, September 2007

A particular point that seemed to cause substantial burdens for the UK companies interviewed
is the issue of bringing sufficient profits and cash into the parent company. Several companies
interviewed conduct a “restructuring programme” every few years to channel the profits/cash
to the parent level. These efforts can take internal efforts of 80 to 860 hours of highly
qualified personnel and external advisor fees ranging from £30,000 to £500,000. However, as
this planning effort may be largely based on tax optimisation any effort in this respect could
also be considered non-incremental.

Again, the results of a CFO questionnaire sent to UK companies listed on main indices show
the importance of tax considerations:

Figure 4.1.5-13: Determinants for the distribution of dividends by the subsidiaries (United Kingdom)

"What ar the determ inants for the distribution of dividends by your

subsidaries?"

5
4,07
4
Importance

4,07 3,14
2,74
UK
3
3,07 EU Average
2,56
2

1
Demands from the ultimate parent Tax rules Own investment decisions

Determ inants

Source: CFO Questionnaire, September 2007

Connection to accounting rules

All UK companies interviewed use IFRS for their consolidated accounts. The majority of
companies interviewed use UK GAAP for their individual accounts, only one uses IFRS. The
very distinctive UK practice of differentiating between accounting profits and realised profits
imposes an additional burden on some of the UK companies interviewed. One company
spends ½ of a man-year (1,040 h) of highly qualified personnel in the adjustments for its
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individual accounts. Another company estimates its burden at 100 hours of highly qualified
personnel. Other, mainly smaller companies do not show differences between accounting and
realised profits due to the nature of their business. In general, we have gained the impression
that UK companies do not seem to put much effort into distinguishing between accounting
and realised profits if they do not use fair value accounting and at the same time have large
“headroom” in profits.

Partly, the companies interviewed indicated reasons why IFRS are not chosen for the
individual statements. The reasons include certain accounting treatments which seem
unfavourable under IFRS, e.g. the off-setting of pre-acquisition retained earnings from the
book value of the investment or the creation of unrealised profits under IAS 39. Another
reason may be the lack of appropriate transitional measures for the introduction of IFRS.

Determination of the distributable amount

From an incremental cost perspective, all UK companies interviewed considered the

preparation of board meetings to establish the value of the distribution to take the most
efforts.

The total time spent on this process amounts to between 30 and 160 hours of highly qualified
personnel of the company. The time effort needed varies depending on the culture and
organisation of the individual company and cannot be clearly linked to certain size criteria.
Most companies reported a time effort of about 40 hours of highly qualified personnel.
Usually, the tax, legal and finance department participate in the preparation.

The second considerable effort concerns the actual payment of dividends. Depending on the
individual arrangements of the companies and the number of shareholders, paying the
dividends will cost several hundred thousand British pounds. The UK companies interviewed
estimated the incremental cost of Alternative A and B (with or without involvement of the
general meeting) to be the same as the general meeting would be held anyway.

The companies interviewed do not generally seem to engage external legal advisors in this
process and rather use in-house solutions.

The remaining steps were considered to be non-incremental as, from the companies’
perspective, they did not originate from the compliance with distribution provisions such as
the original preparation of the accounts, the annual audit or, in case of Alternative B, the
holding of the annual general meeting.

Regarding the establishment of alternative cash-flow projections to be used in the distribution

process, all companies interviewed had a very detailed cash flow planning for at least one
year. However, this planning is based on internal rules on how to prepare such projections and
is clearly linked to the business needs of these companies. Companies interviewed mainly
project their cash flows over a time period of three to five years. One company makes
forecasts over a period of ten years.

One particular practice of UK companies interviewed concerned the delivery of an annual

“going concern report” by the company’s management, specifically mentioned by two
companies interviewed. It is a by-product of the company’s internal operational efforts to
have a good understanding of the company’s cash flow position. The specific effort to prepare
such a report can be estimated at up to 32 hours of highly qualified personnel. “Going concern

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reports” are regarded as common UK practice. This report is regularly reviewed by the
external auditors.

Sanctions

Concerning the efforts to comply with provisions concerning incorrect dividend distributions,
the companies interviewed generally considered the risk of liability for the company’s
management to be low. The reason for this is mainly the high compliance effort invested in
the distribution process.

Related parties

There were also no significant risks seen concerning the monitoring of the relationships with
related parties and potential other refluxes of funds to shareholders. However, this could
depend on the individual shareholder composition of a company.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 30 to 1,200 - -
Hourly rate €100 €70 -
€3,000 to €120,000 - -
Total costs €3,000 to €120,000

4.1.5.3.3 Protection of shareholders / creditors

Under the aspect of shareholder and creditor protection, one can draw the following key
conclusions from the above mentioned provisions on distributions. Firstly, it should be noted
that the clearly formulated legal distribution limitations, including, in particular, the
subscribed capital and the premiums as well as the structured link to the audited financial
statements, provide legal certainty. The authoritative accounting guidance by the ICAEW and
ICAS helps to transform accounting profits into realised profits and, thus, takes a more
realistic view whether profits under UK GAAP are realised. This may also help shareholder
and creditor protection as the guidance seems to be aimed at securing the viability of the
company.

Furthermore it should be noted that, under UK law, a distribution can be decided on by the
directors or be declared by the members in general meeting by a simple majority (in this case
the amount must not exceed that recommended by the directors). This leads to less
shareholder protection in comparison to the countries in which only the general meeting can
decide on the allocation of the profits. The national provisions prescribing the liability of
members of the board for losses caused by unlawful distributions are also shareholder
protective. Regarding creditor protection, the obligation of the shareholders to return to the
company any payment received contrary to the Companies Act is of importance.

4.1.5.4 Capital maintenance

The principle of capital maintenance in UK Company Law is usually discussed in connexion

with four main categories: distributions (see above), share buy-backs, capital reductions, and
financial assistance. Furthermore, measures in case of a serious loss of capital and creditors’
contractual self-help are important.

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4.1.5.4.1 Acquisition by the company of its own shares

4.1.5.4.1.1 Legal framework

The general rule is that a company may not acquire its own shares. There are, however, a
number of exceptions to this. There may be an acquisition and holding of shares (treasury
shares), an acquisition and cancellation without reduction or various other cases.

Own shares can be acquired according to a shareholders’ resolution (majority, time frame,
content) stating a certain amount of fully-paid shares and having regard to a guarantee that net
assets are not affected.

A maximum of 10% of each class of qualifying shares may be held by the company at any
one time. Purchases via a recognised investment exchange (“market purchases”) must be
authorised by a shareholder resolution (simple majority). Such a resolution may relate to a
specific purchase or be general but must specify the maximum number of shares that can be
acquired, a maximum and minimum price that may be paid, and contain an expiry date (not
more than 18 months after the date of the resolution). Different rules apply for purchases of
shares otherwise than via a recognised investment exchange (“off-market purchases”). In
overview, the terms must be authorised by a special resolution (75% majority) and the
resolution must state a date by which the authority will expire, such date not to exceed 18
months from the date of the resolution.

The ability of a company to purchase treasury shares (or make any other type of distribution
of profits) is also controlled by the “net assets test”. This allows a distribution (or purchase of
treasury shares) to be made only if the amount of the company’s net assets is not less than the
aggregate of its called-up share capital and undistributable reserves and provided that the
distribution (or purchase of treasury shares) would not reduce the company’s net assets below
this amount.

The company must deliver to the registrar of companies a prescribed form stating each class
of share purchased as well as the number and nominal value of those shares and the date on
which they were delivered to the company. In addition, public companies shall also state the
aggregate amount paid by the company for the shares; and the maximum and minimum prices
paid in respect of shares of each class purchased. This requirement goes beyond the
requirements of the 2nd CLD.

Other, general exemptions from the prohibition of a company acquiring its own shares are as
follows: acquisition otherwise than for valuable consideration (no restrictions); acquisition as
part of a reduction in capital (no restrictions); acquisition as a result of a court order as a result
of alteration of the company’s objects (1985 Act only), or relief to members unfairly
prejudiced (as the court may order); and the acquisition as a result of forfeiture by a
shareholder for failure to pay an amount due on the shares. The national legislation does not
contain provisions relating to acquisition of own shares explicitly on the grounds of avoiding
harm to the company.

If a company acquires its own shares when this does not fall within one of the permitted
exceptions above, the company is liable to a fine and the directors responsible are liable to a
fine, imprisonment or both and (other than for purchases of treasury shares) the transaction is
void. In the event that the rules governing the maximum holdings of treasury shares are

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contravened, the company must dispose of or cancel the excess shares within 12 months of
the date on which the contravention occurs.

Where shares are held, the company may not exercise voting rights in respect of such shares.
Provided such shares are not cancelled, the existing balances in share capital and share
premiums in respect of these shares remain unchanged. The costs of acquiring the shares must
be met from distributable profits. Where a company acquires shares in itself and those shares
are shown in the balance sheet (albeit that this is no longer permitted under UK GAAP or EU
adopted IFRS), an amount equal to the value of those shares is transferred out of profits to a
non-distributable reserve. Companies accounting under UK GAAP that hold treasury shares
must disclose the number and aggregate nominal value of such shares held.

With respect to the resale of treasury shares, UK law prescribes the same rules as for the issue
for new shares. These require that the existing shareholders are first offered the chance to
purchase the shares on terms at least as favourable as any external offer.

4.1.5.4.1.2 Economic analysis

In the United Kingdom, the amendments to the 2nd CLD in the year 2006 have not yet been
enacted in UK legislation (dropping of the 10 percent limit, prolongation of the authorisation
by another five years). Thus, the interview results still refer to the current UK arrangements
for the acquisition of the company’s own shares. From a company law perspective, most
efforts go into the proposal for the authorisation to purchase such shares. However, the actual
buyback of shares will regularly result into much higher costs which are, from a compliance
perspective, mainly related to securities regulation. We have only received some rough data
on the total cost of the buybacks which underpin this assumption. Nevertheless, only
incremental costs invoked by company law are relevant to this analysis. Thus, these costs
resulting from securities legislation are remarkable - but not from an incremental cost
perspective.

Practical steps

To acquire its own shares a company has to follow this process:

Figure 4.1.5-14: Process for the acquisition of own shares (United Kingdom)

Acquisition of own shares

Step 1 Ascertain whether the company’s articles permit the purchase of treasury shares.
Step 2 Proposal of board to acquire (and hold) own shares.
Shareholders’ meeting called, with requisite notice (at least 14 days, given in
Step 3
writing).
If purchase is from the market, ordinary resolution (simple majority) by
shareholders specifying maximum number of shares that may be acquired,
maximum and minimum prices that may be paid and date on which authority
Step 4 expires (no more than 18 months hence).
If purchase is off-market, the contract must be approved in advance by special
shareholder resolution (75% majority); again such a resolution must specify when
the authority for the purchase expires (a maximum of 18 months hence).
Directors ensure that adequate distributable profits are available by reference to
Step 5 relevant accounts and authoritative accounting guidance, and consider whether
there has been any loss of distributable profits since those accounts.

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Purchase is made, subject to shares being fully paid-up, total holding not
Step 6
exceeding limit of 10% of nominal value of shares.
Return with details of purchase submitted to registrar of companies within 28 days
Step 7 (a return also has to be made for any subsequent cancellation or disposal of treasury
shares).
Step 8 Information given in the annual accounts and directors’ report.

Analysis

Nearly all UK companies interviewed (two exceptions) have an authorisation by the general
meeting to the company’s management to acquire shares of the company. Three companies of
our sample are making use of their authorisation and actually acquire shares of the company.
These companies have permanently been buying back shares and regularly renew their
authorisations in this regard.

Within the legal process, there are several steps that require preparations mainly by the
company’s departments responsible for legal matters and for treasury.

The first step is the proposal by the management board which takes between 2 to 40 hours of
preparation of highly qualified personnel. This proposal is regularly an update of pre-existing
documents which have been elaborated at the time of the initial introduction.

The actual buyback is handled differently from company to company. The amounts charged
by external advisors and facilitators are quite substantial and the data we have received on this
from the companies ranges altogether between £150,000 and £2,000,000. Internal
preparations may amount to up to 200 hours of highly qualified personnel. It has to be kept in
mind that these costs seem to a large extent to be related to requirements from the securities
market and, thus, may not be considered incremental cost from a company law perspective.

The buyback has to be submitted to the registrar. This activity is partly outsourced. We have
not been able to obtain details on the associated costs. If handled internally, preparations may
take around 100 hours of highly qualified personnel.

Another step is the preparation of the notes to the accounts to inform about the repurchase of
shares. Depending on the complexity of the buyback activity, the average time effort will be
between 10 and 80 hours of highly qualified personnel.

In general, we have not noticed significant deviations in the work load between different sizes
of companies. It rather depends on the level of activity of the company in this regard.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 12 – 120 - -
Hourly rate €100 €70 -
€1,200 to €12,000 - -
Total costs €1,200 to €12,000

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4.1.5.4.1.3 Protection of shareholders and creditors

Under the aspect of shareholder and creditor protection, one can draw the following key
conclusions from the above mentioned provisions on the acquisition by a company of its own
shares. Firstly, it should be noted that, with respect to the most important case of acquisitions
of a company’s own shares – purchases via a recognised investment purchase (“market
purchases”) – the shareholders have to authorise the acquisition of the shares by a resolution
which can be valid for a maximum period of 18 months, which is shareholder protective.
Furthermore, the provisions which limit the amount of the shares which can be acquired (the
10% threshold) and the provision which requires the “net assets test”, aim at protecting
shareholders and creditors. Furthermore, the obligation to deliver to the registrar of companies
a prescribed form stating each class of share purchased as well as the number and the nominal
value of those shares and the date on which they were delivered to the company, is creditor
and shareholder protective. The same applies to the obligation of public companies to state
the aggregate amount paid by the company for the shares; and the maximum and minimum
prices paid.

If shares have been purchased, different shareholder and creditor protection rules are
applicable. Of importance are, for example, the provisions which prescribe that voting rights
attached to the acquired shares are suspended. Also of importance is the provision, which
applies when the shares are not cancelled, that the existing balances in share capital and share
premiums in respect of these shares remain unchanged and the costs of acquiring the shares
has to be met from distributable profits. With respect to the reselling of the company’s own
shares, under UK law, the same rules as for the issue for new shares apply. These require that
the existing shareholders are first offered the chance to purchase the shares of terms at least as
favourable as any external offer and this must be characterised as shareholder protective.

4.1.5.4.2 Capital reduction

4.1.5.4.2.1 Legal framework

Under UK Law all public company capital reductions must be permitted by the statutes (1985
Act only) and resolved upon by the members (75% majority) and be confirmed by the court
prior to the reduction being undertaken. The court has power in all cases to ensure that
creditors have been consulted, been paid off or been secured. As part of the court process,
legislation provides that, where the proposed reduction of share capital involves either
diminution of liability in respect of unpaid share capital, the payment to a shareholder of any
paid-up share capital, or in any other case if the court thinks it fit, every creditor of the
company who at the date fixed by the court is entitled to any debt or claim which, if that date
were the commencement of the winding-up of the company, would be admissible in proof
against the company is entitled to object to the reduction of capital.

The so-called convert/discharge procedures may, however, be dispensed with if, having
regard to the circumstances, the court thinks it proper to do so. In practice companies always
seek to have the court dispense with the procedures by demonstrating to the court that the
creditors’ positions are adequately safeguarded. If the court has been satisfied as to the
consent/safeguarding of the creditors it may make an order confirming the reduction in capital
on such terms and conditions as it thinks fit.

The “simplified” procedure under Article 33 (1)) has not been included into UK law.

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The recently amended text of the 2nd Company Law Directive which must be implemented by
15 April 2008, to changes Article 32 with respect to the burden of proof has not already been
implemented into national law nor is there currently any proposal in this context.

4.1.5.4.2.2 Economic analysis

Within our sample of UK companies, we have not encountered any capital reductions.
Especially the larger companies of our sample had conducted capital reductions at subsidiary
level in order to gain distributable reserves at the level of the parent company. However, these
took place under the laws of several jurisdictions.

4.1.5.4.2.3 Protection of shareholders and creditors

Regarding the shareholder and creditor protection existing with respect to capital reductions,
firstly the requirement that the shareholders have to agree to the capital reduction with a
qualified majority, is of importance. Furthermore, the safeguards to creditors, which have,
under certain circumstances, the right to obtain security, are creditor protective.

4.1.5.4.3 Redeemable shares

4.1.5.4.3.1 Legal framework

UK law provides for redeemable shares. Furthermore, UK law provides for the redemption of
the company’s own shares. Not possible is redemption of the subscribed capital without
reduction of the latter.

In accordance with the 2nd CLD, a company may, if authorised to do so by its statutes, issue
shares which, according to their terms (in the statutes), are liable to be acquired and cancelled,
either mandatorily or at the option of the company or the shareholder. These are referred to as
redeemable shares. The company may also have a general power in its statutes to acquire and
cancel shares even though the shares in question are not so liable according to their terms.
This is referred to as a purchase of shares. The procedures for a purchase are the same as for
redemption of redeemable shares (except that the paragraphs referring to market purchases
and off-market purchases are not relevant to the redemption of redeemable shares).

Redeemable shares may not be redeemed unless they are fully paid-up. Redemption may only
be out of distributable profits or the proceeds of a fresh issue of shares made for the purposes
of the redemption. The shares redeemed are treated as cancelled and share capital must be
reduced by the nominal value of the shares. Other than where the share capital has been
replaced by new share capital from a fresh issue of shares, the reduction in capital must be
replaced by a corresponding increase in the capital redemption reserve, which may not be
reduced (other than in the same manner as share capital). When a company redeems its shares,
the company must make a return of specified particulars to the public register.

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4.1.5.4.3.2 Economic analysis

We have not encountered any cases of capital redemption.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.1.5.4.3.3 Shareholder and creditor protection

Regarding the issuance of redeemable shares, it is, with respect to shareholder and creditor
protection, firstly of importance that it is only permissible if the company is authorised by its
statutes to issue redeemable shares. Furthermore, the provisions that redeemable shares may
only be redeemed if they are fully paid-up and that a redemption may only be made out of
distributable profits or the proceeds of a fresh issue of shares made for the purposes of the
redemption, are shareholder and creditor protective.

4.1.5.4.4 Financial assistance

4.1.5.4.4.1 Legal framework

Financial assistance by a company for the acquisition of its own shares is generally
prohibited. There are, however, some exceptions, principally in respect of lending of money
in the ordinary course of business and assisting employees to acquire shares in the company.

The recent amendments to the 2nd CLD have not been implemented in the UK, nor is there
any current, published proposal to do so.

4.1.5.4.4.2 Economic analysis

As the changes to 2nd CLD have not been implemented, there could not have been any
practical cases in the course of the interviews with UK companies.

4.1.5.4.5 Serious loss of half of the subscribed capital

4.1.5.4.5.1 Legal framework

Under UK law, the directors of the company shall call an ordinary general meeting where the
net assets of a public company are half or less of its called-up share capital. The purpose of
the general meeting is to consider whether any, and if so what, steps should be taken to deal
with the situation.

4.1.5.4.5.2 Economic analysis

The UK companies interviewed spend very little time on the direct monitoring of this
provision on the serious loss of subscribed capital. In general, they would see a significant
increase in monitoring activity if the financial position of the company showed indications
that such a situation could actually occur. The management of the companies interviewed
normally use their normal internal reporting and risk management systems as well as cash

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flow projections to monitor the financial position of the company/group. The reporting on
debt covenants can also help in this regard. This would give them sufficient lead time to
recognise critical situations.

4.1.5.4.5.3 Shareholder and creditor protection

The provisions dealing with the serious loss of the subscribed capital have a shareholder and
also creditor protective character, as the general meeting gets the possibility to decide on
safeguarding measures.

4.1.5.4.6 Contractual self protection

4.1.5.4.6.1 Legal framework

Under UK law it is entirely usual for certain creditors to negotiate the terms of contractual
protections with companies. As long as these are not illegal under any statutory provision any
such terms are permitted. There are no standard contracts prescribed, though banks and
similar financial institutions will normally try to impose their institution’s standard terms.
However, each case is negotiated on its own facts. The most common contractual protections
are security for lending (fixed or floating charges); financial covenants in relation to lending
(e.g. ratio based); retention of title over stock; invoice discounting (factoring) of debts; and
guarantees from other parties.

4.1.5.4.6.2 Economic analysis

All UK companies have to adhere to certain covenants. The existence of such covenants is a
matter of negotiation with the banks. Most of the UK companies interviewed have covenant
in the format of financial ratios in loan agreements which are mainly contracted with UK
banks. These covenants do not usually provide direct restrictions on profit distributions.
Instead they refer to certain debt/income and cash flow related ratios that try to capture the
business of the company. These may under certain conditions indirectly result in restrictions
on profit distributions.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.1.5.4.6.3 Shareholder and creditor protection

Regarding the aspect of creditor protection it should be noted, that covenants are based on
private law contracts which are, however, often used in the UK. By these covenants only
individual creditors are directly protected. However, shareholders might be protected by these
agreements indirectly insofar, as they aim at the long-term viability of the company.

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4.1.5.5 Insolvency

4.1.5.5.1 Legal framework

In the UK there are several different types of insolvency process ranging from those to
promote rescue of the company to winding up and dissolution. These are described in the
Insolvency Act 1986. There is also one process contained in the Companies Acts, the Scheme
of Arrangement, which may be used to compromise the claims of creditors outside an
insolvency process.

According to the Insolvency Act 1986, a company is unable to pay its debts if:

• a statutory demand (a formal demand that a debt be paid) is served on the company for a
sum exceeding £750 and remains unpaid for 21 days thereafter,
• the execution of a court order to enforce a debt could not satisfy the whole of the debt
due,
• it is proved to the satisfaction of the court that the company cannot pay its debts as they
fall due (cash flow test),
• it is proved to the satisfaction of the court that the value of the company’s assets is less
than the amount of its liabilities, taking into account prospective and contingent
liabilities (balance sheet test). The inclusion of prospective and contingent liabilities
makes this a difficult test to apply. However, the test is not a strict one but one for the
court’s discretion.

However, there is no formal timeframe for applying these tests, as they are occurrences
instigated by creditors which the directors cannot predict. In practice, responsible directors
will take advice if these events occur on anything more than a one-off basis. The exact point
at which insolvency is inevitable (by which time the directors must act in the creditors’
interests and enter insolvency proceedings) is dependent on the specific facts of each case and
is not set down by statute. There is a general common law test of “a director having
reasonable knowledge, skill and care”. The courts will thus look at what a director ought to
have done in that light. Again, there is substantial case law, but see Re Produce Marketing
Consortium [1989] 5 B.C.C. 569.

There is no statutory obligation on the directors to commence insolvency proceedings.

However the directors are open to statutory liability once they know that there is no prospect
of avoiding insolvent liquidation.

4.1.5.5.2 Economic analysis

Similarly to the provision on the serious loss of subscribed capital, the UK companies
interviewed spent very little time on the monitoring of insolvency triggers. Again, they would
generally see a significant increase in monitoring activity if the financial position of the
company showed indications that such a situation could actually occur. The management of
the companies interviewed normally use their normal internal reporting and risk management
systems to monitor the financial position of the company/group. This would give them
sufficient lead time to recognise critical situations.

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4.1.6 Conclusions for the five EU Member States

The 2nd CLD sets the most significant provisions concerning capital regimes in the European
Union. All five EU Member States under consideration stick closely to the 2nd CLD; there
are few significant additional protective measures in national legislation. This can be
explained by the fact that the main legal instruments used by these EU Member States start
from the basis of the 2nd CLD and that there is only limited room for deviations in favour of
differing approaches. In most cases, we found less important deviations – also with respect to
the incremental costs - arising from the transformation of the 2nd CLD into national
legislation where EU Member States use explicit options or discretions contained in the 2nd
CLD, interpret not clearly defined areas or provide for additional provisions where the 2nd
CLD does not contain any rules (e.g. in the field of sanctions). Deviations of importance also
with respect to the costs were rather seldom and were found in particular with respect to the
use of IFRS and the question of what can be understood by realised profits.

The compliance cost concerning the 2nd CLD company law requirements are generally low for
companies interviewed throughout the five EU Member States; significant costs rather arise
outside the area of the core company law requirements, specifically with regard to securities
legislation (e.g. capital increases; acquisition of own shares).

Main pillars of the capital regime in the European Union

Structure of capital

A main pillar of the current capital regime of the European Union is the structure of capital
that is based on the concept of a subscribed capital. Each company must have a minimum
subscribed capital that consists of the nominal values or accountable pars of the shares. In the
process of formation or capital increase, the subscribed capital has to be contributed and this
amount is accounted for in a specific balance sheet position which is protected from
distributions. In addition, the EU capital regime foresees that shares can be issued with a
premium. The premium amount has to be accounted for in a specific reserve. The capital
regime as embedded in the 2nd CLD offers shares with a nominal value (par value shares) or,
alternatively, shares with an accountable par, so called „notional“ no-par value shares.
Nominal value describes the amount of the contribution which must be paid to subscribed
capital. For shares with an accountable par it is characteristic that every no-par value share
represents the same fraction of the subscribed capital as that in which all no-par value shares
participate in the subscribed capital.

Capital increase

For the injection of additional equity capital after the formation of the company, the 2nd CLD
offers the legal instrument of the capital increase. The contributions received from the
issuance of new shares will be assigned to the subscribed capital or, if applicable, to the
premium reserve. Furthermore, the 2nd CLD prescribes that a capital increase can only be
effectuated if the general meeting so decides via a resolution. The general meeting can also
authorise the management of the company to increase the subscribed capital within certain
limits for a period of up to 5 years (“authorised capital”). Another important element is pre-
emption rights that have to be granted to shareholders in the case of cash contributions. These
could only be waived via a resolution of the general meeting.

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Moreover, the 2nd CLD determines for all EU Member States how capital will be raised, in
the first place for formations and subsequently for capital increases. This includes the
obligation to sign-up for a certain amount and to take over shares that equal at least that
portion of subscribed capital (prohibition of below par emissions). It also concerns the
question of whether a potential contribution is actually contributable and the issue of expert
valuations for contributions in kind.

Distributions

The 2nd CLD prescribes the legal framework for dividend distributions. The EU model refers
to the distribution of the profits of the audited individual financial statements that must be
determined under the national GAAP derived from the 4th CLD or, alternatively, under IFRS
applied to the individual accounts. Distributable are the profits from the current accounting
period and other retained profits from previous periods.

Capital maintenance

The 2nd CLD provides different instruments to maintain the capital of the company. This
includes provisions on the acquisition of the company’s own shares which start from a general
prohibition on the acquisition by a company of its own shares but allow several exemptions.
This is specifically possible if there is a resolution by the general meeting authorising the
acquisition and if the amount of acquired shares is limited to ten percent of the subscribed
capital and the net assets of the company are not impinged by this transaction. Beyond this,
the 2nd CLD provides for a range of different exceptions which include, for example, the case
that the acquisition is necessary to prevent the company from suffering a major harm.
Furthermore, the 2nd CLD provides for additional provisions in this respect dealing, for
example, with treasury shares (the rights linked to them and the necessity to account for a
reserve) as well as the consequences arising from acquisitions or shares held in contravention
of the provisions of the 2nd CLD. In view of the required authorisation of the general meeting,
there are further differences concerning the required quorum in the general meeting.
Furthermore, there are provisions for the reduction of subscribed capital, which in a normal
course envisage a shareholder resolution and particular creditor protection rights. Moreover,
there are provisions on the compulsory withdrawal of shares, redeemable shares, share
redemptions and the amortisation of shares. Also in this respect, the 2nd CLD provides for
different shareholder and creditor protective provisions, in particular provisions which link
the reduction of the shares to an authorisation by the statutes or the general meeting and the
necessity that the net assets are not affected by the transaction. Finally, the 2nd CLD contains a
prohibition of financial assistance which was, however, liberalised by Directive 2006/68 EC
of 6th December 2006.

Structure of capital and shares

Subscribed capital

The five EU Member States under consideration have all set a minimum subscribed capital in
national laws that exceed the minimum subscribed capital required under the 2nd CLD of
€25,000 by at least 100 percent. France is the only one of the five EU Member States that
differentiates between the minimum subscribed capital of listed companies and those of other
companies.

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Figure 4.1.6 – 1: Minimum subscribed capital in the five EU Member States

Minimum subscribed Listed companies Other companies
capital [€] [€]

France 225,000 37,000

Germany 50,000 50,000
Poland 131,000 131,000
Sweden 50,000 50,000
United Kingdom 72,000 72,000

2nd CLD 25,000 25,000

The practical relevance of the subscribed capital for an assessment of the viability of a
company has generally been seen as low by the companies interviewed in the five EU
Member States. These companies and their “peers” like banks, rating agencies and analysts,
rather look at other equity figures like “net equity” and “market capitalisation”.

A survey of CFOs of listed companies in the major stock indices of the five EU Member
States showed that responding companies did not particularly question the distribution
restriction implied by the concept of legal capital. In each country, with the exception of
Poland, which had a poor return rate, the majority of CFOs was not in favour of lifting the
necessity of legal capital because it constitutes a barrier for distributing excess capital.

Figure 4.1.6 – 2: Importance of subscribed capital (EU comparison)

"In general, w e do not consider stated/subscribed capital to be necessary; it

unnecessarily reduces our com pany's flexibility to distribute excess capital."

100%
90%
80%
70%
Percentage

60%
True
50%
False
40% NA
30%
20%
10%
0%
F r ance Ger many Po land Swed en UK EU A ver ag e

Source: CFO Questionnaire

Concerning the role of the subscribed capital in the equity financing of companies, an analysis
of the relation of subscribed capital to the shareholders’ equity for the main stock indices in
the five EU Member States has shown that the subscribed capital as part of the wider equity
of the companies is necessary for the equity financing of the operations of these companies.
This was confirmed in the interviews conducted with selected companies of different sizes
throughout the five EU Member States.

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Figure 4.1.6 – 3: Ratio of subscribed capital to shareholders equity (average for 5 EU Member States)

Average for 5 EU States:

Subscribed Capital to
Total Shareholder's Equity

12%
< 5%
9% 33%
5%- 10%
10%- 20%
20% 20%- 30%
> 30 %
26%

Source: Onesource: Subscribed capital for the FY 2005, shareholders equity (consolidated) for the FY 2005.

These figures illustrate that the equity financing is not largely dependant on the subscribed
capital and there is sufficient equity base to allow for adequate distributions. The existence of
subscribed capital does not seem to be a stumbling block for the companies in the main stock
indices of the five EU Member States in their approach to equity financing and distribution
policy from a group perspective.

Premiums

For the five EU Member States under consideration, there is a mixed picture with regard to a
potential distribution of these premiums to shareholders. In the UK, premiums are treated in
the same way as subscribed capital; in Germany and Poland, premiums can, under certain
circumstances, be used to offset losses, so that the premiums are protected from distributions
in these Member States. In France and Sweden, the premiums belong to the distributable
amount to shareholders.

Figure 4.1.6 – 4: Permissibility to distribute premiums in the five EU Member States

Premiums Distributable

France Yes
Germany No
Poland No
Sweden Yes
United Kingdom No

Furthermore, some of the EU Member States under consideration extend the protection of the
company’s capital beyond the subscribed capital and the premiums. In Germany, for example,
the total assets of the company are protected and cannot be subject to distributions to
shareholders except for those resulting from a formal distribution resolution. This also
includes transactions with shareholders that are not conducted at “arm’s length”. In Sweden,
the concept of value transfer plays a decisive role. This concept prohibits value transfers of
sums so large as to leave the restricted equity without full coverage after the transfer

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(monetary barrier). In France, further limits to distributions can follow in particular from the
prohibition on the misuse of the company’s funds (“abus de biens sociaux”).

Structure of shares

For the five EU Member States under consideration, there is again a mixed picture. France
and Germany allow both shares with a nominal value and an accountable par. The United
Kingdom and Poland have only shares with nominal values. Sweden has introduced shares
with accountable par since it enacted its new Companies Act in 2006; all Swedish companies
had to change over to shares with accountable par and amend their statutes accordingly.

Interviews with companies have shown that there is no significant difference seen in shares
with a nominal value and shares with an accountable par. However, the administration of
shares with an accountable par is considered to be slightly less burdensome. This was also
specifically reconfirmed by the Swedish companies interviewed.

Capital increase

For ordinary capital increases, there are deviations concerning the required quorum for
resolutions. The 2nd CLD provides for a minimum of two thirds of the votes or the subscribed
capital represented by the shares. The required majority varies in the five EU Member States
under consideration from two thirds of the votes up to three quarters of the subscribed capital
represented. Furthermore, it has to be noted that capital increases in France have to take place
in the context of an extraordinary general meeting that, however, can be linked to an ordinary
general meeting.

Concerning authorised capital increases, the 2nd CLD requires, besides a shareholder
resolution or a clause in the statutes, a maximum duration of the authorisation of five years. It
is also required that the authorisation can only be exercised up to a maximum amount. The
authorisation period in Germany and the UK amounts to five years, in France to 26 months
(execution within five years); the maximum amount is limited in Germany to half of the
subscribed capital, in Poland to three quarters of the subscribed capital; in France and the UK,
the maximum amount is set by the general meeting.

For pre-emption rights, there are deviations concerning the question whether the provisions
are only applicable to cash contributions or, alternatively, also applicable to contributions in
kind. In Germany and Poland, there are provisions that are also applicable to contributions in
kind. Moreover, there are differences concerning the required quorum of the general meeting
for the exclusion of pre-emption rights.

Concerning the burdens associated with capital increases, it has to be noted that the
companies interviewed considered the actual burdens stemming from company law to be
marginal in comparison to those resulting from securities regulation. The most burdensome
aspect is the preparation of prospectuses which requires a high effort of internal and external
resources to prepare. Such costs form the major part of total figures indicated to us, e.g. for
the companies interviewed: £6,000,000 to £9,000,000 for UK companies, €1,000,000 for a
German company or PLN620,000 for a Polish company.

There are also differences in how capital increases are actually conducted by the companies
interviewed. For the French and German companies interviewed, it is popular to mainly
increase capital via authorisations to the management board; they have not used any ordinary

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capital increase processes in the recent past. Reasons for this are the inflexibility of the latter
processes. One German company also expressed concerns that the ordinary capital increase
process is too vulnerable in view of possible legal challenges from “professional shareholder
activists” who seek to receive extra compensation for not further pursuing their legal
proceedings in courts. The Polish companies interviewed, on the other hand, mainly use
ordinary increases; one company that had an authorised capital let it expire without using it.
Companies interviewed in the UK showed a mixed picture where authorisations had been
used in connection with stock option programmes.

The incremental burdens to comply with company law requirements are relatively low. The
preparation of the proposal to the general meeting is mainly handled in-house and takes from
1 to 40 hours of highly qualified personnel. External legal costs which are used in some cases
are also moderate and are normally in the range of several thousand Euro or even covered by
general service agreements with law firms. The holding of the general meeting is considered
as non-incremental as it is used for other purposes anyway. The cost portion to be allocated to
the resolution on the capital increase is insignificant. In France, a specific extraordinary
meeting must be held for such kinds of resolutions. However, in general French practice, such
meetings seem to be linked to the ordinary general meetings. Therefore, the French
companies interviewed saw the extra cost for such extraordinary meetings as insignificant.
For the issuance of shares, the incremental burdens ranged from 1 to 80 hours of highly
qualified personnel. This process is typically supported by banks which charge fees for this
service; again, these fees are normally moderate in the range of several thousand Euro. In
France, a specific form of service has emerged to support the administrative side of the capital
increase procedure. There, so called “formalistes” professionally handle the registration
aspects of French companies; again, costs seem to be moderate.

For the specific form of contributions-in-kind, we have only found a few cases with the
companies interviewed. Moreover, we have not received any relevant cost data on the
necessary steps to be taken. However, we were reassured by the companies interviewed that
the most significant burden is the formal valuation of the contribution in kind. This includes
not only the costs for an external expert but also internal preparations for such a valuation.
However, the actual burdens of such an endeavour depend on the complexity of the valuation
object.

In general, burdens are typically not linked to the size of a company and rather depend on
specific circumstances at the individual company.

Distribution

All five EU Member States have implemented the 2nd CLD restrictions on profit distributions
in the form of dividends. In general, the balance sheet profit is the profit for the financial year
after setting off losses and profits brought forward as well as sums in mandatory and optional
reserves. Nevertheless, there may be significant deviations due to the fact that individual EU
Member States only permit their national GAAP (France, Germany, Sweden). Poland also
uses IFRS for profit distribution purposes; interviews showed no particular problems at the
Polish companies concerning the use of IFRS. The UK offers national GAAP as well as IFRS
to its companies; however, the UK companies interviewed nearly all used UK GAAP as it
was considered more favourable concerning certain accounting treatments. A second reason
relates to the fact that the UK GAAP accounting profits are regularly adjusted to “realised
profits” for distribution purposes under guidelines prepared by two major accountancy
institutes ICAEW and ICAS. For IFRS, there is no final guidance in this respect. Furthermore,

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the determination of distributable profits may be influenced by the existence of differing

mandatory reserves which the companies must build-up.

Table 4.1.6 – 5: Characteristics of balance sheet tests and solvency tests (EU comparison)
France Germany Poland Sweden United
Kingdom

Balance sheet test(s)

Statutory testing Balance sheet Balance sheet Balance sheet Balance sheet Balance sheet
requirement net assets test net assets test / net assets test net assets test / net assets test /
/ earned earned surplus / earned earned surplus earned surplus
surplus test test surplus test test test

Mandatory accounting French GAAP German GAAP Polish GAAP Swedish UK GAAP /
basis in accordance / IFRS GAAP IFRS
with 4th CLD or IAS
Regulation
Modification of the No No No No ICAEW / ICAS
accounting basis guidance

Distribution allowed, No No No No No
if (initial) balance
sheet test is not met

Additional No No No “Prudence No
requirements in rule”
company legislation

Concerning the importance of the current legal restriction on profit distribution, a CFO
questionnaire sent to the companies listed in the main indices of the five EU Member States
showed the following results:

Figure 4.1.6 – 6: Deterrents to distributions (EU comparison)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"

4
Dist ribution/Legal capital requirements
Importance

Rating agencies' requirements

3

Contractual agreement s wit h creditors

(covenants)
2
Possible violat ions of insolvency law

1
F r ance Ger many Po land Swed en UK EU
A ver ag e

Source: CFO questionnaire, September 2007

This shows that the legal restrictions concerning profit distribution are considered by the
responding CFOs as more important than market led solutions like rating agencies’
requirements or bank covenants.

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From an economic point of view, the determination of the distributable profits shows a certain
lack of any connection between economic reality and the European Union’s legal restrictions
on profit distribution. The regular practice of the companies interviewed – and not only in the
EU – showed that dividend levels are subject to a “political decision” by the company’s
management with a view to its share price. This includes aspects like dividend continuity or
giving certain signals to the capital market. The consolidated accounts and consolidated cash
flow situation form the starting point for such a decision, i.e. decisions are taken from a group
perspective.

The results of a CFO questionnaire sent to the companies listed in the main indices of the five
EU Member States reconfirm these experiences:

Figure 4.1.6 – 7: Determinants of distribution for holding companies (EU comparison)

"What are the determ inants for the distribution of dividends by your holding
com pany?"

5
Fin. perf ormance (group accounts)

4 Financial perf ormance (individual accounts of

Importance

t he parent company)
Dividend continuit y
3
Signalling device
2
Credit rat ing considerations

1 Tax rules
F r ance Ger many Po l and Swed en UK EU
A ver ag e

Source: CFO Questionnaire, September 2007

To bring the parent company’s financial situation in line with the group perspective, the
companies interviewed in nearly all cases steer the profits and cash flow situation of the
parent company. This is mostly done in a structured planning process over several years,
mainly to achieve tax optimisation for intra-group distributions. Especially some UK
companies have pointed to high expenditures in this regard.

Again, the results of a CFO questionnaire sent to the companies listed in the main indices of
the five EU Member States show the increased importance of tax rules:

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Figure 4.1.6 – 8: Determinants of distributions by subsidiaries (EU comparison)

"Whate are the determ inants for the distribution of dividends by your
subsidiaries?"

4
Importance

3 Demands f rom the ultimat e parent

Tax rules
Own investment decisions
2

1
F r ance Ger many Po land Sw ed en UK EU
A ver ag e

Source: CFO Questionnaire, September 2007

Concerning the profit distribution process, the incremental burden ranged between 2 and 50
hours of highly qualified personnel. In the UK, the transition from accounting profits to
realised profits took in specific cases up to 1200 hours of highly qualified personnel where
certain accounting treatments were heavily used. The holding of a general meeting, the
preparation of accounts as well as the statutory audit of the accounts is considered as not
incremental or insignificant.

Capital maintenance

Acquisition by the company of its own shares

All five EU Member States have used the options of the 2nd CLD to exempt companies from
the prohibition of repurchasing their own shares. In France, Germany and the UK, companies
can acquire their own shares based on an authorisation by the general meeting up to a limit of
10 percent of the subscribed capital; in Sweden this is also the case though under additional
conditions. The necessary quorum for the authorisation of the general meeting varies in the
different Member States. Furthermore, most of the Member States made an extensive use of
the other options allowing the acquisition of the company’s own shares. Several Member
States impose additional provisions as to he publication of the acquisition. With respect to the
holding of treasury shares, differences exist, for example, in so far as some Member States
(Germany and France) provide that not only the voting rights but all rights attached to the
shares are cancelled. The redemption of shares is permitted in all five EU Member States.
With respect to the reselling of the company’s own shares, there are provisions only in some
of the five EU Member States, e.g. Germany and the UK.

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Figure 4.1.6 – 9: Conditions for the repurchasing of own shares (5 EU Member States)
France Germany Poland Sweden United Revised
Kingdom 2nd CLD
2006
1. General Yes Yes No Yes, for Yes Yes
authorisation for listed
any purpose companies
Selected criteria:
Resolution by the Yes Yes N/A Yes Yes Yes
general meeting
Maximum 10 % 10 % N/A 10 % 10 % No
percentage of limitation
subscribed capital (Member
State option)
Maximum 18 months 18 months N/A 18 months 18 months 5 years
authorisation
period
Performance of a Yes Yes N/A Yes Yes Yes
balance sheet test

2. Specific
conditions for
certain situations
Selected situations:
Serious and - Yes Yes - - Yes
imminent harm to
company
Distribution to Yes Yes Yes - - Yes
employees
Capital reduction/ Yes Yes Yes Yes Yes Yes
Withdrawal of
shares
Repurchasing - Yes Yes - - Yes
commission by
financial institution
Gratuitous - Yes Yes Yes Yes Yes
acquisition of fully
paid-up shares
Protection of - Yes - - Yes Yes
minority
shareholders
Universal - Yes Yes Yes Yes Yes
succession
Securities trading - Yes Yes - - Yes

None of the five EU Member States has so far implemented the most recent changes of the 2nd
CLD.

Authorisations of share buybacks have been a very common feature for the EU companies
interviewed. We have encountered them in all five EU Member States. The time effort
required for the proposal amounts from 2 to 80 hours of highly qualified personnel. Mostly,
the proposal is a routine mechanism which requires a regular update of existing material. As
the matter may be legally complex, there is a second opinion on the proposal by an external
law firm. The acquisition is mainly conducted via banks or brokerage houses which handle
the actual buyback of shares to differing degrees. In some of the five EU Member States there
is also an extensive reporting requirement to the local securities regulator on share

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repurchases. This may require enormous effort but as it stems from securities regulation it is
not relevant as an incremental burden.

Capital reduction / share redemption

The procedure of capital reduction is very similar between the five EU Member States. In
most of the Member States, the simplified reduction procedure (following the objective to
cover losses) is possible; in the UK this provision has not been implemented. Regarding the
other means to reduce the number of shares, the following picture exists: France, Germany,
Poland and the UK permit a compulsory withdrawal of shares (Sweden allows for redemption
clauses in the statutes). The amortisation of shares only exists in France and the possibility to
issue redeemable shares in the UK.

We have not encountered a single case of an ordinary capital reduction in the interviews
conducted with EU companies. Concerning share redemption, we have seen some cases but
have mostly not been able to retrieve detailed cost data. Thus, a general characterisation of the
associated burdens is not possible.

Serious loss of subscribed capital

The provision concerning serious losses of subscribed capital is enacted in the five EU
Member States without significant differences. In France, Germany, Sweden and the UK, the
duty exists to call a general meeting if the half of the subscribed capital is lost. In Poland, this
duty already takes effect when there is a loss of a third of the subscribed capital.

In the practice of the companies interviewed, this provision does not play an immediate role
in the daily operations of the company. The board of directors will usually monitor the
general financial situation via at least monthly internal reporting instruments which allow an
assessment of the financial position of the company. Companies would have to significantly
step up their monitoring once they enter into difficult financial circumstances.

Incremental cost table for the five EU countries

The following table summarises the incremental cost implied by the national regulations of
the five EU Member States based on the 2nd CLD. A detailed definition of incremental cost
can be found in the methodology section of this report.

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4.1.6 – 10: Incremental costs for the five EU Member States

France Germany Poland Sweden UK EU
€ € € € € Average
€
Capital €12,260 €8,500 to €55,634 No data €7,603 to €27,774
Increase to €42,000 €23,806
€16,750
Distribution €1,600 to €1,000 to €210 to €3,000 to €3,000 to €15,596
€2,700 €15,000 €5,443 €4,000 €120,000
Acquisition €53,300 €50,300 to €2,800 to No data €1,200 to €29,558
of own to €50,500 €10,960 €12,000
shares €55,400
Capital No data No data No data No data No data No data
reduction
Redemption/ No data €500 to No data No data No data €750
Withdrawal €1,000
of shares
Contractual No data No data No data No data No data No data
Self
Protection

Concerning the shareholder and creditor protection arguments please refer to the sections on
the individual EU Member States.

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4.2 Comparative analysis - situation in non-EU countries

4.2.1 USA – MBCA

4.2.1.1 Introduction

The modern corporation law emerged in the United States (US) at the end of the 19th century6.
The corporate structure was used to pool financial resources needed to realise the big
construction projects at that time. Corporate attributes such as those protecting shareholders
were designed to make the investment an attractive one. Because most of those projects were
of local scale only, their oversight was initially left to the individual states. Furthermore, the
founders of the US had considered and defeated provisions for federal incorporation7. Thus,
US corporations still remain organised under state laws with the consequence that there are, in
general, 50 different corporation statutes.

A US corporation can be formed in any state, no matter where it does business. Management
can choose the state of incorporation and therefore the law that will govern the corporation’s
internal affairs, including procedures for corporate actions and the rights and duties of
shareholders, directors, and officers. As an unintentional result of state regulation, the states
began to compete with each other to attract corporate registrations and the revenue that
followed them. States simplified the registration process and gave protections and other
benefits to those corporations that were established under their laws. Today, the undisputed
champion of this competition is Delaware8. More than half of the publicly traded corporations
are incorporated in Delaware9.

Efforts to harmonise the US corporation law have been made since the 1920s10. The National
Conference of Commissioners on Uniform State Laws published a Uniform Business
Corporation Act in 1928. However, this Act was not widely adopted and was finally
withdrawn. Another attempt to harmonise the corporation law was undertaken by the
American Bar Association in the 1940s. They created the Model Business Corporation Act
(MBCA) which was published for the first time in 1950. The MBCA was designed as a model
corporation statute to be enacted in its entirety by the state legislatures. Since then, the Model
Act has been revised regularly. Far-reaching revisions to the financial provisions of the
MBCA were adopted in the early 1980s. They were made part of the overall revision of the
6
For further details on the historical sources of the US corporate law cf. Choper/Coffee/Gilson, Cases and
Materials on Corporations, 6th edition, 2004, pp. 15-27; Palmiter, Corporations, 5th edition, 2006, pp. 7-8.
7
Cf. Henn/Alexander, Laws of Corporations and other Business Enterprises, 3rd edition, 1983, p. 25. There is,
however, an extensive federal presence through federal securities laws that affects the internal affairs of
corporations.
8
Some commentators describe this process as a “race to the bottom”. Others argue that competition among the
states produced efficiency and benefits for investors and call it a “race to the top”. For further details on this
debate cf. e.g. Gevurtz, Corporation Law, 2000, pp. 41-43; Choper/Coffee/Gilson, Cases and Materials on
Corporations, 6th edition, 2004, pp. 24-25.
9
Cf. Bainbridge, Corporation Law and Economics, 2002, p. 16. There is empirical evidence that the majority of
corporations either incorporate in their home state, i.e. the state where the corporate headquarters is located at, or
in the state of Delaware. Cf. Bebchuk/Cohen, Firms’ Decisions Where to Incorporate, Harvard Law Review,
Vol. 105 (2003), pp. 394-396. There are a number of explanations for Delaware’s dominance: The Delaware
General Corporation Law is designed to give management flexibility in structuring and running the business.
There is a large body of case law interpreting the Delaware statute which provides certainty to corporate decision
makers. Further, Delaware courts and corporate bar have great experience in corporate law matters.
10
Cf. Eisenberg, The Model Business Corporation Act and the Model Business Corporation Act Annotated, The
Business Lawyer, Vol. 29 (1974), pp. 1407-1428; Booth, A Chronology of the Evolution of the MBCA, The
Business Lawyer, Vol. 56 (2000), pp. 63-67; Model Business Corporation Act Annotated, 3rd edition, 2002 (2005
Supplement), Introduction, pp. 27-30.

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MBCA in 198411. The MBCA in its current version has been characterised as a modern,
comprehensible, and rationally structured text of law12.

Contrary to the Uniform Business Corporation Act, the MBCA emerged as a set of laws of
national significance and remarkable influence. Today, approximately 30 states have adopted
the MBCA in its entirety or for the most part and many other states have adopted selected
provisions13. Moreover, the Model Act is frequently cited as the source of or the authority for
current state statutes and in state and federal court decisions14. The commentary on the
MBCA, the Model Business Corporation Act Annotated, is often used to interpret adopted
provisions. As a consequence, by now, there is a considerably high degree of uniformity
between the states compared to former times. However, it has to be pointed out that the states,
although having adopted the MBCA in general, do not enact the constantly added revisions
and amendments immediately and simultaneously. Furthermore, court decisions play an
important role in interpreting and in filling in the gaps of the statutory rules. State court
decisions are usually based on the particular state law and, as a consequence, case law may
differ from state to state. Finally, the most prominent corporate law states of Delaware, New
York and California have their own unique corporation statutes.

The MBCA regulates all aspects of corporate existence, including the formation of a
corporation (Chapters 1 to 5), financial rights of shareholders (Chapter 6), the rights and
duties of shareholders, directors, and officers (Chapters 7, 8), and structural changes such as
the amendment of articles of incorporation and bylaws, mergers and dissolutions (Chapters 10
to 14). The most important provisions on capital formation, capital maintenance and
distributions are described in the following15.

4.2.1.2 Capital formation

Pursuant to § 6.01(a) MBCA, the articles of incorporation must prescribe the classes of shares
and the number of each class that the corporation is authorised to issue. § 6.01(b) MBCA
leaves the design of the shares to the parties in the business transaction, but subject to the
requirements that among all the classes of shares authorised, there must be shares that have
unlimited voting rights and shares that are entitled to receive the residual net assets of the
corporation upon dissolution. § 6.03(c) MBCA requires that at all times shares having these
two characteristics must be outstanding.

The 1980 amendments to the Model Act eliminated the concepts of stated capital and par
value. In the US, practitioners and legal scholars long ago recognised that these concepts are
not only complex and confusing but also fail to meet the original purpose of protecting
creditors and senior security holders from payments to junior security holders and are

11
Because of the substantial amendments, rewriting and consolidation of the MBCA, the Act was renamed
Revised Model Business Corporation Act (RMBCA). In 1994, “Revised” dropped from the name of the Act. Cf.
Booth, A Chronology of the Evolution of the MBCA, The Business Lawyer, Vol. 56 (2000), p. 63; Palmiter,
Corporations, 5th edition, 2006, p. 9. For a description of how the new statute was developed cf. Hamilton,
Reflections of a Reporter, Texas Law Review, Vol. 63 (1985), pp. 1455-1470.
12
Cf. Manning, Assets in and Assets out: Chapter VI of the Revised Model Business Corporation Act, Texas
Law Review, Vol. 63 (1985), p. 1530.
13
Cf. Model Business Corporation Act Annotated, 3rd edition, 2002 (2005 Supplement), Introduction, p. 27.
14
Cf. Booth, A Chronology of the Evolution of the MBCA, The Business Lawyer, Vol. 56 (2000), p. 63.
15
For a very readable description of these provisions at a glance cf. Manning/Hanks, Legal Capital, 3rd edition,
1990, pp. 180-192. For an in-depth description including official comments, case summaries, and statutory cross
references cf. Model Business Corporation Act Annotated, 3rd edition, 2002.

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therefore misleading to the extent security holders and creditors believe in their protection16.
Nonetheless, § 2.02(b)(2)(iv) MBCA permits a corporation to state a par value in its articles
of incorporation if it wishes to do so.

The consideration of the shares issued is determined by the board of directors

(§ 6.21(b) MBCA), or by the shareholders if the articles of incorporation so provide
(§ 6.21(a) MBCA). There are virtually no restrictions on the kind of the consideration
received for the issued shares. The consideration may consist of any tangible or intangible
property or benefit to the corporation, including cash, promissory notes, services performed,
contracts for services to be performed, or other securities of the corporation. “For purposes of
buying shares, John Rockefeller’s promissory note and Barbara Streisand’s contract for a
future concert performance are now recognised as the valuable economic assets that everyone
but lawyers always knew they were.”17 Before the corporation issues shares, the directors
must, however, determine that the consideration received or to be received for them is
adequate (§ 6.21(c) MBCA). While exercising their business judgment as to the adequacy of
consideration received, the directors have to meet the standards of conduct set forth in
§ 8.30 MBCA.

The only obligation of a purchaser of shares from the corporation is to pay the consideration.
§ 6.22(a) MBCA specifies that upon the transfer of the consideration as determined by the
board, the shareholder has no further responsibility to the corporation or its creditors.
§ 6.30 MBCA adopts an “opt in” approach for pre-emptive rights. No pre-emptive rights exist
unless they are explicitly included in the articles of incorporation. If the corporation opts in,
§ 6.30(b) MBCA provides a standard model for pre-emptive rights.

4.2.1.3 Capital maintenance

Definition of distribution

The revision of the MBCA in the 1980ies led to a radical simplification and modernisation of
the provisions relating to distributions. The distribution requirements of § 6.40 MBCA apply
the same tests to all types of distributions. § 1.40(6) MBCA defines “distributions” to include
“direct or indirect transfer of money or other property (except its own shares) or incurrence of
indebtedness by a corporation to or for the benefit of its shareholders in respect of any of its
shares. A distribution may be in the form of a declaration or payment of a dividend; a
purchase, redemption, or other acquisition of shares; a distribution of indebtedness; or
otherwise.” The MBCA abolished the legal capital concepts of stated capital, capital surplus
(paid-in surplus, revaluation surplus, reduction surplus), and earned surplus as well as the
tests that varied with the type of distribution. Instead, distributions may be made if two tests
are passed: the equity insolvency test and the balance sheet test. In addition, limitations upon
distributions under the articles of incorporation have to be obeyed (§ 6.40(a) MBCA). 39
states have adopted dividend provisions substantially similar to the ones of the MBCA18.

Distributable amount

Under the MBCA, the declaration of dividends is generally left to the discretion of the board
of directors and protected by the business judgment rule. However, directors have to obey any

16
Cf. Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.21, pp. 64-65.
17
Manning/Hanks, Legal Capital, 3rd edition, 1990, p. 180.
18
Cf. Black, Corporate Dividends and Stock Repurchases, 2006, § 3:1.

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restrictions in the articles of incorporation and the applicable provisions of the Act, which are
described in the following.

Equity insolvency test

Distributions to shareholders are prohibited if the corporation is, or as a result of the payment
would be, insolvent in the equity sense19. § 6.40(c)(1) MBCA provides that “no distribution
may be made, if, after giving it effect (…) the corporation would not be able to pay its debts
as they become due in the usual course of business.”

The equity insolvency test focuses on the main interests of creditors. The creditors’ primary
concern is to know if the corporation generates enough cash to repay its debts. It is
questionable, however, under what circumstances a corporation is solvent in terms of
§ 6.40(c)(1) MBCA20. There are strong indications that the equity insolvency test is met if the
corporation operates under normal conditions, has significant shareholders’ equity, regularly
audited financial statements and no qualification in its most recent auditor’s opinion
concerning the corporation’s status as a “going concern”. If the corporation faces difficulties
concerning its operation and liquidity the directors have to address the issue and evaluate the
future financial position in detail. The directors have to determine if the predicted demand for
the corporation’s products and services will generate cash flows over a period of time
sufficient to meet its existing and anticipated obligations when due. Furthermore, they have to
determine the future ability to borrow additional money or to refinance indebtedness which
matures in the near future. Contingent liabilities have to be taken into consideration, too.
Finally, there “may be occasions when it would be useful to consider a cash flow analysis,
based on a business forecast and budget, covering a sufficient period of time to permit a
conclusion that known obligations of the corporation can reasonably be expected to be
satisfied over the period of time that they will mature.”21

Balance sheet test

In addition to the equity insolvency test a proposed distribution must meet the balance sheet
test22 of § 6.40(c)(2)MBCA. It requires that, after the distribution, assets must equal or exceed
the sum of liabilities and the dollar amount that would be needed to satisfy the shareholders’
superior preferential rights upon liquidation if the corporation were to be dissolved at the time
of the distribution. Therefore, a solvent corporation that does not have outstanding shares with
liquidation preferences can declare a distribution which will leave no shareholders’ equity23.

Accounting methods

The balance sheet test of § 6.40(c)(2) MBCA is inherently dependent upon the accounting
methods used in determining assets, liabilities and equity. The MBCA leaves a lot of

19
The test is called equity insolvency test, because it was used in equity courts to determine the debtor’s
solvency. Cf. Manning/Hanks, Legal Capital, 3rd edition, 1990, pp. 63-65; Palmiter, Corporations, 5th edition,
2006, p. 535.
20
For the following cf. Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.40, p. 198-199.
21
Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.40, p. 199. The commentary, however, does
not define the term “sufficient period of time”.
22
The test is also referred to as the bankruptcy insolvency test, because it was applied by law courts to determine
the debtor’s solvency. Cf. Manning/Hanks, Legal Capital, 3rd edition, 1990, pp. 64-65; Palmiter, Corporations,
5th edition, 2006, p. 540.
23
Cf. Gevurtz, Corporation Law, 2000, p. 162.

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leeway24. Pursuant to § 6.40(d) MBCA the board of directors may base the test either on
financial statements prepared on the basis of accounting practices and practices that are
reasonable in the circumstances, or on a fair valuation method, or on another method that is
reasonable in the circumstances. Therefore, the directors may depart from historical cost
accounting and revalue their assets above historical cost. The drafters of the MBCA did not
mandate a specific accounting system like the US generally accepted accounting principles
(US GAAP), because they wanted to achieve a high degree of flexibility and considered the
needs of the different types of corporations which are subject to these provisions (e.g. smaller
or closely held corporations which might not prepare their financial statements in conformity
with US GAAP)25. However, the US GAAP are always regarded as “reasonable in the
circumstances”26.

Determination of time of distribution and application of restrictions

A distribution is payable to shareholders of record on a specific record date27. The record date
is usually fixed in the bylaws or by the board of directors (§ 7.07(a) MBCA). If the directors
do not fix it, § 6.40(b) MBCA fixes the record date for distributions as the date when the
board authorises the distribution (this is not applicable to a reacquisition of shares).
§ 6.40(e)(3) MBCA provides that the legality of a distribution (excluding the reacquisition of
shares and distribution of indebtedness) is tested on the date of its authorisation if the
distribution is paid within 120 days after the authorisation date. If, however, the payment
occurs more than 120 days after the authorisation its legality must be tested on the date of
payment. In case of a share buyback, § 6.40(e)(1) MBCA provides that the time for measuring
the effect of a distribution is the earlier of the two dates: (1) the payment date, (2) the date the
shareholder ceases to be a shareholder with respect to the acquired shares. Finally, in case of
indebtedness issued as a distribution, the effect of each payment has to be measured on the
date the payment is made (§ 6.40(g) MBCA).

Directors’ liability for illegal distributions

The potential liability of directors making distributions in violation of the statute or of

restrictions in the articles of incorporation is determined under §§ 8.30 (“Standards of
Conduct for Directors”) and 8.33 MBCA (“Directors’ Liability for Unlawful Distributions”).
A director who votes for or assents to an improper distribution is personally liable to the
corporation for the amount that exceeds the permissible limit (§ 8.33(a) MBCA). However, a
plaintiff must show within two years that the director did not comply with the standards of
conduct set forth in § 8.30 MBCA. § 8.30(a), (b) MBCA requires that the director acts in
good faith, in a manner he reasonably believes to be in the best interests of the corporation
and with the care that a person in a like position would exercise under similar circumstances.
§ 8.30(c)-(e) MBCA further provides that a director is entitled to rely on reports from
corporate officers, legal counsel, accountants, and other external experts. A director, for
example, will be protected by his reliance on an investment bank stating that both the equity
insolvency test and the balance sheet test are met and a legal opinion that the dividend is
proper, as long as he has no knowledge that would cause his reliance to be unwarranted.
24
Bainbridge, Corporation Law and Economics, 2002, p. 778, puts it this way: “A sad truth is that 90 percent of
what we do as corporate lawyers is not very creative. (…) Figuring out ways for a company to pay a dividend
despite the literal terms of the statute and the present state of the firm’s balance sheet, however, is one item that
falls within the 10 percent or so where creativity is desirable. And lawyers have gotten quite good at what
accountants would cf. as juggling the books.”
25
Cf. Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.40, pp. 200-201.
26
Cf. Model Business Corporation Act Annotated, 3rd edition, 2002, § 6.40, p. 201.
27
Cf. Hamilton, The Law of Corporations, 5th edition, 2000, p. 583.

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Under § 8.33(b) MBCA, a director who is held liable for an unlawful distribution is entitled to
contribution from all other directors who voted for or assented to the illegal distribution and
from all shareholders who accepted the distribution with knowledge of its illegality28. The
MBCA imposes liability solely in favour of the corporation and generally does not allow
actions by creditors against the directors. Creditors may be able to recover the amount of the
unlawful distribution in the corporation’s bankruptcy proceedings29.

28
Apart from this contribution obligation the MBCA does not otherwise impose any liability on shareholders.
Cf. Bainbridge, Corporation Law and Economics, 2002, p. 777.
29
Cf. Gevurtz, Corporation Law, 2000, p. 166; Eisenberg, Corporations and other Business Organizations, 9th
edition, 2006, pp. 858-860. For a discussion of the relevant case law on the federal Bankruptcy Act and state
fraudulent transfer statutes cf. Black, Corporate Dividends and Stock Repurchases, 2006, § 4:10, pp. 29-30,
§§ 4:36-4:48.

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4.2.2 USA – Delaware

4.2.2.1 Structure of capital and shares

4.2.2.1.1 Legal framework

Delaware follows traditional legal capital rules and divides shareholders’ equity into two
basic categories: capital and surplus. However, capital does not necessarily equal what the
shareholders paid for their stock. Instead, a Delaware corporation may, by resolution of its
board of directors, determine that only a part of the consideration received by the corporation
for the shares issued shall be capital. The amount of capital depends on the design of the
stock. A Delaware corporation may issue stock with par value or stock without par value (no-
par shares). In the case of par value shares, the minimum amount of capital is determined by
multiplying the number of shares issued by their par value. In addition, the board of directors
may designate an additional portion of the consideration received by the corporation for its
shares as capital. In the case of no-par shares, capital is that part of the consideration received
designated by the directors as capital. Therefore, directors can designate zero to be capital.
The excess, if any, of the “net assets” (total assets less total liabilities) of the corporation over
the amount so determined to be capital is surplus.

Structure of capital

Subscribed capital

The Delaware General Corporation Law does not prescribe a minimum capital. Instead the
certificate of incorporation shall set forth the total number of shares of stock which the
corporation shall have authority to issue and the par value of each of such shares, or a
statement that all such shares are to be without par value.

Premiums

Under Delaware law, the term “share premiums” does not exist. The determination of the
amount that is to be “capital” and the amount that is to be “surplus” is one that essentially is
within the control and discretion of the board of directors with one exception: an amount
equal to the par value of all shares with par value must be allocated to capital.

Protection of the stock corporations assets

As already mentioned, under Delaware’s statute, capital initially represents the portion of the
consideration the corporation received in exchange for its shares which the directors, at the
time the corporation sold the shares, decided to designate as capital. This can be the entire
purchase price or any fraction of it, as long as the amount is no less than the sum of the par
value of those shares sold which have a par value. The rest of the consideration is deemed
surplus. In the case of no-par shares directors can designate zero to be capital. As a
consequence, theoretically, a legal distribution can leave no shareholders’ equity (surplus
test). Furthermore, a corporation can even pay so called “nimble dividends” when the equity
is negative (net profits test). It has to be pointed out, however, that these kinds of distributions
might violate the federal Bankruptcy Act, statutory fraudulent transfer law, and case law and
as a consequence increase the liability risk of the directors.

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Structure of shares

In Delaware, every corporation may issue stock with par value or stock without par value as
shall be stated in the certificate of incorporation, or in the resolution providing for the issue of
such stock adopted by the board of directors pursuant to authority expressly vested in it by the
provisions of its certificate of incorporation. If stock is issued without par-value, the
corporation has to specify this in the certificate of incorporation.

4.2.2.1.2 Economic analysis

Practical relevance of capital and structure of shares for an assessment of the viability of
a company

The corporations interviewed had shares with a par value in a range from US$0.0001 to
US$0.1. The interviewees were unanimously of the opinion that par value and capital are
irrelevant nowadays for the assessment of a company’s viability. The reason for having a par
value at all instead of issuing no-par shares is that the Delaware franchise tax is based on the
capital in the case a corporation has par value shares. The franchise tax would be higher in
case of no-par shares because then it would be based on a higher fictitious par value fixed by
the tax statute.

This constellation of very low capital does not raise concerns by banks, rating agencies or
shareholders because it is not considered unusual. Instead, the Delaware corporations
interviewed rather looked at the figures “net equity” and “market capitalisation” as relevant to
determine their equity position and the assessment of their chances to preserve their business
or to attract additional capital. In respect to the corporations’ viability, banks typically rely on
cash flow predictions.

To verify the importance of capital, we have additionally performed an analysis of certain

ratios concerning the stated capital of S&P 500 companies:

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Figure 4.2.2-1: Ratio of share capital to market capitalisation (USA)

USA: Share Capital to Market Capitalisation

3%
4%
5%

5% < 5%
5%- 10%
10 %bis 20 %
20 %bis 30 %
> 30 %

83%

Source: One source: Share capital for the FY 2005, market capitalisation as of September 2006

Compared to the market capitalisation, the capital is mostly below 5 percent of the market
capitalisation. This is true in 83 percent of these companies. The overall importance of the
capital figure seems to be marginal.

Restriction on distribution

The capital as a profit distribution restriction does not play a significant role.

Role of the capital in equity financing

Based on their latest audited consolidated financial statements prepared under generally
accepted accounting principles (US GAAP), the corporations interviewed had an equity ratio
of 43 to 86 percent. Except for a negligible small capital, these high amounts of equity mainly
comprise surplus and retained earnings. This increases the leeway for corporations to make
distributions. However, the interviewees pointed out that other restrictions on the corporation
and fraudulent transfer statutes as well as market forces limit the practical relevance of this
possibility.

For the S&P 500 companies, the ratio of capital to total shareholder’s equity shows that for 64
percent of the companies the capital portion stays under 5 percent of total shareholders'
equity.

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Figure 4.2.2-2: Ratio of share capital to total shareholder`s equity (USA)

USA: Share Capital to Total Shareholder's

Equity

13%

3% < 5%
9% 5%- 10%
10 %bis 20 %

11% 64% 20 %bis 30 %

> 30 %

Source: One source: Share capital for the FY 2005, shareholders' equity (consolidated) for the FY
2005

This indicates that the equity financing is not largely dependent on the capital and that there is
a sufficient equity base in these companies and their subsidiaries to allow for adequate
distributions. The existence of capital does not seem to be a stumbling block for the S&P 500
companies in their approach to equity financing and distribution policy from a group
perspective.

Formations

The Delaware corporations interviewed are already in existence for a longer period.
Therefore, it was neither feasible nor useful to extract data on the initial foundation of these
corporations.

4.2.2.2 Capital increase

4.2.2.2.1 Legal framework

Under Delaware law, there are provisions concerning capital increases by the use of
authorised capital including mechanisms to ensure the contribution of capital. In addition,
public corporations have to obey specific rules of US stock exchanges.

Increase of capital

Under Delaware law, the authority of the corporation to issue new shares is set forth in the
certificate of incorporation. The issuance of new shares must be by the use of authorised
capital. Delaware law requires that if the corporation has only a single class of stock, the
certificate must recite the number of shares authorised for the issue and whether they are par
or no-par. If the corporation has authority to issue more than one class of shares, then the
certificate must set forth the number of shares of all classes and of each class and whether the
shares are par or no-par.

The board of directors must authorise any issuance of stock by the corporation. There is no
maximum amount the authorised shares may cover set by law.
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If all shares that are covered by the certificate of incorporation have already been issued, the
corporation may amend its certificate of incorporation to increase its authorised capital. The
amendment must first be proposed by the board of directors in a resolution setting forth the
proposed amendment, declaring its advisability and submitting it to the stockholders entitled
to vote on the approval of the amendment. After the proposed amendment has been duly
approved by the board of directors, it must then be submitted to the stockholders at the next
annual meeting, or at a special meeting called for the purpose of considering the amendment,
or it may be submitted to the stockholders entitled to vote thereon for adoption by written
consent, if the certificate so allows. If a majority of the outstanding stock entitled to vote
thereon, and a majority of the outstanding stock of each class entitled to vote thereon as a
class has voted in favour of the amendment, a certificate setting forth the amendment and
certifying that such amendment has been duly adopted in accordance with statutory
requirements shall be executed, acknowledged and filed and shall become effective.

In addition to the rules of the Delaware General Corporation Law there are rules of US stock
exchanges (e.g. Listed Company Manual of the New York Stock Exchange) that require
stockholder approval for issuing shares under certain circumstances.

Mechanisms to ensure the contribution of capital

With respect to the subscription of new shares which were issued during a capital increase,
the same rules apply which Delaware law provides for the subscription of shares during the
formation of the corporation.

Regarding capital contributions and their payment at the stage of a capital increase, the same
regulations apply as those at the stage of formation. As in the stage of formation, the
Delaware General Corporation Law allows both contributions in cash and contributions in
kind. The board of directors has the responsibility of valuing contributions in kind. Delaware
law allows stockholders to determine the contribution if the certificate of incorporation so
provides. If the certificate of incorporation reserves to the stockholders the right to determine
the consideration for the issue of any shares, the stockholders shall, unless the certificate
requires a greater vote, do so by a vote of a majority of the outstanding stock entitled to vote
thereon.

Pre-emption rights

Delaware adopts an “opt-in” approach for pre-emption rights. The Delaware General
Corporation Law states that no stockholder shall have any pre-emption right to subscribe to an
additional issue of stock or to any security convertible into such stock unless, and except to
the extent that, such right is expressly granted to such stockholder in the certificate of
incorporation.

4.2.2.2.2 Economic analysis

The corporations interviewed have not increased their capital for a long time. In order to
avoid capital increases and the necessary amendments of the articles of incorporation as a
consequence, the corporations have set a very high authorised share capital (e.g. several
hundred million).

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Practical steps

The following practical steps would be necessary for a capital increase in chronological order:

Figure 4.2.2-3: Process of capital increase (USA-Delaware)

Capital increase
Step 1 Directors propose to issue new shares.
Directors check if the shares to be issued are covered by the certificate of
Step 2
incorporation (authorised capital).
If all shares covered by the certificate of incorporation have already been issued:
Step 3
Resolution of the board of directors setting forth the proposed amendment.
Step 4 Approval of the amendment by the board of directors.
Amendment is submitted to the stockholders at the next annual meeting, or at a
Step 5 special meeting, or submitted to the stockholders entitled to vote thereon for adoption
by written consent (if the certificate so allows).
Step 6 Amendment is executed, acknowledged and filed.

The injection of contributions and the valuation process would comprise the following steps:

Figure 4.2.2-4: Process of injection of contributions (USA-Delaware)

Injection of contributions
The board authorises capital stock to be issued for consideration consisting of
Step 1 tangible or intangible property or any benefit to the corporation, or any combination
thereof
If consideration is outstanding, the amount of consideration outstanding shall be
Step 2 documented on the face or back of each stock certificate issued to represent partly
paid shares, or upon the books and records of the corporation
Board of directors’ judgment of value of consideration received for stock is
Step 3 conclusive in the absence of “actual fraud” (if sold to the corporation itself there
is heightened scrutiny to show independent evidence of the market value of stock)

Analysis

Because theses processes have not been relevant to the corporations interviewed in recent
years, we have not received any information on practical cases of capital increases, or
contributions in kind.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.2.2.2.3 Protection of shareholders and creditors

Based on the legal analysis, one can draw the following key conclusions concerning the
shareholders’ and creditors’ protection under the Delaware provisions on capital increases.

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Shareholders are protected insofar as the board of directors can only increase the capital if the
additional shares are covered by the authorised capital set forth in the certificate of
incorporation. If all shares covered by the certificate of incorporation have already been
issued, the shareholders’ approval is needed to amend the certificate of incorporation.
However, it has to be pointed out that a very high authorised share capital can be fixed in the
certificate with the consequence that the shareholders will not have to be asked for approval.
In specific circumstances, public corporations are required to get stockholders’ approval for
issuing shares pursuant to rules of US stock exchanges.

Under Delaware law, it is not necessary to draw up a report by an independent expert in the
case of contributions in kind. Instead, it is the directors’ duty to determine the consideration
for stock. Case law suggests that directors should seek independent evidence of the market
value of the consideration when selling stock to themselves. If the certificate of incorporation
reserves to the stockholders the right to determine the consideration for the issue of any
shares, the stockholders shall, unless the certificate requires a greater vote, do so by a vote of
a majority of the outstanding stock entitled to vote thereon.

Stockholders, receivers in the case of an insolvent corporation, or creditors may make claims
concerning unpaid or partially paid stock. The party bringing the claim generally has the
burden of proof. Furthermore, the Delaware statute states that when the whole of the
consideration payable for shares of a corporation has not been paid-up, and the assets are
insufficient to satisfy the claims of its creditors, each holder of or subscriber for such shares
shall be bound to pay on each share held or subscribed for by such holder or subscriber the
sum necessary to complete the amount of the unpaid balance of the consideration for which
such shares were issued or are to be issued by the corporation.

Under Delaware law, pre-emption rights that safeguard a stockholder’s right to maintain
ownership of his proportionate share of the assets and protect a proportion of the voting
control, are possible. However, such a right has to be expressly granted in the certificate of
incorporation (“opt-in approach”).

4.2.2.3 Distribution

4.2.2.3.1 Legal framework

The Delaware General Corporation Law contains several requirements for legal distributions
as well as provisions concerning the consequences of unlawful distributions. In addition, there
is case law on the question of what accounting rules have to be applied in determining the
distributable amount.

Calculation of the distributable amount

Under the Delaware General Corporation Law, there are two alternative tests for determining
the legality of a distribution: the surplus test (also referred to as capital impairment test) and
the net profits test (so-called nimble dividends). The Delaware statute contains no explicit
prohibition against dividends when the corporation is, or would be rendered, insolvent.
However, directors violate their fiduciary duties to creditors if they make a distribution when
the corporation is insolvent.

The surplus test provides that the directors of every corporation, subject to any restrictions
contained in its certificate of incorporation, may declare and pay dividends upon the shares of

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its capital stock out of its surplus. As mentioned above, the term “surplus” is defined as the
excess, if any, at any given time, of the net assets (total assets less total liabilities) of the
corporation over the amount so determined to be capital. “Capital” is generally the sum of the
aggregate par value of all issued shares with par value. In addition, the directors may
designate an additional portion of the consideration received when shares are issued as
capital. In the case of no-par shares, capital is that part of the consideration received
designated by the board as capital. Thus, under Delaware law, a dividend cannot be paid if,
before or after payment of the dividend, the capital is or would be impaired.

Under the net profits test, a Delaware corporation may pay dividends even if there is no such
surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the
preceding fiscal year. However, these “nimble dividends” may not be paid if capital
representing preferred shares is impaired.

There is a special rule for corporations in the business of exploiting a non-replenishable asset,
such as a mine, an oil well, or a rock quarry. Such “wasting assets corporations” may add
accumulated depreciation, amortisation, or depletion to net profits for purposes of calculating
dividend paying capacity. In Delaware, wasting assets include not only natural resources but
also other wasting assets, including patents.

Connection to accounting rules

Delaware law does not specify particular accounting methods. Thus, Delaware corporations
do not have to adhere to US GAAP or any other specific accounting method in determining
whether a dividend may lawfully be paid.

The Delaware Supreme Court has made it clear that directors may revalue assets at current
value or fair market value for purposes of calculating net assets even though US GAAP
requires historical costs. To be sure, any such revaluation must be undertaken in good faith
and should thus include a consistent and comprehensive review of both assets and liabilities
and not merely a selective write-up of particular assets. The board of directors may rely on
outside experts such as accountants. The Delaware courts have taken a broad view of board
discretion concerning revaluation. The Delaware Supreme Court approved the calculation of
net assets based on a valuation of discounted cash flow less long-term liabilities. This test
ignores the balance sheet altogether. It rather permits the use of projected cash flows.

Determination of the distributable amount – responsibilities

In Delaware, the declaration of dividends generally is within the discretion of the board of
directors and protected by the business judgement rule. However, directors have to obey any
restrictions in the certificate of incorporation and the applicable statutory provisions.

Sanctions

Under Delaware law, directors are jointly and severally liable for any illegal dividends
resulting from wilful misconduct or negligence, at any time within six years after paying such
unlawful dividend. Liability for unlawful dividends cannot be limited by the corporation in its
certificate of incorporation. Liability runs to the corporation and to its creditors in the event of
its dissolution or insolvency, to the full amount of the dividend unlawfully paid.

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Even if a director voted for an illegal dividend, he is not liable if he relied in good faith on the
corporation’s records, or other kinds of information presented to the corporation by an officer,
employee, a committee of the board of directors or by any other expert who has been selected
with reasonable care by or on behalf of the corporation. They may provide the board with
information as to the value and amount of the assets, liabilities and/or net profits of the
corporation, or any other facts pertinent to the amount of surplus or other funds from which
dividends might properly be paid.

Any director against whom a claim is successfully asserted is entitled to contribution from the
other directors who voted for or concurred in the unlawful dividend. Furthermore, a director is
entitled by subrogation to the right of the corporation against shareholders who received the
dividend with knowledge of facts indicating that the dividend was illegal.

4.2.2.3.2 Economic analysis

Overall, the Delaware corporations participating in the interviews considered the Delaware
law on this issue to be very straightforward and easy to comply with. They derive the
distributable amount from the audited consolidated US GAAP financial statements. To avoid
different sets of accounts, they have never performed a revaluation of assets and liabilities for
the purpose of the surplus test. The net profits test (nimble dividends) and the exception for
wasting asset corporations have never been applied, either. Due to the very good economic
situation, high retained earnings and high amounts of cash, the compliance with the solvency
test is not seen as a major issue. The decision of the board of directors on the distribution
policy and its preparation takes a lot of time, but the associated costs are not incremental.

However, it was pointed out that distribution law is one of the few areas in US corporate law
where there is an increased necessity for directors to underpin their business judgment in
order to avoid personal liability. As a general rule of thumb, the more difficult the business
condition of the company becomes the higher and the more burdensome are the precautions in
this respect.

Practical steps

Based on the legal analysis, the distribution process generally requires the following practical
steps which are the basis for the economic analysis.

Figure 4.2.2-5: Due process for distributing profits (USA-Delaware)

Due process for distributing profits

Step 1 Directors establish the value of the distribution they wish to make.
Directors determine whether the dividend would render the corporation unable to
Step 2 pay its debts as they become due in the usual course of business (performance of
the solvency test).
Directors consult the relevant accounts of the corporation and determine whether,
after the distribution, assets will exceed liabilities plus stated capital (performance
Step 3 of the surplus test/capital impairment test). If necessary, directors perform a
revaluation of assets and liabilities before applying the surplus test/capital
impairment test.
If necessary, directors declare nimble dividends (performance of the net profits
Step 4 test).

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If applicable, directors add accumulated depreciation to net profits (applying the

Step 5
exception for wasting asset corporations).
Directors check if there are any additional restrictions contained in the certificate
Step 6
of incorporation.
The board of directors authorises the distribution by the corporation (amount,
Step 7
date of payment, etc.)
Directors who do not vote in favour of the dividend make sure that their dissent is
Step 8
recorded in the minutes at the time of the resolution.
Step 9 Payment to shareholders.

Analysis

Calculation of the distributable amount

All Delaware corporations interviewed use their audited consolidated financial statements in
conformity with US GAAP as the basis for determining the distributable amount. There is no
specific effort needed in this regard as the preparation and the audit of the annual accounts is
not considered as an incremental cost. The statutory calculations are seen as simple, technical
and cheap.

The results of a CFO questionnaire sent to US companies listed on main indices reconfirm
this:

Figure 4.2.2-6: Determinants for the distribution of dividends in the holding company (USA)

"What are the determ inants for the distribution by your holding com pany?"

5
4,10
Importance

3,49
4
3,19
3,66 2,78
2,54
USA
3
3,30 2,26 3,39 Non-EU Average
2
2,35 1,90 2,19
1
Fin. Fin. Dividend Signalling Credit rating Tax rules
performance performance continuity device considerat ions
(group (individual
accounts) accounts of the
parent
company)

Determ inants

Source: CFO Questionnaire, September 2007

However, concerning the importance of the current legal restrictions on profit distribution, the
CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market
led solutions like rating agencies’ requirements or bank covenants. However, the compliance
with bank covenants is ranked higher than compliance with insolvency legislation.

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Figure 4.2.2-7: Important deterrents when considering the level of profit distribution (USA)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"

3,94 3,58 3,47

Importance

4
3,93 USA
3
2,22 3,38 3,38 Non-EU Average
2
2,19
1
Distribut ion/Legal Rating agencies' Contractual agreements Possible violations of
capit al requirements requirement s with credit ors insolvency law
(covenants)

Deterrents

Source: CFO Questionnaire, September 2007

The results of a CFO questionnaire sent to US companies listed on main indices show the
importance of tax considerations as determinant of dividends distributions from subsidiaries.
Tax rules are ranked higher than distribution demands from the ultimate parent and own
investment decisions.

Figure 4.2.2-8: Determinants for the distribution of dividends by the subsidiaries (USA)

"What are the determ inants for the distribution of dividends by your
subsidiaries?"

5
3,95 4,10
4
Importance

3,73 3,87 2,88 USA

3
Non-EU Average
2,73
2

1
Demands from the ult imate Tax rules Own investment decisions
parent

Determ inants

Source: CFO Questionnaire, September 2007

Determination of the distributable amount

From a cost perspective, all Delaware corporations interviewed considered step 1, the
preparation of the decision of the board of directors, to be the most time-consuming effort in
this process.

Before the initial distribution, the companies started wider consultation processes in various
ways. Amongst other things, the business situation, forecasts and debt covenants were taken
into consideration. Tax considerations are taken into account when bringing cash to the top of
the group pyramid. One corporation based the initial decision on internal cash flow forecasts
covering a period of time of at least five years in order to make sure that it was able to
increase the amount of dividends every year and to avoid negative publicity in the US when
dividends are decreased.
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In general, there are several main drivers of the distribution policy of the corporations
interviewed. With the involvement of public relations experts, the corporations predict how
the market would react to certain levels of dividend. The needs of the company’s investor
base are taken into consideration as well. This leads one corporation to demonstrate continuity
as far as cash dividends are concerned and to perform share repurchases at the same time.
Another corporation discontinued paying (small) dividends because there was no positive
market reaction to dividends with the consequence that the money was wasted. In addition,
this corporation rather wants to be recognised as a growth company and is of the opinion that
paying dividends is a signal to the market that there are no longer enough internal investment
opportunities. As a consequence, this company uses the cash previously used to pay the
dividend for its stock repurchase program which is seen as a better device to meet the
shareholders’ expectations.

One corporation mentioned that, under specific circumstances, governmental rules encourage
corporations to distribute cash. In the US, a company with too much cash will be regarded as
an investment company, which has to apply special investment company accounting rules.

All corporations interviewed spend a lot of time to determine the distribution policy and to
prepare the distribution decision of the board of directors. In this process, highly qualified
personnel of the company are involved. We have not been able to obtain details on the
associated cost. They are not, however, considered to be incremental.

The pure legal compliance effort of the corporations interviewed, i.e. applying the technical
requirements of the Delaware distribution law, is only a matter of minutes to approximately
20 hours of highly qualified personnel of the company. Thus, the incremental costs can be
considered as negligible. One major reason for this result might be that all the corporations
interviewed are very profitable companies which generate a lot of cash and therefore do not
even get close to the statutory limits on distributions.

Overall, the performance of the solvency test (step 2), which is not mandatory by law, is not
seen as a big issue. The actual design of this test varies. The treasury department of one
corporation performs the test as a matter of prudence and to demonstrate continuous practice
in this regard, even though the corporation knows what the result of the test will be in advance
due to high amounts of cash and very good economic conditions. The solvency test is balance
sheet driven and therefore is based on historic figures. Specific ratios are calculated in the
format of an excel spreadsheet. Another corporation only initially performed a solvency test,
but mainly for tax reasons. When performing the solvency test, this company mainly looks at
the payables as shown in the consolidated US GAAP financial statements. The company’s
liquidity of the following 12 months at a minimum as well as long-term debts and leases are
taken into consideration. The interviewee pointed out that, in the case of a dividend in a
“crisis situation”, a good explanation and a cash flow analysis might be appropriate.
Furthermore, the company would make sure that all debts are in the books. In addition,
already at the stage of distributions, the company already takes into account the insolvency
provisions of the federal Bankruptcy Law. One corporation neither performs an explicit
solvency nor an explicit surplus test. Instead, on the basis of the audited US GAAP accounts,
it is assumed that the tests are met.

Applying the surplus test (step 3) is described as an easy task. However, one company is of
the opinion that this would change drastically in “crisis situations” or in case e.g. goodwill
and other intangibles were impaired. The corporations interviewed have never performed a

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revaluation of assets and liabilities and do not depart from US GAAP to keep the calculations
simple and avoid separate calculations. Also, a revaluation is not considered necessary due to
much headroom. It would, in general, only be considered under rather exceptional
circumstances, e.g. for certain real estate with low book values. Additional tests (net profits
test, wasting asset exemption) have never been applied, either.

As mentioned before, the clear point of reference for the determination of the distributable
amount is the audited consolidated financial statements prepared under US GAAP. The fact
that the calculations are based on audited figures adds additional confidence. At present, the
corporations perform the statutory tests on their own and the calculations are not explicitly
reviewed by the accountants.

The preparation of the distribution decision typically involves selected high ranking company
representatives (e.g. CFO, Chief Administrative Officer, General Counsel, Head of Treasury,
and Head of Accounting) as well as highly qualified personnel in the controlling, treasury and
accounting departments. The results of the preparation work are usually presented to the
board of directors. Depending on the risk awareness, the directors simply rely on the work
done by the officers or ask their staff and outside experts explicit questions with regard to
compliance.

Sanctions

Concerning the efforts to monitor compliance with distribution regulations, the companies
interviewed considered the risk of liability for the company’s directors to be low. The reason
for this is mainly the very good economic condition of the corporations interviewed.

However, one interviewee pointed out that distribution is one of the few areas in US corporate
law where there is an increased necessity for directors to underpin their judgment with
sufficient evidence. Because directors are individually liable in case of illegal distributions,
the company makes sure that the distribution requirements are applied correctly in the first
place. The effort needed to comply with the statutory distribution rules would be a lot higher
and would involve outside experts if the economic situation was negative. In performing the
surplus test, a revaluation would, in general, only be considered under rather exceptional
circumstances. This would also need some underpinning as to the fair value to be used in the
surplus test (some reliable value). From a conservative legal point of view, this would limit
deviations from the US GAAP accounts in order to avoid potential liability for directors.

Related parties

There has not been a significant issue concerning the monitoring of the relationships with
related parties and potential other refluxes of funds to shareholders.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 1 to 20h - -
Hourly rate €100 €70 -
€100 to €2,000 - -
Total costs €100 to €2,000

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4.2.2.3.3 Protection of shareholders / creditors

Based on the legal and economic analysis, one can draw the following key conclusions
concerning the shareholders’ and creditors’ protection of the Delaware distribution rules. The
decision whether or not to make a distribution generally rests in the discretion of the board of
directors of the corporation. Therefore, the shareholders have no statutory right to share in the
corporation’s profits unless the board of directors declares a distribution. The board’s
declaration of a dividend creates a legal obligation to the shareholders which generally cannot
be repealed. Notwithstanding the foregoing, (minority) shareholders might bring a lawsuit
against directors, arguing that the board abused its discretion either in declaring, or in refusing
to declare, dividends. There are cases in which courts ordered closely-held corporations to
pay, or not to pay, a dividend. Because the decision to pay a dividend, and its size, are
normally matters protected by the business judgment rule, the courts generally are hesitant to
reverse the board’s decision. As long as directors can identify some arguable corporate need
to retain funds, courts generally will not second guess the board’s decision. There seems to be
no case where the court ordered a dividend of a public corporation. However, due to the
market forces, public corporations, such as those taking part in the interviews, take the
shareholders’ expectations into consideration in order to increase the value of the shares.
Because the shareholders elect the directors, and the directors are often substantial
shareholders themselves, one might suppose that the directors have a strong incentive to make
distributions when consistent with maximising shareholder value.

Creditors do not seem to be protected by the Delaware legal capital system and statutory
distribution requirements. By allowing directors to designate as capital sums which are less
than what the company received for its shares, creditors cannot rely on the original investment
by the shareholders as a cushion. In Delaware, distributions that leave the corporation without
equity or even with a deficit in equity, are allowed. However, due to other federal and
statutory restrictions as well as liability risks, it does not seem realistic that corporations make
use of these possibilities. Furthermore, there are various contractual protections.

From the directors’ perspective, the distribution rules leave a lot of leeway and flexibility.
They can retain money when needed for internal investments and future growth of the
business and they can easily distribute excess cash. Pursuant to the interviews conducted,
directors seem to live well with the statutory directors’ liability for illegal distributions. When
determining the distributable amount they refer to the audited consolidated financial
statements and to internal cash flow predictions. Complying with the Delaware distribution
requirements does not cause much of a burden, as long as the economic condition of the
corporation is good, i.e. there is headroom in retained earnings and cash. In the case of
operating difficulties of the corporation, a liquidity problem etc., the risk of liability increases
if the directors nevertheless declare a distribution. Therefore, considerable work is needed to
underpin distributions in such circumstances.

4.2.2.4 Capital maintenance

As described above, Delaware follows the concept of legal capital, thus providing various
measures which supposedly preserve the corporation’s capital. However, there is no statutory
minimum capital and capital does not necessarily equal what the shareholders paid for their
stock. Instead, capital generally is whatever sum directors choose to call capital. In the case of
no-par shares, capital can equal zero. Furthermore, there are statutory provisions on share
repurchases, capital reductions, related party transactions and fraudulent transfers. In addition,
in practice, contractual self-protection of creditors is of importance.

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4.2.2.4.1 Acquisition by the company of its own shares

4.2.2.4.1.1 Legal framework

The Delaware law generally allows share repurchases provided the corporation adheres to
certain statutory restrictions. With specified exceptions, the financial limitations on
repurchases are the same as those for dividends. The Delaware General Corporation Law
contains one main test for determining the legality of a share repurchase: a corporation must
satisfy the surplus test/capital impairment test. There is no explicit solvency test under the
Delaware statute; it is part of case law. Directors violate their fiduciary duties to creditors if
they repurchase shares when the corporation is or would be insolvent.

A Delaware corporation may purchase its own stock, provided that it may not do so if its
capital is impaired or if the repurchase would cause its capital to be impaired. A corporation
may also purchase preferred or, if there are no preferred shares outstanding, common shares
out of capital, so long as the shares are retired, and the corporations’ capital is reduced. If the
shares are acquired out of surplus, the corporation may retire them or retain them as treasury
shares.

Directors are not restricted in the way they calculate surplus. The Delaware Supreme Court
allows directors to revalue assets in order to show a surplus, as long as they evaluate assets
and liabilities in good faith, on the basis of acceptable data, by methods that they reasonably
believe reflect present values, and arrive at a determination of surplus that is not so far off the
mark as to constitute actual or constructive fraud. Under Delaware law, as long as the
mentioned restrictions are met, there is no specific maximum amount of its own shares which
the company may acquire.

A Delaware corporation, registered with the Securities and Exchange Commission (SEC) as a
publicly traded corporation, has to follow certain disclosure obligations. In accordance with
the Exchange Act, in each quarterly report on Form 10-Q and in the annual report on Form
10-K, the corporation must provide a table showing, on a month-to-month basis the
following: the total number of shares purchased, the average price paid per share, the total
number of shares purchased under publicly announced repurchase programs, and the
maximum number of shares that may be repurchased under these programs (or maximum
dollar amount if the limit is stated in those terms).

In the case of an illegal share repurchase, the same statutory liability applies as for illegal
dividends. Directors are jointly and severally liable for any wilful or negligent violation of the
statute. Liability runs to the corporation and, in the event of its dissolution or insolvency, to
its creditors.

A director is specifically protected against liability if he relies in good faith on the accounts of
the corporation or on reports of officers or outside experts selected with reasonable care in
determining whether there are sufficient funds legally available for the purchase of stock.

A director who has been found liable and who has paid back moneys to the corporation is
entitled by subrogation to the rights of the corporation against shareholders who received
assets with knowledge of facts indicating that the transaction was unlawful.

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In case the Delaware corporation is publicly traded and therefore has to obey the rules of the
SEC, there are a number of sanctions if shares were acquired in contradiction of the law and
SEC rules respectively.

4.2.2.4.1.2 Economic analysis

All the Delaware corporations interviewed have stock repurchase programs approved by their
board of directors authorising their company to buy back a specific number of shares or a
specific dollar amount of shares over an agreed upon period of time. One of the corporations
has not executed the program yet. Due to the fact that the statutory requirements for dividends
and stock repurchases are nearly identical and the necessary calculations are done only once
for both kinds of distributions, the evaluation of the law by the corporations is the same: only
a minimal amount of work is needed to comply with the rules. Thus, the associated
incremental costs are negligibly low.

Practical steps

To acquire its own shares, a company generally has to follow this process:

Figure 4.2.2-9: Process of acquisition of own shares (USA-Delaware)

Acquisition of own shares

Step 1 Directors establish the amount of shares they wish to buy back.
Directors determine whether the share repurchase would render the corporation
Step 2 unable to pay its debts as they become due in the usual course of business
(performance of the solvency test).
Directors consult the relevant accounts of the corporation and determine whether,
after the share repurchase, assets will exceed liabilities plus stated capital
Step 3 (performance of the surplus test/capital impairment test). If necessary, directors
perform a revaluation of assets and liabilities before applying the surplus
test/capital impairment test.
Step 4 The board of directors authorises the share repurchase by the corporation.
Directors who do not vote in favour of the share repurchase make sure that their
Step 5
dissent is recorded in the minutes at the time of the resolution.
If publicly traded, the corporation must disclose in the Form 10-Q quarterly
report and in the Form 10-K annual report in a table showing, on a month-to-
month basis: the total number of shares purchased, the average price paid per
Step 6
share, the total number of shares purchased under publicly announced repurchase
programs and the maximum number of shares that may be repurchased under these
programs

Analysis

All Delaware corporations interviewed dispose of an authorisation by the board of directors

that allows the corporation to repurchase shares. Three companies of our sample are making
use of their authorisation and constantly acquire their own shares. These companies purchase
shares from time to time in the open market or through privately negotiated transactions at
management’s discretion, depending upon market conditions and other factors. They regularly
renew their authorisation by the board of directors in this regard.

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The decision to buy back shares is part of the overall distribution policy of the board
described above. Except for one company of our sample that has not executed its share
repurchase program yet, the amount of the distribution to shareholders via share repurchases
plays a much more important role than dividends, if dividends are paid at all. The companies
interviewed by us explained different reasons for buying back shares. Most of the companies
are of the opinion that their shareholders, or at least a group of them, prefer share repurchases
to dividends. One corporation designed a stock repurchase program to return value to its
shareholders and minimise dilution from stock issues in the past. Another corporation uses
share buy-backs to distribute excess cash to its shareholders and to improve ratios such as
“earnings per share”.

The application of the statutory requirements (steps 2 and 3) – as described in detail above –
is described as not burdensome. Therefore, practically no incremental costs are involved in
this legal process. Again, due to the comfortable financial situation of the corporations
interviewed, the compliance with the tests is not a big issue.

Another step in this process is the preparation of the notes to the accounts to provide
information about the acquisition of the company's own shares. Two corporations describe the
compliance with the SEC quarterly disclosure requirements as a time-consuming process,
especially concerning the open market transactions. Furthermore, whenever new stock
repurchase programs are approved by the board, a lot of disclosure requirements have to be
met (e.g. press release). The other two corporations, however, described the disclosure
requirements as very simple, being a by-product of the accounting process. Anyway, the
associated costs occur because of the requirements of the US securities legislation, not
because of statutory requirements and are not, therefore, incremental.

Depending on the design and the size of the stock repurchase program, setting up the program
and managing the stock repurchase process leads to high amounts of time spent by highly
qualified personnel. In addition, there are substantial amounts of money charged by external
advisors and investment banks. We did not obtain exact data in this regard. The associated
costs, however, are not incremental and therefore not important for the purposes of this study.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 15 - -
Hourly rate €100 €70 -
€1,500 - €3,935
Total costs €5,435

4.2.2.4.1.3 Protection of shareholders and creditors

Due to the fact that, under Delaware law, the statutory restrictions on dividends and share
repurchases are nearly identical, one can draw the same key conclusions concerning the
associated shareholders’ and creditors’ protection of these rules based on the legal and
economic analysis.

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4.2.2.4.2 Capital reduction

4.2.2.4.2.1 Legal framework

Delaware law provides that a corporation, by resolution of its board of directors, may reduce
its capital in any of the following ways: (1) by reducing or eliminating the capital represented
by shares of capital stock which have been retired; (2) by applying to an otherwise authorised
purchase or redemption of outstanding shares of its capital stock some or all of the capital
represented by the shares being purchased or redeemed, or any capital that has not been
allocated to any particular class of its capital stock; (3) by applying to an otherwise authorised
conversion or exchange of outstanding shares of its capital stock some or all of the capital
represented by the shares being converted or exchanged, or some or all of any capital that has
not been allocated to any particular class of its capital stock, or both, to the extent that such
capital in the aggregate exceeds the total aggregate par value or the stated capital of any
previously unissued shares issuable upon such conversion or exchange; or (4) by transferring
to surplus (i) some or all of the capital not represented by any particular class of its capital
stock, or (ii) some or all of the capital represented by issued shares of its par value capital
stock, which capital is in excess of the aggregate par value of such shares, (iii) some of the
capital represented by issued shares of its capital stock without par value.

Under Delaware law, board resolutions are sufficient in order to reduce the capital of a
corporation. Board resolutions are considered corporate documents and are available to the
corporation’s stockholders.

The Delaware statute provides that no reduction of capital shall be made or effected unless the
assets of the corporation remaining after such reduction shall be sufficient to pay any debts of
the corporation remaining after such reduction for which payment has not been otherwise
provided. No reduction of capital shall release any liability of any stockholder whose shares
have not been fully paid.

4.2.2.4.2.2 Economic analysis

Capital reductions have never been relevant to the corporations in our sample. Therefore, we
have not obtained any information concerning this process.

4.2.2.4.2.3 Protection of shareholders and creditors

The provisions on capital decreases generally do not protect shareholders or creditors.

However, there may be a minimum protection due to the fact that the par value of the shares
cannot be reduced without the shareholders’ approval. In this context, we would like to note
that we have encountered companies with a marginal stated capital in relation to total
shareholders’ equity.

4.2.2.4.3 Share redemption

4.2.2.4.3.1 Legal framework

A Delaware corporation can distribute assets to stockholders by acquiring outstanding shares

through redemption or repurchase. While a repurchase is a voluntary buy-sell transaction
between the corporation and a stockholder, redemption refers to a forced sale initiated by the
corporation, in accordance with a contract or the certificate of incorporation.

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Delaware law provides that any stock of any class or series may be made subject to
redemption by the corporation at its option or at the option of the holders of such stock or
upon the happening of a specified event; provided however, that, immediately following any
such redemption, the corporation shall have outstanding one or more shares of one or more
classes or series of stock, which share, or shares together, shall have full voting powers.

Shares may be made redeemable at such price or prices or at such “rate or rates, and with such
adjustments” as are stated in the certificate of incorporation or appropriate board resolution.
The redemption of stock cannot, however, be used as a technique to maintain management in
control of the corporation.

If the shares are redeemed, the corporation may reduce its capital by applying to an otherwise
authorised purchase or redemption of outstanding shares of its capital stock some or all of the
capital represented by the shares being purchased or redeemed, or any capital that has not
been allocated to any particular class of its capital stock.

Any redeemable stock may be redeemed for cash, property or rights, including securities of
the same or another corporation, at such time, price, or rate, and with such adjustments, as
shall be stated in the certificate of incorporation or in the resolution providing for the issue of
such stock adopted by the board of directors.

4.2.2.4.3.2 Economic analysis

Within our sample of Delaware corporations, we have not received any information on share
redemptions.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - -
Hourly rate €100 €70
Total costs No data

4.2.2.4.3.3 Shareholder and creditor protection

Shareholders and creditors are protected in so far as the terms of the redemptions have to be
stated in the certificate of incorporation. Furthermore, if the stockholders do not believe that
the price they receive for their redeemed shares is appropriate, they generally have the
possibility to challenge this. Principles of good faith and fair dealing may be involved in the
setting of a redemption price.

4.2.2.4.4 Financial assistance

4.2.2.4.4.1 Legal framework

Delaware law does not deal directly with transactions such as leveraged buy-outs (LBOs).
However, Delaware law does restrict certain business combinations between a Delaware
corporation and an “interested stockholder” (in general, a stockholder owning 15 % or more
of the outstanding voting stock of such corporation).

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4.2.2.4.4.2 Economic analysis

Within our sample of Delaware corporations, we have not received any information on
financial assistance.

4.2.2.4.5 Serious loss of half of the subscribed capital

4.2.2.4.5.1 Legal framework

Under Delaware law, there is no provision which requires the board of directors to call a
general meeting in case of a loss of half of the subscribed capital.

4.2.2.4.5.2 Economic analysis

Not applicable.

4.2.2.4.5.3 Shareholder and creditor protection

Not applicable.

4.2.2.4.6 Contractual self protection

4.2.2.3.6.1 Legal framework

Delaware law does not bar corporations from entering into contractual credit agreements
which might have, amongst other things, an impact on the distribution capacity, as long as
statutory requirements are not violated. For over a century, it has been common practice in the
US that banks and other institutional lenders who extend a large amount of credit for a
substantial period of time to corporations protect themselves by negotiating a bond or
debenture indenture, or a loan agreement. These contracts usually contain elaborate provisions
concerning what the borrowing company has obliged itself to do and not to do, and the
consequences in an event of breach.

4.2.2.3.6.2 Economic analysis

All Delaware corporations interviewed have credit agreements with banks and other financial
institutions. All these contracts contain various affirmative and negative covenants including
financial covenants (specific financial ratios). The interviewees unanimously pointed out that
the monitoring of the covenants involves more time than applying the statutory distribution
rules. Unfortunately, we have not received detailed information concerning the associated
costs. One corporation estimated that, for the whole process, 20 hours of work of highly
qualified personnel is needed four times a year. While the covenants of the corporations
interviewed differed in design and range, there is a substantial similarity in the process of
entering into a credit agreement and of monitoring the compliance with the covenants.

The financial ratios are defined by the banks and normally try to capture the business model
of the borrower. The most recent audited consolidated financial statements are the starting
point for the computation of the ratios. However, there are certain (minor) departures from the
US GAAP accounts, so that the additional information has to be gathered and processed into
the calculation. These departures are explicitly described in the loan contract. Most of the
corporations created a “little model”, plug in the numbers in an excel spreadsheet, and report

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the calculations and further necessary documents to the banks and other financial institutions
on a quarterly basis. The financial ratios of the companies in our sample comprise: leverage
ratios (e.g. a specific leverage ratio like EBITDA to total debt must be maintained), and other
financial ratios concerning liquidity (e.g. certain specified levels of cash and cash equivalents
have to be maintained) and profitability. In addition, there are usually many affirmative and
negative covenants which do not require calculations. In order to make sure that these
covenants are not in breach, one corporation sends a checklist to key people of the corporation
(tax and controlling department, etc.) who have to tick them off. None of the corporations
have covenants directly restricting the payment of dividends or share repurchases. One
company had such a dividend covenant many years ago. To change the dividend covenant
with the lending institution, costs of approximately US$20,000 were incurred.

For every quarterly filing with the SEC, a letter by the audit firm is needed stating that
compliance with the debt covenants has been reviewed. In addition, analysts frequently ask
questions in this regard which have to be answered.

Overall, all the companies interviewed are comfortable with the limitations and believe they
will not impact their credit or cash in the future or restrict the ability to execute their business
plan. Due to the very good economic situation and the flexible covenants initially negotiated,
the risk of breaching the covenants is presently seen as very low. In addition, one company is
of the opinion that it could easily renegotiate the covenants when necessary.

All the Delaware corporations pointed out, however, that the described process is very
burdensome for companies operating on the edges of the restrictions on credit agreements. A
breach of debt covenants can be very costly. The consequences are that the whole loan may be
due immediately (in the worst case, this might also lead to a breach of the statutory dividend
restrictions) or a waiver has to be negotiated.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 80 - -
Hourly rate €100 €70 -
€8,000 - -
Total costs €8,000

4.2.2.4.6.3 Shareholder and creditor protection

The terms of the credit agreements are negotiated between the corporation and an individual
creditor or a group of creditors, and thus reflect a realistic view of what creditors desire for
their protection. The creditors of the companies interviewed rely on the future prospects of a
company, mainly its profitability and its ability to generate cash necessary to pay the debts
when due. These creditors will not enter into the transaction without having a close look at the
general economic condition and future cash flow and earning potential. The maintenance of
specific liquidity and leverage ratios as well as limitations on further issuance of debt, as
frequently negotiated in loan contracts, reduce the leveraged risk of the corporation. It is thus
apparent that creditors do not focus on the sufficiency of assets remaining upon liquidation of
the corporation for the settlement of their claims, but rather on the corporation’s prospects for
remaining a viable, on-going concern. Corporation statutes, in contrast, do not deal with the
borrowers’ incurring additional debt.

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In addition to the creditors who negotiated the contract, other (weak) creditors lacking
adequate bargaining power (e.g. certain trade creditors) also benefit from these provisions, as
long as the covenants are not breached.

Obviously, credit agreements and financial covenants are not specifically designed for the
shareholders’ needs. However, shareholders might be protected by these contractual
agreements indirectly to the extent that their aim is the long-term viability of the corporation.

4.2.2.5 Insolvency

4.2.2.5.1 Legal framework

Delaware law does not discuss filing for insolvency. Federal bankruptcy law neither requires
an insolvent company to file for bankruptcy, nor is insolvency a requirement to commence a
bankruptcy proceeding. Corporations may seek to accomplish an out of court restructuring.

Under the Delaware Uniform Commercial Code, “insolvent” means: (a) having generally
ceased to pay debts in the ordinary course of business other than as a result of a bona fide
dispute; (b) being unable to pay debts as they become due; or (c) being insolvent within the
meaning of federal bankruptcy law.

There are no specific duties of the board of directors concerning insolvency. A board of
directors of a solvent company always owes duties of care and loyalty to the shareholders.
Some court cases suggest, however, that, when a company moves toward the “zone of
insolvency”, those duties may broaden to include a duty to creditors.

4.2.2.5.2 Economic analysis

The corporations interviewed only spend very little on the monitoring of insolvency triggers,
because they not only generate high amounts of cash, but also have very good levels of
equity. However, the companies are of the opinion that significant efforts would be needed if
they were “close to the edge”. In case of bankruptcies, the trustees focus on illegal
distributions prior to the bankruptcy. Under the federal bankruptcy law, creditors can already
attack a dividend as fraudulent in the case of unreasonably small remaining assets after the
distribution. Therefore, already at the stage of distributions, the corporations, in general, have
to take into account the insolvency law provisions of the federal bankruptcy and statutory
laws.

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4.2.3 USA – California

4.2.3.1 Structure of capital and shares

4.2.2.1.1 Legal framework

In 1977, California was the first US state to eliminate the traditional concept of legal capital.
There is no statutory requirement for a California corporation to have a par value or
subscribed capital. The California Corporations Code, however, permits a corporation to state
a par value in its articles of incorporation if it wishes to do so.

Structure of capital

Subscribed capital

The California law neither prescribes subscribed capital nor a minimum capital. Instead, the
members of the board of directors, or the shareholders if the articles of incorporation so
provide, determine the consideration for the shares being issued. Notwithstanding the
foregoing, the Supreme Court of California has held that a corporation needs to be adequately
capitalised and has found that a corporation is inadequately capitalised if the corporation is
likely to have insufficient assets to meet its debts or if the capital is “illusory” or “trifling”
compared with the business to be done and the risk of loss.

Premiums

Under California law, the term “share premiums” does not exist. Accounting principles and
terminology generally divide the shareholders’ equity section of the balance sheet into two
parts: contributed capital and retained earnings. The California law eliminates “stated capital”
and thereby eliminates the necessity for dividing contributed capital under US generally
accepted accounting principles (US GAAP).

Protection of the stock corporations assets

Under California’s statute, contributed capital initially represents the whole consideration the
corporation received in exchange for its shares. In California, the board of directors cannot
designate parts of the consideration to be “surplus” which can be distributed to the
shareholders. In general, in California a distribution can only be made out of the retained
earnings with the consequence that the entire purchase price of the shares cannot be
distributed. However, the board of directors may declare a distribution in excess of retained
earnings if the equity insolvency test is satisfied and the equity ratio is still at least 20 percent
after the distribution has been made (for details see below).

Structure of shares

As mentioned above, the California law does not require par value shares. A corporation is,
however, permitted to state a par value in its articles of incorporation. Besides that, each
corporation must have at least one class of shares. The articles of incorporation are required to
state the authorised number of each class of shares that (or series within a class) the
corporation is permitted to issue. The number of issued shares of each class cannot exceed the
number authorised under the articles of incorporation.

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4.2.3.1.2 Economic analysis

Practical relevance of capital and structure of shares for an assessment of the viability of
a company

In our interviews, we have only encountered no-par value shares. The complete contribution
is accounted for under common stock. The interviewees pointed out that common stock is for
economic reasons not distributed to shareholders. This is a major difference compared with
Delaware law, where directors can determine large parts or even all of the consideration to be
“surplus” which can be distributed. Nevertheless, we were told that banks do not rely on the
California Corporations Code provisions concerning capital formation and distributions when
entering into loan agreements with California corporations.

Concerning the verification of the importance of capital in the United States, please refer to a
general analysis of certain ratios concerning the stated capital of S&P 500 companies in the
Delaware section of this report.

Restriction for distribution

As already mentioned before, contributed capital generally cannot be distributed.

Role of the capital in equity financing

Concerning the role of equity financing in the United States, please refer to the Delaware
section of this report where for the S&P 500 companies the ratio of capital to total
shareholder’s equity shows has been analysed.

Formations

Our sample consisted of companies being already in existence for a longer period. Therefore,
it was neither feasible nor useful to extract data on the initial foundation of this corporation.

4.2.3.2 Capital increase

4.2.3.2.1 Legal framework

Under California law, there are provisions concerning capital increases by use of authorised
capital including mechanisms to ensure that the contribution is paid. In addition, public
corporations have to obey specific rules of US stock exchanges.

Increase of capital

A California corporation, through the board of directors (or the shareholders if the articles of
incorporation so provide), has the statutory power to create, value and issue authorised shares.
The number of shares authorised for issuance must be stated in the articles of incorporation.
There is no maximum amount the authorised shares may cover set by law. If there are not
enough authorised shares, the articles need to be amended for new issuances to occur. If a
new class or series of shares are being issued, an amendment to the articles or other certificate
of determination must be filed with the California Secretary of State that describes the
characteristics of such new class or series of shares.

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In California, shares may also be created by the exercise of an option or warrant to purchase
or subscribe to shares of any class or series, the exercise of a conversion right, stock split or
share divided, reverse stock split, reclassification of outstanding shares into shares of another
class, conversion of outstanding shares into shares of another class, exchange of outstanding
shares for shares of another class or other change affecting outstanding shares.

In addition to the rules of the California Corporations Code there are rules of US stock
exchanges (e.g. Listed Company Manual of the New York Stock Exchange) that require
stockholder approval for issuing shares under certain circumstances.

Mechanisms to ensure the contribution of capital

With respect to the subscription of new shares which were issued during a capital increase the
same rules apply which California law provides for the subscription of shares during the
formation of the corporation. The California Corporations Code provides that the board of
directors, or the shareholders if the articles so provide, may authorise capital stock to be
issued for consideration consisting of cash. In addition, in-kind consideration such as labour
done; services actually rendered to the corporation or for its benefit or in its formation or
reorganisation; debts or securities cancelled; and tangible or intangible property actually
received either by the issuing corporation or by a wholly owned subsidiary are allowed.
However, consideration may not consist of promissory notes of the purchaser (unless
adequately secured by collateral other than the shares acquired or unless permitted as part of
an employee stock purchase plan) nor future services.

The board of directors (or the shareholders if the articles of incorporation so provide) has the
responsibility of valuing contributions in kind. If the articles of incorporation grant the
stockholders this right, such determination shall be made by approval of the majority of the
outstanding stock entitled to vote thereon. If the articles do not grant the shareholders this
right, then only the board is empowered to decide whether and what in-kind contributions the
corporation will accept.

Pre-emption rights

Under the California Corporations Code, shareholders of a corporation are entitled to pre-
emption rights only if the articles of incorporation explicitly provide for them (“opt in”
approach).

4.2.3.2.2 Economic analysis

In order to avoid capital increases and necessary amendments of the articles of incorporation
as a consequence, one corporation interviewed has authorised almost one billion shares. It
continually has slight increases in share numbers due to a stock option program for
employees. To this end, the board had to approve the program including number and price of
shares. The program ends after ten years. The board delegates to senior officers the power to
negotiate the underwriting. The interviewees pointed out that under California law, companies
would rarely have to amend the article as the number of share capital authorised can be set
very high.

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Practical steps

The following chronological order of practical steps would be necessary for a capital increase:
Figure 4.2.3-1: Process for capital increase (USA-California)

Capital increase
Step 1 Directors consider to issue new shares.
Directors check if the shares to be issued are covered by the articles (authorised
Step 2
capital).
If all shares covered by the articles have already been issued: Resolution of the board
Step 3
of directors setting forth the proposed amendment.
Step 4 Approval of the amendment by the board of directors.
Approval of the amendment by the affirmative vote of the majority of the
Step 5
outstanding shares entitled to vote.
Step 6 Amendment is filed with the California Secretary of State.

The injection of contributions and the valuation process would comprise the following steps:

Figure 4.2.3-2: Process for the injection of contribution (USA-California)

Injection of contributions
The board authorises capital stock to be issued for consideration consisting of
any or all of the following: money paid; labor done; services actually rendered to
the corporation or for its benefit or in its formation or reorganisation; debts or
securities cancelled; and tangible or intangible property actually received either by
Step 1
the issuing corporation or by a wholly owned subsidiary. However, consideration
may not consist of promissory notes of the purchaser (unless adequately secured
by collateral other than the shares acquired or unless permitted as part of an
employee stock purchase plan) nor future services.
If consideration is outstanding, the amount of consideration outstanding shall be
Step 2
documented on the certificate issued to represent partly paid shares.
Board of directors’ determination on value of consideration is conclusive
Step 3
absent fraud.

Analysis

Because theses processes have not been relevant to the corporation interviewed in recent
years, we have not received any information on practical cases of capital increases, or
contributions in kind.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

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4.2.3.2.3 Protection of shareholders and creditors

Based on the legal analysis one can draw the following key conclusions concerning the
shareholders’ and creditors’ protection of the California provisions on capital increases.
Shareholders are protected insofar, as the board of directors can only increase the capital if the
additional shares are covered by the authorised capital set forth in the articles of
incorporation. In the case all shares covered by the certificate of incorporation have already
been issued, the shareholders’ approval is needed to amend the articles of incorporation.
However, it has to be pointed out that a very high number of authorised share capital can be
fixed in the articles with the consequence that the shareholders will not have to be asked for
approval later. In specific circumstances, public corporations are required to get stockholders’
approval for issuing shares pursuant to rules of US stock exchanges.

Under California law, it is not necessary to draw up a report by an independent expert in the
case of contributions in kind. Instead, it is the directors’ (or shareholders’) duty to determine
the consideration for stock. Although the California Corporations Code provides directors
with broad discretion in the issuance and valuation of shares, the directors are constrained by
their fiduciary duty as directors of the corporation to act in the best interests of all the
shareholders of the corporation, and not for the purpose of personal profit or gain. If the board
attempts to manipulate the issuance of shares where the shares are issued at an unreasonably
low price or in favour of certain persons without a legitimate corporate purpose, then the
transaction may be enjoined by the courts or the persons responsible may be held liable in
damages.

Under California law, pre-emptive rights that safeguard a stockholder’s right to maintain
ownership of his proportionate share of the assets and protect a proportion of the voting
control are possible. However, such a right has to be expressly granted in the certificate of
incorporation (“opt in approach”).

4.2.3.3 Distribution

4.2.3.3.1 Legal framework

The revision of the California Corporations Code in the mid-1970ies led to major changes in
the treatment of distributions to shareholders by a corporation. The California law prescribes
the circumstances under which a “distribution to its shareholders” may be made. Whether a
corporation can do so generally depends on the ability to pay its debts as they become due and
upon its retained earnings or its financial position, determined almost entirely in accordance
with generally accepted accounting principles. In addition, there are statutory provisions
concerning directors’ and shareholders’ liability for illegal distributions.

Calculation of the distributable amount

The California Corporations Code contains three tests for determining the legality of distribu-
tions. A corporation cannot make a distribution if the corporation is, or as a result of the
distribution would be likely to be unable to meet its liabilities (equity insolvency test). In
addition, the corporation must satisfy two tests. Dividends are permitted out of a corporation’s
retained earnings (retained earnings test). Alternatively, a corporation may pay a dividend if
two balance sheet tests are satisfied (also referred to as remaining assets test). The first
compares total assets to total liabilities (quantitative solvency test), and the second compares
current assets to current liabilities (liquidity test). Furthermore, there are additional

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restrictions imposed on dividends on junior shares if a corporation has preferred stock

outstanding.

In California, distributions are prohibited which would cause the corporation to be rendered
insolvent in the equity sense. The California Corporations Code provides: “Neither a
corporation nor any of its subsidiaries shall make any distribution to the corporation’s
shareholders (Section 166) if the corporation or the subsidiary making the distribution is, or as
a result thereof would be, likely to be unable to meet its liabilities (except those whose
payment is otherwise adequately provided for) as they mature.”

If a California corporation meets the equity insolvency test a “distribution may be made if the
amount of the retained earnings of the corporation immediately prior thereto equals or
exceeds the amount of the proposed distribution”.

In the event that sufficient retained earnings are not available for the proposed distribution,
only one alternative is provided (remaining asset test). Under California law, the corporation
must meet two balance sheet tests. First, the quantitative solvency test requires that,
immediately after the distribution, total assets are no less than one and one-quarter times total
liabilities, i.e. the equity ratio must be at least 20 percent. For the purpose of the quantitative
solvency test only, goodwill, capitalised research and development expenses and deferred
charges have to be subtracted from the assets. Deferred taxes, deferred income, and other
deferred credits have to be subtracted from the liabilities.

Secondly, the liquidity test requires that after the distribution, current assets equal current
liabilities. However, if the average earnings of the corporation before income taxes and inter-
est expense were less than the average interest expense for the preceding two fiscal years, the
current assets are required to be at least one and one-quarter times current liabilities after
distribution (contrary to US GAAP, the statutory provisions – under certain conditions –
permit the inclusion of projected receipts as current assets if they are to be received pursuant
to contracts obligating customers to make future payments).

Where there are two or more classes of stock, additional restrictions are imposed on
distributions to the junior shares. A corporation with outstanding shares entitled to liquidation
preferences, cannot make a distribution to shareholders on junior shares if, after the
distribution, the excess of its assets (exclusive of goodwill, capitalised research and
development expenses, and deferred charges) over its liabilities (exclusive of deferred taxes,
deferred income, and other deferred credits) would be less than the liquidation preference of
the senior shares. A corporation with outstanding shares with dividend preferences may not
make a distribution on junior shares unless, after the distribution, there would be sufficient
retained earnings to cover all dividends in arrears on such preferred shares. The statute
expressly authorises the creation of additional restrictions on distributions by provision in the
articles of incorporation, bylaws, indenture or other agreement.

The California law specifies the time at which the tests are to be applied. § 166 CCC provides
that the time of any distribution by way of dividend shall be the date of declaration thereof.
Therefore, the directors must act upon the latest financial statements available and on the
basis of their general knowledge of the affairs of the corporation to the effect that its financial
condition has not substantially deteriorated in the interim between the date of that balance
sheet and the time when they take the action.

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Shareholders must be notified if a dividend is not chargeable to retained earnings. The notice
must state the accounting treatment of the dividend. It must accompany the dividend or be
given within three months after the end of the fiscal year in which it was paid.

Connection to accounting rules

California is the only state in the US which explicitly states what accounting rules have to be
the basis of the distribution requirements. Wherever the California Corporations Code refers
to “financial statements, balance sheets, income statements, and statements of cash flows, and
all references to assets, liabilities, earnings, retained earnings, and similar accounting items of
a corporation” it means that those items are prepared “in conformity with generally accepted
accounting principles then applicable”.

California also is the only state that requires the use of consolidated financial statements in
determining the amount available for distributions. The purpose of consolidated financial
statements is to present the financial position of the parent and its subsidiaries as if the group
were a single company. The term “subsidiary” is defined under the California statute as “a
corporation shares of which possessing more than 50 percent of the voting power are owned
directly or indirectly through one or more subsidiaries by the specified corporation.” “Voting
power” means the power to vote for the election of directors. The mere fact that a parent-
subsidiary relationship exists does not always mean that a consolidated statement is required
under US GAAP, and in case of doubt, attention will have to be given to US GAAP to
determine where it is required or permitted.

The California Corporations Code requires that the restrictions on distributions be applied to
each corporation in the group. A separate determination has to be made for each corporation
and its subsidiaries. Therefore, in a three-tier corporate group, for example, the ultimate
parent must satisfy the tests based on the consolidated group financial statements
(consolidation of the parent and both subsidiaries). The middle corporation must meet these
tests based on the consolidated financial statements of the sub-group (consolidation of the
middle corporation and its one subsidiary). The bottom level subsidiary must satisfy the tests
on the basis of its single financial statements.

The California Corporations Code contains a limited number of special modifications of the
US GAAP accounts. Contrary to US GAAP, the profits derived from an exchange of assets
shall not be included unless the assets received are currently realizable in cash. In conjunction
with the application of the quantitative solvency and liquidity tests, the California law
specifies several accounting practices. Even though such practices may contravene US
GAAP, adherence to them is mandatory (for details see above “Calculation of the
distributable amount”).

Notwithstanding the foregoing, the financial statements of any corporation with fewer than
100 holders of record of its shares are not required to be prepared in conformity with US
GAAP, if they reasonably set forth the assets and liabilities and the income and expense of the
corporation and disclose the accounting basis used in their preparation.

Determination of the distributable amount – responsibilities

The California law provides that the declaration of distributions is left to the corporation
subject to any restrictions in the articles of incorporation and by the applicable statutory
provisions. In practice, the declaration of distributions generally is within the discretion of the

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board of directors and protected by the business judgement rule. However, directors have to
obey any restrictions in the articles or bylaws or any other agreement and the applicable
statutory provisions.

Sanctions

Directors who approve a distribution which violates the statutory restrictions are jointly and
severally liable to the corporation for the benefit of non-consenting creditors or shareholders.
In order to avoid liability an individual director has to vote against the illegal distribution. If a
director voted for an illegal distribution, he is not liable if he performed his duties as a
director with the care specified in the California Corporations Code. Directors may rely in
good faith on the corporation’s financial statements, or other kinds of information presented
to the corporation by an officer, employee, a committee of the board of directors or by any
other expert who has been selected with reasonable care. For example, the directors are
entitled to rely on the reports of independent accountants.

Any director who is sued for recovery of improper distributions may implead all other
directors liable and may compel contribution. If a director is liable for such improper distri-
bution, he is subrogated to the rights of the corporation against shareholders.

Shareholders who received the distribution with knowledge of facts indicating its impropriety
are liable to the corporation for the benefit of all creditors or shareholders entitled to institute
an action. The measure of liability is the amount of the unlawful distribution received plus
interest thereon at the legal rate on judgments until paid. A shareholder who is sued for
recovery of an illegal distribution may implead other shareholders who may be liable in order
to compel their contribution. In addition, the California law explicitly provides that
shareholder’s liability is not exclusive and shareholders may be liable under the fraudulent
transfer law of the California Civil Code.

4.2.3.3.2 Economic analysis

Overall, California law on distributions is considered to be very straightforward and easy to

comply with. The distributable amount is derived from the most recent audited consolidated
US GAAP financial statements. The tests are described as very mechanical. Due to the very
good economic situation, high retained earnings and high amounts of cash, the compliance
with the solvency test is not seen as a major issue. The decision of the board of directors on
the distribution policy and its preparation takes a lot of time, but the associated costs are not
incremental.

Practical steps

Based on the legal analysis, the distribution process generally requires the following practical
steps which are the basis for the economic analysis.

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Figure 4.2.3-3: Due process for distributing profits (USA-California)

Due process for distributing profits

Step 1 Directors establish the value of the distribution they wish to make.
Directors determine whether the distribution would likely render the corporation
Step 2 unable to meet its liabilities (except those whose payment is otherwise adequately
provided for) as they mature (performance of the equity solvency test).
Directors consult the US GAAP (consolidated) financial statements of the
corporation and determine whether, immediately prior to the distribution, the
Step 3
retained earnings equal or exceed the amount of the proposed distribution
(performance of the retained earning test).
In case there are no or not sufficient retained earnings, directors determine
whether, immediately after the distribution,
(a) total assets (exclusive of goodwill, capitalised research and development
expenses, and deferred charges) are no less than 125 % of total liabilities
(exclusive of deferred taxes, deferred income, and other deferred credits)
Step 4
(quantitative solvency test) and
(b) current assets equal current liabilities (in case the corporation has not
earned its interest expense before taxes in the preceding two years the current
ratio is increased to 1 ¼ to 1) (liquidity test)
(performance of the remaining assets test).
If there are shares outstanding entitled to liquidation preferences, directors
Step 5 determine whether the additional restrictions imposed on distributions to junior
shares are satisfied (§ 502 CCC).
If there are shares outstanding with dividend preferences, directors determine
Step 6 whether the additional restrictions imposed on distributions to junior shares are
satisfied (§ 503 CCC).
Directors check if there are any additional restrictions contained in the articles,
Step 7
bylaws, indenture or other agreement.
The board of directors authorises the distribution by the corporation (amount,
Step 8
date of payment, etc.)
Step 9 Payment to shareholders.
If applicable, notice must be given to shareholders identifying such distribution
Step 10
as being made from a source other than retained earnings.

Analysis

Calculation of the distributable amount

The basis for both the equity insolvency and the retained earnings test are the most recent
audited US GAAP consolidated financial statements. Therefore, the performance of the tests
is not very time-consuming; the numbers are already available. Due to the high retained
earnings, the performance of the quantitative solvency test (total assets are no less than 125
percent of total liabilities) and the liquidity tests (current assets equal current liabilities) are
not regarded as an issue. It is not intended to distribute more than the retained earnings. As a
consequence, the statutory calculations are seen as simple and mechanical.

Concerning the results of the CFO questionnaire with regard to determinants for distributions
of US holding companies and their subsidiaries, please refer to the Delaware section of this
report.

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Determination of the distributable amount

Dividend policies and the intended target payout ratio are regularly communicated to the
market. The decision of the board of directors is normally prepared by different departments
of a company. The financial planning and accounting group performs a mid-term projection to
determine how much cash will be available for paying dividends and buying back shares.
They take into consideration how much cash will be required for operating purposes, the
financial commitments, and the budget. These calculations result in the figure “cash available
for distribution” which is not disclosed in the SEC report of the company (being a non-US
GAAP number) but is made public via the company’s web-site. The treasury group normally
reviews these calculations on behalf of the CFO. The whole process is primarily done for
economic reasons. In addition, the calculations are used for meeting the statutory distribution
requirements, especially the equity insolvency test.

A quarter to a half person’s work (approximately 500 to 1,000 hours) per year is needed by
average for the distribution process. The cash projections take 95 percent of the time; the
actual calculation to see if the proposed dividend can be declared (i.e., can the corporate law
tests be met) take only 5 percent of the time. Therefore, there are only about 25 to 50 hours of
work incurred by application of the California distribution rules.

Sanctions

Much effort is put into applying the distribution requirements correctly in the first place and it
is made sure that there is enough headroom concerning retained earnings and cash and cash
equivalents. Therefore, the risk of a possible liability of the board of directors is seen as low.
The application of the tests and the monitoring are purely internal processes. No external
experts are involved, except for the fact that the tests are based on financial statements which
have been audited before by the corporation’s audit firm.

Related parties

There were also no significant issues concerning the monitoring of the relationships with
related parties and potential other refluxes of funds to shareholders.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 25 – 50 - -
Hourly rate €100 €70 -
€2,500 to €5,000 - -
Total costs €2,500 to €5,000

4.2.3.3.3 Protection of shareholders / creditors

Based on the legal and economic analysis one can draw the following key conclusions
concerning the shareholders’ and creditors’ protection of the California distribution rules. The
decision whether or not to make a distribution generally rests in the discretion of the board of
directors of the corporation. Therefore, the shareholders have no statutory right to share in the
corporation’s profits unless the board of directors declares a distribution. The board’s
declaration of a dividend creates a legal obligation owed to the shareholders which generally
cannot be repealed. Not withstanding the foregoing, (minority) shareholders might bring a
lawsuit against directors, arguing that the board abused its discretion either in declaring, or in

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refusing to declare, dividends. In the United States, there are cases in which courts ordered
closely-held corporations to pay, or not to pay, a dividend. Because the decision to pay a
dividend, and its size, are normally matters protected by the business judgment rule, the
courts generally are hesitant to reverse the board’s decision. As long as directors can identify
some arguable corporate need to retain funds, courts generally will not second guess the
board’s decision. There seems to be no case where the court ordered a dividend of a public
corporation. However, due to the market forces public corporations take the shareholders’
expectations into consideration in order to increase the value of the shares. Because the
shareholders elect the directors, and the directors are often substantial shareholders
themselves, one might suppose that the directors have a strong incentive to make distributions
when consistent with maximizing shareholder value.

Shareholders and creditors are protected by the California statutory capital formation and
distribution requirements. As explained above, the entire purchase price for the shares issued
generally cannot be distributed. In case a corporation wants to distribute an amount in excess
of retained earnings, there has to be an equity ratio after the distribution of at least 20 percent.
It has to be pointed out that for the purpose of the quantitative solvency test (applicable where
the proposed distribution is higher than the retained earnings) the US GAAP consolidated
financial statements have to be adjusted. For example, goodwill has to be subtracted from the
asset side of the balance sheet. Goodwill usually is a significant asset and its subtraction
reduces the distribution capacity a lot. In addition, it has to be mentioned that – based on the
interviews conducted in the US – distributions in excess of retained earnings do not seem to
be common practice. In fact, all the corporations interviewed indicated that they have never
done it and do not plan doing it. Because of other federal and statutory restrictions as well as
liability risks it does not seem realistic that corporations make use of these possibilities.
Another strong mean of creditor protection can be seen in the mandatory equity insolvency
test. Furthermore, there are various contractual protections.

From the directors’ perspective, the distribution rules leave less leeway and flexibility
compared with other US state statutes. Nevertheless, directors can retain money when needed
for internal investments and future growth of the business without asking for shareholders’
approval and they can easily distribute excess cash. Pursuant to the interview conducted,
directors seem to live well with the statutory directors’ liability for illegal distributions. When
determining the distributable amount they refer to the audited consolidated financial
statements and to internal cash flow predictions. Complying with the California distribution
requirements is not considered very burdensome, as long as the economic condition of the
corporation is good, i.e. there is headroom in retained earnings and cash. In the case of
operating difficulties of the corporation, a liquidity problem etc., the risk of liability increases
if the directors nevertheless declare a distribution. Therefore, there are high efforts needed to
underpin distributions in such circumstances.

4.2.3.4 Capital maintenance

As described above, California law provides various provisions which preserve the
corporation’s contributed capital. The capital of a California corporation generally equals
what the shareholders paid for their stock and cannot be distributed (for details on the
exemptions to this rule see above). Furthermore, there are statutory provisions on share
repurchases, capital decreases, related party transactions and fraudulent transfers. In addition,
in practice, contractual self protection of creditors is of importance.

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4.2.3.4.1 Acquisition of own shares

4.2.3.4.1.1 Legal framework

California law generally allows share repurchases. It authorises the corporation to have the
power to issue, purchase, redeem, receive, take or otherwise dispose of, pledge, use and
otherwise deal in and with its own shares, bonds, debentures and other securities, subject to
the statutory provisions and any limitations contained in the articles and any other applicable
laws, including, importantly, the California Corporations Code restrictions on distributions.

The California law applies identical restrictions to cash and property dividends, redemptions
and share repurchases (for details see above). The California Corporations Code contains the
following tests for determining the legality of a share repurchase. A corporation cannot
acquire own shares if the corporation is, or as a result of the repurchase would likely be
unable to meet its liabilities (equity insolvency test). If the proposed distribution meets the
equity insolvency test, additional tests must be satisfied as well. The corporation may make
purchases out of its retained earnings (retained earnings test). Alternatively, a corporation
may purchase own shares if two balance sheet tests are satisfied (also referred to as remaining
assets test). The first compares total assets to total liabilities (quantitative solvency test), and
the second compares current assets to current liabilities (liquidity test). Furthermore, there are
additional restrictions imposed on repurchases of the junior securities if a corporation has
preferred stock outstanding. Finally, the California law expressly authorises additional
restrictions upon repurchases under the articles of incorporation or the bylaws, or under an
indenture or other agreement.

A California corporation registered with the Securities and Exchange Commission (SEC) as a
publicly traded corporation has to follow certain disclosure obligations. In accordance with
the Exchange Act, in each quarterly report on Form 10-Q and in the annual report on Form
10-K the corporation must provide a table showing, on a month-to-month basis the following:
the total number of shares purchased, the average price paid per share, the total number of
shares purchased under publicly announced repurchase programs, and the maximum number
of shares that may be repurchased under these programs (or maximum dollar amount if the
limit is stated in those terms).

In the case of an illegal share repurchase, the same statutory liability applies as for illegal
dividends. Directors are jointly and severally liable to the corporation for the benefit of non-
consenting creditors or shareholders. Shareholders who received the distribution with
knowledge of facts indicating its impropriety are liable to the corporation for the benefit of all
creditors or shareholders entitled to institute an action. In case the Delaware corporation is
publicly traded and therefore has to obey the rules of the SEC, there are a number of sanctions
if shares were acquired in contradiction of the law and SEC rules respectively.

Economic analysis

One California corporation interviewed entered into an accelerated share repurchase

agreement with an investment bank approved by the board of directors authorising the
company to buy back a specific number of shares or a specific dollar amount of shares over a
agreed upon period of time. Because of the fact that the statutory requirements for dividends
and stock repurchases are nearly identical and the necessary calculations are done only once
for both kinds of distributions, the evaluation of the law by the corporation is more or less the
same: only a minimal amount of work is needed to comply with the rules. Thus, the

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associated incremental costs are low. If a company decided to buy back shares despite
difficult business conditions, we would expect that the incremental costs of the application of
the statutory requirements would increase in order to achieve legal certainty.

Practical steps

The series of practical steps comprises:

Figure 4.2.3-4: Process for the acquisition of own shares (USA-California)

Acquisition of own shares

Step 1 Directors establish the amount of shares they wish to buy back.
Step 2 Directors perform the equity solvency test.
Directors consult the US GAAP (consolidated) financial statements of the
Step 3
corporation and perform the retained earning test.
In case there are no or not sufficient retained earnings, directors perform (a) the
Step 4
quantitative solvency test and (b) the liquidity test.
If there are shares outstanding entitled to liquidation and/or dividend
Step 5 preferences, directors determine whether the additional restrictions imposed on
distributions to junior shares are satisfied (§§ 502-503 CCC).
Directors check if there are any additional restrictions contained in the articles,
Step 6
bylaws, indenture or other agreement.
Step 7 The board of directors authorises the share repurchase by the corporation.
Step 8 If applicable, notice of distribution that is not chargeable to retained earnings.
If publicly traded, the corporation must disclose in the Form 10-Q quarterly
report and in the Form 10-K annual report in a table showing, on a month-to-
month basis: the total number of shares purchased, the average price paid per
Step 9
share, the total number of shares purchased under publicly announced repurchase
programs and the maximum number of shares that may be repurchased under these
programs

Analysis

One California corporation interviewed disposes of an authorisation by the board of directors

that allows the corporation to repurchase shares. The decision to buy back shares is part of the
overall distribution policy of the board described above.

The corporation pointed out that the internal process to comply with the statutory
requirements applicable to stock repurchases is similar to the dividend distribution process
described in detail above. A procedural difference is seen in the fact that for California
corporate law purposes the board must approve the aggregate amount of repurchases, a cap
per share, and a definite time period within which the repurchases must be made. The board
delegates to the CFO the power to enter into the relevant agreements within the parameters
approved by the board.

In addition, provisions of the federal Securities Exchange Act of 1934 (Section 10(b) and
SEC Rule 10b-18) have to be applied which are more time-consuming and burdensome than
the requirements of the California Corporations Code. SEC Rule 10b-18 provides a “safe
harbour” for repurchases that comply with the conditions of the rule. If the conditions are met,
the repurchase will not be deemed manipulative of the share price. The associated costs occur

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because of the requirements of the US securities legislation, not because of statutory

requirements and, therefore, are not incremental. Therefore, practically no incremental costs
are involved in this legal process. Again, due to the comfortable financial situation, the
compliance with the tests is not a big issue.
Incremental Costs
HighQ LowQ Other Costs
Hours spent 500 - -
Hourly rate €100 €70 -
€50,000 - -
Total costs €50,000

4.2.3.4.1.3 Protection of shareholders and creditors

Due to the fact that, under California law, the statutory restrictions on dividends and share
repurchases are nearly identical, one can draw the same key conclusions concerning the
associated shareholders’ and creditors’ protection of these rules based on the legal and
economic analysis.

4.2.3.4.2 Capital decrease

4.2.3.4.2.1 Legal framework

The California Corporations Code does not specifically address capital decreases. As
previously stated, the California Corporations Code does not prescribe a (minimum) stated
capital.

4.2.3.4.2.2 Economic analysis

Capital “decreases” have never been relevant to corporations in our sample. Therefore we
have not obtained any information concerning this process.

4.2.3.4.2.3 Protection of shareholders and creditors

The California provisions on capital “decreases” protect shareholders and creditors if a

shareholders’ approval is needed (in case so required by the articles of incorporation). In
general, the capital “decrease” has to be disclosed to the public.

4.2.3.4.3 Share redemption

4.2.3.4.3.1 Legal framework

A California corporation can distribute assets to stockholders by acquiring outstanding shares

through redemption or repurchase. While a repurchase is a voluntary buy-sell transaction
between the corporation and a stockholder, redemption refers to a forced sale initiated by the
corporation, in accordance with a contract or the articles of incorporation.

California law provides that a corporation may redeem any or all shares which are redeemable
at its option by (a) giving notice of redemption, and (b) payment or deposit of the redemption
price of the shares as provided in its articles or deposit of the redemption price pursuant to a
trust fund.

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The trust fund shall be set up by the corporation with any bank or trust company in the state
of California if, on or prior to any date fixed for redemption of redeemable shares, the
corporation deposits (a) a sum sufficient to redeem, on the date fixed for redemption thereof,
the shares called for redemption, (b) in the case of redemption of any uncertificated securities,
an officer’s certificate setting forth the holders thereof registered on the books of the
corporation and the number of shares held by each, and (c) irrevocable instructions and
authority to the bank or trust company to publish the notice of redemption thereof (or to
complete publication if theretofore commenced) and to pay, on and after the date fixed for
redemption or prior thereto, the redemption price of the shares to their respective holders
upon the surrender of their share certificates, in the case of certificated securities, or the
delivery of the officer’s certificate in the case of uncertificated securities, then from and after
the date of the deposit (although prior to the date fixed for redemption) the shares called shall
be redeemed and the dividends on those shares shall cease to accrue after the date fixed for
redemption.

The deposit shall continue full payment of the shares to their holders and from and after the
date of the deposit the shares shall no longer be outstanding and the holders thereof shall
cease to be shareholders with respect to the shares and shall have no rights with respect
thereto except the right to receive from the bank or trust company payment of the redemption
price of the shares without interest, upon surrender of their certificates therefore, in the case of
certificated securities, and any right to convert the shares which may exist and then continue
for any period fixed by its terms.

The California Corporations Code permits a corporation to establish one or more classes or
series of shares which are redeemable, in whole or in part, (a) at the option of the corporation
or (b) to the extent and upon the happening of one or more specified events.

Subject to special exceptions for investment companies and professional or other corporations
whose ability to conduct business is contingent upon certain shareholders continuing to hold
shares, no redeemable common shares shall be issued or redeemed unless the corporation at
the time has outstanding a class of common shares that is not subject to redemption provided
with a few limited exceptions. The circumstances under which the corporation may reacquire
its own shares also may be established by contract.

The corporation may give notice of the redemption of any or all shares subject to redemption
by causing a notice or redemption to be published in a newspaper of general circulation in the
county in which the principal executive office of the corporation is located at least once a
week for two successive weeks, in each instance on any day of the week, commencing not
earlier than 60 nor later than 20 days before the date fixed for redemption.

The notice of redemption shall set forth: (1) the class or series of shares or portion thereof to
be redeemed; (2) the date fixed for redemption; (3) the redemption price; and (4) if the shares
are certificated securities, the place at which the shareholders may obtain payment of the
redemption price upon surrender of their share certificates. Notice also should be provided to
the holder of books and records for the corporation.

A corporation’s redemption is one of the transactions within the meaning of “distribution to

its shareholders” by a corporation. Such redemption, therefore, is subject to the same
restrictions imposed on all such distributions, like for example the equity solvency test and
the retained earnings test.

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4.2.3.4.3.2 Economic analysis

We have not received any information on share redemptions and the associated costs.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs -

4.2.3.4.3.3 Shareholder and creditor protection

Shareholders and creditors are protected insofar, as the terms of the redemptions have to be
stated in the articles of incorporation. Furthermore, if the stockholders do not believe that the
price they receive for their shares redeemed is appropriate, they generally have the possibility
to challenge this. Principles of good faith and fair dealing may be implicated in the setting of
a redemption price.

4.2.3.4.4 Financial assistance

4.2.3.4.4.1 Legal framework

California law does not deal directly with transactions such as leveraged buy-outs (LBOs).

4.2.3.4.4.2 Economic analysis

We have not received any information on financial assistance.

4.2.3.4.5 Serious loss of half of the subscribed capital

4.2.3.4.5.1 Legal framework

Under California law, there is no provision which requires the board of directors to call a
shareholders’ meeting in case of a loss of half of the subscribed capital.

4.2.3.4.5.2 Economic analysis

Not applicable.

4.1.1.4.5.3 Shareholder and creditor protection

Not applicable.

4.2.3.4.6 Contractual self protection

4.2.3.4.6.1 Legal framework

California law does not bar corporations to enter into contractual credit agreements which
might have, amongst other things, an impact on the distribution capacity, as long as statutory
requirements are not violated. For over a century it has been common practice in the US that
banks and other institutional lenders who extend a large amount of credit for a substantial

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period of time to corporations protect themselves by negotiating a bond or debenture

indenture, or a loan agreement. These contracts usually contain elaborate provisions
concerning the things, the borrowing company has obliged itself to do and not to, and the
consequences in an event of breach.

4.2.3.4.6.2 Economic analysis

The interviewees pointed out that the monitoring of the covenants involves much more time
than applying the statutory distribution rules. Approximately one person’s work per year is
needed (2,080 hours).

Incremental Costs
HighQ LowQ Other Costs
Hours spent 2.080 - -
Hourly rate €100 €70 -
€208,000 - -
Total costs €208,000

4.2.3.4.6.3 Shareholder and creditor protection

The terms of the credit agreements are negotiated between the corporation and an individual
creditor or a group of creditors, and thus reflect a realistic view of what creditors desire for
their protection. The creditors of the company interviewed rely on the future prospects of a
company, mainly its profitability and its ability to generate cash necessary to pay the debts
when due. These creditors will not enter into the transaction without having a close look at the
general economic condition and future cash flow and earning potential. The maintenance of
specific liquidity and leverage ratios as well as limitations on further issuance of debt, as
frequently negotiated in loan contracts, reduce the leveraged risk of the corporation. It is thus
apparent that creditors do not focus on the sufficiency of assets remaining upon liquidation of
the corporation for the settlement of their claims, but rather on the corporation’s prospects for
remaining a viable, on-going concern. Corporation statutes, in contrast, do not deal with the
borrowers’ incurring additional debt. The interviewees pointed out that banks do not rely on
the California Corporations Code restrictions.

In addition to the creditors who negotiated the contract, other (weak) creditors lacking
adequate bargaining power (e.g. certain trade creditors) benefit from these provisions as well,
as long as the covenants are not breached.

Obviously, credit agreements and financial covenants are not specifically designed for the
shareholders’ needs. However, shareholders might be protected by these contractual
agreements indirectly insofar, as they aim at the long-term viability of the corporation.

4.2.3.5 Insolvency

4.2.3.5.1 Legal framework

California law does not discuss filing for insolvency. Federal bankruptcy law neither requires
an insolvent company to file for bankruptcy, nor is insolvency a requirement to commence a
bankruptcy proceeding. Corporations may seek to accomplish an out of court restructuring. In
the United States, under the Bankruptcy Code, an entity is insolvent if its debts are greater
than its assets, at a fair valuation, exclusive of property exempted or fraudulently transferred.

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The subject of fraudulent transactions by a debtor has been codified in California by the
enactment of the Uniform Fraudulent Transfer Act (UFTA), which is contained in the
California Civil Code. This statute applies in connection with any debtor and, in general, its
application is not affected by the fact that the debtor is a corporation. However, the UFTA
does have a particular application in connection with any distributions by a corporation to its
shareholders.

The California Civil Code provides that a transfer made or obligation incurred by a debtor is
fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was
made or the obligation was incurred, if the debtor made the transfer or incurred the obligation:
(1) with actual intent to hinder, delay or defraud any creditor of the debtor; or (2) without
receiving a reasonably equivalent value in exchange for the transfer or obligation, and the
debtor: (a) was engaged or was about to engage in a business or a transaction for which the
remaining assets of the debtor were unreasonably small in relation to the business or
transaction; or (b) intended to incur, or believed or reasonably should have believed that the
debtor would incur, debts beyond the debtor’s ability to pay as they became due.

4.2.3.5.2 Economic analysis

Generally, little time is spent on the monitoring of insolvency triggers, because companies
generate high amounts of cash, but also have very good levels of equity. Economic aspects
still prevail over legal form. However, it was pointed out that significant efforts are needed in
periods of economic crisis. In case of bankruptcies the trustees focus on illegal distributions
prior to the bankruptcy. Under the federal bankruptcy law, creditors can already attack a
dividend as fraudulent in the case of unreasonably small remaining assets after the
distribution. Therefore, already at the stage of distributions, the corporation, in general, takes
into account the insolvency law provisions of the federal bankruptcy and statutory laws.

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4.2.4 Canada

4.2.4.1 Structure of capital and shares

4.2.4.1.1 Legal framework

Canada does not follow the traditional system of legal capital rules. The general framework
for Canadian companies is the federal Canada Business Corporations Act (CBCA) which
includes provisions on Corporate Finance in Part V. It explicitly states that shares shall be
without nominal or par value.

As is the United States, Canada is a federal jurisdiction subdivided into ten provinces and
three territories. However, both the federal government and the provincial governments
regulate in the area of corporate law. Accordingly, there are fourteen corporate law statutes.
For purposes of the study, only the federal CBCA will be examined.

Structure of capital

Subscribed capital

Under the CBCA, there is no minimum capital requirement in Canada. Generally, a Canadian
company will choose to have unlimited authorised capital. It may, however, in its articles,
provide for a limit on capital. The more usual practice is to have no limit on authorised
capital. In either case, this capital is referred to as authorised capital – not stated capital. The
board of directors establishes the price for which shares are issued, including the value of any
non-cash consideration. This consideration must represent the fair value of the goods or
services provided – a matter to be determined by the board, which is entitled to rely on the
assistance of experts. The articles deal only with authorised capital – not with issued capital.

According to the CBCA the articles of incorporation shall set out the classes and any
maximum number of shares that the corporation is authorised to issue, if there will be two or
more classes of shares, the rights, privileges, restrictions and conditions attaching to each
class of shares and if a class of shares may be issued in series, the authority given to the
directors to fix the number of shares in, and to determine the designation of, and the rights,
privileges, restrictions and conditions attaching to, the shares of each series.

Except that there must be one class of shares which is characterised as common shares, these
being shares which carry the right to elect directors, the right to dividends and the right to
distribution of any remaining assets after obligations to all creditors and all other classes of
shares have been satisfied, there are no limitations on the classes of shares which may be
issued and the rights attaching to them. Since authorised capital may be unlimited, there is no
requirement to subscribe for all authorised shares in either the articles or the CBCA nor is
there any time limit by which shares must be subscribed.

Premiums

Because there is no concept of par value securities, there is no premium or contributed

surplus. A company shall maintain a separate stated capital account for each class and series
of shares it issues and shall add the appropriate stated capital account the full amount of any
consideration it receives for the shares it issues. In the financial statements, stated capital (the
consideration received for the issuance of shares) is usually described under the heading

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“shareholders equity” as “share capital“. Unless the company is a reporting issuer, its
statements are generally not available to the public – that is, there is no public disclosure of
stated capital.

Protection of the stock corporations assets

In Canada a distribution can generally only be made out of the retained earnings with the
consequence that the entire purchase price of the shares cannot be distributed.

Structure of shares

In Canada, the CBCA requires that share capital must not have a nominal or par value and
therefore shares do not have a stated value.

Only non-par value shares may be issued. Most companies have only one class of shares
(common) but a company may issue shares of as many classes with as many preferences
and/or restrictions as the articles provide. Further, Canadian corporate and securities law
permit multiple-voting and subordinate-voting shares. Shares of a class may be issuable in
series with each series having certain common rights (for example, voting rights) but varying
other rights (for example, the right to, or the amount of, a preferential dividend).

If the company has more than one class of shares, one class is usually designated as common
shares with the attributes described above and the other class or classes are generally entitled
to a preference on dividends and distributions and either entitled to special voting rights or
restricted from voting except in limited circumstances. However, the common shore rights
may be in one or more classes of shares and need not be in a single class.

The share conditions must be fully set out in the articles, which are a public document.

4.2.4.1.2 Economic analysis

Practical relevance of capital and structure of shares for an assessment of the viability of
a company

There is no par value of shares in Canada. Based on interviews conducted, we have not been
able to identify a particular view of Canadian companies regarding no-par value shares.

Regarding the importance of capital, we have additionally performed an analysis of certain

ratios concerning the capital of the main Canadian stock exchange index TSX 50.

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Figure 4.2.4-1: Ratio of share capital to market capitalisation (Canada)

Canada: Share Capital to Market

Capitalisation

15% 11%

< 5%
5%- 10%
22%
19% 10 %bis 20 %
20 %bis 30 %
> 30 %

33%

Source: One source: Share capital for the FY 2005, market capitalisation as of September 2006

Compared to market capitalisation, the capital is below of 10 % of the market capitalisation in

33 percent of the companies. For 15 percent of the companies, the capital figure amounts to
more than 30 percent.

These ratios may also be influenced by the fact that the companies shall add to the appropriate
stated capital account the full amount of any consideration it receives for the shares it issues,
including premiums. In the financial statements, stated capital is usually described under the
heading “shareholders equity” as “share capital“.

In any case, the overall importance of the capital figure does not seem to be significant.

Restriction for distribution

As the share capital does not serve as a restriction for distributions there is no role for share
capital in this regard.

Role of the capital in equity financing

Even though the capital amounts do not serve as distribution restrictions, the amounts
allocated to share capital are quite substantial.

Again, these ratios may also be influenced by the fact that the companies shall add to the
appropriate stated capital account the full amount of any consideration it receives for the
shares it issues, including premiums. In the financial statements, stated capital is usually
described under the heading “shareholders equity” as “share capital“.

The following figures have been accumulated for TSX50 companies:

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Figure 4.2.4-2: Ratio of share capital to total shareholder`s equity (Canada)

Canada: Share Capital to Total

Shareholder's Equity

2% 0%
9%

< 5%
17% 5%- 10%
10 %bis 20 %
20 %bis 30 %
> 30 %
72%

Source: One source: Share capital for the FY 2005, shareholder’s equity (consolidated) for the FY
2005

Formations

Companies interviewed are regularly in existence for a longer period. Therefore, it was
neither feasible nor useful to extract data on the initial foundation.

4.2.4.2 Capital increase

4.2.4.2.1 Legal framework

In Canada, the number of shares which a company can issue is unlimited unless a company
chooses to limit the number of shares authorised by its articles.

Increase of capital

Under Canadian law it is possible for a company to choose to have unlimited authorized
capital. Generally, shares will be issued by resolution of the directors and no shareholders’
resolution is necessary. An exceptional situation would arise if a company limited the number
of shares via an authorisation in its articles. However, such situations are rather unusual. The
company would need to amend its articles to issue shares beyond its authorised capital. This
would entail shareholder approval by an extraordinary resolution – that is, by two-thirds of
those voting - and filing of the articles of amendment with the governmental authority.

A proposal by a company to capitalise retained earnings (reserves) would be extremely rare as

there are tax disincentives to a step of this nature but, to effect this step, a company must
obtain the approval of two-thirds of the shareholders voting on the resolution.

If a listed company sets aside shares for stock option plans, it must comply with applicable
stock exchange rules (under the rules of the Toronto Stock Exchange (TSX), a shareholder
vote is required). Under TSX rules, the strike price for stock options must not be less than the
formula market price at the time of grant.

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In addition to the above TSX rules, the most important securities regulatory rule relates to
related party transactions. In this situation, if, as a result of the transaction, the number of new
shares (together with, in some cases, shares already held by the related party) cannot exceed
25% of the issued capital at the time of the transaction, on a undiluted basis, without the
approval by the requisite majority of all shareholders (for many transactions, two-thirds of
those voting) together with the favourable vote of a “majority of the minority” – that is, a
majority of the shareholders who do not have an interest in the transaction.

If a class of shares is issuable in series, the directors may authorise a new series complying
with the class conditions and, in doing so, must file articles of amendment to authorise the
series.

The shareholders have no right to set any aspect of share consideration except where this right
has been removed from the directors under an unanimous shareholders agreement. In
connection with certain related party transactions in a public company context, shareholders
may have the right to review and approve the decision of the directors to issue shares to a
related party.

Mechanisms to ensure the contribution of capital

The directors determine the consideration for shares. A share shall not be issued until the
consideration is fully paid.

Principles applicable to the purchase price on share issuance are as follows:

(i) shares may be issued at such times and to such persons and for such consideration as the
directors determine;
(ii) shares may only be issued as fully-paid and non-assessable
(iii) if the consideration is property or past services, the directors must determine that
payment in kind is not less in value than the equivalent of the money that the company would
have received if the shares had been issued for money
(iv) none of a promise to pay, a promissory note or an obligation to provide future services is
acceptable property for the payment of shares.

Pre-emption rights

The issue of pre-emptive rights is governed by the CBCA. In Canada, there is no general pre-
emptive right. The legislation specifically allows a company to include pre-emptive rights in
its articles but provides that no pre-emptive right exists if shares are to be issued for a non-
cash consideration, as a share dividend or on the exercise of a conversion, option or similar
right.

4.2.4.2.2 Economic analysis

We have not been able to retrieve reliable data for capital increases for Canada. We have been
reassured that the bulk of the compliance cost regarding capital increases of public companies
are mainly related to securities regulation, i.e. for the preparation of a prospectus.
The efforts regarding the valuation of contributions in kind mainly depend on the size and
complexity of the transaction. Smaller private deals are internally handled by M&A groups;
for large public deals, a formal valuation by investment firms are performed; such a valuation
could cost several million Can$.

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Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.2.4.2.3 Protection of shareholders and creditors

Based on the legal analysis one can draw the following key conclusions concerning the
shareholders’ and creditors’ protection of the Canadian provisions on capital increases.
Shareholders are protected insofar, as the board of directors can only increase the capital if the
additional shares are covered by the authorised capital set forth in the articles of
incorporation. Usual practice is to have no limit on authorized capital. The board of directors
establishes the price for which shares are issued; No shareholders resolution is necessary. In
some exceptional cases, e.g. (1) a listed company sets aside shares for stock option plans, it
must comply with applicable stock exchange rules, where a shareholder vote is required; (2)
In connection with certain related party transactions in a public company context,
shareholders may have the right to review and approve the decision of the directors to issue
shares to a related party.

Under Canadian law, it is not necessary to draw up a report by an independent expert in the
case of contributions in kind. Instead, it is the board of directors’ duty to determine the
consideration for stock expect where this right has been removed from the directors under an
unanimous shareholders agreement.

Generally, in Canada, there is no pre-emptive right. Pre-emptive rights can be included under
certain circumstances in the company’s articles (“Opt in approach”).

4.2.4.3 Distribution

4.2.4.3.1 Legal framework

The board of directors has the sole right to declare dividends. A dividend becomes a debt
owing by the company only after it has been declared and not paid when due. Directors have
the right to pay dividends in cash or in specie and to permit shareholders to elect to receive
stock dividends in lieu of cash. If they do, the company, in effect, buys the stock and
distributes it to the shareholders.

If a company is a reporting issuer, there are requirements relating to the setting of record dates
for the payment of dividends so that the stock can trade ex-dividend after the appropriate date
and publication requirements of these dates established by the stock exchanges.

A dividend (even a fixed dividend on preferred shares) may be declared and paid only if the
company can meet the applicable solvency test after the payment of the dividend.

Calculation of the distributable amount

The only Canadian condition applicable to payment of a dividend is a solvency test. The
Canadian test for the declaration of dividends is quite simple. A company is not entitled to
declare or pay dividends if there are reasonable grounds for believing that:

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(a) the company is, or would be after the payment is made, unable to pay its liabilities as
they fall due; or
(b) after payment of the dividend, the realisable value of its assets will be less than the
total of its liabilities and its stated capital.

This is not a GAAP test nor is there any requirement as to the accounting method to be used.
There is no direction as to the method of valuation but it must be appropriate in the
circumstances; accordingly, the going concern assumption is usually most appropriate.

In the ordinary course, a company which has earnings in excess of its dividend requirements
generally is not concerned with the solvency test. The test only becomes an issue when there
is a concern as to whether the company can meet the test. As directors will be personally,
jointly and severally liable for repayment of an improper dividend, they generally take care in
this area. The decision is ultimately that of the board but, for its own protection (it is entitled
to rely on the advice of experts if it has a reasonable belief in their credibility), it will engage
financial advisors for this purpose.

Connection to accounting rules

The solvency test is not a GAAP test nor is there any requirement as to the accounting method
to be used. There is no direction as to the method of valuation but it must be appropriate in the
circumstances; accordingly, the going concern assumption is usually most appropriate.

Determination of the distributable amount – responsibilities

The directors generally have the sole responsibility for determining whether a dividend is to
be declared and paid.

Each shareholder will know about the dividend when he or she receives his or her pro rata
payment. Further, the financial statements of the company will show what dividends have
been paid in the preceding year. Finally, if the company is a reporting issuer, the company
will have an obligation to publish a dividend notice in advance setting out the amount and
timing of dividends to allow trading pre- and ex-dividend.

Sanctions

Shareholders are entitled to challenge a dividend which has been made in violation of the
solvency test. Otherwise, the board is free to declare a dividend in whatever amount it thinks
fit. The only other remedy available to the shareholders is the oppression remedy. Because
dividends are paid pro rata, it is difficult to see how this would be effective unless the
company is closely held and there is an argument that the money is being siphoned out
through wages or consulting contracts to the benefit of certain shareholders and the detriment
of others.

4.2.4.3.2 Economic analysis

Compliance requirements concerning dividend distributions mainly derive from solvency

certificates whose format is determined by the provincial rules of Canada.

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Practical steps

Based on the legal analysis, the distribution process generally requires the following practical
steps which are the basis for the economic analysis.

Figure 4.2.4-3: Due process for distributing profits (Canada)

Due process for distributing profits

Step 1 Directors determine if the applicable solvency test is met
Step 2 Directors fix a record date
Step 3 If required, directors publish the record date (dividend notice)
Step 4 Directors declare the dividend
Step 5 The company pays the dividend.

Analysis

Calculation of the distributable amount

From an economic point of view, Canadian companies seem to follow an array of policies
concerning the level of dividend distributions. Some companies seem to determine a certain
percentage to their consolidated profits; others put more emphasis on investor relation aspects
to individually determine what could be an appealing level of dividends to the capital
markets. Companies conduct financial planning for several years ahead to make sure that the
dividend can be paid not only in the current year but is also sustainable in the future. An
interruption in constant dividend payments could have an adverse effect on the share price.

As companies are not formally bound to an accounting framework, the starting point to check
the legal compliance of a foreseen dividend payment is the solvency certificate which based
on provincial law prescribes in more or less precise legal terms which conditions the company
has to meet.

The results of a CFO questionnaire sent to Canadian companies listed on main indices name
the following factors as important and reconfirm the importance of the consolidated accounts:

Figure 4.2.4-4: Determinants for the distribution of dividends in the holding company (Canada)

"What are the determ inants for distribution of dividends by your holding
com pany?"

5
4,10
Importance

4 3,49
3,75
3,38
2,54 2,26
3,19 Canada
3
3,25
2 2,78 2,88 Non-EU Average
2,50
1,50
1
Fin. Fin. Dividend Signalling Credit rating Tax rules
performance performance continuity device considerat ions
(group (individual
accounts) accounts of the
parent
company)

Determ inants

Source: CFO Questionnaire, September 2007

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However, concerning the importance of the current legal restrictions on profit distribution, the
CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market
led solutions like rating agencies’ requirements or bank covenants. Bank covenants are ranked
higher than insolvency legislation.

Figure 4.2.4-5: Important deterrents when considering the level of profit distribution (Canada)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"

5
3,93
3,47
Importance

4
3,38
Canada
3
3,50 2,22
2,63
Non-EU Average
2
2,38
1,25
1
Distribution/Legal Rating agencies' Cont ract ual agreements Possible violations of
capit al requirements requirements with credit ors insolvency law
(covenants)

Deterrents

Source: CFO Questionnaire, September 2007

Concerning the determinants of distributions from subsidiaries, CFOs ranked tax rules higher
than demands from the ultimate parent and own investment decisions.

Figure 4.2.4-6: Determinants for the distribution of dividends by the subsidiaries (Canada)

"What are the determ inants for the distribution of dividends by your
subsidiaries?"

5
4,00 4,14
4
Importance

3,14
3,95 3,87 Canada
3
Non-EU Average
2,73
2

1
Demands from t he ultimate parent Tax rules Own investment decisions

Determ inants

Source: CFO Questionnaire, September 2007

Determination of the distributable amount

The legal compliance process is organised in the following way: the company consults with a
legal counsel concerning the required form of the solvency certificate of the relevant
provincial law under which the company is incorporated. The formats may vary from
province to province and may contain vague legal terms which need judgment calls from the
company’s side.

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The exact wording of the solvency certificate is the starting point for all legal compliance
efforts. Typically, a solvency assessment is conducted by certain key executives of the
company, e.g. CFO or vice president of treasury, and would include a check of the current
(consolidated) balance sheet position, current cash at hand to pay dividends and a projection
into the mid-term future. The relevant documentation may already be in existence for other
purposes, e.g. bank covenants. This is possible because the requirements are not exactly
defined by the solvency certificates.

The certificate is presented with additional documentation to the finance/audit committee of

the board of directors. The overall internal effort can require up to 520 hours of highly
qualified personnel (¼ man year) depending on the financing of the company. In this context
it is important to note that this effort may already include documentation for other purposes,
i.e. bank covenants. The board of director finally decides on the dividend after the
finance/audit committee has concluded on the solvency certificate. The solvency certificate is
part of the board minutes; it is normally not available to the general public.

Sanctions

As directors will be personally, jointly and severally liable for repayment of an improper
dividend, they generally take care

Related parties

We have not received any specific information concerning the monitoring activity in this
regard.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 52 - -
Hourly rate €100 €70 -
€5,200 - -
Total costs €5,200

4.2.4.3.3 Protection of shareholders / creditors

The decision whether or not to make a distribution generally rests in the discretion of the
board of directors of the company. Therefore, the shareholders have no statutory right to
decide on a dividend unless the board of directors declares a distribution. However, due to
market forces public companies normally will take the shareholders’ expectations into
account when deciding on strategies concerning the levels of dividends or an increase of the
share value.

Creditors are not explicitly protected by the Canadian capital system and statutory distribution
requirements. In Canada, distributions are allowed that leave the company almost without any
equity. However, due to the required testing as well as associated liability risks, it does not
seem realistic that companies make use of these possibilities.

Concerning incentives to comply with distribution restrictions, every director who votes in
favour of a distribution must sign a certificate stating that, in his opinion, the company
satisfies the solvency test. The solvency certificate could support shareholders and creditors in

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their assessment of the viability of the company. However, the certificate is part of the
minutes of the board and normally not publicly accessible.

4.2.4.4 Capital maintenance

Canadian law provides for different instruments dealing with capital maintenance. Among
these are the provisions on the limitation of the acquisition by the company of its own shares
and the prohibition of financial assistance as well as the provisions on capital reductions and
the withdrawal of shares. Furthermore, contractual self protection may play a certain role in
the company’s practices concerning capital maintenance.

4.2.4.4.1 Acquisition of own shares

4.2.4.4.1.1 Legal framework

Under Canadian law, the general principle is a prohibition on the acquisition of own shares,
except as permitted in the legislation, a company may neither:
(a) hold its own shares or the shares of its controlling shareholder; nor
(b) permit any subsidiary to acquire its shares.

If, however, a subsidiary does hold shares of the parent (for example, it was a shareholder
before it became a subsidiary), it must dispose of the shares within five years.

There are some specific exceptions – for example, a corporation can hold its own shares in a
representative capacity (a trustee for a third party beneficial owner) or by way a security for a
loan made in the ordinary course of business. There is also an exception if the shareholding is
necessary to enable the company to meet a minimum Canadian content share ownership
requirement of regulatory legislation - for example, telecom legislation.

Most importantly, shares may be purchased or redeemed under a provision in the articles and
according to the CBCA if, after paying for the acquired shares, the company meets the
applicable solvency test. Unusually, the shares must be cancelled except in the case of a
company with limited authorised capital where the shares can be restored to treasury. Further,
in all cases, the stated capital account of the applicable class of shares will be reduced by the
pro rata stated capital of the cancelled shares and the balance of the payment will be made
from retained earnings.

A reporting issuer may make either an “issuer bid” or a “normal course issuer bid” in
accordance with applicable securities legislation. An issuer bid must comply, to the extent
applicable, with the same regime as is applicable to related party transactions and takeover bid
rules. These include timely disclosure, a formal valuation unless an exemption exists and pro
rata treatment of all shareholders except for those who agree before the bid not to tender.

A “normal course issuer bid” is a process by which a company can acquire up to 5% of its
shares in any twelve-month period provided that no more than 2% of the shares is acquired in
any thirty-day period. It is preceded by a timely disclosure report in a form required by
securities legislation. Generally, the issuer is not active in the market in periods when insiders
are free to trade and an issuer under a normal course issuer bid cannot make the market – that
is, it can only respond at the market price from time to time by buying at market.

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If shares have been improperly purchased or redeemed, the company may apply for a court
order requiring the shareholder to return the improperly paid money and the directors are also
jointly and severally liable for any improper payment, subject to their ability to recover from
the shareholder. In both cases, the action must be brought within two years.

4.2.4.4.1.2 Economic analysis

We have not received any specific data on share buybacks. We were reassured that the
procedure as such was very burdensome if it entailed the preparation of a prospectus.

Furthermore, we have encountered “normal course issuer bids”. However, this instrument has
in fact not been used. The internal preparations covered a financial analysis based on the
normal documentation as used for distribution purposes or covenants.

Incremental Costs
HighQ LowQ Other Costs
Hours spent -
Hourly rate €100 €70
Total costs No data

4.2.4.4.1.3 Protection of shareholders and creditors

Based on the legal and economic analysis one can draw the following key conclusions
concerning the shareholders’ and creditors’ protection of the Canadian rules for acquisition of
own shares.
A Canadian company may generally neither hold its own shares or the shares of its
controlling shareholder; nor permit any subsidiary to acquire its shares. However, some
specific exceptions are possible. Most importantly in those cases, after paying for the acquired
shares, the company meets the applicable solvency test. Further, in all cases, the stated capital
account of the applicable class of shares will be reduced by the pro rata stated capital of the
cancelled shares and the balance of the payment will be made from retained earnings.
Moreover, a reporting issuer has to consider special safety measures: e.g. limited number of
shares and disclosure duties.

4.2.4.4.2 Capital decrease

4.2.4.4.2.1 Legal framework

A company may/must reduce its stated capital by the pro rata stated capital of the class of any
shares acquired by the company on:
(a) a purchase or redemption made by agreement or tender;
(b) a purchase to compromise a debt, eliminate fractional shares or cash out a director,
officer or employee;
(c) a purchase under a shareholders’ right of dissent and appraisal where a shareholder is
opposed to a fundamental corporate action (for example, an amalgamation) and the holders of
a majority of the shares have approved the transaction; and
(d) a purchase to satisfy an oppression remedy court order.

In addition, a company may reduce its capital for any purpose by a special resolution under a
favourable vote of two-thirds of the shares voting on the resolution. Unless the purpose is,

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however, to reduce its capital to an amount represented by realisable assets, it may not do so
unless it meets the applicable solvency test.

4.2.4.4.2.2 Economic analysis

We have not encountered any cases of capital decreases.

4.2.4.4.2.3 Protection of shareholders and creditors

The Canadian rules are in so far shareholder and creditor protective, as they allow a reduction
of the company’s stated capital only in specified cases by law or when special resolution of
the shareholders meeting with a qualified majority of two-thirds has been past. Furthermore
under certain circumstances a solvency test is necessary.

4.2.4.4.3 Share redemption

4.2.4.4.3.1 Legal framework

Redeemable shares are expressly permitted under the Canadian legislation. Generally, the
articles of a company will set out the terms of redemption of a class of shares and, if shares
are issuable in series, the articles will set out what terms are common to the class and what
terms may be set for each series issued within the class. If the shares are issuable in a series,
the directors must approve an appropriate amendment to the articles to designate the terms of
the series.

The articles will, therefore, set out a complete code for the redemption of shares including
matters such as notice and, on a partial redemption, the manner in which the shares to be
redeemed are to be selected (pro rata, by lot, etc.). The one provision stipulated by the
legislation is that shares may be redeemed only if the company can meet the applicable
solvency test.

If a company is a reporting issuer, the main features of its redeemable shares must be set out
in its financial statements and accompanying notes as must any financial condition (for
example, breach of a covenant in a loan document) which might impair redemption in
accordance with the share conditions.

4.2.4.4.3.2 Economic analysis

We have not received any information on share redemptions.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.2.4.4.3.3 Shareholder and creditor protection

Shareholders and creditors are protected insofar, as the terms of the redemptions have to be
stated in the terms of the issuance of shares or/and the constitution of the company.

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Furthermore, shares may be redeemed only if the company can meet the applicable solvency
test.

4.2.4.4.4 Financial assistance

4.2.4.4.4.1 Legal framework

Restrictions on financial assistance to shareholders are gradually being eliminated in Canada

and have been eliminated in the federal legislation. Accordingly, the only rules that apply are
where the target is a reporting issuer and the transaction is a takeover bid, an insider bid, an
issuer bid, a business combination or a related party transaction. There are no specific rules
applicable to LBOs.

4.2.4.4.5.2 Economic analysis

We have not received any information on financial assistance.

4.2.4.4.5 Serious loss of half of the subscribed capital

Under Canadian law, there is no provision which requires the board of directors to call a
shareholders’ meeting in case of a loss of half of the subscribed capital.

4.2.4.4.6 Contractual self protection

4.2.4.4.6.1 Legal framework

Both traditional lenders (banks) and corporate bondholders negotiate both negative and
positive covenants in their loan and bond purchase agreements, as applicable. In recent years,
these covenants have grown increasingly lax. The effect of this trend has been particularly
noticed in private equity transactions (where investment grade corporate bonds are often
reduced to junk bonds) as a result of the additional leverage employed by the private equity
firms and in the recent period of economic uncertainty. The most common of these provisions
do not deal with distributions; rather they impose a limit on leverage and an interest coverage
test. Accordingly, dividends and other distributions to shareholders are often only impacted if
their payment would lead to the company failing to meet these tests. On default, further
distributions to shareholders are normally prohibited. In addition, if there is subordinated
shareholder debt, repayment of this will be restricted as will payment of interest if the senior
loan is in jeopardy.

In times of economic uncertainty, covenants tend to be more tightly negotiated. There are no
standard forms.

If a company fails, small creditors will generally be unprotected – primarily because they are
unsecured and, in these situations, there is usually only money available for secured creditors.
In a CCAA-style workout, unsecured creditors may not be treated as well as bondholders but
there are some protections available to them. To the extent that they extend credit to the
company while it is under the CCAA protection (“rescue money”), this credit is generally a
priority. Further, there are priority protections available in bankruptcy to employees and, to a
much lesser extent, landlords. Finally, they may enjoy a class vote on the restructuring
proposal, which may give them some negotiating leverage.

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The main reasons why lenders typically negotiate these contractual arrangements are:
(a) on default, their debt crystallizes and they can demand repayment, subject to the
ability of the company to repay and to whatever CCAA protection it negotiates;
(b) these protections give them a leverage in negotiating favourable terms on bankruptcy
or a workout, as applicable;
(c) these provisions give them some control over the operations of the company during
the period of negotiation; and
(d) in the case of operating lenders (for example, banks), they can withhold further
advances if it is in their best interests to do so.

4.2.4.4.6.2 Economic analysis

Debt covenants play an important depending on the finance leverage of the company.
Covenants relate to key performance figures of the companies, e.g. cash flow or EBITDA.
Covenants may require enormous documentation and reporting efforts. However, this
documentation may also be used for distribution and other purposes where a solvency
assessment is required.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 468 - -
Hourly rate €100 €70 -
€46,800 - -
Total costs €46,800

4.2.4.4.6.3 Shareholder and creditor protection

The terms of the credit agreements are negotiated between the corporation and the creditor,
and thus reflect a realistic view of what creditors desire for their protection.
In addition to the creditors who negotiated the contract, other (weak) creditors lacking
adequate bargaining power (e.g. certain trade creditors) benefit from these provisions as well,
as long as the covenants are not breached.
Even though, debt contracts and financial covenants are not specifically designed for the
shareholders’ needs. However, shareholders might be protected by these contractual
agreements indirectly insofar, as they aim at the long-term viability of the corporation.

4.2.4.5 Insolvency

4.2.4.5.1 Legal framework

In Canada, a company is insolvent for insolvency legislation purposes if it is unable to meet

its liabilities as they fall due (the going concern test) or if the realisable value of its assets is
less than the amount of its liabilities. In theory, both of these tests are maintenances test which
must be met at all times. In practice, however, the board is concerned with the tests only if the
company is financially troubled.

The duty of the directors is to the company and not to the creditors or even the shareholders,
although some aspects of the U.S. concept of the “zone of insolvency” are beginning to be
discussed in Canada.

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The directors must apply their business judgment as to whether and when a company files for
protection under the Bankruptcy and Insolvency Act (BIA) or the Companies Creditors
Arrangement Act (CCAA). The latter statute is a somewhat novel alternative to a standard
bankruptcy proceeding. In general terms, it affords the company and its board greater time to
effect a workout. Some companies have been under CCAA protection for up to two years. In
other words, CCCA affords a U.S.-style debtor-friendly opportunity to negotiate a workout
from insolvency.

Under the bankruptcy and insolvency legislation, however, unless a workout proposal
receives speedy creditor approval, a trustee-in-bankruptcy is appointed and control of the
company is then effectively removed from the board.

Because Canada does not have par value shares, there are no share premiums. Stated capital
ranks as the last priority on an insolvency. Subject to any claim made under the oppression
remedy, shareholder loans are treated in the same manner as any other debt and are afforded
whatever contractual rights they enjoy.

If there is a going concern issue, the board monitors both the financial pressures on the
company and its ability to meet the solvency test. If the company is not forced into
insolvency, the board determines whether to assign the company into bankruptcy under the
BIA or to seek protection under the CCAA.

Generally, if the board believes the company is viable, it will pre-emptively move under the
CCAA to avoid being forced into bankruptcy and to retain control of the situation.

4.2.4.5.2 Economic analysis

It was indicated that the specific effort of monitoring triggers of insolvency is low. The
monitoring takes place via the regular internal reporting of key financial figures. The mindset
of directors is directed towards the current assessment of the company’s financial position,
especially from a cash perspective.

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4.2.5 Australia

4.2.5.1 Structure of capital and shares

4.2.5.1.1 Legal framework

Australia does not follow the traditional system of stated legal capital. The Australian
Corporations Act 2001 specifically requires that share capital must not have a stated value and
therefore shares must also not have a par value.

Structure of capital

Subscribed capital

Under the Corporations Act 2001, shares in all companies have no par value (effective from 1
July 1998). The concept of having a par value was abolished as, amongst other things, it was
considered that par values could mislead unsophisticated investors as to the value of a
particular share. The Explanatory Memorandum to the Company Law Review Bill 1997 notes
the par value was simply an arbitrary monetary denomination which was attributed to shares
and gave no indication of the value of a share at any particular time.

There is no stated capital amount provided in the statutes although limits on capital can be
specified in the constitution of the company and companies may have a numerical limit on
shares in their constitution. For various (tax and practical) reasons, the minimum number of
shares issued is generally at least two shares although these can be of any dollar value.
Different share types can be issued which may be issued at various prices as determined by
the board of the company.

Premiums

Under Australian law, the term “share premiums” does not exist. Shares are accounted for in
accordance with the amount received since the concept of par value does not exist under
current corporation legislation. All money received is credited to the company’s share capital
account with no distinction between “par value” and “share premiums”.

Australian Accounting Standard AASB 101: Presentation of Financial Statements prescribes

the basis for preparation of general purpose financial reports for reporting entities - Clause 76
requires disclosures in the financial statements details in respect of share capital.

Protection of the stock corporations assets

In Australia a distribution can generally only be made out of the retained earnings with the
consequence that the entire purchase price of the shares cannot be distributed.

Structure of shares

In Australia, the Corporations Act specifically requires that share capital must not have a
nominal or par value and therefore shares do not have a stated value.

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4.2.5.1.2 Economic analysis

Practical relevance of capital and structure of shares for an assessment of the viability of
a company

In Australia shares do not have a par value. Upon the introduction of no-par value shares the
companies interviewed which were effected by that change faced no specific problems in
transitioning to no-par value shares. There was just a reclassification in equity with no
immediate impact on the distribution capability. The companies interviewed saw no merit in
the concept of a par value of shares and one company called the par value an “outdated
concept”.

Regarding the importance of capital, we have additionally performed an analysis of certain

ratios concerning the capital of the main Australian stock exchange index ASX 50.

Figure 4.2.5-1: Ratio of share capital to market capitalisation (Australia)

Australia: Share Capital to Market

Capitalisation

17% 13%

< 5%
5%- 10%
10 %bis 20 %
21% 30%
20 %bis 30 %
> 30 %

19%

Source: One source: Share capital for the FY 2005, market capitalisation as of September 2006

Compared to market capitalisation, the contributions allocated to capital are below of 10 % of

the market capitalisation for 43 percent of the companies. The overall importance of this
capital figure does not seem to be too significant.

Restriction for distribution

The capital as a profit distribution restriction does not play a significant role.

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Role of the capital in equity financing

Figure 4.2.5-2: Ratio of share capital to total shareholder`s equity (Australia)

Australia: Shared Capital to Total

Shareholder's Equity
2%

0% 2%

13%
< 5%
5%- 10%
10 %bis 20 %
20 %bis 30 %
> 30 %
83%

Source: One source: Share capital for the FY 2005, shareholder’s equity (consolidated) for the FY
2005

As contributions are allocated to the company’s capital, the ratio of this capital in relation to
the total shareholder’s equity is relatively high in comparison to other countries. For more
than 83 percent of the companies the ratio stays above 30 percent.

Formations

Most of the Australian companies interviewed were already in existence for a longer period
and one recently formed company faced a specific situation which can not be considered as
representative for the “regular” formation of a company. Therefore, it was neither feasible nor
useful to extract data on the initial foundation of these companies.

4.2.5.2 Capital increase

4.2.5.2.1 Legal framework

Australia law disposes of different rules regarding the issuance of new shares.

Increase of capital

When issuing securities including the issue of new shares, the process to be followed is
prescribed by the Corporations Act 2001.

The issuance of shares can be to existing shareholders or the general public (which will
include existing shareholders) and generally needs a shareholder approval. However, the
Australian regulatory environment allows shares to be issued from time to time subject to the
internal company constitution at whatever price is sought. Where the share capital of a
corporation is restricted in some way by the constitution of the company, then it will be
necessary to alter the constitution in order to provide for additional capital. This process will
be defined to some extent by the specific provisions of the constitution.

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There are certain rules relating to the listing requirements of the Australian Stock Exchange.
The key features of these rules are as follows:
• Shares can be issued without the approval of the holders of the ordinary shares (commonly
referred to as a share placement) where the issue and any other issues in the last 12 months, is
less than 15 percent of the shares outstanding at the beginning of the 12 month period;
otherwise
• Approval of the issue is required by the shareholders at a general meeting.

Mechanisms to ensure the contribution of capital

In Australia contributions in cash and in kind are possible. Non cash consideration is
permissible under the Corporations Law subject to certain notices and requirements being
satisfied. Australian case law shows that not only the general adequacy but also the particular
value of non-cash consideration for the issue of shares has traditionally been regarded as a
question for the directors' judgment.

Pre-emption rights

The Corporations Act 2001 provides pre-emption rights for existing shareholders. When a
company decides to issue shares in a particular class it is required to offer those shares on a
pro-rata basis to existing holders of shares of that class. That offer is to be made in a
statement to shareholders setting out the terms of the offer, including the number of shares
offered and the period of time that the offer will remain open. Where the pre-emption right is
not exercised by the existing shareholders, any shares not taken up may be issued by the
directors in any manner they see fit. As an alternative to complying with the foregoing, the
company may, in general meeting, pass a resolution authorising the directors to make a
particular issue of shares.

4.2.5.2.2 Economic analysis

The cost for capital increases of public companies seem to be mainly dominated by
compliance cost with securities regulation, e.g. for the preparation of a prospectus.

Practical steps

The following chronological order of practical steps would be necessary for a capital increase:

Figure 4.2.5-3: Process for capital increase (Australia)

Capital increase
Step 1 Proposal of the board to issue new shares
Step 2 Invitation to shareholders’ meeting
Resolution by shareholders on capital increase and amendment to the Constitution
Step 3
(Memorandum and Articles of Association)
Step 4 Amending the Constitution to raise the amount of capital / funds
Step 5 Publication

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The injection of contributions and the valuation process would comprise the following steps:

Figure 4.2.5-4: Process for the injection of contributions (Australia)

Injection of contributions
Step 1 Monitoring if assets can be contributed
Step 2 Monitoring of the requirements linked to the payment
Performance of the valuation process by the board / possibility of shareholders
Step 3
setting the amount that must be paid in themselves

Analysis

Because theses processes have not been relevant to nearly all of the corporations interviewed
in recent years, we have only received very limited information on practical cases of regular
capital increases including contributions-in-kind.
Only one company interviewed had a capital increase in form of a major “rights issue”. In this
case, there had not been any shareholder approval needed for this “rights issue”. A board
approval was sufficient.
The issue represented a major effort for the company in which the legal, tax and treasury
departments were involved. Eight to twelve man-months were spent on the preparation of the
respective decision. The board discussions could have taken approximately 20 hours.
Furthermore external advice is needed including legal advice and accounting. Overall several
million A$ were spent on this advice. Furthermore the publications necessary amounted to a
minor expense (compared to the overall expense) as well. This process included the
documentation of the issue and the preparation of a prospectus. Overall, the burdens for this
issue were mainly driven by securities legislation and, thus, do not represent incremental costs
stemming from company law. The specific circumstances of this “rights issue” would also not
necessarily be indicative for the Australian situation concerning capital increases.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 20 - -
Hourly rate €100 €70 -
€2,000 - -
Total costs €2,000

4.2.5.2.3 Protection of shareholders and creditors

Under Australian law preventive rights exist. Based on the legal analysis one can draw the
following key conclusions concerning the shareholders’ and creditors’ protection of the
Australian provisions on capital increases. The issuance of shares generally needs a
shareholder approval. However, the Australian regulatory environment allows shares to be
issued from time to time subject to the internal company constitution at whatever price is
sought. With respect to listed companies the following exception exists: Shares can be issued
without the approval of the holders of the ordinary shares (commonly referred to as a share
placement) where the issue and any other issues in the last 12 months, is less than 15 percent
of the shares outstanding at the beginning of the 12 month period.

Under Australian law, it is not necessary to draw up a report by an independent expert in the
case of contributions-in-kind. Instead, it is the directors’ duty to determine the consideration
for stock.

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4.2.5.3 Distribution

4.2.5.3.1 Legal framework

The Australia Corporations Act does not define “distributions”. However, pursuant to the
prevailing opinion, distributions include distributions of profits, being dividends and
distributions of capital. In addition, the directors may fix the method of payment of a
dividend. The methods of payment include the payment of cash, the issue o shares, the grant
of options and the transfer of assets.

Calculation of the distributable amount

In Australia, the profit distribution rules are straight forward: any amount can be distributed
as long as they are paid out of profits and do not render the corporation insolvent.

In addition to the statutory requirements there are court decisions on distributions. Therefore,
the principles established by case law have to be taken into consideration, too, when an
Australian corporation determines the amount of a legal distribution. This series of rules
governing the payment of dividends comprises that (1) dividends must not be paid if the result
is that the company is unable to pay its debts; (2) current revenue profits may be distributed
without making good revenue losses of previous periods; and (3) undistributed profits remain
profits which can be distributed in later years.

According to the profits test, in Australia dividends may only be paid out of the corporation’s
profits. Moreover, Australian law provides that a dividend may be payable by way of cash,
the issue of shares, the grant of options and the transfer of assets. Being a replaceable rule,
technically, the company could amend that definition by adopting an alternate rule as part of
its constitution.

In Australia, there is case law on the treatment of losses of fixed assets when determining the
distributable amount. Losses in circulating assets in the current accounting period must be
taken into account in calculating divisible profit.

With respect to solvency tests, in Australia, there is a need for an overriding condition of
solvency. Australian law makes it clear that the payment of a dividend may be an act of
insolvent trading. While it is well established that a company may borrow in order to obtain
the cash necessary to pay the dividend it appears that the money borrowed together with funds
in hand must be sufficient to cover not only the dividend but also liabilities presently due and
payable.

The relevant guiding principles are defined by Australian case law:

“(1) Dividends including capital dividends may be paid only out of profits, or putting the
matter conversely, may not be paid out of paid up capital without the Court’s approval of a
reduction of capital.

(2) The payment of a dividend out of paid up capital will occur if the payment has the effect
of reducing the company’s net assets (often referred to as shareholders’ funds) below the
amount of its paid up capital. The expression ‘net assets for present purposes’ means the
amount which remains after deducting all the company’s liabilities both actual and contingent
prudently assessed from the sum of all its assets prudently valued. Accounts should be taken

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to demonstrate the company’s position overall. A capital or income transaction should

ordinarily not be viewed in isolation.

(3) Whether there are profits and if so how much thereof should be paid out as dividend is
essentially a matter of commercial assessment and judgment but that assessment and
judgment must be made and exercised with these and the following propositions in mind.

(4) No dividend may be paid, whether out of capital or income profits, if the company is in a
state of trading insolvency.

(5) No dividend may be paid, whether out of capital or income profits, if the company is in a
state of balance sheet insolvency, or will enter that state as a result of the payment.

(6) No dividend may be paid, whether out of capital or income profits, if the company is in a
state of doubtful trading or balance sheet solvency [sic] unless the directors can demonstrate,
if later challenged, that they believed in good faith and on reasonable grounds that the
payment of the dividend would not jeopardise the company’s ability promptly to satisfy its
creditors present and future and whether secured or unsecured.

(7) Even if the company is fully solvent in both the trading and balance sheet senses no
dividend may be paid whether out of capital or income profits if the directors ought to have
appreciated that such payment was likely to jeopardise the company’s balance sheet or trading
solvency.”

All companies, registered schemes and disclosing entities required to prepare annual financial
statements must also prepare a directors' declaration about the financial statements. The
directors' declaration must state firstly: whether, in the directors' opinion, there are reasonable
grounds to believe that the company, scheme or entity will be able to pay its debts as and
when they become due and payable (known as the "solvency declaration); secondly: whether,
in the directors' opinion, the financial statements and notes have been prepared in accordance
with the Act including accounting standards present a true and fair view. While not
specifically stated in the Act, because the directors' declaration on the financial statements
forms part of the financial report. Both, ASIC and the AuASB, hold the view that the
directors' declaration forms part of the financial statements and should be audited. The
auditor's duty is to form an opinion as to whether the directors' declaration is in accordance
with the Act.

With respect to nimble dividends, there are Australian court decisions concerning the question
whether or not current revenue profits may be distributed without making good revenue losses
of previous periods. It was held that losses in prior years need not be made good before
ascertaining available profit for the current year.

Connection to accounting rules

All companies in Australia are subject to IFRS as adopted in Australia. The profits/retained
earnings determined under these standards form the basis for dividend distributions. Shares
are accounted for in accordance with the amount received since the concept of par value does
not exist under current corporation legislation. All money received will be credited to the
company’s share capital account with no distinction between “par value” and “share
premiums”.

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Australian Accounting Standard AASB 101: Presentation of Financial Statements prescribes

the basis for preparation of general purpose financial reports for reporting entities - Clause 76
requires disclosures in the financial statements details in respect of share capital.

The Australian equivalents of International Financial Reporting Standards (AIFRS) apply for
reporting periods on or after 1 January 2005. ASIC has clarified that its interpretation of the
impact of the AIFRS is that retained profits reported on a pre-AIFRS basis will not be
relevant for the payment of dividends. Thus, for the purposes of determining whether or not
companies are able to pay dividends, only retained profits and current year profits recorded
under AIFRS will be relevant from that time going forward: This will include unrealised gains
under AIFRS.

Determination of the distributable amount – responsibilities

In Australia, the declaration of dividends generally is within the discretion of the board of
directors. Pursuant to Australian law, the directors may determine that a dividend is payable
and fix the amount, the time for payment and the method of payment. However, directors
have to obey any restrictions in the statutes and the applicable statutory provisions as well as
the principles derived from case law.

Unless a public company has a constitution which provides for shares in a class to have
different dividend rights or different dividend rights are provided for by special resolution,
each share comprised in that class has the same dividend rights. In relation to listed
companies, the holders of partly-paid securities are entitled to a dividend no greater than the
proportion paid up (ignoring amounts being paid in advance of calls).

Sanctions

A dividend that is paid other than out of profits would result in a reduction of capital. The
directors may be liable to the creditors or liquidator of a company for the amount of a
dividend paid which exceeds available profits Auditors may be liable in negligence for acts or
omissions which result in a payment of dividends out of capital.

It would also appear that a right of action may exist against shareholders who receive wrongly
paid dividends. This right of action may depend on the shareholders’ state of mind when the
payment was received. At least in the case of a knowing recipient who was aware of the
wrongfulness of the payment, liability is fairly settled. The position of innocent recipients is
less clear. Their liability may turn on the nature of the action.

4.2.5.3.2 Economic analysis

The Australian requirements concerning profit distributions are mainly governed by

comprehensive jurisprudence. However, this large amount of jurisprudence is rather focussed
on extreme situations that companies may face and is not likely to affect companies with a
good earnings position.

Practical steps

Based on the legal analysis, the distribution process generally requires the following practical
steps which are the basis for the economic analysis.

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Figure 4.2.5 -5: Due process for distributing profits (Australia)

Due process for distributing profits

Directors determine the amount of dividend to be paid
Step 1 (Performance of impairment of capital test/ retained earnings test etc; Performance
of solvency test)
Step 2 Final dividend formally approved by shareholders at a general meeting
Amount, ex-dividend date, taxable amount (franked versus unfranked amounts)
Step 3
and payment date
Step 4 Payment to shareholders

Analysis

Calculation of the distributable amount

From an economic point of view, the management of the companies interviewed follow
diverse policies concerning the level of dividend distributions. For example, some companies
generally determine a certain percentage to their consolidated profits; others put more
emphasis on investor relation aspects to individually determine what could be an appealing
level of dividends to the capital markets. Another aspect that is taken into account is the fact
that Australian taxation regarding dividends paid is based on a “franking system”.

All companies in Australia have to apply the Australian adoption of International Financial
Reporting Standards. One company applied the international version of IFRS additionally.
The profits/retained earnings determined under these standards form the basis for dividend
distributions.

The results of a CFO questionnaire sent to Australian companies listed on main indices show
the following determinants for distributions from subsidiaries:

Figure 4.2.5-6: Determinants for the distribution of dividends in the holding company (Australia)

"What are the determ inants for the distribution of dividends by your holding
com pany

5 4,74
Importance

3,89 3,44
4
4,10 2,89 2,74
3,21 Australia
3 3,49 3,19
2
2,78 2,54 Non-EU Average
2,26
1
Fin. Fin. Dividend Signalling Credit rat ing Tax rules
perf ormance perf ormance continuit y device considerations
(group (individual
accounts) account s of the
parent
company)

Determ inants

Source: CFO Questionnaire, September 2007

However, concerning the importance of the current legal restrictions on profit distribution, the
CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market
led solutions like rating agencies’ requirements or bank covenants.

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Figure 4.2.5-7: Important deterrents when considering the level of profit distribution (Australia)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"^

5
3,95
3,63
Importance

4 3,38
3,93
2,58 3,47
Australia
3
3,26 Non-EU Average
2
2,22

1
Distribution/Legal Rating agencies' Cont ract ual agreements Possible violations of
capit al requirements requirements with credit ors insolvency law
(covenants)

Deterrents

Source: CFO Questionnaire, September 2007

Concerning the determinants of the distributions from subsidiaries, the results of a CFO
questionnaire sent to Australian companies listed on main indices shows the following
picture.

Figure 4.2.5-8: Determinants for the distribution of dividends by the subsidiaries (Australia)

"What are the determ inants for the distribution of dividends by your
subsidiaries?"

5
4,61
3,87
4
Importance

3,95
3,72 2,73 Australia
3
Non-EU Average
2,50
2

1
Demands from the ultimat e parent Tax rules Own investment decisions

Determ inants

Source: CFO Questionnaire, September 2007

Determination of the distributable amount

The responsibility for the decision on dividend distributions lies with the board of directors.
The CFO, the tax and treasury departments are regularly involved in the process of preparing
that decision and proposing a dividend to the board. In one company a specifically dedicated
employee of the CFO team prepares a document which after the review by the CFO is used as
a basis for the decision of the board. Also the audit committee of the company may get
involved in the discussion on the distribution proposal. Generally, the companies undergo this
process twice a year due to an interim dividend paid.

The preparation time was estimated in a range between 5 to 20 hours of highly qualified
personnel and the board decisions including discussions of the board and the audit committee
take between 1.5 to 84 man hours of the same category. The actual time spent also depends on
the size and complexity of the company.
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The companies interviewed generally perform cash flow projections, budget forecasts or
business plans for the management of the company. This information is also used for the
decisions concerning distributions. But no company indicated that a special cash flow
projection system was set up exclusively for distribution purposes. Furthermore, some
companies stated that the board has to issue a “solvency declaration” in another context. Even
though not dedicated for distribution purposes, distributions are an issue when there are
discussions in the board on this “solvency declaration”.

It depends on the specific situation of the company whether a significant effort is necessary to
channel up profit and cash to the parent company level in order to be able to make
distributions. Some of the companies interviewed stated that this was not an issue due to their
group structure; others indicated significant efforts in this regard. We have neither been given
specific reasons nor have we been in a position to receive detailed cost data on these efforts.

All companies engage specific agencies for the final payment of dividends. These costs are
covered by service agreements and depend on the number of shareholders as well. Since these
costs are mainly driven by capital market requirements, they may not be seen as incremental.
One company indicated that 4 hours of highly qualified personnel were spent for the internal
preparations for the payment of the dividends.

Sanctions

One company regarded the effort spent on monitoring the compliance with distribution
regulations as high; the other companies saw the specific monitoring effort as low. All
companies regarded the liability risk due to non-compliance as low. This may be based on the
reliance on distribution process implemented and/or simply due to a positive economic
situation of the company.

Related parties

The level of monitoring concerning related party transactions depends on the individual
shareholder structure of the companies interviewed. Half of the companies interviewed
considered the efforts to be high and the other half of the companies to be low. One company
has a major shareholder and reviews related party transactions regularly every three month.
Some of the companies interviewed do not have significant related parties outside the group.

The focus of tracking related party transactions generally lies on related party disclosures
required in the financial statements of the companies. The reflux of funds does not appear to
be an immediate focus of the monitoring processes.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 6.5 to 104 - -
Hourly rate €100 €70 -
€650 to €10,400 - -
Total costs €650 to €10,400

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4.2.5.3.3 Protection of shareholders / creditors

Based on the legal and economic analysis one can draw the following key conclusions
concerning the shareholders’ and creditors’ protection of the Australia distribution rules. The
decision whether or not to make a distribution generally rests in the discretion of the board of
directors of the corporation. Therefore, the shareholders have no statutory right to share in the
corporation’s profits unless the board of directors declares a distribution.
Shareholders and creditors are protected by the Australian statutory capital formation and
distribution requirements. As explained above, a dividend may only be paid out of profits of
the company, accordingly the entire purchase price for the shares issued generally cannot be
distributed. All companies in Australia are subject to IFRS as adopted in Australia. The
profits/retained earnings determined under these standards form the basis for dividend
distributions. Furthermore, in Australia, there is a need for an overriding condition of
solvency. The Corporations Act makes it clear that the payment of a dividend may be an act
of insolvent trading.

4.2.5.4 Capital maintenance

Australian law provides for different instruments dealing with capital maintenance. Among
these are the provisions on the limitation of the acquisition by the company of its own shares
and the prohibition of financial assistance as well as the provisions on capital reductions and
the withdrawal of shares. Furthermore, contractual self protection may play a certain role in
the company’s practices concerning capital maintenance.

4.2.5.4.1 Acquisition of own shares

4.2.5.4.1.1 Legal framework

A prohibition of the self-acquisition of shares (or units in shares) reflects the concerns
expressed in the case law. It was held that persons who deal with a company “are entitled to
assume that no part of the capital which has been paid into the coffers of the company has
been subsequently paid out, except in the legitimate course of its business.”

According to the Corporations Act 2001, a company must not acquire shares in itself except:

(a) in buying back shares under § 257A CA; or

(b) in acquiring an interest (other than a legal interest) in fully-paid shares in the company if
no consideration is given for the acquisition by the company or an entity it controls; or
(c) under a court order; or
(d) in circumstances covered by § 259B(2) or (3) CA, i.e. taking security over own shares
under an employee share scheme or by a financial institution.

Concerning the conditions for share repurchases, it is firstly required that buy-backs do not
materially prejudice the company’s ability to pay its creditors and secondly, the company
must follow procedures laid down by the Corporations Act 2001. The solvency test only
refers to the ability to pay the creditors and is confined to a material impact. Under the
Corporations Act, the directors may have to compensate the company if the company is, or
becomes, insolvent when the company enters into the buy-back agreement.

A table in the Corporations Act specifies the steps required for, and the sections that apply to,
the different types of buy-back. An ordinary resolution is required if the buy-back exceeds

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10% of the voting rights during a period of 12 month (10/12 limit), a selective buy-back
requires a special or unanimous resolution.

Immediately after the registration of the transfer to the company of the shares bought back,
the shares are cancelled.

Regarding disclosure, in cases of a selective buy-back or a share buy-back under an equal

access scheme the offer documents must be lodged with the Australian securities regulator
ASIC and the company must include with the offer to buy back shares a statement setting out
all information known to the company that is material to the decision whether to accept the
offer.

4.2.5.4.1.2 Economic analysis

Some of the companies interviewed have acquired own shares in the recent past. One of the
reasons given for the repurchase of own shares was excess funds of the companies.

The share buyback processes implemented in the companies are comparable to those for
dividend distributions. Generally, the treasury function is involved in the buybacks.
Depending on the specific circumstances the time spent on the preparation of the board
decision amounts from 30 to a few hundred hours of highly qualified personnel. The board
decision itself takes between 5.5 and 24 man hours. Additionally, one company has spent a
significant amount of fees (approx. A$ 380,000) for legal advice deemed necessary for a
major buyback of shares.

In addition to the buyback itself there are reporting requirements. One company indicated that
it takes 5 minutes per month of reporting time.

Some interviewees had stock option programmes in which share-buybacks are an essential
element. One company outsourced this task to a trustee. One other company estimated the
effort for these buybacks between two and three hours of highly qualified personnel. Overall,
the efforts for these acquisitions are not as burdensome as the “regular” re-acquisitions of own
shares.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 35.5 to 325 - -
Hourly rate €100 €70 -
€3,550 to €32,500 - -
Total costs €3,550 to €32,500

4.2.5.4.1.3 Protection of shareholders and creditors

Under Australian law a company generally must not acquire shares in itself. An acquisition of
own shares is only possible, if the buy-back does not materially prejudice the company’s
ability to pay its creditors. Furthermore, shareholders are protected insofar as a shareholders’
resolution is required if the buy-back exceeds 10% of the voting rights during a period of 12
month (10/12 limit); a selective buy-back requires a special or unanimous resolution.

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4.2.5.4.2 Capital decrease

4.2.5.4.2.1 Legal framework

Australian Law applies the alternative model for capital in that no par value applies.
Nonetheless there are various means by which capital can be returned to the company.

The Corporations Act defines the means and requirements for reductions in capital and share
buy-backs. The rules are designed to protect the interests of shareholders and creditors by:

(a) addressing the risk of these transactions leading to the company’s insolvency
(b) seeking to ensure fairness between the company’s shareholders
(c) requiring the company to disclose all material information.

Subject to a company’s constitution, a company may reduce its share capital in a way that is
not otherwise authorised by law if the reduction is fair and reasonable to the company’s
shareholders as a whole and does not materially prejudice the company’s ability to pay its
debts. A cancellation of a share for no consideration is generally a reduction of share capital.
One of the ways in which a company might reduce its share capital is cancelling uncalled
capital.

The company must not make the reduction unless it complies with these requirements. If the
company contravenes the requirements, the contravention does not affect the validity of the
reduction or of any contract or transaction connected with it and the company is not guilty of
an offence. Any person who is involved in such a company’s contravention and the
involvement is dishonest, commits an offence.

Reductions in capital are either an equal reduction or a selective reduction. The reduction is
an equal reduction if it relates only to ordinary shares, it applies to each holder of ordinary
shares in proportion to the number of ordinary shares they hold and the terms of the reduction
are the same for each holder or ordinary shares. Otherwise, the reduction is a selective
reduction. The Corporations Act requires that if the reduction is an equal reduction, it must be
approved by a resolution passed at a general meeting of the company.

If the reduction is a selective reduction, it must be approved by either (a) a special resolution
passed at a general meeting of the company, with no votes being cast in favour of the
resolution by any person who is to receive consideration as part of the reduction or whose
liability to pay amounts unpaid on shares is to be reduced, or by their associates; or (b) a
resolution agreed to, at a general meeting, by all ordinary shareholders.

If the reduction involves the cancellation of shares, the reduction must also be approved by a
special resolution passed at a meeting of the shareholders whose shares are to be cancelled.

The company must lodge with ASIC a copy of any resolution concerning a selective reduction
within 14 days after it is passed. The company must not make the reduction until 14 days after
the lodgement.

Furthermore, the company has to pass the solvency test, otherwise the directors may have to
compensate the company if the company is, or becomes, insolvent when the company reduces
its share capital.

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4.2.5.4.2.2 Economic analysis

Within our sample of Australian companies, we have not encountered any “regular” capital
decreases. One similar situation encountered was company specific and is not covered by the
rules of Australian corporation law.

4.2.5.4.2.3 Protection of shareholders and creditors

Both kinds of reductions in capital, i.e. an equal reduction or a selective reduction, require a
resolution of the shareholders. Therefore, in both cases shareholders are involved in the
decision making process. Furthermore, the company has to pass the solvency test, otherwise
the directors may have to compensate the company if the company is, or becomes, insolvent
when the company reduces its share capital.

4.2.5.4.3 Share redemption

4.2.5.4.3.1 Legal framework

An Australian company may issue redeemable preference shares. Under the Corporations Act,
a company’s power to issue shares includes the power to issue preference shares including
redeemable preference shares. The power to issue redeemable shares is also determined by the
constitution of the company, and follows the approval process as set out in the constitution
(including the statutes) or by approval of the shareholders by special resolution.

The conditions under which the redeemable shares can be redeemed are prescribed by the
terms of issue (included in any offering document such as a Prospectus or Information
Statement). On redemption, the shares are cancelled. A company may only redeem
redeemable preference shares if the shares are fully paid-up and out of profits or the proceeds
of a new issue of shares made for the purpose of the redemption.

Furthermore, the company has to pass the solvency test, otherwise the directors may have to
compensate the company if the company is, or becomes, insolvent when the company reduces
its share capital.

If a company redeems shares in contravention of the Corporations Act, the contravention does
not affect the validity of the redemption or of any contract or transaction connected with it;
and the company is not guilty of an offence. Any person who is involved in a company’s
contravention of the Corporations Act and the involvement is dishonest, commits an offence.

4.2.5.4.3.2 Economic analysis

Within our sample of Australian corporations, we have not received any information on share
redemptions.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

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4.2.5.4.3.3 Shareholder and creditor protection

Shareholders and creditors are protected insofar, as the terms of the redemptions have to be
stated in the terms of the issuance of shares or/and the constitution of the company.
Furthermore, the company has to pass the solvency test, otherwise the directors may have to
compensate the company if the company is, or becomes, insolvent when the company reduces
its share capital.

4.2.5.4.4 Financial assistance

4.2.5.4.4.1 Legal framework

The Australian Corporations Act 2001 deals directly with assistance by a company in the
purchase of its own shares. Pursuant to the Corporations Act, a company may financially
assist a person to acquire shares (or units of shares) in the company or a holding company of
the company only if (a) giving the assistance does not materially prejudice the interests of the
company (or its shareholders), or the company’s ability to pay its creditors; or (b)
shareholders’ approval is given by special resolution or a resolution agreed to by all ordinary
shareholders; or (c) the assistance is exempted under § 260C CA. The provision includes in
particular an exemption for financial institutions, for subsidiaries of debenture issuers, and for
cases in which other provisions must be complied with, such as capital reduction or share
buy-backs.

There is no definition in the Corporations Act of what is meant by “financially assist”. The
issue of what constitutes financial assistance only becomes relevant for a transaction which
involves a material prejudice to the company, its shareholders or its ability to pay its creditors.
If there is no material prejudice it is unnecessary to decide whether the transaction involves
the giving of financial assistance.

As with “material prejudice”, it would seem that what constitutes financial assistance is a
question of fact to be answered in light of the prevailing circumstances. In the absence of
legislative guidance to the contrary, the expression would appear to be intended to be given a
wide meaning. To that end, the illustrative examples given in the former § 205(2) CA of the
Law can be taken as illustrative for the purposes of the present Act, these examples include
the making of a loan, the giving of a guarantee, the provision of security, the release of an
obligation and the forgiving of a debt. It is further submitted that in assessing whether a
transaction constitutes financial assistance, the economic and commercial substance and effect
of the transaction should prevail over its legal form. Accordingly, a transaction may have the
effect of providing financial assistance for the acquisition of shares (or units of shares) in a
company, notwithstanding the existence of an alternate intent. The use of the expression “on
ordinary commercial terms” in § 260C(5)(d) CA may indicate that the whole of a transaction
could be viewed as providing financial assistance where it is made other than on ordinary
commercial terms.

Consistent with the Law applying prior to 1 July 1998, the person to whom the financial
assistance is given need not be the person who acquires the shares or unit of shares. The
section is directed to the provision of financial assistance to whomsoever given (including the
vendor), provided that it be for the purpose of, or in connection with, the acquisition of shares
or units of shares.

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Concerning disclosure, the notice of a shareholders’ meeting must include a statement setting
out all the information known to the company or body that is material to the decision on how
to vote on the resolution under § 260B CA. The company must lodge with ASIC a copy of the
notice of the meeting and any document relating to the financial assistance that will
accompany the notice of the meeting sent to the members. Furthermore, the company must
lodge with ASIC, at least 14 days before giving the financial assistance, a notice in the
prescribed form stating that the assistance has been approved.

If a company fails to comply with the requirements, neither the financial assistance nor any
transaction or contract connected to it is not void or voidable. The company is not guilty of an
offence. A person involved in the company’s contravention is liable according to civil penalty
provisions, and commits an offence if the involvement is dishonest.

4.2.5.4.4.2 Economic analysis

Within our sample of Australian corporations, we have not received any information on
financial assistance.

4.2.5.4.4.3 Shareholder and creditor protection

Australian law contains provisions with respect to financial assistance concerning

shareholders and creditors protection. If a financial assistance entails a “material prejudice” to
pay its creditors, than the board could be liable.

4.2.5.4.5 Serious loss of half of the subscribed capital

Under Australian law, there is no provision which requires the board of directors to call a
shareholders’ meeting in case of a loss of half of the subscribed capital.

4.2.5.4.6 Contractual self protection

4.2.5.4.6.1 Legal framework

In Australia, debt arrangements and supplier or other creditor arrangements are negotiated
between the lender and an authorised person in the company. Such authorisations are
generally delegated to various persons in the company depending upon the size of the
commitment and their area of accountability. For example, supplier arrangements will be
negotiated with the procurement division. Large debt will be negotiated with the Treasurer or
the Chief Financial Officer etc. The documentation in relation to debt is not a prescribed
uniform contract, although many contracts contain similar provisions and content as practices
have developed over time.

Smaller creditors and suppliers do not generally have the means for mitigation of the credit
exposure described for the debt providers below. Rather, such suppliers are reliant upon strict
billing and collection procedures to ensure amounts are collected within a reasonable time of
the goods and services being provided.

Banks and other financial institutions that provide debt to corporations negotiate the terms
and conditions of the debt directly with the Corporation. Debt providers conduct assessments
of the borrower before providing funds and this influences the amount of security or other
credit mitigation they will seek to obtain before providing the funds. Broadly speaking, the

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less confidence the lender has in the ability of the company to meet the debt repayments, the
more terms and conditions associated with the debt will be sought.

In order to protect themselves against losses from the lending to the corporate it is usual to
negotiate certain terms and conditions. The terms and conditions negotiated reflect the type of
lending provided. The two broad categories of lending and common terms and conditions are
(a) cash flow lending (where recovery is based on the profitability and cash flows of the
business in order to meet repayments of the debt), and (b) asset lending (where the funds are
provided for the purposes associated with a particular asset such as property and plant;
accordingly the debt is generally secured by a charge over the asset. A mortgage over the title
to the property is a common example).

4.2.5.4.6.2 Economic analysis

All Australian companies interviewed have entered into debt arrangements with covenants.
These are required by Australian as well as international banks. One company issued debt in
the United States. We have not received any information on the specific nature of these
covenants.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs -

4.2.5.4.6.3 Shareholder and creditor protection

The terms of the credit agreements are negotiated between the corporation and the creditor,
and thus reflect a realistic view of what creditors desire for their protection.

In addition to the creditors who negotiated the contract, other (weak) creditors lacking
adequate bargaining power (e.g. certain trade creditors) benefit from these provisions as well,
as long as the covenants are not breached.

Even though, debt contracts and financial covenants are not specifically designed for the
shareholders’ needs, shareholders might be protected by these contractual agreements
indirectly insofar, as they aim at the long-term viability of the corporation.

4.2.5.5 Insolvency

4.2.5.5.1 Legal framework

The legislative basis for identifying and managing insolvent companies is the Corporations
Act 2001. Under the Act, there are a number of mechanisms that trigger the laws in relation to
insolvency.

Pursuant to the Corporations Act, the company, a creditor, a contributory, a director, a

liquidator, the ASIC or a prescribed agency may apply to the court for a company to be
wound up in insolvency. Under Australian law, a person is solvent if, and only if, the person
is able to pay all the person’s debts, as and when they become due and payable (a person who
is not solvent is insolvent). In determining, for the purposes of such an application, whether or

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not the company is solvent, the Court may take into account a contingent or prospective
liability of the company. The directors of a company must pass a solvency resolution within 2
months after each review date for the company (and at least once every year).

The legislative basis for identifying and managing insolvent companies is the Corporations
Act 2001. A company is solvent if it is able to pay its debts as and when they fall due –
otherwise the company is insolvent. The directors of a company must attest to the solvency of
a company each year in accordance with the Act. The decision whether a company should be
wound up by the court is a matter for the discretion of the relevant court. The matters that the
court might take into account have been discussed in various cases. In one case, the court held
that the decision whether or not a winding up order will be made is a matter entirely within
the discretion of the judge whose decision cannot be interfered with unless the judge is wrong
in law. Further, the court held that where there is a voluntary liquidation in progress and the
majority of the creditors oppose the making of a winding up order the court would require the
applicant to show special reasons or circumstances why an order should be made.

4.2.5.5.2 Economic analysis

All companies indicated that the specific effort of monitoring triggers of insolvency is low.
The monitoring takes place via the regular internal reporting of key financial figures.

Two companies indicated that the potential insolvency is regarded as one aspect of the
solvency declaration that has to be signed by the company’s management twice a year for
other purposes.

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4.2.6 New Zealand

4.2.6.1 Structure of capital and shares

4.2.6.1.1 Legal framework

New Zealand does not follow the system of a fixed legal capital. The Companies Act 1993
specifically requires that share capital must not have a nominal or par value and therefore
shares do not have a stated value.

Structure of capital

Subscribed capital

In New Zealand, the Companies Act clarifies that a share must not have a nominal or par
value. However, nothing would prohibit the company from stating that a share will be
redeemed at a specified value.

Premiums and other forms of equity financing

With the introduction of the Companies Act 1993, the legal concept of capital maintenance
distributions has been discarded in favour of the solvency test. Therefore a distinction
between components of equity is no longer needed unless an accounting standard requires
separate disclosure in the financial statements (e.g. retained earnings, fixed asset revaluation
reserves). While there is no necessity for a distinction to be made between the components of
equity, a company may choose to maintain records of (and report) those components of equity
which it deems relevant. Generally, entities that take this option would present consideration
received from shareholders as “share capital”. Share capital does not serve as a limit on
corporate distributions. Instead, so long as the trading solvency test is met, a company can
declare a distribution up to the amount by which its assets exceed its liabilities (balance sheet
solvency test). Theoretically, NZ$1 of equity will satisfy that test. In addition, where equity is
compartmentalised, there is no requirement that any component of equity must have a credit
balance. That is, a component (e.g. retained earnings) may be negative. Contributed capital
can be repurchased or redeemed for a greater amount than was originally subscribed.

Subject to the constitution of the company, different classes of shares may be issued. These
shares may be redeemable, confer preferential rights to distributions of capital or income,
confer special, limited, or conditional voting rights or not confer voting rights.

The board of directors determines the consideration payable for a share issue. However,
unless the constitution or another contract calls for it, no amount is actually payable in respect
of the shares issued. The shares will be presented as unpaid, partly paid-up or paid-up share
capital depending on the case.

Protection of the company's assets

In New Zealand, the Companies Act states that the consideration for which a share is issued
may take any form and may be cash, promissory notes, contracts for future services, real or
personal property, or other securities of the company. The board determines the consideration
and the terms on which the shares will be issued. Where consideration is other than cash, the
Companies Act requires the directors to determine the reasonable present cash value of the

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consideration, to sign a certificate to this effect, and to file such certificate which must be
handed in to the Registrar of Companies. There are no further disclosure requirements in
respect of the value at which shares are issued.

Structure of shares

In New Zealand, the Companies Act specifically requires that share capital must not have a
nominal or par value and therefore shares do not have a stated value.

4.2.6.1.2 Economic analysis

Practical relevance of capital and structure of shares for an assessment of the viability of
a company

There is no par value of shares in New Zealand. The companies interviewed do not see a
particular merit in a par value of shares. The abandonment of par values is seen as an
“improvement” and a reduction in complexity.

However, New Zealand companies are appropriating significant amounts to the capital of the
company. These amounts can be fairly high in comparison to the market capitalisation of the
company. As mentioned above, companies can choose to divide their equity into different
components (e.g. share capital, other reserves, retained earnings). However, the separation has
no consequence on the distribution capacity. As long as the solvency test is met, a distribution
can be made out of all these equity components.

The following figures have been accumulated for NZX 10 and NZX MidCap companies:
Figure 4.2.6-1: Ratio of share capital to market capitalisation (New Zealand)

New Zealand: Share Capital to Market

Capitalisation

23%
< 5%
37%
5%- 10%
10 %bis 20 %
20 %bis 30 %

3% 26% > 30 %

11%

Source: One source: Share capital for the FY 2005, market capitalisation as of September 2006

Restriction on distribution

As already mentioned, in New Zealand, the capital generally does not serve as a restriction for
distributions. As long as the trading solvency test is satisfied, a company can make a
distribution up to the amount by which its assets exceed its liabilities. Therefore, a distribution
would be lawful if equity of NZ$1 is left.
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Role of the capital in equity financing

Even though the capital amounts do not serve as distribution restrictions, the amounts
allocated to subscribed capital are quite substantial.

The following figures have been accumulated for NZX 10 and NZX MidCap companies:

Figure 4.2.6 -2: Ratio of share capital to total shareholder`s equity (New Zealand)

New Zealand: Share Capital to Total

Shareholder's Equity

0%

6%

20% < 5%
5%- 10%
0% 10 %bis 20 %
20 %bis 30 %
> 30 %
74%

Source: One source: Share capital for the FY 2005, shareholder’s equity (consolidated) for the FY
2005

Formations

The New Zealand companies interviewed are already in existence for a longer period.
Therefore, it was neither feasible nor useful to extract data on the initial foundation of these
companies.

4.2.6.2 Capital increase

4.2.6.2.1 Legal framework

Under New Zealand law, there are provisions concerning capital increases by use of
authorised capital including mechanisms to ensure the contribution of capital.

Increase of capital

New Zealand law allows a company to issue additional shares, as long as the requirements of
the constitution are adhered to.

If the constitution allows, the board is responsible for issuing new shares. § 42 CA 1993 states
that, subject to the Companies Act and the constitution of the company, the board of a
company may issue shares at any time, to any person, and in any number it thinks fit. The
board must deliver a notice of the issue of the new shares by the company to the Registrar for
registration within 10 working days. If the board of a company fails to comply with those
requirements, every director of the company commits an offence and is liable on conviction to
the penalty set out in the Companies Act.
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In case of a prohibition or limitation in the constitution on the issue of new shares, the
shareholders can, by special resolution, authorise the share issue, i.e. the board may issue
shares if it obtains the approval for the issue in the same manner as approval is required for an
amendment of the constitution that would permit such an issue. The board must ensure that
notice of that approval, having been given by the shareholders, is delivered to the Registrar
for registration within 10 working days.

However, a failure to comply with these requirements does not affect the validity of an issue
of shares.

In some instances, the company’s constitution may contain a limitation or a restriction in on

the issue of new shares.

The general way to issue new shares, provided that the requirements of the constitution are
adhered, is:

• Proposal of the board to issue new shares

• Invitation to general meeting
• Resolution by shareholders on capital (share) increase
• Registration of decision with Registrar
• Issue of shares and update of share register
• Lodgement of necessary documentation with Registrar

A decision regarding the consideration need not to be made when the issued shares are fully
paid-up from the reserves of the company and issued to all shareholders of the same class in
proportion to the number of shares held by each shareholder. The same applies to the
consolidation or division of shares or any class of shares in the company in proportion to their
pre-existing number and the subdivision in proportion to those shares.

The company has to register a certificate in respect of reasonableness of consideration for

shares with the Registrar within 10 working days of the decision. After issuing shares and
updating the share register, the board of the company must deliver a notice of the issue by the
company in the prescribed form to the Registrar for registration within 10 working days of the
issue of shares in case of an amalgamation or an issue of other shares (other than during the
formation). If the board of a company fails to comply with these requirements, every director
of the company commits an offence and is liable on conviction to a penalty.

Mechanisms to ensure the contribution of capital

With respect to the subscription of new shares which were issued, generally the same rules
apply which New Zealand law provides for the subscription of shares during the formation of
the company. This applies to the prohibition of subscriptions of shares by the company itself,
the setting of the price of the shares, the design of shares and the information linked to the
share. A difference between the subscription of new shares and the subscription of shares
during the formation is that the board may issue new shares to any person it thinks fit (barring
pre-emption rights and other rules stated in the company’s constitution) while the shares on
registration have to be issued to the person or persons named in the application for
registration.

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Pre-emption rights

New Zealand law acknowledges pre-emption rights. According to the Companies Act, shares
issued or proposed to be issued by a company that rank or would rank as to voting or
distribution rights, or both, equally with or prior to shares already issued by the company
must be offered for acquisition to the holders of the shares already issued in a manner and on
terms that would, if accepted, maintain the existing voting or distribution rights, or both, of
those holders. The constitution of the company may negate, limit, or modify these
requirements. There are no specific time limits on these offers, but the Act requires a
“reasonable time” for acceptance.

4.2.6.2.2 Economic analysis

None of the companies interviewed have performed regular capital increases in the recent
past. Instead we encountered simplified procedures in connection with dividend reinvestment
plans and share purchase plans.

Practical steps

The following practical steps would be necessary, in chronological order, for a capital
increase:

Figure 4.2.6 -3: Process for the capital increase (New Zealand)

Capital increase
Step 1 Proposal of the board to issue new shares
Step 2 Invitation to general meeting
Step 3 Resolution by shareholders on capital increase
Step 4 Registration of decision with Registrar
Step 5 Issue shares

The injection of contributions and the valuation process would comprise the following steps:

Figure 4.2.6 -4: Process for the injection of contribution (New Zealand)

Injection of contributions
Step 1 Monitoring if assets can be contributed
Step 2 Monitoring of the requirements linked to the payment
Step 3 Performance of the valuation process by the board
Step 4 Communication to Registrar
Step 5 Issue shares and update register
Step 6 Lodge documentation with Registrar

Analysis

Because these processes have not been relevant to the companies interviewed in recent years,
we have not received any information on practical cases of regular capital increases including
contributions in kind.

The companies interviewed had dividend reinvestment plans. Under these plans, shareholders
can choose to receive their dividends in the form of cash or in the form of additional shares.

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Fees for external advice arise for the initial set-up of the plan. Once such a plan is
implemented the renewal of the plan is a routine process. One company indicated a time
frame of approximately 4.5 hours of highly qualified personnel for the plan, including the
determination of share prices, the review of the work of an external registrar as well as
notification to the stock exchange.

In one case, it was stated that the board of directors of the company has an authorisation under
the Companies Act and its constitution to issue up to 15% of new shares every year. Beyond
that limit a special shareholders’ approval would be needed. Since the companies interviewed
have never required such an approval, no time estimate is available.

Another extraordinary way to issue capital is a so called “share purchase plan”. Under a share
purchase plan, companies are entitled to use a simplified procedure to issue shares. In this
context, it is possible to issue shares up to NZ$5,000 to each shareholder. External fees and
three weeks of CFO time were spent by one company on such an issue of shares.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 4.5 - -
Hourly rate €100 €70 -
€450 - -
Total costs €450

4.2.6.2.3 Protection of shareholders and creditors

Based on the legal analysis, one can draw the following key conclusions concerning the
shareholders’ and creditors’ protection of the New Zealand provisions on capital increases.
Shareholders are protected in that the board of directors can only increase the capital if the
additional shares are covered by the authorised capital set forth in the certificate of
incorporation. If all shares covered by the certificate of incorporation have already been
issued, the shareholders’ approval is needed to amend the certificate of incorporation.
However, it has to be pointed out that a very high authorised share capital can be fixed in the
certificate with the consequence that the shareholders will not have to be asked for approval.

Under New Zealand law, it is not necessary to draw up a report by an independent expert in
the case of contributions in kind. Instead, it is the directors’ duty to determine the
consideration for shares.

4.2.6.3 Distribution

4.2.6.3.1 Legal framework

In New Zealand, the various distributions which may be made, including dividends, shares
instead of dividends, shareholder discounts, reduction of shareholder liability, etc, are subject
to a body of rules set out in the constitution of a company and the Companies Act. The most
important of these is the requirement that the solvency test must be satisfied before the
distribution is made.

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Calculation of the distributable amount

Being satisfied on reasonable grounds that the company will satisfy the solvency test
immediately after the distribution, the board of a company may, subject to the constitution of
the company, authorise a distribution at a time, and of an amount, and to any shareholders it
thinks fit. Therefore, the benchmark for making a distribution is whether the solvency test is
met. The content of this test is set out in the Companies Act. There are two limbs to the test,
and a company must satisfy both. First, the company must be able to pay its debts as they
become due in the normal course of business. This aspect of solvency is frequently referred to
as trading solvency. Secondly, the value of the company’s assets must be greater than the
value of its liabilities including its contingent liabilities, i.e. the company must demonstrate
balance sheet solvency.

To satisfy the trading solvency test (cash flow solvency test), the company must be able to
pay its debts as they become due in the normal course of business. The jurisprudence has
established five requirements that have to be fulfilled: (1) the ability to pay its debts must be
fulfilled at the present time in consideration of the recent past, especially the company’s
position in recent weeks; (2) outstanding debts have to be considered; (3) the liabilities have
to become due in the legal sense; (4) non-cash assets may be taken into account if there is a
substantial element of immediacy about the ability to obtain cash from non-cash assets; debts
which mature while non-cash assets are converted must be considered; and (5) the test of
solvency is an objective one.

Regarding the balance sheet solvency test, the directors are directed to two mandatory factors
for the purposes of determining whether the value of a company’s assets is greater than the
value of its liabilities. The directors must have regard to (1) the most recent financial
statements of the company that comply with § 10 of the Financial Reporting Act 1993, and
(2) all other circumstances which the directors know or ought to know which affect, or may
affect, the value of the company’s assets and the value of its liabilities, including its
contingent liabilities. In addition, the directors may rely on valuations of assets or estimates of
liabilities that are reasonable in the circumstances.

However, where the company’s financial statements are subject to audit, the auditor will have
to verify that the directors have complied with the requirements of the Companies Act with
regard to distributions. There is no concrete guidance for auditors in New Zealand how to
audit the solvency test; it is part of the general test of compliance with legislation (enquiry
and inspection of records and resolutions/minutes of meetings).

The directors who vote in favour of a distribution must sign a certificate stating that, in their
opinion, the company will, immediately after the distribution, satisfy the solvency test and the
grounds for that opinion. The certificate must be available for inspection by any shareholder
of the company.

Connection to accounting rules

When performing the balance sheet solvency test, directors must have regard to the most
recent single financial statements of the company that comply with § 10 of the Financial
Reporting Act 1993. Therefore, financial statements prepared under New Zealand GAAP are
the basis for the test. New Zealand GAAP is already similar to the International Financial
Reporting Standards (IFRS). From periods beginning on or after 1 January 2007, all
companies will prepare individual and consolidated financial statements under IFRS.

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In New Zealand, there are only minor modifications of the IFRS as approved by the
International Accounting Standards Board (IASB). Those modifications mainly concern
specific disclosure requirements. There are limited modifications for differential reporting
entities with regard to measurement (essentially they are only exempted from including
deferred taxes in their financial statements). Listed entities, however, cannot qualify for
differential reporting.

The accounting treatment of the shareholders’ equity section (e.g. issued capital and reserves
pursuant to IAS 1.68(o), (p)) is of no importance with regard to the distributable amount.

Determination of the distributable amount – responsibilities

The directors generally have discretion as to the amount to be distributed. While the company
may have a dividend policy in place, this normally only acts as a guideline/target for the
directors. Dividends paid and proposed are presented in the financial statements. Otherwise
under the New Zealand law, there is no requirement for companies to disclose the amount of
dividends. The same applies with respect to the solvency certificate which must be available
for inspection by any shareholder of the company, but does not have to be disclosed in the
notes to the financial statements.

Sanctions

A director may be personally liable to the company to make good any shortfall in a
distribution which cannot be recovered from a shareholder. A director will be personally
liable in four circumstances.

The first relates to procedural irregularity through failure to follow the procedure set out in
law. A director who fails to take reasonable steps to ensure that the requisite procedure is
followed is personally liable to repay the company that amount of the distribution which is
not recoverable from shareholders.

Second, personal liability may follow where there were no reasonable grounds for believing
that the company would satisfy the solvency test at the time of execution by the directors of
the solvency certificate. A director who signed the certificate in those circumstances is
personally liable to repay the company so much of the distribution as is not recoverable from
shareholders.

Third, the Companies Act deals with the situation where a distribution is deemed not to have
been authorised because, after authorisation, the board ceased to be satisfied on reasonable
grounds that the company would satisfy the solvency test at the time the distribution was
made. In this case, a director who ceased so to be satisfied and who failed to take reasonable
steps to prevent the distribution being made is personally liable to repay the company so
much of the distribution as is not recoverable from shareholders.

Fourth, under the Companies Act a discount paid to a shareholder is recoverable from a
director who failed to take reasonable steps to prevent the discount being paid where the
discount is deemed in terms of § 55(5) CA 1993 not to have been authorised. This provision
applies where the board ceased to be satisfied on reasonable grounds that the company would
satisfy the solvency test.

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In some instances, a distribution of a lesser amount would not have caused the company to
fail the solvency test. In an action against a shareholder or director in such a case, the court
may in effect give the defendant “credit” for the amount which could legitimately have been
distributed. Thus, a defendant shareholder may be permitted to retain an amount equal to the
value of any distribution that could properly have been made and a defendant director may be
relieved from liability to the same extent. The Companies Act creates a discretion.

At common law, a dividend improperly paid out of capital is recoverable from shareholders
who knew or ought reasonably to have known of the impropriety of the payment. It is likely
that the common law rule applies even where the company is not insolvent and there is no
immediate prejudice to creditors in the payment of the dividend. In this respect, the common
law rules (which are superseded by the Companies Act) are more stringent and permit
recovery where the Companies Act does not. Recovery under the Companies Act is dependent
upon breach of the solvency test.

The Companies Act deals with recovery from a director where a dividend improperly paid
under the Act cannot be recovered from a shareholder to whom it was paid. But this does not
mean that a company can only recover compensation from a director for a dividend paid in
breach of the solvency test. A dividend can be paid without technically infringing the
solvency test, for example, in circumstances where the solvency of the company is
jeopardised by the payment. At common law, a director may be liable in negligence where a
dividend payment merely jeopardises the solvency of the company without actually infringing
the rule that dividends may not be paid out of capital. Similarly, it is submitted that a director
who authorises a dividend which jeopardises solvency, while not technically infringing the
solvency test, does not act with the care, diligence and skill of a reasonable director as
required by the Companies Act.

4.2.6.3.2 Economic analysis

The fundamental reform of New Zealand dividend distribution provisions in favour of

solvency tests in 1993 has become a routine process for New Zealand companies. The testing
effort required for the solvency test is relatively low. So far, balance sheet tests have been
performed under New Zealand GAAP. Experiences with IFRS will be gathered for the first
time in the financial year 2007, by which IFRS will be applicable for individual and
consolidated financial statements. As both accounting frameworks are very similar, there is an
expectation that there will not be any practical consequences of the application of IFRS with
respect to distributions.

Practical steps

Based on the legal analysis, the distribution process generally requires the following practical
steps which are the basis for the economic analysis.

Figure 4.2.6 -5: Due process for distributing profits (New Zealand)

Due process for distributing profits

Step 1 Decision of the board
Step 2 Performance of solvency test
Step 3 Certification of solvency
Step 4 Disclosure

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Analysis

Calculation of the distributable amount

From an economic point of view, the management of the companies interviewed base their
decisions concerning distributable amounts on consolidated profits. Some companies make
modifications to eliminate “exceptional items” and determine “normalised profits” which are
the basis for the distribution decision. The dividends paid are also seen as a signalling device
for the capital markets. Tax considerations may also play a role in the determination of
dividends paid.

Concerning the compliance with New Zealand distribution restrictions, the companies
interviewed do not suffer from a high compliance burden.

The trading solvency test refers to the cash flow situation of the company. Trading solvency is
seen as an “obvious” fact based on the current cash situation of the company. Companies may
also resort to the regular operational reporting mechanisms. The companies usually monitor
cash flows and generally perform cash flow projections for internal management purposes.
However, these projections or budgets are not specifically prepared for distribution purposes
and, thus, are not formally linked to the dividend distribution process.

With respect to the balance sheet solvency test, the companies interviewed verified the
envisaged distribution on the basis of the audited single financial statements. The companies
in our sample did not perform specific balance sheet revaluations; but one company applied
the revaluation option of IAS 16 for property, plant and equipment. The original
determination of the level of distributions, however, is primarily based on the consolidated
accounts.

Concerning subsequent events after financial year end, the board of directors of one of the
companies interviewed usually examines management accounts which include a balance sheet
and an income statement and a cash flow analysis for the occurrence of such subsequent
events up to the time of documentation of solvency tests. But the ultimate decision is
primarily based on the year-end financial statements. For interim dividends, it is the half-year
accounts. One company explicitly also referred to notes of the financial statements where
contingent liabilities and commitments on capital expenditure are included. This helps to take
such factors into account when making a dividend distribution decision.

The results of a CFO questionnaire sent to New Zealand companies listed on main indices
reconfirm the key importance of the consolidated accounts as a determinant of dividend
distribution:

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Figure 4.2.6-6: Determinants for the distribution of dividends in the holding company (New Zealand)

"What are the determ inants for the distribution of dividends by your holding
com pany?"

5
4,67
Importance

3,44 3,56
4
4,10 3,00 3,19 New Zealand
3 3,49
2,26
2 2,78 2,78 Non-EU Average
2,54 2,22
1
Fin. Fin. Dividend Signalling Credit rating Tax rules
performance performance continuity device considerat ions
(group (individual
accounts) accounts of the
parent
company)

Determ inants

Source: CFO Questionnaire, September 2007

However, concerning the importance of the current legal restrictions on profit distribution, the
CFO questionnaire shows that the responding CFOs rank legal restrictions higher than market
led solutions like rating agencies’ requirements or bank covenants.

Figure 4.2.6-7: Important deterrents when considering the level of profit distribution (New Zealand)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"

5
4,44
4,22
Importance

4
3,56
3,93 New Zealand
3,47
3
2,44 3,38 Non-EU Average
2
2,22

1
Distribution/Legal Rating agencies' Cont ractual agreements Possible violations of
capital requirements requirement s with creditors insolvency law
(covenants)

Deterrents

Source: CFO Questionnaire, September 2007

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Concerning the distributions from subsidiaries, the results of a CFO questionnaire show the
importance of tax considerations.

Figure 4.2.6-8: Determinants for the distribution of dividends by the subsidiaries (New Zealand)

"What are the determ inants for the distribution of dividends by your
subsidiaries?"

5
3,95 3,87
4
Importance

2,73 New Zealand

3
3,29
3,00
Non-EU Average
2 2,29

1
Demands from t he ultimate parent Tax rules Own investment decisions

Determ inants

Source: CFO Questionnaire, September 2007

Determination of the distributable amount

The board of directors is the key decision-making body concerning the distribution process.
The board decisions are not always prepared by means of formal documentation.

The board members must sign a solvency certificate. However, there is no specific form of
this statement required. We encountered different formats of these certificates. These
certificates are kept at the office of the company for inspection. There is no significant
incremental burden associated with this and such inspections do not take place frequently.

The companies have set up different documentation processes for the determination of
solvency. For one company, it was stated that the vice president of finance has to sign a letter
that he has made all necessary enquiries to determine solvency. Before he signs this letter he
will consult with key personnel of this company in this regard. These consultations include
the discussion of contingent liabilities. In each group company, a specific dedicated person
must sign a letter that the necessary procedures concerning solvency have been performed.

Because New Zealand distribution rules refer to the parent company, there is a necessity to
channel-up sufficient profits and cash to the parent company level. Depending on individual
circumstances, the efforts by companies interviewed to bring up profits and cash to top
company level differs from case to case. The level of personnel involved in the distribution
process also depends on the circumstances of the company.

The time estimated for the entire dividend distribution process up to the pay-out ranges from
16 to 25 man-hours. In every case, senior management (CEO, CFO, the Audit Committee and
other Board members) is heavily involved in determining the range of possible distributions.
Additionally, fees for professional tax advice may arise. One company referred to the
involvement of the CFO and less qualified staff in the final payout of dividends. Generally,
the companies engage an external registry service for the payout of the dividends.

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Sanctions

The companies describe the effort spent on monitoring compliance with legislation on
distributions (in addition to the efforts described above) as low. The risk of liability in
connection with illegal distributions is also seen as low. This may partially stem from the
good financial situations of the companies interviewed.

In addition to the distribution process, the companies interviewed continuously monitor

compliance with bank covenants. This monitoring process may also mitigate the problem of
potential violations of legal distribution provisions.

Related parties

The time spent on monitoring related party transactions depends on the specific situation of a
company. The efforts were characterised as medium or low. Nevertheless, this assessment
was highly dependant on the absence of significant related parties / related party transactions
outside the group of companies.

Incremental Costs
HighQ LowQ Other Costs
Hours spent 16 to 25 - -
Hourly rate €100 €70 -
€1,600 to €2,500 - -
Total costs €1,600 to €2,500

4.2.6.3.3 Protection of shareholders / creditors

The decision whether or not to make a distribution generally rests in the discretion of the
board of directors of the company. Therefore, the shareholders have no statutory right to
decide on a dividend unless the board of directors declares a distribution. However, due to the
market forces public companies such as those taking part in the interviews take the
shareholders’ expectations into consideration when deciding on measures on dividends or on
increasing the value of the shares.

Creditors are not explicitly protected by the New Zealand capital system and statutory
distribution requirements. In New Zealand, distributions are allowed that leave the company
almost without any equity. However, due to the required testing as well as associated liability
risks, it does not seem realistic that companies make use of these possibilities.

Concerning incentives to comply with distribution restrictions, every director who votes in
favour of a distribution must sign a certificate stating that, in his opinion, the company will,
immediately after the distribution, satisfy the solvency test and the grounds for that opinion.
The solvency certificate could support shareholders and creditors in their assessment of the
viability of the company. However, the certificate must be requested from the company’s
office and this seems to take place very rarely. Every director who fails to comply commits an
offence and is liable on conviction to penalties. In addition, if there were no reasonable
grounds to believe that the company will satisfy the solvency test at the time the certificate is
signed, every director that signed the certificate is personally liable to the company to repay
so much of the distribution as is not recovered from shareholders.

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When a company is placed in liquidation, certain transactions might be set aside. The
Companies Act sets out certain provisions that deal with voidable transactions and charges,
transactions at an undervalue, and transactions which appear to give an advantage to persons
who have a special relationship with the company and that will ensure that persons who have
received some advantage at the expense of the company and its creditors in general be made
to account for that advantage. Transactions which are set aside under this Part of the Act are
for the benefit of creditors generally and not for the benefit of any single creditor and
generally relate to a period of up to two years before the company goes into liquidation.

New Zealand law also includes a specific Act (the Corporations (Investigation and
Management) Act 1989) that applies to any company that is, or may be, operating
fraudulently or recklessly or to which it is desirable that this Act applies (1) for the purpose of
preserving the interests of the company’s members or creditors, (2) for the purpose of
protecting any beneficiary under any trust administered by the company, or (3) for any other
reason in the public interest, if those members, creditors or beneficiaries or the public interest
cannot be adequately protected under the Companies Act 1993 or in any other lawful way.

This Act confers powers on the Registrar of Companies to obtain information and investigate
the affairs of companies and to limit or prevent further action and also to enable the Registrar
or its agent (called a “statutory manager“) to take over the operation of the company.

4.2.6.4 Capital maintenance

New Zealand law concerning the formation and maintenance of the capital relies considerably
on the assessment of the cash flow situation of New Zealand companies especially via means
of solvency tests. This approach can also be specifically found in the regulation of the
acquisition of the company's own shares, capital reductions/share redemptions as well as in
financial assistance. In all these proceedings, solvency assessments play a crucial role in duly
determining whether the management of a New Zealand company should take such a
measure. Other relevant fields such as the contractual self-protection of creditors and
insolvency legislation are further pillars in giving incentives to the New Zealand companies to
maintain the viability of the company.

4.2.6.4.1 Acquisition by a company of its own shares

4.2.6.4.1.1 Legal framework

When a company purchases its own shares, corporate assets flow out to shareholders. In New
Zealand, a company is generally allowed to purchase its own shares, hold those shares and
resell them. In New Zealand, the requirements for the repurchase of a company's own shares
are regulated in the Companies Act.

For an acquisition of a company's own shares, the directors of the company must certify that
the solvency test is met. That means, firstly, that they have to confirm that the company is
able to pay its debts as they become due in the normal course of business, and secondly, that
the value of the company's assets is greater than the value of its liabilities including its
contingent liabilities.

In addition, certain other procedures set out in law must be followed, i.e. the directors have to
certify the reasonableness and fairness of the offer and that the acquisition is in the interests of

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the company. They have to send a disclosure document to the shareholders. Finally, the board
has to deliver a notice of acquisition or repurchase to the Registrar within 10 working days.

Shares listed on the stock exchange may, in certain instances, be acquired without prior notice
to shareholders. That is possible when the board resolved that the acquisition is in best
interests of the company and shareholders, the terms of and consideration for the acquisition
are fair and reasonable, the board is not aware of any information that is not available to
shareholders and the number of shares acquired in the preceding 12 months does not exceed 5
% of the shares in the same class at the beginning of that period.

Subject to the provisions of the company’s constitution, the Companies Act 1993 and a
resolution by directors, shares so acquired can be held by the company. All rights and benefits
relating to the shares held by the company are suspended, i.e. the shares will have no voting
rights and the company cannot pay dividends in respect of those shares.

The normal rules (as set out above) apply when the company so resolves to re-issue such
shares unless they are transferred by means of a system that is approved under section 7 of the
Securities Transfer Act 1991 (a scripless trading system).

The number of shares acquired, when aggregated with shares of the same class held by the
company, must not exceed 5 % of the shares in the same class previously issued by the
company.

Shares which are not acquired in accordance with all the requirements mentioned are deemed
to be immediately cancelled on acquisition. As set out above, a shareholder that considers
itself prejudiced in the process of acquisition of the company's own shares can apply to the
court and the court can issue various orders, including awarding the costs of the proceedings.

In general, a share that a company holds may be cancelled by the board of the company
resolving that the share be cancelled.

4.2.6.4.1.2 Economic analysis

In New Zealand, none of the companies interviewed has repurchased shares recently.
Therefore, no measures have been taken regarding the acquisition of the company's own
shares and, thus, cost estimates were not feasible. Concerning the performance of the
solvency test, the general observations from the distribution process apply concerning
incremental burdens for the company.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.2.6.4.1.3 Protection of shareholders and creditors

Shareholder and creditor protection is mainly provided by the disclosure document. The offer
to repurchase shares, which must be made not less than 10 working days and not more than 12
months after the disclosure document is sent to each shareholder, can be made to all
shareholders in proportion to their existing holdings or selectively to one or more

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shareholders, if all shareholders have consented to this in writing or it is expressly permitted

by the constitution. Where an offer is made to all shareholders, the offer may also permit the
company to acquire additional shares from a shareholder to the extent that another shareholder
does not accept the offer or accepts the offer only in part. A shareholder or the company may
apply to the court for an order restraining the proposed acquisition on the grounds that it is not
in the best interests of the company and for the benefit of the remaining shareholders or the
terms of the offer and the consideration offered for the shares are not fair and reasonable to
the company and the remaining shareholders.

In the case of acquisitions by the company of its own shares under 5 percent of the same
class, these protections may not be in place. The suspension of the rights attached to the
repurchased shares does not dilute the position of shareholders. This is also true for the
cancellation of the unlawfully repurchased shares.

4.2.6.4.2 Capital reduction

4.2.6.4.2.1 Legal framework

In a New Zealand company, capital reductions may be performed in different ways. The
process of reducing share capital is the same as noted under the acquisition by a company of
its shares, under distributions and redeemable shares. Depending on the way in which the
transaction is effected, the following must be satisfied: (1) the constitution must allow the
transaction to take place, (2) the board must resolve that the solvency test is met, (3) the board
must resolve that it is in the best interests of the company and on terms that are fair and
reasonable; and (4) proper/detailed disclosures to the shareholders, including the information
required by the law.

4.2.6.4.2.2 Economic analysis

Within our sample of New Zealand companies, we have not encountered any “regular” capital
reductions. Concerning the performance of the solvency test, the general observations from
the distribution process apply concerning incremental burdens for the company.

4.2.6.4.2.3 Protection of shareholders and creditors

In general, the provisions on capital reductions do not protect shareholders or creditors via an
active participation in the process. Protection takes place via the constitution of the company,
the requirement that the solvency test must be met and disclosure requirements.

4.2.6.4.3 Share redemption

4.2.6.4.3.1 Legal framework

In New Zealand, redemption refers to a forced sale initiated by the company, the shareholders
or a fixed date in accordance with the terms of issue or/and the constitution of the company.
According to New Zealand law, it is possible to redeem shares. Subject to an entity’s
constitution, it may issue redeemable shares and redeem those shares as provided in the terms
of issue. Generally, the shares would be redeemable by either the company, the shareholders
or both and the consideration would be specified or calculated using a formula or fixed by an
independent suitably qualified person.

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The directors must also resolve and certify that the redemption is in the best interests of the
company, the consideration is fair and reasonable to the company and the solvency test is
satisfied.

Depending on which requirement is not fulfilled, either the company or the directors commit
an offence and are liable on conviction to a penalty as set out in the Companies Act.

When shares are redeemed, they are deemed to be cancelled immediately although they may
be reissued in the future.

4.2.6.4.3.2 Economic analysis

Within our sample of New Zealand companies, we have not received any information on
share redemptions. Concerning the performance of the solvency test, the general observations
from the distribution process apply concerning incremental burdens for the company.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.2.6.4.3.2 Shareholder and creditor protection

Shareholders and creditors are protected in that the terms of the redemptions have to be stated
in the terms of the issuance of shares or/and the constitution of the company.

An option by the company to redeem shares should only be exercised if it applies to all
shareholders in a class and affects all equally, or in relation to one or more shareholders where
all shareholders have consented in writing or the option is expressly permitted by the
constitution. If the option is exercised in relation to one or more shareholders and permitted
by the constitution, the directors must forward a disclosure document to the shareholders
before exercising the option and shareholders should have a period of between 10 and 30
working days after the document has been sent to consider the option. A shareholder or the
company may apply to the court for an order restraining the proposed exercise of the option
on the grounds that it is not in the best interests of the company or of benefit to the remaining
shareholders, or the consideration for the redemption is not fair or reasonable to the company
or remaining shareholders.

If a share is redeemable at the option of the holder of the share, and the holder gives proper
notice to the company requiring the company to redeem the share, the company must redeem
the share on the date specified in the notice, or if no date is specified, on the date of receipt of
the notice. The share is deemed to be cancelled on the date of redemption and from the date of
redemption the former shareholder ranks as an unsecured creditor of the company for the
consideration payable on redemption.

If a share is redeemable on a specified date, the company must redeem the share on that date
and the share is deemed to be cancelled on that date and from that date the former shareholder
ranks as an unsecured creditor of the company.

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4.2.6.4.4 Financial assistance

4.2.6.4.4.1 Legal framework

New Zealand law deals directly with assistance by a company in the purchase of its own
shares.

A company may give financial assistance (which includes loans, guarantees or the provision
of security) to a person for the purpose of the purchase of a share issued by the company, or
by its holding company, whether directly or indirectly, only if the board has previously
resolved that the company should provide the assistance, given that the assistance is in the
best interests of the company; and the terms and conditions under which the assistance is
given are fair and reasonable to the company. In other words, the financial assistance should
not disadvantage the ongoing operations or business of the company and should be on terms
that would benefit the company or at least leave it in the same position as it would have been
in if the assistance was not provided (i.e. a neutral position).

Moreover, the company must, immediately after giving the assistance, satisfy the solvency
test. The directors who vote in favour of giving the financial assistance must sign a certificate
stating that, in their opinion, the company will, immediately after the financial assistance is
given, satisfy the solvency test and the grounds for that opinion. In applying the solvency test
for financial assistance, “assets” excludes amounts of financial assistance given by the
company in the form of loans and “liabilities” includes the face value of all outstanding
liabilities, whether contingent or otherwise, incurred by the company at any time in
connection with the giving of financial assistance.

In addition, one of the following circumstances must apply: (a) all shareholders have
consented to giving the assistance; or (b) the board has previously resolved that giving the
assistance in question is of benefit for those shareholders not receiving the assistance and that
the terms and conditions under which the assistance is given are fair and reasonable to them;
(c) or the amount of the financial assistance would not exceed 5 % of the shareholders' funds.

The directors who vote in favour of a resolution on financial assistance must sign a certificate
which contains that the legal requirements are complied with.

If a company fails to comply with those requirements, it commits an offence and is liable to a
penalty. Furthermore, every director commits an offence and is liable to a penalty.

4.2.6.4.4.2 Economic analysis

Within our sample of New Zealand companies, we have not received any information on
financial assistance. Concerning the performance of the solvency test, the general
observations from the distribution process apply concerning incremental burdens for the
company.

4.2.6.4.5 Serious loss of half of the subscribed capital

Under New Zealand law, there is no provision which requires the board of directors to call a
general meeting in case of a loss of half of the subscribed capital.

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4.2.6.4.6 Contractual self protection

4.2.6.4.6.1 Legal framework

In New Zealand, contractually negotiated self-protection such as the limitation on payment of

dividends would only generally be incorporated where a large amount of finance is provided
or where another class of shares is issued that ranks behind other creditors. Normal trade
terms would apply for smaller creditors.

4.2.6.4.6.2 Economic analysis

All New Zealand companies interviewed are subject to covenants. Such covenants were
negotiated with US and UK banks as well as Australian banks and their New Zealand
branches. In one case, there were specific restrictions with regard to distributions. It was
specifically provided that the covenants were not to be violated by means of distributions.

Incremental Costs
HighQ LowQ Other Costs
Hours spent - - -
Hourly rate €100 €70 -
Total costs No data

4.2.6.4.6.3 Shareholder and creditor protection

The terms of the credit agreements are negotiated between the company and the creditor, and
thus reflect a realistic view of what creditors desire for their protection. Creditors rely on the
future prospects of a company, mainly its profitability and its ability to generate cash
necessary to pay the debts when due.
In addition to the creditors who negotiated the contract, other (weak) creditors lacking
adequate bargaining power (e.g. certain trade creditors) benefit from these provisions as well,
as long as the covenants are not breached.

Obviously, credit agreements and financial covenants are not specifically designed for the
shareholders’ needs. However, shareholders might be protected by these contractual
agreements indirectly in that their purpose is the long-term viability of the company.

4.2.6.5 Insolvency

4.2.6.5.1 Legal framework

A company which is unable to pay its due debts is insolvent for the purposes of the Act. For
determining insolvency, the objective “test of insolvency” has to be executed. If a company
passes the test of insolvency, various avenues of approach exist for creditors or shareholders
to protect themselves.

The test of insolvency is an objective test. The belief or state of mind of the company is
irrelevant. In each case, it will be a question of fact to be determined in all the relevant
circumstances.

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There is no requirement that the board of directors conduct a solvency analysis. But anyone,
including the company, directors and creditors can apply to the courts for the appointment of
a liquidator.

4.2.6.5.2 Economic analysis

The companies interviewed described their efforts in respect of monitoring triggers of

insolvency as medium or high. The focus of the companies in this respect lies on the ongoing
analysis of bank covenants. One company has a quarterly (internally generated) report on
covenants, another company has an external consultant prepare a report on covenants which is
included in the board papers after review by the CFO. It was also stated by one company that
it prepares weekly a report of the cash position of the company which includes the position of
every subsidiary. Debts are also included into the consideration.

One company also states that it regularly monitors insurance coverage and contracts entered
into.

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4.2.7 Conclusions for the four non-EU countries

The four non-EU countries show a mixture of alternatives to the capital regime used in the
EU. These systems have mainly abandoned the concept of legal capital or the importance of
legal capital is low. Instead, the emphasis has shifted to increased testing procedures for
dividend payments and other kinds of distributions like the repurchase of shares by means of
different kinds of solvency and balance sheet tests. In performing the balance sheet test, the
audited consolidated accounts are used in some of the jurisdictions due to legal or practical
considerations. The distribution decision regularly lies within the discretion of the board of
directors. The increased responsibility of the board in this regard translates into a fiduciary
duty or personal liability. Furthermore, fraudulent transfer legislation may come into play.

From a compliance cost perspective these non-EU systems are also not overly burdensome.

Main pillars of the capital regime in the non-EU countries

Structure of capital – With the exception of Delaware, all non-EU countries neither
prescribe subscribed capital nor a minimum capital. In Delaware, where the traditional legal
capital system is still applied, capital, however, does not play an important role in practice.
Because Delaware corporations usually issue shares with a very low par value (e.g. US$0.01
and less), capital is negligibly low.

Capital increase – The companies incorporated in the non-EU countries have the statutory
power to create, value and issue authorised shares. The number of shares authorised for
issuance must be stated in the statutes. There is no maximum amount the authorised shares
may cover set by law.

Distributions – All statutory laws in our sample have a variety of distribution requirements.
In addition to a solvency test there are different forms of balance sheet tests which have to be
satisfied for lawful distributions. In performing the balance sheet test, the audited
consolidated financial statements are frequently used in some of the jurisdictions due to legal
or practical considerations.

Capital maintenance – The non-EU jurisdictions have various provisions which preserve the
company’s contributed capital. In particular, there are statutory provisions on share
repurchases, capital decreases, related party transactions and fraudulent transfers. In addition,
contractual self protection of creditors is of importance.

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Figure 4.2.7 – 1: Overview on capital regimes in the four non-EU countries

USA - USA -
Canada Australia New Zealand
Delaware California
Application of
the concept of Yes No No No No
legal capital
(Minimum)
subscribed No No No No No
capital
Requirements
for share No No No No No
premiums
Mandatory
No No No No No
reserves
Not
regulated
Par value or (par value
Structure of Only no-par Only no-par Only no-par
no-par value or no-par
shares value shares value shares value shares
shares value
shares
possible)
Distribution
rules
Equity
No Yes Yes Yes Yes
insolvency test
Balance sheet
Yes Yes Yes Yes Yes
test(s)
Mandatory
accounting No US GAAP No IFRS NZ GAAP
basis
Determination
of the Board of Board of Board of Board of Board of
distributable directors directors directors directors directors
amount
Restrictions
Distribution Distribution Distribution Distribution Distribution
on share
rules rules rules rules rules
repurchases

The set-up of the capital regime of the five non-EU jurisdictions can be summarised as
follows:

USA - Delaware
The Delaware General Corporation Law follows traditional legal capital rules and divides
shareholders’ equity into two basic categories: capital and surplus. However, capital does not
necessarily equal what the shareholders paid for their stock. Instead, a Delaware corporation
may, by resolution of its board of directors, determine that only a part of the consideration
received by the corporation for the shares issued shall be capital. The amount of capital
depends on the design of the stock. A Delaware corporation may issue stock with or without
par value. In the case of par value shares, the minimum amount of capital is generally
determined by multiplying the number of shares issued by their par value. In the case of no-
par shares, capital is that part of the consideration received designated by the directors as
capital. Therefore, directors can designate zero to be capital. The excess, if any, of the “net
assets” (total assets less total liabilities) of the corporation over the amount so determined to
be capital is surplus. The Delaware distribution rules leave a lot of leeway. A corporation may
pay dividends not only out of surplus but also out of “current profits” even though there is a
deficit in the equity account. Furthermore, the Delaware Supreme Court has made it clear that

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directors may depart from US GAAP accounting and revalue assets at fair market value for
purposes of calculating net assets. The Delaware statute does not contain an equity insolvency
test. However, directors violate their fiduciary duties to creditors if they make a distribution
when the corporation is insolvent. In practice, the distributable amount is frequently derived
from the audited consolidated US GAAP financial statements.

USA - California
California was the first US state to eliminate the traditional concepts of par value and stated
capital. Further significant and innovative features of the California Corporations Code are
the distribution requirements which are based on (consolidated) financial statements in
conformity with US generally accepted accounting principles (US GAAP). The California law
applies identical restrictions to the different kinds of distributions (e.g. cash and property
dividends, redemptions, and share repurchases). In general, a distribution can only be made
out of the retained earnings if, after the distribution, the corporation remains able to pay its
debts when due. However, the board of directors may declare a distribution in excess of
retained earnings if the equity insolvency test is satisfied and the equity ratio is still at least 20
percent after the distribution has been made. The declaration of distributions generally is
within the discretion of the board of directors and protected by the business judgement rule.
However, to avoid liability, directors have to obey any restrictions in the articles or bylaws
and the applicable statutory provisions. In addition, already at the stage of distributions, the
corporations, in general – especially if the economic situation of the corporation is negative –,
have to take into account the insolvency law provisions of the federal bankruptcy and
statutory laws.

Canada
The Canada Business Corporations Act (CBCA) which regularly complemented by provincial
laws explicitly states that shares shall be without nominal or par value. Canadian federal law
applies identical restrictions to the different kinds of distributions (e.g. cash and property
dividends, redemptions, and share repurchases). In general, a distribution can only be made if
the company can meet the applicable solvency test after the distribution (payment of the
dividend). A company is not entitled to declare or pay dividends if there are reasonable
grounds for believing that (a) the company is, or would be after the payment is made, unable
to pay its liabilities as they fall due; or (b) after payment of the dividend, the realisable value
of its assets will be less than the total of its liabilities and its stated capital. Stated capital
comprises the contribution for the issued shares. In Canada, there is not a requirement
concerning the accounting framework to be used. There is no direction as to the method of
valuation but it must be appropriate in the circumstances; accordingly, the going concern
assumption is usually most appropriate. The directors generally have the sole responsibility
for determining whether a dividend is to be declared and paid. However, shareholders are
entitled to challenge a dividend which has been paid in violation of the solvency test. To
ensure that legal requirements are met, directors will be personally, jointly and severally
liable for repayment of an improper dividend.

Australia
The Australian Corporations Act 2001 specifically requires that share capital must not have a
stated value and therefore shares must also not have a par value. Under the Australian profit
distribution rules, any amount can be distributed as long as it is paid out of profits and does
not render the corporation insolvent. In addition to the statutory requirements, there are court
decisions on distributions. The principles established by case law therefore also have to be
taken into consideration, when an Australian company determines the amount of a legal
distribution. This series of rules governing the payment of dividends comprises that (1)

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dividends must not be paid if the result is that the company is unable to pay its debts, (2)
current revenue profits may be distributed without making good revenue losses of previous
periods, and (3) undistributed profits remain profits which can be distributed in later years.
Furthermore, there is voluminous case law to guide companies in their distribution decisions.
In Australia, the declaration of dividends generally is within the discretion of the board of
directors. Pursuant to Australian law, the directors may determine that a dividend is payable
and fix the amount, the time for payment and the method of payment. However, directors
have to obey any restrictions in the statutes and the applicable statutory provisions as well as
the principles derived from case law. All companies in Australia are subject to IFRS as
adopted in Australia. The profits/retained earnings determined under these standards form the
basis for dividend distributions. A dividend that is paid other than out of profits would result
in a reduction of capital. The directors may be liable to the creditors or liquidator of a
company for the amount of a dividend paid which exceeds available profits.

New Zealand
New Zealand does not follow the concept of legal capital. The Companies Act 1993
specifically requires that share capital must not have a nominal or par value and therefore
shares do not have a stated value. In New Zealand, the board of a company that is satisfied on
reasonable grounds that the company will, immediately after the distribution, satisfy the
solvency test may, subject to the constitution of the company, authorise a distribution.
Therefore, the benchmark for making a distribution is whether the solvency test is met. There
are two limbs to the test, and a company must satisfy both. First, the company must be able to
pay its debts as they become due in the normal course of business (trading solvency test).
Secondly, the value of the company’s assets must be greater than the value of its liabilities
including its contingent liabilities, i.e. the company must demonstrate balance sheet solvency.
When performing the balance sheet solvency test, directors must have regard to the most
recent single financial statements of the company that comply with New Zealand GAAP. New
Zealand GAAP is already similar to the IFRS; from periods beginning on or after 1 January
2007 all companies will be preparing financial statements under IFRS. The contributed share
capital does not serve as a limit on corporate distributions. Instead, as long as the trading
solvency test is met, a corporation can declare a distribution up to the amount by which its
assets exceed its liabilities (balance sheet solvency test). Theoretically, $1 of equity will
satisfy that test. The directors who vote in favour of a distribution must sign a certificate
stating that, in their opinion, the company will, immediately after the distribution, satisfy the
solvency test and the grounds for that opinion. The certificate must be available for inspection
by any shareholder of the company.

Structure of capital and shares

Capital

The practical relevance of the capital for an assessment of the viability of a company has
generally been seen as low by the companies interviewed in the four non-EU countries. These
companies and their “peers” such as banks, rating agencies and analysts rather look at other
equity figures like “net equity” and “market capitalisation” as relevant to determine their
equity position and to assess their chances of preserving their business and to attract further
capital. In Delaware where we have encountered a stated capital based on par value shares,
banks as creditors rather relied on cash flow predictions.

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Premiums

In the non-EU countries, the concept of “share premium” as a restriction to distributions does
not exist.

Structure of shares

In general, the non-EU countries do not require par value shares. In Delaware, the
corporations may issue stock with or without par value. In California, corporations usually
issue no-par value shares; they are, however, permitted to state a par value in their statutes if
they wish to do so. In New Zealand, Canada and Australia, shares cannot have a par value. In
all non-EU countries, the statutes are required to state the authorised number of each class of
shares that (or series within a class) the company is permitted to issue. The number of issued
shares of each class cannot exceed the number authorised under the statutes.

Capital increase

The companies interviewed have the statutory power to create, value and issue authorised
shares. The number of shares authorised for issuance must be stated in the statutes. There is
no maximum amount the authorised shares may cover set by law. If there are not enough
authorised shares, the statutes must be amended for new issuances to occur. In order to avoid
capital increases and necessary amendments of the statutes as a consequence, the companies
interviewed set a high number of authorised share capital. With respect to the subscription of
new shares which are issued during a capital increase the same rules apply which are
applicable to the subscription of shares during the formation of the company.

We have only encountered very few instances of capital increases in the interviews in the five
non-EU jurisdictions. Therefore, we have not been able to retrieve sufficient relevant detailed
data concerning capital increases. In general, we have been reassured that the bulk of the
capital increase burden is due to securities regulation, i.e. costs of prospectuses.

Distribution

The five non-EU jurisdictions have various distribution requirements. These statutory rules
usually apply to all kinds of distributions (e.g. cash and property dividends as well as share
repurchase and redemption).

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Table 4.2.7 – 2: Characteristics of balance sheet tests and solvency tests (non-EU countries)
USA - USA - Canada Australia New
Delaware California Zealand

Balance sheet
test(s)
Statutory testing Surplus test: Retained Balance sheet Profits test: Balance sheet
requirement capital shall not earnings test: test: Dividends may solvency test:
be impaired distributions The realisable only be paid assets must
(capital can be can only be value of the out of the exceed
zero) made out of assets shall not corporation’s liabilities
retained be less than profit
earnings the total of
liabilities and
stated capital
Mandatory No US-GAAP No IFRS (as NZ-GAAP
accounting basis adopted in (with possible
Australia) modifications)
Practical application
- starting base (Audited) US- (Audited) US- (Audited) (Audited) IFRS (Audited) NZ-
GAAP GAAP Canadian financial GAAP
consolidated consolidated GAAP statements individual
accounts accounts consolidated accounts
accounts

- modifications by Allowed, but Not allowed Not allowed

directors seldom; Allowed Allowed, but
regularly well seldom;
established regularly well
criteria established
criteria

Distribution No; exception: Yes, but No No No

allowed, if (initial) nimble remaining
balance sheet test is dividends, assets tests
not met “wasting assets need to be met
corporations”
Nature of exceptions Net profits test Remaining N/A N/A N/A
(nimble assets tests
dividends): comprises
Corporation both:
may pay a) Quantitative
dividends out solvency test:
of net profits Total assets
from the exceed total
current and/or liabilities by
preceding 125%;
fiscal year deduction of
certain balance
Wasting assets sheet items
corporations: from assets
may determine and liabilities
the net profits b) Liquidity
without regard test:
to depletion In general,
current assets
must exceed
current
liabilities

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Solvency test (=
Equity insolvency
test)
Statutory No (but case Yes Yes Yes Yes
requirements law)
Equity Solvency test: Solvency test: Trading
insolvency test: Company shall Company must solvency test:
Company or be able to to be able to pay Company shall
subsidiary pay liabilities its debts remain able to
must be able to as they fall due pay debts as
meet liabilities they become
as they mature due in the
course of
business

Formal calculation No No No No No
requirements,
including minimum
projection periods
Implementation in Current cash Current cash Current cash Current cash Current cash
practice situation and situation and situation and situation and situation and
future cash- future cash- future cash- future cash- future cash-
flow flow flow flow flow
projections projections projections projections projections
based on based on based on based on based on
internal internal internal internal internal
reporting; reporting; reporting; reporting; reporting;
intensity of the intensity of the intensity of the intensity of the intensity of the
cash flow cash flow cash flow cash flow cash flow
analysis analysis analysis analysis analysis
depends on the depends on depends on depends on depends on
financial health financial health financial financial health financial health
of the company of the health of the of the company of the company
company company

Solvency certificate No No Yes Yes Yes

(provincial
law)

Audit requirement No No No Yes Yes, if financial

statements are
audited

The requirements are laid down in law and relevant jurisprudence. In New Zealand and
Canada, company directors must sign a certificate stating that, in their opinion, the company
will satisfy the statutory distribution rules and the grounds for that opinion. In the four non-
EU countries, the distribution decision lies within the discretion of the boards of directors.
The board members, however, regularly have to obey the statutory rules as well as possible
additional requirements in the statutes. They usually face personal liability if they declare
unlawful distributions. If the company is rendered insolvent by the distribution the board
generally also owes a fiduciary duty to the creditors.

Companies in the non-EU countries can only make a distribution if, after the distribution, they
remain able to pay their debts as they become due in the usual course of business. This so-
called equity insolvency test is mandatory because of the statutory law or – in the case of
Delaware – because of case law.

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In the United States, Canada and New Zealand, a majority of CFOs believe that dividend
levels are better determined via solvency tests. In Australia, this view was opposed.
Figure 4.2.7 – 3: CFO survey results: Solvency tests and dividend determination (non-EU countries)

Liquidity-oriented/solvency tests: "Is the ability to pay dividends better

determ ined via liquidity tests that take into account projected future cash-
flow s?"

100%
90%
80%
Percentage

70%
60% Yes
50%
40% No
30%
20% NA
10%
0%
U SA C anad a A ust r al ia N ew Z ealand N o n EU
A ver ag e

Source: CFO questionnaire, September 2007.

In addition to this solvency test, all companies have to perform balance sheet tests. From a
legal point of view, these tests significantly differ from country to country. In all jurisdictions,
(large) parts or even the whole contribution received from the issuance of the shares can be
distributed. In New Zealand, for example, a distribution is possible up to the amount by which
the corporation’s assets exceed its liabilities by NZ$ 1. In Delaware, distributions can even
lead to a negative equity account. In contrast, a California corporation can only distribute an
amount in excess of its retained earnings if, after the distribution, the equity ratio is still at
least 20 percent (solvency margin).

Another important characteristic of the majority of the non-EU company laws is that
significant leeway is provided for with respect to the accounting methods used in determining
assets, liabilities, and equity for the purpose of the balance sheet tests. California is the only
non-EU jurisdiction which explicitly states what accounting rules have to be the basis of the
distribution requirements without allowing companies to adjust these themselves. A
California corporation has to use financial statements in conformity with US GAAP (there are
only a limited number of mandatory modifications of the US GAAP accounts which are rarely
of importance in practice). In the case of a group, the use of consolidated financial statements
is required by California law.

In this context, CFOs have perceived their accounting standards as sufficiently tailored to
adequately determine the level of profit distributions. This may indicate that the CFOs are not
dissatisfied with the concept of a balance sheet test and that they consider their audited
accounts as a good starting point to determine distributable profits.

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Figure 4.2.7 – 4: CFO survey results: accounting standards and profit distribution (non-EU countries)

Balance-sheet-oriented distributions tests: "Are in your opinion the accounting

standards applied by your com pany sufficiently tailored to adequately
determ ine the level of profit distribtuions?"

100%
90%
80%
Percentage

70%
60% Yes
50%
40% No
30%
20% NA
10%
0%
U SA C anad a A ust r ali a N ew Z eal and N o n EU
A ver ag e

Source: CFO questionnaire, September 2007.

It has to be pointed out, however, that despite the legal differences the practical approach of
the companies in all the non-EU countries shows remarkable similarities: The companies
usually use the most recent audited accounts when performing the distribution tests. Even if
allowed by law, the companies interviewed do not depart from their audited GAAP financial
statements in order to keep the calculations simple and to avoid possible liability risks.

The regular practice of the companies interviewed showed that dividend levels are subject to a
“political decision” by the company’s management with a view to its share price. This
includes aspects like dividend continuity or giving certain signals to the capital market. As
general alternative to dividend distribution, it is also regularly considered to repurchase own
shares. The starting points for such a decision are the consolidated accounts and consolidated
cash flow situation, i.e. decisions are taken from a group perspective.

The results of a CFO questionnaire sent to the companies listed in the main indices of the four
non-EU countries reconfirm these experiences:

Figure 4.2.7 – 5: Determinants of dividends for holding companies (non-EU countries)

"What are the determ inants for the distribution of dividends by your holding
com pany?"

5
Fin. performance (group accounts)

4
Fin. performance (individual accounts of the
Importance

parent company)
Dividend continuity
3

Signalling device
2
Credit rating considerations

1 Tax rules
U SA C anad a A ust r alia N ew N o n- EU
Z ealand A ver ag e

Source: CFO Questionnaire, September 2007

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To bring the parent company’s financial situation in line with the group perspective, the
companies interviewed in nearly all cases steer the profits and cash flow situation of the
parent company. This is mostly done in a structured planning process over several years,
mainly to achieve tax optimisation for intra-group distributions.

Again, the results of a CFO questionnaire sent to the companies listed in the main indices of
the four non-EU countries show the increased importance of tax rules:
Figure 4.2.7 – 6: Determinants to profit distributions for subsidiaries (non-EU countries)

"What are the determ inants for the distribution of dividends by your
subsidiaries?"

4
Importance

3 Demands f rom the ultimat e parent

Tax rules
Own investment decisions
2

1
U SA C anad a A ust r alia N ew N o n- EU
Z ealand A ver ag e

Source: CFO Questionnaire, September 2007

By average, the time required amounted to approximately 35h.

Capital maintenance

Acquisition by the company of its own shares

Figure 4.2.7 – 7: Conditions for the repurchasing of own shares (5 non-EU jurisdictions)
USA USA Canada Australia New
Delaware California Zealand
1. General Yes Yes Yes Yes Yes
authorisation for
any purpose
Selected criteria:
Resolution by the No No No No. if No
general meeting immaterial
(see specific
conditions)
Maximum percentage No limitation No limitation No limitation No limitation No limitation
of capital
Maximum No No No No No
authorisation period
Performance of a Yes Yes Yes “company Yes
balance sheet test / (share (share must be able to
solvency test repurchases repurchases pay its
and dividends and dividends creditors”
are treated are treated (=solvency
nearly the identically) test)
same;
exception: no
net profits test,

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no special rule
for wasting
assets
corporations)

2. Specific conditions - (Federal) - (Federal) Inter alia: Inter alia: Inter alia:
for certain situations securities securities - issuer bids: - buybacks in - for listed
regulations: regulations: Inter application of excess of 10 % companies: no
Inter alia: alia: extensive the regime for of voting prior notice to
extensive disclosure related party rights in 12 shareholders
disclosure requirements of transactions months required if
requirements of the Securities and and takeover requires own shares are
the Securities Exchange bids rules ordinary less than 5 %
and Exchange Commission (disclosure, resolution of the same
Commission (SEC) formal - selective class
(SEC) valuation, pro buybacks
rata treatment require special
of all or unanimous
shareholders) resolutions
- normal
course issuer
bids:
acquisition of
up to 5 % of
shares in 12
months; not
more than 2 %
of shares in 30
days;
precondition:
timely
disclosure
report
-minimum
Canadian
share
ownership
requirement

Share repurchases are allowed in all five non-EU jurisdictions. With limited exceptions, the
statutory requirements for legal share repurchases are the same as those for dividends (see
above). By average, the time required amounted to approximately 232h.

Capital reduction / share redemption

As already mentioned, in the non-EU jurisdictions the concept of legal capital has either been
abandoned or does not play an important role (e.g. Delaware). Therefore, most of the
company laws do not specifically address capital reductions. The companies can, however,
distribute assets to shareholders by acquiring outstanding shares through redemption of
shares. While a share repurchase is a voluntary buy-sell transaction between the company and
a shareholder, redemption refers to a forced sale initiated by the company, in accordance with
a contract or the statutes. Such redemption, generally, is subject to the same restrictions
imposed on all other kinds of distributions, such as, for example, the solvency and balance
sheet tests (see above).

We have not been able to retrieve any detailed cost data in the interviews conducted with
companies in the five non-EU jurisdictions.

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Contractual self-protection of creditors (covenants)

In the non-EU jurisdictions, debt arrangements between the company and major creditors, e.g.
banks, are a common phenomenon as we observed in the interviews conducted. In this way,
most companies have entered into debt arrangements with covenants.

The importance of covenants is supported by the CFO questionnaire sent to the companies
listed in the main indices of the four non-EU countries:

Figure 4.2.7 – 8: Deterrent for profit distributions (non-EU countries)

"Which of the follow ing deterrents are im portant for you w hen you consider
the level of profit distributions?"

4
Distribution/Legal capital requirements
Importance

3 Rating agencies' requirements

Contractual agreements with creditors

2 (covenants)
Possible violations of insolvency law

1
U SA C anad a A ust r alia N ew N o n- EU
Z ealand A ver ag e

This shows that the legal restrictions concerning profit distribution are considered by the
responding CFOs as mostly slightly more important than market-led solutions like rating
agencies’ requirements or bank covenants. However, bank covenants play a much more
significant role in comparison with the responses from EU jurisdictions.

Due to the wide spread practice, we have been able to retrieve some cost data on the
necessary compliance effort with regard to these covenants. However, it has be remembered
that the costs largely depend on the individual circumstances of the company and how close
the reporting requirements for bank covenants are aligned with already existing reporting
procedures of these companies. By average, the time required amounted to approximately
876h.

Incremental cost table for the five non-EU jurisdictions

The following table summarises the incremental costs implied by the national regulations of
the five non-EU jurisdictions. A detailed definition of incremental cost can be found in the
methodology section of this report.

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Figure 4.2.6 – 9: Summary of incremental cost for the five non-EU jurisdictions
USA USA Canada Australia New Non EU
Del. Cal. Zealand Average
€ € € € € €
Capital No data No data No data €2,000 €450 €1,225
Increase
Distribution €100 to €2,500 to €5,200 €650 to €1,600 to €3,515
€2,000 €5,000 €10,400 €2,500
Acquisition of €5,435 €50,000 No data €3.550 to No data €24,487
own shares €32.500
Capital No data No data No data No data No data No data
reduction
Redemption/ No data No data No data No data No data No data
Withdrawal
of shares
Contractual €8,000 €208,000 €46,800 No data No data €87,600
Self
Protection

In considering these averages it needs to be kept in mind that the data was retrieved from
companies in good financial health. These figures may change once a company would enter
into a more difficult financial situation. Especially with regard to a potential dividend
distribution, the non-EU burden may rise as more detailed considerations concerning their
financial position would have to take place.

Concerning the shareholder and creditor protection arguments please refer to the sections on
the individual non-EU jurisdictions.

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4.3 Alternative regimes proposed by literature

4.3.1 High Level Group

4.3.1.1 The proposal

4.3.1.1.1 Outline

The core element of the alternative regime proposed by the High Level Group of Company
Law Experts chaired by Jaap Winter30 is a two-stage distribution test which serves as a means
to determine the maximum amount available for distribution and which should apply to all
forms of distributions, namely (interim) dividends, share buy-backs and distributions as part
of capital reduction. The two-stage distribution test consists of a balance sheet test and a
liquidity test. Further study should, inter alia, consider prescribing a certain solvency margin
in order to reinforce the tests. Company assets may be distributed provided that a distribution
complies with both tests and that the members of the management board issue a solvency
certificate in which they confirm that the proposed distribution complies with the two-stage
distribution test. An auditor’s certificate is not required. It is recommended that the solvency
certificate to be issued by the management board should be linked to a comprehensive system
of sanctions at the centre of which is the personal liability of directors and directors’
disqualification. The alternative regime should, furthermore, be supplemented by insolvency
legislation, comprising a European framework rule on wrongful trading which should be
extended to “shadow directors” and the concept of subordination of insiders’ (directors and
shareholders) claims. Alongside the introduction of a two-stage distribution test and
supplementary regulation, the High Level Group proposes the repeal of various provisions
concerning the raising of capital, for instance the prohibition to issue true no-par value shares,
the prohibition on the contribution of an undertaking to perform work or supply services and
the valuation requirements in cases in which shares are issued for a consideration other than
in cash. With a view to improving the protection of shareholders it is, furthermore, proposed
to prescribe that shares must be issued at fair value.

4.3.1.1.2 Necessary amendments to the 2nd CLD

Capital maintenance – distributions to shareholders, share repurchases, financial

assistance, redemption of shares, capital reductions

In the alternative regime proposed by the High Level Group the two-stage distribution test
serves as a means to determine the maximum amount available for distributions to
shareholders. It is required for dividend payments and other forms of distributions to
shareholders, including share buy-backs and capital reductions – the latter if the concept of a
reserve for share capital which is not distributable is retained.31 As a consequence, the
substantive restrictions on dividend payments (Art. 15), share buy-backs (Art. 19),
redemption of shares (Art. 39) and reductions in capital (Art. 32) will be replaced:

Any requirement for an enhancement of a simple net assets test by requiring the establishment
of a reserve for the aggregate nominal value of the subscribed capital (Art. 15), will be
abolished.

30
High Level Group of Company Law Experts, Report on a Modern Regulatory Framework for Company Law
in Europe of 4 November 2004 (available under http://europa.eu.int/comm/internal_market/company/
docs/modern/report_en.pdf).
31
High Level Group (2004), p. 87.

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The statutory regulation on share buy-backs (Art. 19) can be limited to prescribing that an
authorisation of the general meeting is required.

It is proposed to facilitate financial assistance for the acquisition of the company’s own shares
(Art. 23) as it is now possible due to the changes introduced by Directive 2006/68/EC32.33
Whether in the alternative regime financial assistance should be permitted up to the
distributable amount determined on the basis of the two-stage distribution test, is not
explicitly stated, but can be assumed.

In the alternative regime, the obligation to set up a capital redemption reserve in cases in
which redeemable shares are redeemed (Art. 39), can be repealed.

The statutory regulation concerning the reduction of subscribed capital can be limited to
prescribing that an authorisation of the general meeting (Art. 30) is required. The creditors’
right to object to capital reductions (Art. 31) can, therefore, be abolished.

The High Level Group, furthermore, recommends extending the possibility of compulsory
withdrawal of shares when a shareholder has acquired 90% of the capital as an exception to
the provision of Art. 36 that the compulsory withdrawal of shares is only permissible if this is
provided in the deed of incorporation or the statutes.34

Raising of capital – contributions, issuance of shares, increase of share capital, pre-

emption rights

Alongside the changes that concern the capital maintenance regime provisions of the 2nd
Company Law Directive, it is recommended that the provisions concerning the raising of
capital be repealed as they are thought to be costly, not entirely effective and impede
business:

The minimum capital requirement (Art. 6) should be retained.35

The prohibition on the contribution of an undertaking to perform work or supply services

(Art. 7 s. 2) should be repealed.36

In the alternative regime, the valuation requirements of the 2nd CLD in cases in which shares
are issued for a consideration other than in cash should be replaced. Share issues for a
consideration other than in cash should be subject to a shareholders’ resolution and the
management board shall be required to certify the appropriateness of the issue in exchange for
the contribution in view of the fair value of shares. In this connection, it is also suggested that
an appropriate protection of minorities be provided.37

The prohibition on the issue of true no-par value shares (Art. 8 (1)) should be abandoned.38

32
Directive 2006/68/EC of the European Parliament and of the Council of 6 September 2006, OJ L 264 of 25
September 2006, pp. 32.
33
High Level Group (2004), p. 85.
34
High Level Group (2004), p. 85 et seq.
35
High Level Group (2004), p. 82.
36
High Level Group (2004), p. 82 et seq.
37
High Level Group (2004), p. 89.
38
High Level Group (2004), p. 83.

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The general rule that equity issues for a cash consideration must be subject to pre-emption
and that any withdrawal or restriction of pre-emption rights is subject to a general meeting
authorisation based on objective criteria (Art. 29 (4), (5)) shall be retained in the alternative
regime.39 Beyond that, in order to better prevent dilution, it should be provided that shares
must be issued at fair value. For listed companies the market price should be an indication of
the fair value. The High Level Group suggests that the market price is calculated as the
average market price in a period immediately preceding the new capital issue. A limited scope
for issues below the market price should be allowed for a marketable discount and
underwriting activities. With respect to unlisted companies, it is suggested that the rule that
the value of shares derived from the audited annual accounts is presumed to be the minimum
price for which shares can be issued, be introduced. The presumption should only be rebutted
on the basis of clear evidence of a lower fair value of shares at the time of the proposed issue
of new shares. In cases in which accounts are not audited, the directors should be required to
certify the appropriateness of the consideration for the shares to be issued and the
shareholders’ meeting should explicitly agree.40

4.3.1.1.3 Distributions

Overview

The two-stage distribution test proposed by the High Level Group consists of a balance sheet
test and a liquidity test. Further study should consider prescribing a certain solvency margin
in order to reinforce the tests.41

Both tests constitute substantive restrictions on distributions: company assets may only be
distributed to shareholders if the distribution complies with both tests. Hence, in cases in
which the balance sheet test indicates that the proposed distribution is not covered by net
assets whereas according to the liquidity test the company is solvent, a distribution may not
take place. In cases in which the two-stage distribution test has been performed on the basis of
accounts which have not been drawn up in accordance with generally accepted accounting
methods and have not been audited, a distribution is prohibited if the audited accounts of the
company indicate that the proposed distribution does not comply with the two-stage
distribution test.42

Balance sheet test

According to the simple balance sheet test, a distribution is permissible if the assets fully
cover or exceed the liabilities after the proposed dividend payment or distribution.43 Hence,
only the surplus of assets over liabilities including provisions as shown in the company’s
accounts is available for distributions. Unlike the balance sheet test of the 2nd Company Law
Directive, the balance sheet test does not require a margin in a way that the net assets balance
must be sufficient to cover the subscribed capital.

The accounts which form the basis of the balance sheet test need not be drawn up in
accordance with a generally accepted accounting method, namely national GAAP, the source
of which is the 4th Directive, or IFRS. The High Level Group recommends that such valuation

39
High Level Group (2004), p. 84.
40
High Level Group (2004), p. 89.
41
High Level Group (2004), p. 87 et seq.
42
High Level Group (2004), p. 88.
43
High Level Group (2004), p. 87 et seq.

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method should be applied which is justified by the position the company is in (going concern,
liquidation).44 However, further study should take place in order to develop the valuation
methods to be used and the relationship with valuation methods applied in the audited
accounts of the company.45 The result of permitting companies to use various accounting
methods is that the net assets may vary depending on the accounting/valuation method used.
For instance, as under IFRS fair value accounting is permissible, to an increasing extent book
profits are shown in the accounts and are, thus, also taken into account when applying the
balance sheet test.

The High Level Group does not state whether the going concern assumption should be
applied. The relevance of the going concern concept should be considered in a further study.
The management board has little discretion when applying the simple balance sheet test
besides the regular options contained in the accounting framework. Distributions may only be
made if and to the extent there is a surplus of assets over liabilities.

The proposal of the High Level Group does not explicitly state how long-term liabilities (e.g.
pensions) are to be treated. However, it follows from the format of the test that, where the
application of a specific accounting method requires recognizing long-term liabilities in the
accounts, they are to be taken into account when applying the test.

Liquidity test or current assets/current liabilities test

The liquidity test proposed by the High Level Group constitutes a short term liquidity
requirement. According to the liquidity test, a distribution is permissible if the company has
sufficient liquid assets to pay liabilities as they fall due in the following period, e.g. the
forthcoming twelve months.46

The test is not, in the strict sense, cash-flow based as it arguably requires the management
board to refer to a balance sheet ratio. In order to determine whether the company will be
solvent in the period following the distribution, the current assets are to be compared to the
current liabilities (current ratio). Although the proposal does not explicitly state what is
understood under liquid assets/current, such assets and liabilities are arguably to be derived
from the company’s individual accounts. The High Level Group does not state whether
reference is to be made to a specific accounting method.47

According to the form and wording of the test, only liquid assets are to be taken into account
when applying the liquidity test. The proposal does not explicitly state what is understood
under liquid assets. However, it follows from the title of the test (“current assets/current
liabilities”) that liquid assets constitute current assets as shown in the accounts. Off-balance
sheet items, such as contingent or prospective assets, are not, therefore, taken into account.
The use of invested capital that can be transformed into liquid assets in time is possible
insofar as it constitutes current assets, e.g. inventories.

According to the test, liabilities which fall due in the period following the distribution need to
be taken into account when applying the test. The proposal does not explicitly state what is
understood under those liabilities. However, from the wording and the title of the test
(“current liabilities”), it follows that current liabilities as shown in the accounts must be taken

44
High Level Group (2004), p. 87 et seq.
45
High Level Group (2004), p. 88.
46
High Level Group (2004), p. 88.
47
High Level Group (2004), p. 88.

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into account. Therefore, off-balance sheet items, such as contingent and prospective or future
liabilities are ignored.

The liquidity test has to cover the “period following the distribution”. According to the High
Level Group, a period of twelve months is adequate.48

The members of the management board have no discretion when applying the liquidity test.
This is inherent in the format of the test: The liquidity test is an objective test in that, when
applying the test, the management board may take resort to a balance sheet ratio, namely the
current ratio. If the liquid assets do not cover the current liabilities, a distribution may not be
made.

Solvency margin

According to the proposal of the High Level Group, a further study should consider
reinforcing the two-stage distribution test by requiring a certain solvency margin. The purpose
of a solvency margin is to integrate legal and statutory reserves into a regime in which there is
no legal capital. In the opinion of the High Level Group, the functions performed by reserves
are more effective than under the current capital maintenance regime established by the 2nd
Company Law Directive as the balance sheet test is reinforced by an additional solvency
margin.49

A solvency margin would ensure that the assets, after the proposed distribution, exceed the
liabilities by a certain margin and/or current assets, after the distribution, exceed current
liabilities by a certain margin.50

The proposal of the High Level Group does not state what - in this respect - is understood
under liabilities, current assets and current liabilities. Nor does the proposal state whether they
are to be derived from the consolidated or individual accounts. The question of whether a
specific accounting method is to be referred to also remains unanswered.

The proposal does not give details of the concrete form of such a solvency margin. It should
be noted that solvency margins already form part of distribution rules in other legal systems.
For instance, the California Corporation Code (§ 500 (b) (1)) prescribes that a distribution
may only be made "if immediately after giving effect thereto the sum of the assets of the
corporation (exclusive goodwill, capitalised research and development expenses and deferred
charges) would be at least equal to 1 ¼ times its liabilities (not including deferred taxes,
deferred income and other deferred credits)." The observance of a solvency margin may also
depend on whether creditors in the preceding fiscal years were exposed to default risks, e.g.
pursuant to § 500 (b) (2) CCC, if the average of the earnings of the corporation before taxes
on income and before interest expense for the two preceding fiscal years was less than the
average of the interest expense of the corporation for those fiscal years, a distribution may
only be made if the current assets would be at least equal to 1 1/4 times its current liabilities.

48
High Level Group (2004), p. 88.
49
High Level Group (2004), p. 88.
50
High Level Group (2004), p. 88.

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Responsibility for performing the test, solvency certificate, relevance of audited

accounts, consultation of an accountant

According to the proposal of the High Level Group, the management board is responsible for
performing the two-stage distribution test.51

The members of the management board are required, on the basis of the tests, to issue a
solvency certificate in which they explicitly confirm that the proposed distribution meets the
two-stage distribution test. A valid distribution can only be made when the directors have
issued a solvency certificate. In cases in which the audited accounts of the company indicate
that the proposed distribution cannot meet the two-stage distribution test, directors should not
be allowed to issue a solvency certificate.52 The proposal of the High Level Group does not
state whether the solvency certificate should also be published.

Under the alternative regime proposed by the High Level Group, the two-stage distribution
test need not be certified by an accountant.

Liability of management or shareholders

The High Level Group recommends implementing a comprehensive system of sanctions:

The proposal does not give particulars of whether recipients of unlawful

dividends/distributions are obliged to return them, but is exclusively concerned with
proposing rules concerning the liability of members of the management board.

Members of the management board should be responsible for the correctness of the solvency
certificate and EU Member States should impose proper sanctions if the certificate is proven
to be misleading. As proper sanctions, personal liability of directors and director’s
disqualification which should be extended to “shadow directors”, are proposed.53 The
proposal does not give particulars as to the extent of the personal liability, particularly as to
which standard of care should apply. The criteria for disqualification of a person from serving
as a director of companies are not given, either. According to the High Level Group, the
introduction of director’s disqualification at EU level should operate as a strong deterrent
against misconduct by directors which in practice is not achieved by criminal and civil
sanctions that are often difficult to enforce.54

Link of insolvency legislation to the alternative regime

The High Level Group argues for implementing a European framework rule on wrongful
trading to enhance responsibility of directors when the company is threatened with
insolvency.55 A European framework rule on wrongful trading should hold directors,
including “shadow directors”, accountable for permitting the company to continue to do
business when it should be foreseen that it will not be able to pay its debts.56 The wrongful
trading rule is thought to protect creditors without restricting companies and their directors as
they can and must make a choice in the case of foreseeable, not yet actually imminent,

51
High Level Group (2004), p. 88.
52
High Level Group (2004), p. 88.
53
High Level Group (2004), p. 88.
54
High Level Group (2004), p. 69.
55
High Level Group (2004), p. 88.
56
High Level Group (2004), p. 68 et seq.

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insolvency whether to attempt to rescue the company or to put it into liquidation. According
to the High Level Group, a general obligation to file for insolvency in case of actual
insolvency usually comes too late. That is the reason why liability should be imposed on
directors for misconduct prior to insolvency. It should, however, be noted that in Britain,
where the offence of wrongful trading is in place, no reported case has turned on pre-
insolvency duties of directors. Rather, judges usually regard the company’s cash flow
insolvency as the starting point of wrongful trading.57

According to the High Level Group, in order to enhance creditor protection, the introduction
of the concept of subordination of insiders’ (directors and shareholders) claims should also be
considered as part of the alternative regime where the assets of the company are deemed
insufficient for the company’s activities.58 Further particulars are not, however, given in this
respect.

4.3.1.2 Economic analysis

The High Level Group proposal fundamentally changes the overall concept of the 2nd CLD
and its implementation requires changes to nearly all basic elements of capital regimes.

Areas with no specifically mentioned substantial changes encompass:

- Capital increases (certification of contributions in kind by the board of directors and shares
issue at the market price).
- Financial assistance
- Contractual self-protection of creditors

Consequently, the following analysis will not elaborate either on potential burdens for
companies or on shareholder and creditor protection in this regard.

Structure of capital and shares

Analysis

The High Level Group proposal foresees the abolishment of the concept of legal capital as
such yet retains the minimum capital requirement. This circumstance as such does not have an
immediate effect on the equity financing of companies as the capital in most cases only
represents an insignificant fraction of the company’s total equity as the analysis of the five
EU countries has shown.

The structure of shares is fundamentally changed by the abolition of the par value concept for
shares. The complete changeover may cause a once-off burden which concerns the update of
the company’s statutes and the actual change of the format of the shares. Subsequently, the
abolition of par values may lead to less complexity in the administration of shares. However,
we do not have reliable data or estimates to assess the associated costs, as companies having
to apply par-value consider such a situation as hypothetical.

57
For an analysis of court decisions cf. Bachner, 5 EBOR (2004), pp. 293, 300 et seq.; Habersack/Verse, ZHR
168 (2004), pp. 174, 184 et seq.
58
High Level Group (2004), p. 92.

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Protection of shareholders and creditors

In view of the individual company, the position of shareholder and creditors is negatively
affected by the fact that the distribution could also be made out of the proceeds of the share
issue of the company if the solvency test allowed for this. The 2nd CLD as such only protects
the subscribed capital, not the share premiums from distributions. Under the High Level
Group proposal the subscribed capital is not protected if the solvency test allows for this. The
introduction of a solvency margin could help to overcome this issue.

To counteract this, the High Level Group proposal provides for an increased level of
formalised solvency testing by the company’s management. However, this is a consideration
based on current ratios which does not take into account the future obligations of a company.
Therefore, the question can be raised whether this test helps to assess the long term viability
of the company.

Distribution

Analysis

Calculation of the distributable amount

The proposal of the High Level Group does not fundamentally change the procedure for the
distribution of profits. The key element that is changed concerns the compliance test as to
whether a distribution is actually feasible. Currently, this is a very light touch procedure in the
EU Member States concerned.

The balance sheet test as proposed by the High Level Group refers to a surplus which does
not necessarily need to be determined on the basis of the annual accounts prepared under the
4th CLD or IFRS. The company is rather free to decide whether a different valuation method
should be applied which is justified by the position the company is in. To this end, the High
Level Group suggests that the development of valuation methods to be used should be the
subject of further study. The acceptance of the application of valuation methods other than
those provided for by national GAAP or IFRS is not in line with current EU practice where a
majority of EU Member States directly use the unaltered annual accounts. Therefore, in cases
in which different valuation methods are used, the associated costs may rise for the companies
concerned. The costs will depend on the extent these valuation methods will differ from
national GAAP valuation methods. The final costs can only be determined if this basic issue
has been resolved.

The liquidity test as foreseen by the High Level Group is an additional formal testing element
which is currently not required in EU Member States. The test obviously relies on certain
current accounting ratios. If these current accounting ratios can be immediately derived from
the external financial reporting of the company, this procedure would be very light and
associated with very low burdens within the range of a few hours of highly qualified
personnel. In any case, this part of the test will cause additional burdens.

Furthermore, the High Level Group has suggested studying the possibility of a solvency
margin. However, it is not clear how high such a solvency margin should be and how this
should be exactly calculated. A high solvency margin may impede potential distributions and
cause additional incremental efforts for the companies concerned to mobilise sufficient profits
and cash from subsidiaries to allow for distributions. In this way, the actual impact of

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solvency margins on companies is not clear. The associated burden will depend on the chosen
level of a solvency margin and cannot be exactly determined at this stage. The calculation
whether a solvency margin is met by the company concerned seems to be easily performed
and will range within a few hours of highly qualified work.

Determination of the distributable amount

The High Level Group proposal does not change the manner in which the distributable
amount is determined. An additional element is a solvency certificate by the board. This
declaration should regularly be a by-product of the above mentioned testing procedures and is
not likely to cause major burdens in its preparation.

The main burdens in EU Member States, i.e. the preparation of the proposal and the actual
payment of the dividend, will remain unchanged. This also concerns the necessity to channel-
up profits and cash to the parent company.

Sanctions

The High Level Group proposal requires a comprehensive system of sanctions which includes
the personal liability of directors and director’s disqualification. Depending on how rigid this
system actually is, the directors will take certain measures that will secure them from
potential sanctions. The level of measures will reflect the level of legal certainty needed for
their actions. Concerning the introduction of a solvency test which is based on current ratios,
there is a high degree of legal certainty for directors when the performance of such a test
satisfies their legal diligence obligations.

Related parties

The High Level Group proposal does not specifically touch on the question of the monitoring
of the relationships with third parties.

Protection of shareholders and creditors

The departure from the audited accounts for purposes of performing the balance sheet test will
bring more uncertainty to shareholders and creditors as to whether the calculation of the
distributable amount is factually correct.

The liquidity test as an additional testing element requires a conscious formal assessment by
management whether there is sufficient cash to justify the dividend distribution. However, the
reference to current ratios may raise doubts whether future developments are adequately
reflected in the assessment by management and, thus, are effective. The conclusions would
need to be confirmed by the management in the format of a solvency certificate which will be
publicly available. By means of this solvency statement, shareholders and creditors may
receive additional information on the viability of the company from a cash flow perspective.
However, as this statement refers to current balance sheet ratios future cash-flows – especially
longer term payment obligation – may not be adequately reflected.

The potential use of a solvency margin may help to increase the certainty for shareholders and
creditors that the company will not distribute dividends too excessively. Depending on the
size of the margin, this amount would be increased. However, it has to be noted that a very

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high solvency margin could also impede potential dividends to shareholders and may further
limit the flexibility for the company’s management to determine dividends.

Shareholders and creditors may benefit from a comprehensive system of sanctions.

Capital maintenance

Acquisition by the company of its own shares

Analysis

Under the High Level Group proposal, the testing procedures applied for distribution have
also to be applied in the case of repurchases of the company's own shares. There is a
continued need to authorise the buy-back decision by the general meeting. In this way, the
basic elements of the buy-back process still persist while the restriction of share repurchases
is, according to the proposals of the High Level Group, subject to a testing procedure by the
management board. The management board should communicate the results of its testing via
a solvency certificate to the shareholders.

Compared to the system enforced by the 2nd CLD, there are only additional costs to the extent
that the testing procedures cause burdens for the company.

Protection of shareholders and creditors

The solvency test concerned with the aspect of the company’s short-term liquidity ensures a
conscious formal assessment by management whether there is sufficient cash to justify the
dividend distribution. So far, such assessments would be rather part of actual management
practice concerning the preparation of distributions.

Accordingly, both shareholders and creditors are provided with a higher level of confidence
concerning the current cash situation. The long-term viability may not be adequately
addressed. Furthermore, the net assets as a protective cushion against excessive dividend
distributions are not part of this protection concept. However, the introduction of a solvency
margin may provide protection of a similar kind.

Capital reduction / withdrawal of shares

Economic analysis

The High Level Group proposes to facilitate capital reduction by applying the testing
procedures to capital reduction and withdrawal of shares. The formal requirements concerning
capital reductions, namely the authorisation by the general meeting, will continue to apply.

The companies interviewed in the survey have not regularly been using the instrument of
capital reduction. Therefore, we have not been able to assemble relevant cost data associated
with capital reductions. However, it is evident that the additional solvency test would
constitute an additional burden for the companies. On the other hand, costs associated with
the right of creditors to object to reductions will fall away.

Whether the proposed measure will give incentives to companies to reduce capital remains to
be seen.

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Protection of shareholders and creditors

Shareholders and creditors may benefit from an insight into the current cash situation of the
company.

The position of creditors worsens due to the fact that their right to object to capital reductions
would be abolished.

The extended possibility to withdraw shares from minority shareholders would take away
rights from the shareholders.

Serious loss of half of the subscribed capital

Analysis

The 2nd CLD requires that a general meeting be called in the case of a loss of half of the
subscribed capital. The High Level Group proposal remains unclear how it deals with this
alert function. It could be assumed that this requirement should be waived due to the fact that
the High Level Group intends to abolish the concept of minimum legal capital.

Shareholder and creditor protection

The provisions dealing with the serious loss of the subscribed capital have a shareholder and
also creditor protective character, as the general meeting has the possibility of deciding on
safeguarding measures. A transition to a capital regime without legal capital would render this
protection ineffective and redundant.

Insolvency

Economic analysis

The High Level Group argues for implementing a European framework rule on wrongful
trading to increase the level of responsibility of directors when the company is threatened
with insolvency. It should hold directors accountable for permitting the company to continue
to do business when it is foreseeable that it will not be able to pay its debts.

Depending on how rigid this system actually is, the directors will take certain measures that
will secure them from potential sanctions. The level of measures will reflect the level of legal
certainty needed for their actions. As the precise sanctioned behaviour as well as the intended
level of sanctions are not very clear, it is not possible to make estimations on associated
burdens for companies at this stage.

Shareholder and creditor protection

Shareholders and creditors may benefit from a comprehensive and consistent EU framework
for a system of sanctions. However, any European system would need to be consistent with
EU Member States’ legal systems.

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4.3.2 Rickford Group

4.3.2.1 The proposal

4.3.2.1.1 Outline

The core element of the alternative regime proposed by the Interdisciplinary Group on Capital
Maintenance chaired by Professor Jonathan Rickford59 is a two-stage distribution test which
serves as a means of determining the maximum amount available for distribution and which
should be applied to all forms of distributions to shareholders, that is (interim) dividends,
share buy-backs and distributions as part of a capital reduction. The two-stage distribution test
consists of a solvency test and a complementing balance sheet net assets test. Company assets
may be distributed provided that a distribution complies with the solvency test. The balance
sheet net assets test does not, by contrast, constitute a substantive restriction on distributions
but prescribes additional disclosure and specification requirements. If, according to the
balance sheet test, the distribution is not covered by net assets, the management board may
still make a distribution provided it states the reasons why it is of the opinion that a
distribution is nevertheless justified. The management board is required to provide and
publish a solvency certificate in which it declares that in its assessment, after an enquiry into
the affairs and the prospects of the company proper for the purpose, the distribution complies
with the requirements. A mandatory auditor’s certificate is not required. Yet, in respect to
large companies whose accounts must be audited, the proposal of the Rickford Group follows
an audit-based approach insofar as the audit report for the financial year in which the
distribution has taken place must consider the legality of the distribution and, in cases in
which there are doubts as to the lawfulness of distributions, members of the management
board are required to consult an auditor prior to the distribution. The Rickford Group
recommends linking the solvency certificate to be issued by the management board to a
comprehensive system of remedies and sanctions, which should include the personal liability
of directors and directors’ disqualification. It is emphasised that the efficacy of the alternative
regime depends in part on fiduciary duties of the members of the management board which
should apply where legal rules have not been established. To the extent that such fiduciary
duties do not exist in EU Member States, they should be introduced. Furthermore, it is
recommended that the alternative regime should be supplemented by insolvency legislation,
namely a wrongful trading standard at EU level. Alongside the introduction of a two-stage
distribution test and supplementary regulation, the Rickford Group proposes that various
provisions concerning the raising of capital, for instance the minimum capital requirement,
the prohibition to issue true no-par value shares and the valuation requirements in cases in
which shares are issued for a consideration other than in cash, be repealed. In essence, only
the 2nd Company Law Directive’s rules on shareholder and minority protection should
remain intact.

4.3.2.1.2 Necessary amendments to the 2nd CLD

Capital maintenance – distributions to shareholders, share repurchases, financial

assistance, redemption of shares, capital reductions

In the alternative regime, the two-stage distribution test serves as a means of determining the
maximum amount available for distributions to shareholders and should be applied to all
forms of distributions, that is (interim) dividend payments, share buy-backs and distributions

59
Rickford, Reforming Capital, 15 EBLR (2004), pp. 919 et seq.

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as part of a capital reduction. As a consequence, the substantive restrictions on dividend

distributions (Art. 15), share buy-backs (Art. 19), redemption of shares (Art. 39) and
reductions in capital (Art. 32) will be abolished whereas the special rules on shareholder and
minority protection will remain.

Any requirement for an enhancement of a simple net assets test by requiring that a reserve for
the aggregate nominal value of the subscribed capital (Art. 15) be set up, will be abolished.60

The statutory regulation on share buy-backs (Art. 19) can be limited to prescribing that a
general meeting authorisation for the purchases of acquiring the company’s own shares is
required. The 10% limit in the purchase regulation – which was still in force at the time the
proposal of the Rickford Group was published – can be abolished alongside the required
reserve (Art. 19).61

It is recommended that the prohibition on giving financial assistance for the acquisition of the
company’s own shares as part of company law (Art. 23) which had not been relaxed at the
time the proposal of the Rickford Group was published, be repealed. Special risks arising
from market abuse, for example inappropriate share buy-backs and financial assistance
transactions, should be addressed by properly focused and targeted securities regulation.62

The obligation to set up a capital redemption reserve in cases in which redeemable shares are
redeemed (Art. 39) can be abolished.63

The statutory regulation concerning the reduction in subscribed capital can be limited to
prescribing that an authorisation of the general meeting (Art. 30) is required. The creditors’
right to object to capital reductions (Art. 32) can be repealed.64 The application of the two-
stage distribution test in cases in which a company distributes company assets as part of
capital reduction is thought to provide sufficient protection for creditors.

The general meeting authorisation requirement for the reduction in capital by compulsory
withdrawal of shares (Art. 37) and for the redemption of capital without reduction (Art. 35),
should remain.65

In the alternative regime, the 4th Directive’s rules on accounting reserves to be set up in order
to prevent distributions in cases in which the company exercises a specific accounting option
(Art. 33 (2), Art. 34), will disappear.66

Raising of capital – contributions, issuance of shares, increase of share capital, pre-

emption rights

Alongside the changes that concern the capital maintenance provision of the 2nd Company
Law Directive, the Rickford Group recommends repealing various provisions concerning the
raising of capital as they are thought to be costly, not to be entirely effective and to impede
business.

60
Rickford (2004), p. 983.
61
Rickford (2004), pp. 983 and 986.
62
Rickford (2004), p. 986.
63
Rickford (2004), p. 983.
64
Rickford (2004), p. 986.
65
Rickford (2004), p. 986.
66
Rickford (2004), p. 983.

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Subscribed capital as a mandatory requirement, including the minimum capital requirement

(Art. 6), should be abolished.

As a result, the rules on the publicity for subscribed capital (Art. 2 lit. c, Art. 3 lit. b) should
be repealed.67

The prohibition on issuing shares at a discount (Art. 8 (1)) and related rules about
commissions and discounts, should be repealed.68

The prohibition on the issue of true no-par value shares (Art. 8 (1)), should be abolished.

The prohibition on the contribution of an undertaking to perform work or supply services

(Art. 7 s. 2), should be repealed.

The valuation requirements in cases in which shares are issued for a consideration other than
in cash on formation and in subsequent capital increases (Art. 10, Art. 27) - which were
relaxed after the proposals of the Rickford Group were published - should be abolished.69 It is
proposed that the function of these rules should be achieved by transparency regulation,
namely the requirement to disclose at the companies register the relevant contracts in writing
and the consideration given. Furthermore, the fiduciary duty of members of the management
board to act in the best interests of the company – a duty which already exists under common
law - should apply. If a director’s breach of duty results in the dilution of capital, shareholder
remedies shall be provided for to sanction these breaches.70

The general meeting authorisation requirement for capital increases (Art. 25) and for any
departure from the general rule that equity issues for a cash consideration must be subject to
pre-emption rights (Art. 29 (4), (5)), should remain.71

4.3.2.1.3 Distributions

Overview

The two-stage distribution test proposed by the Rickford Group consists of a solvency test and
a balance sheet net assets test.72 The solvency test requires an assurance of the company’s
short-term liquidity and, in addition to this, an indefinite assurance of the company’s viability.
Only the combination of a strict short-term liquidity requirement and the assurance of the
company’s positive prospects for the longer term, is thought to be of real value for creditors.

Only the solvency test serves as a substantive restriction on distributions. Company assets
may only be distributed to shareholders if the distribution complies with both solvency tests.73
By contrast, the balance sheet net assets test does not constitute a substantive distribution
requirement. If, by application of the balance sheet net assets test, the proposed distribution is
not covered by net assets whereas, according to the solvency test, the company is solvent, the

67
Rickford (2004), p. 986.
68
Rickford (2004), p. 983.
69
Rickford (2004), p. 983.
70
Rickford (2004), p. 987.
71
Rickford (2004), p. 986.
72
Rickford (2004), pp. 985 et seq.
73
Rickford (2004), p. 986.

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management board is still allowed to make a distribution provided it states the reasons why it
is of the opinion that a distribution is nevertheless justified.74 The reason why the balance
sheet test does not constitute a substantive restriction on distributions is that a mere
mechanical application of a calculation of balance sheet net assets is not thought to make
proper allowances for the quality of the company’s assets and liabilities, their volatility and
linkage over time and the quality of the company’s performance.75 In the alternative regime,
the balance sheet net assets test serves as an additional formal requirement in that it stipulates
disclosure and specification requirements. It should function as a measure to discipline the
management.76

Solvency test

Short-term liquidity requirement

The first part of the solvency test as proposed by the Rickford Group consists of a short-term
liquidity requirement and is cash-flow based. Pursuant to the proposal, a distribution may
only take place if the directors certify that, having regard to their intentions and the resources
in their view likely to be available, for the year immediately following the distribution the
company will be able in the ordinary course of business to meet all its debts as they fall due as
a going concern throughout the year.77

Debts to be taken into account in this context comprise liquidated claims, contingent liabilities
and prospective liabilities.78 A contingent liability means a liability which is vested – in the
sense that the legal relationship which may give rise to an obligation to pay exists – but which
may or may not mature into an obligation to pay, according to whether some contingency
occurs. Contingent liabilities are, for example, a liability on a guarantee agreed, an insurance
policy underwritten by the company or a claim on a warranty given by the company. A
prospective liability means a liability which has already accrued or is substantially certain to
do so.79 Examples are a liability for rent under a lease, a liability under a non-matured bill of
exchange or a liability for progress payments on a construction contract yet to be assessed.
Therefore, also off-balance sheet items need to be taken into account when applying the test.

With respect to the liquid funds to be taken into account in the context of the short-term
liquidity test, not only the liquid funds that exist at the time of the distribution are relevant.
But the management board may also take into account the future influx of liquid funds, as, for
example, the funds arising from a realisation of assets or income from investments.80 For this
purpose also future and contingent assets may be taken account of.81

Extraordinary circumstances are, by definition of the short-term liquidity test (“in the ordinary
course of business”), not to be taken into account. A definition of the term “extraordinary
circumstances” does not, however, exist.

The period the solvency test has to cover is the year following the distribution.82

74
Rickford (2004), p. 980.
75
Rickford (2004), p. 975.
76
Rickford (2004), p. 980.
77
Rickford (2004), p. 980.
78
Rickford (2004), p. 978.
79
Rickford (2004), p. 978.
80
Rickford (2004), p. 980: “[…] the resources in their view likely to be available […].”
81
Rickford (2004), p. 979.
82
Rickford (2004), p. 980.

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The members of the management board have discretion when applying the short-term
liquidity test. This is intrinsic to the form of the test. The short-term liquidity requirement is
not an objective test in that, when applying the test, the management board may resort to a
balance sheet ratio. Instead, the board’s subjective perspective is relevant when assessing the
company’s solvency for the year immediately following the distribution (“in their view”) and,
in doing so, contingent and prospective circumstances not yet shown in the accounts are also
to be taken account of when assessing whether the company will have sufficient funds
available to be able to pay its debts when they are due. Whether the company has actually
resources available to remain a going concern, is to be assessed on the balance of probabilities
(“likely”). This also grants discretion to the management board.

The proposal does not expressly state how long-term liabilities are treated. Yet, it follows
from the nature of the short-term liquidity test that only those liabilities are to be taken into
account which mature into obligations to pay within the period of one year immediately
following the distribution. Hence, long-term liabilities need not be taken into account in the
context of the short-term liquidity test.

Indefinite assurance of the company’s viability

The second part of the solvency test requires an indefinite assurance of the company’s
viability. This test is also in essence cash flow based. Pursuant to the proposal, the members
of the management board are required to certify that, in their view, for the reasonably
foreseeable future, taking into account the company’s expected prospects in the ordinary
course of business, it can reasonably be expected to meet its liabilities.83

Beyond the liabilities which are to be taken into account in the context of the short-term
liquidity test, namely liquidated claims, contingent and prospective liabilities, the liabilities
that the company will incur in the future in the course of normal trading must also be taken
into account in the context of the viability test.

By of the same reasoning, future assets arising in the ordinary course of business may also be
considered apart from the assets which are to be taken into account in the context of the short-
term liquidity test, namely liquid funds, contingent and prospective assets.84

In the context of the viability test, extraordinary circumstances are, by definition of the test
(“in the ordinary course of business”), not to be taken into account. The proposal does not
give an exact definition of what extraordinary circumstances are. Following from the wording
of the viability test, extraordinary circumstances are those which do not occur in the ordinary
course of business. From the statement of reasons of the proposal it can, furthermore, be
concluded that extraordinary transactions in connection with assets are those which are too
contingent and remote to be eligible for consideration, e.g. the prospect of a capital increase
may not be taken into account.85

The period the solvency test has to cover is, according to the wording of the test, “the
reasonably foreseeable future”. It is, therefore, indefinite.

83
Rickford (2004), p. 979.
84
Rickford (2004), p. 979.
85
Rickford (2004), p. 979.

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When applying the viability test, the members of the management board also have discretion.
This is due to the form of the test. Firstly, the viability test is not an objective test in that
reference cannot be made to balance sheet ratios when determining the company’s viability.
Instead, the management board’s subjective perspective is relevant when determining the
company’s viability (“in their view”) and in doing so, to an substantial degree, off-balance
sheet items are to be taken into account, namely contingent, prospective and future liabilities
and assets. Secondly, the question whether the company will be able to meet its liabilities is to
be assessed on the standard of reasonable expectation (“it can reasonably be expected”). The
standard of reasonable expectation should, according to the proposal, be the normal one of the
balance of probabilities taking the situation and the prospects of the business as a whole. This
also grants discretion to the management board. The fact that the viability test is indefinite
(“for the reasonable foreseeable future”) requires that the test is by nature more judgmental,
thus also leaving the management board with wider discretion than in the context of the short-
term liquidity test.

The proposal does not explicitly state how long-term liabilities, such as pensions, are treated.
However, it follows from the form of the viability test that long-term liabilities are also to be
taken into account as they will mature into obligations to pay in the “foreseeable future”. In
this connection, it is important to note that the viability test does not require a strict reference
to balance sheet items. The consequence is that, for example, pension liabilities shown in the
company’s accounts at the time of the distribution do not necessarily need to be considered
provided that the company’s prospects of solvency are not otherwise in doubt.86 Rather, the
management board may consider changes in the value of pension liabilities which are likely to
occur in the course of the years until the liability matures into an obligation to pay.

Balance sheet net assets test

According to the proposal of the Rickford Group, in issuing the solvency certificate, the
members of the management board are required to take account of the company’s accounts
and annual report as a whole.87 In this connection, they need to apply the balance sheet net
assets test.

According to the balance sheet net assets test, a distribution is permissible if, immediately
after the distribution, the assets cover the liabilities.88 Hence, the net assets i.e. the surplus of
assets over liabilities including provisions as shown in the company’s accounts, may be
distributed. Preferential shareholders’ claims are also treated as liabilities by way of a default
rule, variable in the terms of issue or by agreement.89 Unlike the balance sheet test of the 2nd
Company Law Directive, the balance sheet net assets test does not require an additional
margin, e.g. the net assets balance does not need to be sufficient to cover the subscribed
capital or subscribed capital plus an accumulating margin of up to 10 or 20 percent of such
capital.90

The proposal does not explicitly prescribe which accounting method is to be applied when
drawing up the company’s accounts which form the basis of the balance sheet test. However,

86
Rickford (2004), p. 980.
87
Rickford (2004), p. 980.
88
Rickford (2004), pp. 969 and 980.
89
Rickford (2004), p. 982.
90
Rickford (2004), pp. 982 et seq.

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as reference is to be made to the “financial statements of the company”91, the accounting

methods to be used will arguably be either those based on the 4th Directive or IFRS.

The management board has discretion when applying the balance sheet net assets test. If the
result of the application of the balance sheet net assets test is that a distribution is not covered
by net assets whereas the result of the application of the solvency test is that the company is
solvent, the management board may still make a distribution provided it states the reasons
why it is of the opinion that a distribution is justified.92 The balance sheet net assets test must,
therefore, be applied. However, a distribution may be permissible even if it does not comply
with the balance sheet test.

If the application of national GAAP or IFRS requires long term liabilities (e.g. pensions) to be
stated in the accounts, they are also taken into consideration when applying the balance sheet
net assets test. However, it follows from the nature of the balance sheet net assets test that
long-term liabilities included in the accounts are not material for the question whether
distributions are permissible. The ultimate test is the solvency test.

Responsibility for performing the test, solvency certificate, consultation of an accountant

According to the proposal of the Rickford Group, the management board is responsible for
performing the two-stage distribution test.93

The members of the management board are required to provide and publish a certificate in
which they state that, in their view, after enquiry into the affairs and the prospects of the
company proper for the purpose, the distribution complies with the requirements of the tests.
Where the solvency test and the balance sheet net assets test diverge, the certificate should
include explanations why the management board is of the opinion that a distribution is
justified. The form of the enquiry requirement takes account of the fact that a full enquiry into
the affairs and prospects of the company is not necessary in all cases, e.g. in cases in which
the company has massive liquid resources and current profits which greatly exceed the
proposed distribution. It is also emphasised that such an enquiry does not provide an absolute
guarantee of ongoing solvency.94

Under the alternative regime proposed by the Rickford Group, a mandatory auditor’s
certificate is not required. However, in respect to large companies whose accounts must be
audited, the proposal of the Rickford Group follows an audit-based approach insofar as the
audit report for the financial year in which the distribution has taken place must consider the
legality of the distribution and the directors’ “going concern assurances”. In cases in which
there are doubts as to the lawfulness of distributions, the members of the management board
are, furthermore, required to consult an auditor prior to the distribution.95 In respect to small
companies whose accounts need not be audited, such requirements are not applicable.

Liability of the management or shareholders

The Rickford Group proposes a comprehensive system of sanctions, emphasising that the
alternative system depends in part on the existence of the availability of effective sanctions.

91
Rickford (2004), p. 986.
92
Rickford (2004), p. 980.
93
Rickford (2004), p. 980.
94
Rickford (2004), pp. 980 et seq.
95
Rickford (2004), p. 981.

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Along the lines of sec. 277 CA 85, civil liability for recipients of unlawful distributions
should be based on fault. Hence, recipients of unlawful payments are liable to return the
payment if they knew or had reasonable grounds to believe that the distribution was irregular.

Members of the management board are responsible for the correctness of the solvency
certificate and should be held personally liable if fault is present. The criteria for fault liability
should be that applicable to the normal director’s duty of care, skill and diligence. Directors
exercising normal standards of care are required to make an enquiry into the affairs and the
prospects of the company proper for the purpose when providing the solvency certificate. In
large companies whose accounts must be audited, directors exercising normal standards of
care will also have to consult the auditors in case of doubt as to the legality of the
distribution.96

Furthermore, it is proposed that members of the management board should be liable under
criminal law for unlawful distributions.

According to the proposal, the directors at fault should also be disqualified along the lines of
the British Company Directors Disqualification Act 1986 (CDDA 86).97 A disqualification
order of the court prohibits a person from being a director of a company and from being
otherwise concerned with a company’s affairs (sec. 1 (1) CDDA 86). Under current law, a
disqualification is made against directors of insolvent companies whose conduct of the
company has made them unfit to be concerned in the management of the company (sec. 6
CDDA 86). Matters for determining unfitness of directors include misfeasance or breach of
fiduciary duties (para. 1 Part I Schedule 1 CDDA 86), misapplication of company money or
property (para. 2 Part. I Schedule 1 CDDA 86) and the extent of the director’s responsibility
for the company becoming insolvent (para. 6 Part. II Schedule 1 CDDA 86). Judging from the
case law at hand, courts make disqualification orders in cases of “incompetence and
negligence to a very marked degree”98. By contrast, courts are not prepared to make
disqualification orders in cases of commercial misjudgement.

Link of insolvency legislation to the alternative regime

Against the background that the alternative system depends in part on the existence of the
availability of effective sanctions, the Rickford Group recommends that the solvency test
should be supported by properly sanctioned general behavioural standards covering wrongful
trading and non-commercial or unfair transactions in conditions of insolvency or anticipated
insolvency.99 To this end, it is suggested that the concepts of wrongful trading and fraudulent
trading law along the lines of the British Insolvency Act 1986 (IA 86) be introduced at EU
level.100

Fraudulent trading refers to cases in which liability is imposed on directors where, in the
course of the winding-up of a company, it appears that a director has carried on the business
of the company with the intent to defraud creditors of the company (sec. 213 IA 86).

96
Rickford (2004), p. 980.
97
Rickford (2004), p. 980.
98
Re Stanford Services Ltd [1987] 3 BCC 326, 334; Re Churchill Hotel (Plymouth) Ltd [1988] BCLC 341; Re
Sevenoaks Stationers (Retail) Ltd [1991] Ch 164, 184, CA.
99
Rickford (2004), p. 984.
100
Rickford (2004), p. 984.

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Wrongful trading imposes liability on the directors in cases in which the company has gone
into insolvent liquidation and at some time before the commencement of the winding-up of
the company the director knew or ought to have concluded that there was no reasonable
prospect that the company would avoid going into insolvent liquidation and the director did
not take every step he ought to have taken to minimise the potential loss to the company’s
creditors (sec. 214 IA 86). The earliest point at which a director may become personally liable
for wrongful trading is, therefore, some time before the onset of material insolvency, namely
when the prognosis of the company staying solvent is negative. It should, however, be noted
that no reported case in Britain has yet turned decisively on such pre-insolvency duties of
directors.101 Judges usually fix as the starting point of wrongful trading, the company’s cash-
flow insolvency.

4.3.2.2 Economic analysis

The Rickford proposal fundamentally changes the overall concept of the 2nd CLD and its
implementation requires changes to nearly all basic elements of capital regimes.

Areas with no substantial changes include:

- Capital increases and pre-emption rights

- Contractual self-protection of creditors

Consequently, the following analysis will not elaborate either on potential burdens for
companies or on shareholder and creditor protection in this regard.

Structure of capital and shares

Analysis

The Rickford proposal foresees the abolition of the minimum capital requirement. This
circumstance as such does not have an immediate effect on the equity financing of companies
as the subscribed capital in most cases only represents an insignificant fraction of the
company’s total equity as the analysis of the five EU countries has shown.

The structure of shares is fundamentally changed by the abolition of the par value concept for
shares. The complete changeover may cause a once-off burden which concerns the update of
the company’s statutes and the actual change of the format of the shares. Subsequently, the
abolishment of par values may lead to less complexity, specifically in the administration of
shares. However, we do not have reliable data or estimates to assess the associated costs as
companies having to apply par-value consider such a situation as hypothetical.

Protection of shareholders and creditors

The position of shareholders and creditors is negatively affected by the fact that the
distribution could also be made out of the contributions received from shareholders of the
company if the solvency test allowed for this. The balance sheet test can be overruled.

As a remedy, the Rickford proposal foresees an increased level of formalised solvency testing
by the company’s management concerning both the company’s short-term liquidity and its
101
For an analysis of court decisions cf. Bachner, 5 EBOR (2004), pp. 293, 300 et seq.; Habersack/Verse, ZHR
168 (2004), pp. 174, 184 et seq.

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viability in the long term. Both tests are linked to a system of sanctions at the centre of which
is the personal liability of the directors. In implementing such a system, it would be crucial
whether the threat of sanctions to directors serves as means to discipline the management to
act prudently. Under the envisaged format of the solvency test, the directors are partly
required to make highly judgmental decisions about the prospects of the company. This may
result into legal uncertainty for directors. Therefore, the actual design of the test and the
format of the certification by the company’s directors will be decisive in determining the right
balance between the legal uncertainty for directors and the interest of stakeholders in a viable
company.

Distribution

Analysis

Calculation of the distributable amount

The proposal of the Rickford Group makes fundamental changes concerning the procedure for
the distribution of profits. Under the Rickford proposal, the particular emphasis switches from
the balance sheet to the solvency tests because, under certain conditions, companies could
make distributions even if a balance sheet test was not passed.

The solvency test is the core testing element which is, by statute, not currently required in EU
Member States. We have encountered in our interviews that the management of companies
distributing dividends will regularly consult with the treasury department whether there is
cash available for distribution and this will normally be planned at least a year ahead of the
actual distribution. However, the actual calculation will be based on internal cash flow
reporting standards.

Concerning the actual practice of performing the test, the Rickford Group does not specify
exact requirements to allow for an ultimate assessment of the associated burdens. The
solvency test consists of a short-term liquidity requirement and, in addition, an indefinite
assurance of the company’s viability. In the context of the solvency test, off-balance sheet
items are also to be taken into account. The foreseeable future that has to be taken into
account, is not further defined.

The solvency test is subject to a formal certification by the company’s management. The
intensity of this burden depends on how detailed the prescribed calculation methods are and
how much they deviate from internal practices at the companies concerned. Accordingly, the
way the calculation is conducted will heavily influence the workload associated with this test.

Determination of the distributable amount

The Rickford proposal does not change how the distributable amount is determined. An
additional element is a solvency certificate by the board. This declaration should normally be
a by-product of the above mentioned testing procedures and is not likely to cause major
burdens in its preparation. However, the board has to inquire into the affairs and prospects of
the company to an extent deemed adequate for the purpose. The associated burdens associated
with this enquiry obligation depend on the financial state the company is in. Furthermore,
there is a need to consult the auditors in case of doubt as to the legality of the distribution.
Again, the engagement of the auditors specifically for this purpose will invoke specific
financial burdens for the company.

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The other main burdens in EU Member States, i.e. the preparation of the proposal and the
actual payment of the dividend will remain unchanged. This also concerns the necessity to
channel-up profits and cash to the parent company.

Sanctions

The Rickford proposal requests a comprehensive system of sanctions which includes the
personal liability of, as well as criminal sanctions for, directors. As such, the Rickford
proposal requires explicit judgment on future developments concerning the cash flow of the
company. This may lead to legal uncertainties with directors whether, in performing their
assessment, they comply with their legal obligations. Depending on how rigid this system
actually is, the directors will take certain measures that will secure them from potential
sanctions. The level of measures will reflect the level of legal certainty needed for their
actions. As the ultimate level of sanctions is not very clear, it is not possible to estimate the
associated burdens for companies.

Related parties

The Rickford proposal does not specifically touch on the question of the monitoring of the
relationships with third parties.

Protection of shareholders and creditors

The departure from the audited accounts, for the purpose of performing the balance sheet test,
will cause more uncertainty to shareholders and creditors as to whether the calculations are in
fact correct.

The “solvency test”, which is the core testing element, requires a conscious assessment by
management as to whether there is sufficient cash to justify the dividend distribution. So far,
such assessments are rather part of actual management practice concerning the preparation of
distributions. The management will usually also make such assessments to allow its accounts
to be prepared under the going concern assumption. Nevertheless, projections into the future
may always lead to higher uncertainties than calculations with actual figures. The conclusions
would need to be confirmed by the management in the format of a solvency certificate which
will be publicly available

By means of this solvency statement, shareholders and creditors may receive additional
information on the viability of the company from a cash flow perspective.

Shareholders and creditors may benefit from a comprehensive system of sanctions depending
on its actual enforcement in practice.

Capital maintenance

Acquisition by the company of its own shares

Analysis

Under the Rickford proposal, the solvency test procedures applied to distribution also have to
be applied in the case of repurchases of shares. There is a continued need to authorise the buy-

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back decision by the general meeting. In this way, the basic elements of the buy-back process
still persist while the restriction of share repurchases is under the Rickford proposal subject to
the solvency testing procedure by the management board. The management board will
communicate the results of its testing via the solvency certificate to the shareholders.

Compared to the system enforced by the 2nd CLD, there are additional costs to the extent that
the solvency test causes burdens for the company.

Protection of shareholders and creditors

Under the Rickford proposal, the buy-back process as foreseen under the current 2nd CLD
will be subject to a solvency test not yet required. The testing ensures a conscious formal
assessment by management whether there is sufficient cash to justify the share repurchase. So
far, such assessments would be rather part of actual management practice concerning the
preparation of distributions.

Accordingly, both shareholders and creditors may benefit from a higher level of confidence
concerning the viability of the company from a cash-flow perspective. It is a matter of the
effectiveness of this test whether there is a positive or negative impact on the protection of
shareholders and creditors. The effectiveness is mainly determined by systems of sanctions
foreseen in the Rickford proposal which is intended to discipline the management to act
prudently.

Capital reduction / withdrawal of shares

Analysis

The Rickford Group proposes to facilitate capital reductions by applying the solvency test
procedures to capital reductions and the withdrawal of shares in case the concept of a reserve
for share capital which is not distributable is retained at EU level. The formal requirements
concerning capital reductions, namely authorisation by the general meeting, will continue to
apply.

The companies interviewed in the survey have not regularly been using the instrument of
capital reduction. We have not, therefore, been able to assemble relevant cost data associated
with capital reductions. However, it is clear that the additional solvency test would constitute
an additional burden for the companies. Costs associated with the right of creditors to object
to reductions will fall away.

Whether the proposed measure will give incentives to companies to reduce capital remains to
be seen.

Protection of shareholders and creditors

The solvency test may help shareholders and creditors to assess whether the company is a
going concern from a cash-flow perspective for at least one year.

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Financial assistance

Analysis

The Rickford Group proposal does not explicitly address the question whether the solvency
test procedures are to be used for distribution purposes for financial assistance transactions.

Shareholder and creditor protection

The solvency test procedures may give shareholders and creditors certainty about the viability
of company from a cash flow perspective, and not affected by outflowing money which is lent
to shareholders. It is a matter of the effectiveness of this test whether there is a positive or
negative impact on the protection of shareholders and creditors. The effectiveness is mainly
determined via the actual design of the tests filling certain gaps in the Rickford proposal.

Serious loss of half of the subscribed capital

Analysis

The 2nd CLD requires that a general meeting be called in the case of a loss of half of the
subscribed capital. The Rickford proposal remains unclear how it deals with this alert
function. It could be assumed that this requirement should be waived due to the fact that the
Rickford Group intends to abolish the concept of minimum legal capital. Instead fiduciary
duties of directors could apply.

Shareholder and creditor protection

The provisions dealing with the serious loss of the subscribed capital have a shareholder and
also creditor protective character, as the general meeting has the possibility of deciding on
safeguarding measures. A transition to a capital regime without minimum legal capital would
make this protection ineffective and redundant. Instead, safeguarding measures will be subject
to the discretion of the management board.

Insolvency

Analysis

The Rickford Group recommends that the solvency test should be supported by a European
framework of properly sanctioned general behavioural standards covering wrongful trading
and non-commercial or unfair transactions in conditions of insolvency or anticipated
insolvency.

Depending on how rigid this system actually is, the directors will take certain measures that
will secure them from potential sanctions. The level of measures will reflect the level of legal
certainty needed for their actions. As the precise sanctioned behaviours as well as the
intended level of sanctions are not very clear, it is not possible to give estimates of associated
burdens for companies at this stage.

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Shareholder and creditor protection

Shareholders and creditors may benefit from a comprehensive and consistent EU framework
for a system of sanctions. However, any European system would need to be suitable to EU
Member States’ legal systems.

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4.3.3 Lutter Group

4.3.3.1 The proposal

4.3.3.1.1 Outline

The Expert Group on “Legal Capital in Europe” chaired by Professor Marcus Lutter
(“Lutter-Group”) comes to the conclusion that abolishing the legal capital regime is not
recommendable as long as the function and effectiveness of the proposed alternative regimes
are tested. Such a test is still owing. The mere reference to other jurisdictions, such as the US
state laws, is of limited help since the legal surroundings (e.g. enforcement of directors’
duties) differ materially.

4.3.3.1.2 Necessary amendments to the 2nd CLD

For these reasons, the members of the Expert Group recommend not to repeal the Second
Company Law Directive as recently amended with one exception: Art. 15 of the Directive
dealing with the identification of the distributable amount should be reconsidered.

4.3.3.1.3 Distributions

The Expert Group recognises the problem of the identification of profits due to new
accounting standards (IFRS) that brought changes regarding the principles of realisation and
imparity.102 In particular, the declaration of unrealised profits is regarded as a serious danger.
Different methods were contemplated and considered as unconvincingly (an extra balance
sheet is considered as being too costly; countermeasures with an additional cushion are too
restrictive; the solvency test alone would abolish the legal capital system and permit the
distribution of capital at the expense of creditor protection). Therefore, the Group comes to
the conclusion that a dual solution should be introduced: Either the company advances a
balance sheet according to commercial accounting principles that is reviewed and certified or
it draws up the IFRS balance sheet which is reviewed by an auditor and certified by the
management plus an additional solvency test. This solvency test should be based on current
information summarised in a financial budget and on a longer- term capital budget document
that the intended distribution will highly likely leave the firm with sufficient funds to meet
liabilities as they become due for one to two years. The management should be liable for the
test.

102
Cf. Lutter in: Lutter (Ed.), Legal Capital in Europe, ECFR Special Volume 1, 2006, p. 9 and in detail
Pellens/Sellhorn, ibid., p. 364-393.

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4.3.3.2 Economic analysis

As the Lutter proposal maintains the overall concept of the 2nd CLD and focuses on the
treatment of IFRS for profit distribution purposes. For the remaining basic elements of a
capital regime, there will be no changes in terms of burdens for the companies concerned.
These areas with no substantial change encompass:

- Structure of capital and shares

- Capital increases
- Acquisition of own shares
- Capital decrease
- Withdrawal of shares
- Financial assistance
- Serious loss of subscribed capital
- Contractual self-protection
- Insolvency

Therefore, the position of shareholder and creditors in this regard will not change.

Distribution

With respect to distributions the proposal differentiates between the calculation of the
distributable amount, the determination of the amount to be distributed, sanctions and related
parties.

Calculation of the distributable amount

As already embedded in the current 2nd CLD, the distributable amount shall be determined on
the basis of the audited financial statements through a combination of balance sheet net assets
test and a combination of profit and loss account test. This testing will not continue the
current practices of companies in this respect and will not change the burden.

If a company prepares its individual accounts under IFRS, the company will have to perform
an additional “solvency test” covering a projective period of one to two years. This obligation
does not concern other individual accounts prepared under national GAAP, respectively the
4th CLD. We have encountered in our interviews that the management of companies
distributing dividends will regularly consult with the treasury department whether this is
available cash for distribution and this will normally be planned at least a year ahead of the
actual distribution. However, the actual calculation will be based on internal cash flow
reporting standards.

Concerning the actual practice of performing the test, the Lutter proposal does unfortunately
not specify exact requirements to allow for an ultimate assessment of the associated burdens.
The intensity of this burden depends on how detailed the prescribed calculation methods are
and how much they deviate from internal practices at the companies concerned. Accordingly,
the way of how the calculation is conducted will heavily influence the workload associated
with this test.

Another issue of the Lutter Group concerns the burdens of the company resulting from their
financial reporting. The Lutter Group argues that by the use of a combination of IFRS
individual accounts and solvency tests the necessity to prepare individual accounts under the

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4th CLD may fall away. However, there are still EU Member States where the accounts under
the 4th CLD play a significant role in taxation. The benefit of lighter accounting burdens could
only be realised if there were parallel changes in the taxation of these EU Member States. For
the time being and for the purposes of this study this benefit cannot be taken into account.

Determination of the distributable amount

The Lutter proposal does not change the way how the distributable amount is determined. An
additional element is a solvency declaration by the board. This declaration should normally be
a by-product of the above mentioned testing procedures and is not likely to cause high
burdens in its preparation.

The other main burdens in EU member states, i.e. the preparation of the proposal and the
actual payment of the dividend will remain unchanged. This also concerns the necessity to
channel up profits and cash to the parent company.

Sanctions

The Lutter proposal maintains the responsibility of management. This responsibility is

extended to the solvency declaration. The solvency test will be founded on projections into
the future that in certain cases may be subject to a high degree of subjective assessment. In
general, it can be stated that a prognosis is usually associated with a higher liability risk due to
the uncertainties attached.

This prognosis element depends on the actual design of the solvency test. Also the solvency
declaration will require a certain level of representation from the management’s side. These
representations by management and the connected uncertainty concerning the validity of the
predictions may have an effect on the sanctions. Therefore, potential additional burdens from
compliance efforts can only be determined if the design of the solvency test and the concept
of representation by management are clarified. Furthermore, it is a matter of the litigation
culture in the respective country whether it is easy to sue members of the company’s
management.

Protection of shareholders and creditors

Due to the fact that the proposal only concerns IFRS individual accounts, there only effects on
the position of shareholders and creditors whose company actually prepares IFRS accounts.

In these cases, the “solvency test” is an additional testing element which requires a conscious
assessment by management whether there is sufficient cash to justify the dividend
distribution. So far, such assessments are rather part of actual management practice
concerning the preparation of distributions. The management will regularly also make such
assessments to allow its accounts to be prepared under the going concern assumption. The
conclusions would need to be confirmed by the management in the format of a solvency
declaration which will be publicly available. By means of this solvency statement,
shareholders and creditors may receive additional information on the viability of the company
from a cash flow perspective.

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4.3.4 Dutch Group

4.3.4.1 The proposal

4.3.4.1.1 Outline

The core element of the alternative regime proposed by the Dutch Group chaired by J.N.
Schutte-Veenstra103 is a two-stage distribution test which serves as a means to determine the
maximum amount available for distribution and which should be applied to all forms of
distributions to shareholders, namely (interim) dividends, share buy-backs and distributions as
part of a capital reduction. The two-stage distribution test consists – similar to that proposed
by the Rickford Group and the High Level Group – of a balance sheet test and a liquidity test.
Company assets may be distributed provided that a distribution complies with both tests and
that the members of the management board issue and publish a solvency statement in which
they declare that, in their assessment, the distribution complies with the requirements. An
auditor’s certificate is, by contrast, not required. The proposal does not contain any
specifications as to whether the solvency statement to be issued by the management board
should be linked to the personal liability of directors. Unlike the High Level Group and the
Rickford Group, the Dutch Group does not propose that the alternative regime should be
supplemented by insolvency legislation, e.g. a European framework rule on wrongful trading.
Alongside the introduction of a two-stage distribution test, the Dutch Group proposes the
repeal of various provisions concerning the raising of capital, for instance the minimum
capital requirement and the payment obligation for shares, including the valuation
requirements in cases in which shares are issued for a consideration other than in cash on
formation or in subsequent capital increases. It is, furthermore, proposed to abolish the
nominal value of shares and to introduce true no-par value shares.

4.3.4.1.2 Necessary amendments to the 2nd CLD

Capital maintenance – distributions to shareholders, share repurchases, financial

assistance, redemption of shares, capital reductions

In the alternative regime, the two-stage distribution test serves as a means to determine the
maximum amount available for distribution and should be applied to all forms of distributions
to shareholders, namely (interim) dividend payments, share buy-backs and distributions as
part of a capital reduction.104 As consequence, the 2nd Company Law Directive’s substantive
restrictions on dividend distributions (Art. 15), share buy-backs (Art. 19) and reductions in
capital (Art. 32), will be repealed:

Any requirement for an enhancement of a simple net assets test by requiring that a reserve for
the aggregate nominal value of the subscribed capital be established (Art. 15), will be
abolished.

The statutory regulation on share buy-backs (Art. 19) can be limited to prescribing that the
acquisition by the company of its own shares is subject to an authorisation by the general
meeting and to prescribing the criterion for payment of the acquisition price of the shares. The
10 percent limit in the purchase regulation - which was still in force at the time of the
proposal of the Dutch Group - can either be eased to e.g. 50 % or repealed.105

103
Boschma/Lennarts/Schutte-Veenstra, Alternative Systems for Capital Protection, Final Report 2005.
104
Boschma/Lennarts/Schutte-Veenstra (2005), p. 72.
105
Boschma/Lennarts/Schutte-Veenstra (2005), p. 72.

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It is also recommended that the separate regulation for the provision of financial assistance for
the acquisition of the company’s own shares be abolished (Art. 23). The risks linked to giving
financial assistance should instead be addressed by the fiduciary duties of directors who are
obliged to assess whether such a transaction is in the company’s interest or not and to check
whether the company, after giving financial assistance, is still in a position to meet the claims
of its creditors. If the management board does not fulfil its duty adequately, it incurs liability
risks. If a separate regulation for the provision of financial assistance will, nevertheless,
continue to exist for the giving of financial assistance for the acquisition of the company’s
own shares, the balance sheet test and liquidity test should be applicable to these
transactions.106 Hence, financial assistance could be given up to the limit at which the
company’s solvency would be affected by the transaction.

The creditors’ right to object to a capital reduction (Art. 32) can be abolished.107 The
application of the two-stage distribution test in cases in which a company distributes company
assets as part of a capital reduction is thought to provide sufficient protection for creditors.

Raising of capital – contributions, issuance of shares, increase of share capital, pre-

emption rights

Alongside the changes that concern the capital maintenance provisions of the 2nd Company
Law Directive, the Dutch Group proposes the repeal of various provisions concerning the
raising of capital as they are thought to overreach their objective, namely creditor protection,
and impose unnecessary costs on businesses:

The minimum capital requirement (Art. 6) should be abolished.108

The prohibition on the contribution of an undertaking to perform work or supply services

(Art. 7 s. 2) should be repealed. The risks associated with the contribution of work or supply
of services in the future - the risk is that work or services is not carried out because the
contributor is no longer in a position to do so - should instead be calculated in the
determination of the economic value of such considerations unless the shareholder provides
security by way of a bank guarantee or takes out insurance to cover these risks with itself as a
beneficiary.109

The provisions regarding the payment obligation for shares (statement of the bank that cash
consideration is paid) should be abandoned.

The valuation requirements in cases in which shares are issued for a consideration other than
in cash on formation or in subsequent capital increases (Art. 10, Art. 27) – which have, after
the submission of the proposal of the Dutch Group, been relaxed but not abolished110 – should
be repealed.111

106
Boschma/Lennarts/Schutte-Veenstra (2005), p. 73.
107
Boschma/Lennarts/Schutte-Veenstra (2005), p. 73.
108
Boschma/Lennarts/Schutte-Veenstra (2005), p. 64.
109
Boschma/Lennarts/Schutte-Veenstra (2005), pp. 64 et seq.
110
Cf. Directive 2006/69/EC of the European Parliament and of the Council of 6 September 2006, OJ L 264 of
25 September 2006, pp. 32 et seq.
111
Boschma/Lennarts/Schutte-Veenstra (2005), p. 64.

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The Dutch Group recommends the abolition of the criterion of nominal value of shares which
should be replaced by other measures variable in the concrete case. In this context, it is also
proposed to abolish the prohibition of the issue of no-par value shares (Art. 8 (1)). If the
nominal value of shares is abolished, the introduction of true no-par value shares should be
made compulsory. In the Dutch Group’s opinion it is conceivable that two systems, par value
shares and no-par value shares, will continue to exist alongside each other.112

The possible abolition of the provision concerning subsequent formation is also proposed
(Art. 11).113

4.3.4.1.3 Distributions

Overview

The two-stage distribution test proposed by the Dutch Group consists of a balance sheet test
and a liquidity test. Whereas the liquidity test serves to assess the company’s solvency for a
relatively short term, the balance sheet test serves to take into account the company’s financial
position for a longer term.114 The combination of the tests is thought to offer creditors a
reasonable prospect that, after the distribution, the company will be able to pay its debts as
they fall due.

Both tests constitute substantive restrictions on distributions: company assets may only be
distributed to shareholders if the distribution complies with both tests.115 Hence, in cases in
which the balance sheet test indicates that the proposed distribution is not justified by
sufficient net assets whereas according to the liquidity test the company is solvent - or vice
versa - a distribution may not take place.

Balance sheet test

According to the balance sheet test, a distribution is permissible if the company’s equity is not
negative as a result of the distribution to shareholders.116 Hence, after the distribution, the
assets of the company must at least be equal to the liabilities including provisions.
Distributions may only be made if and to the extent there is a surplus. Unlike the balance
sheet test of the 2nd Company Law Directive, the balance sheet test of the Dutch Group does
not require a margin in a way that the net assets balance must be sufficient to cover the
subscribed capital.

Whether the requirement of the balance sheet test is met is to be assessed on the basis of the
information set out in the annual accounts.117 It is not clear if the term "annual accounts" also
comprises the company’s consolidated accounts.118

When drawing up the accounts which form the basis of the balance sheet test, companies must
apply the accounting methods which they are allowed to use according to the legislation in
force at the time of the decision to distribute company assets.119 Accordingly, companies may
112
Boschma/Lennarts/Schutte-Veenstra (2005), pp. 73 et seq.
113
Boschma/Lennarts/Schutte-Veenstra (2005), p. 64.
114
Boschma/Lennarts/Schutte-Veenstra (2005), p. 72.
115
Boschma/Lennarts/Schutte-Veenstra (2005), p. 72.
116
Boschma/Lennarts/Schutte-Veenstra (2005), p. 70.
117
Boschma/Lennarts/Schutte-Veenstra (2005), p. 70.
118
Boschma/Lennarts/Schutte-Veenstra (2005), p. 71.
119
Boschma/Lennarts/Schutte-Veenstra (2005), p. 71.

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use national GAAP the source of which is the 4th Directive and may, inter alia depending on
the legislation in force in the EU Member State concerned, also apply IFRS. Hence, the
valuation methods a company may use will be those which are permissible under national
GAAP and IFRS.

The management board has no discretion when applying the balance sheet test except for
potential options included in the accounting framework applied. It may only make
distributions if and to the extent the result of the balance sheet test is that there is a surplus of
assets over liabilities including provisions.

So far as the application of national GAAP or IFRS requires recognizing long-term liabilities
(e.g. pensions) in the accounts, they are also taken into account when applying the test.

Liquidity test

The Dutch Group proposes to prescribe a liquidity test alongside the balance sheet test.120

The content and details of the liquidity test have not been defined. The Dutch Group proposes
that the actual requirements which the liquidity estimate must meet be established in
consultation with accounting organisations.121 Hence, at this stage it is unknown whether the
test will actually be cash flow based or will resort to an accounting ratio, what payments and
debts are to be included in the liquidity test, whether the debts must be paid out of the liquid
assets or if invested capital that can be transformed into liquid assets can be used, whether it is
possible not to take extraordinary circumstances into account and whether the management
board has discretion when applying the test.

At this stage, it is only defined that the period the liquidity test has to cover is twelve months
following the distribution.122

In respect to the treatment of long-term liabilities, such as pensions, becoming due after the
twelve months period, it follows from the short-term requirement that those will not be taken
into account.

Responsibility for performing the test, solvency statement, consultation of an accountant

According to the proposal of the Dutch Group, the management board is responsible for
performing the two-stage distribution test.123

The members of the management board are required to provide and publish a solvency
statement in which they declare that, in their assessment, the distribution complies with the
applicable requirements. In legal systems in which the company’s profits are at the disposal of
a company body other than the management board, the members of the management board
should only be allowed to implement a resolution passed by the other company body
concerning the payment of the dividend amount on the condition that the management board
provides such solvency statement.124

120
Boschma/Lennarts/Schutte-Veenstra (2005), pp. 71 et seq.
121
Boschma/Lennarts/Schutte-Veenstra (2005), p. 72.
122
Boschma/Lennarts/Schutte-Veenstra (2005), p. 72.
123
Boschma/Lennarts/Schutte-Veenstra (2005), p. 67.
124
Boschma/Lennarts/Schutte-Veenstra (2005), pp. 67 et seq.

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The solvency statement does not need to be certified by an auditor.125

Liability of the management or shareholders

Unlike the proposals of the Rickford Group and the High Level Group, the Dutch Group’s
proposal for an alternative regime does not contain any details concerning the consequences
of distributions that are made contrary to the rules, namely the liability of shareholders and
board members.

Link of insolvency regulation to the alternative regime

The proposal of the Dutch Group does not provide for insolvency legislation geared towards
supplementing the solvency test, e.g. a wrongful trading standard.

4.3.4.2 Economic analysis

The Dutch Group proposal fundamentally changes the overall concept of the 2nd CLD and its
implementation requires changes to nearly all basic elements of capital regimes.

Areas with no specifically mentioned substantial changes encompass:

- Capital increases
- Serious loss of half of the subscribed capital
- Contractual self-protection of creditors
- Withdrawal of shares
- Insolvency

Consequently, the following analysis will not elaborate either on potential burdens for
companies or on shareholder and creditor protection in this regard.

Structure of capital and shares

Analysis

The Dutch group proposal foresees the abolition of minimum capital requirements. This
would not have an immediate effect on companies as their equity is normally higher than the
minimum amount foreseen by law.

Furthermore, the Dutch group proposes the abolition of the par value of shares. This may
happen gradually with the co-existence of both systems in the way that only no-par value
shares could be issued in the future.

By administering different systems, the administrative burden would be slightly increased

based on the experience from our interviews. The complete changeover may cause a once-off
burden with no significant changes in burdens for the future.

125
Boschma/Lennarts/Schutte-Veenstra (2005), p. 68.

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Protection of Shareholders and Creditors

In general, the position of shareholder and creditors is negatively affected by the fact that the
distribution could also be made out of the subscribed capital and premiums of the company if
both the balance sheet and the liquidity test allowed for this.

To counteract this, the Dutch Group proposal foresees an increased level of formalised
solvency testing by the company’s management concerning the viability of the company. It is
a matter of the effectiveness of this test whether there is a positive or negative impact on the
protection of shareholders and creditors. The effectiveness is mainly determined via the actual
design of the tests filling certain gaps in the Dutch Group proposal.

Distribution

Analysis

Calculation of the distributable amount

The proposal of the Dutch group does not fundamentally change the procedure for the
distribution of profits. The key element that is changed concerns the compliance testing
whether a distribution is actually feasible. Currently, this is a very light touch procedure in the
EU Member States concerned.

The balance sheet test refers to a surplus which must be determined on the basis of the annual
accounts prepared under the 4th CLD or IFRS. This is basically in line with current EU
practice where a majority of EU Member States directly use the annual accounts. Therefore,
there is no change in the costs associated with this part of the testing.

The liquidity test is an additional testing element which is not currently required in EU
Member States. We have encountered in our interviews that the management of companies
distributing dividends will regularly consult with the treasury department whether there is
sufficient cash available for distribution and this will normally be planned at least a year
ahead of the actual distribution. However, the actual calculation will be based on internal cash
flow reporting standards.

Concerning the actual practice of performing the test, the Dutch group does not,
unfortunately, specify exact requirements to allow for an ultimate assessment of the
associated burdens. Instead, the Dutch group proposes to establish these requirements in
consultation with accounting organisations. It is only defined that the period will need to
cover the twelve months following the distribution. This could point to a requirement for a
cash flow projection, even though it could also be assumed that certain current accounting
ratios would also suffice. Experiences in other non-EU countries have shown that such tests
can take both forms. In any case, this test will cause additional burdens. The intensity of this
burden depends on how detailed the prescribed calculation methods are and how much they
deviate from internal practices at the companies concerned. Accordingly, how the calculation
is conducted will heavily influence the workload associated with this test.

Determination of the distributable amount

The Dutch proposal does not change how the distributable amount is determined. An
additional element is a solvency declaration by the board. This declaration is a by-product of

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the above mentioned testing procedures and is not likely to cause major burdens in its
preparation.

The main burdens in EU Member States, i.e. the preparation of the proposal and the actual
payment of the dividend, will remain unchanged. This also concerns the necessity to channel-
up profits and cash to the parent company.

Sanctions

The Dutch proposal does not contain any specifications concerning changes in the sanctioning
of incorrect distributions. Therefore, from an economic point of view there is no change to be
expected.

Related parties

The Dutch proposal does not specifically touch on the question of the monitoring of the
relationships with third parties.

Protection of shareholders and creditors

The liquidity test provides a conscious formal assessment by management whether there is
sufficient cash to justify the dividend distribution. However, it is not clearly determined how
such a liquidity test would work and, thus, its effectiveness remains unclear. So far, such
assessments are rather part of actual management practice concerning the preparation of
distributions. The management will regularly also make such assessments to allow its
accounts to be prepared under the going concern assumption. The conclusions would need to
be confirmed by the management in the format of a solvency statement which will be publicly
available.

By means of this solvency statement, shareholders and creditors may receive additional
information on the viability of the company from a cash flow perspective.

Capital maintenance

Acquisition by the company of its own shares

Analysis

Under the Dutch Group proposal, the testing procedures applied for distribution have also to
be applied in the case of repurchases of the company's own shares. There is a continued need
to authorise the buy-back decision by the general meeting. In this way, the basic elements of
the buy-back process still persist with the addition of the testing procedure by the
management board. However, the protective cushion of net assets may fall away as net assets
would not have to be secured against distributions. It is not clear how the management board
should communicate the results of its testing to the shareholders.

Therefore, there are only additional costs to the extent that the additional testing causes
burdens for the company.

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Protection of shareholders and creditors

The additional testing ensures a conscious formal assessment by management as to whether

there is sufficient cash to justify the dividend distribution. So far, such assessments would be
rather part of actual management practice concerning the preparation of distributions.

Accordingly, both shareholders and creditors are provided via a formalised assessment by the
management with a higher level of confidence concerning the viability of the company from a
cash-flow perspective. However, it is a matter of the effectiveness of this test whether there is
a positive impact on the protection of shareholders and creditors. The effectiveness is mainly
determined via the actual design of the tests filling the gap of the Dutch Group proposal.

Capital reduction

Analysis

The Dutch group proposes to facilitate the capital reduction by applying the testing
procedures (balance sheet test in combination with a liquidity test) to distributions. It remains
unclear whether the remaining requirements concerning capital reductions have been applied
(approval of the general meeting). One key element is the abolition of the right of creditors to
object to a capital reduction which may save the companies costs for potential legal battles
with creditors. Again, we are not able to confirm that these costs are substantial due to lack of
company data.

The companies interviewed in the survey are normally not using the instrument of capital
reduction. Therefore, we have not been able to assemble cost data associated with capital
reductions.

Whether these proposed measures will give incentives to companies to reduce capital remains
to be seen.

Protection of shareholders and creditors

Due to the abolition of the right to object to capital reductions, the legal position of creditors
would suffer. This could partly be made good by a higher certainty that the company is a
going concern from a cash flow perspective for at least one year. Indications for this can be
derived from the required additional testing.

Financial assistance

Economic analysis

The Dutch Group proposes to abolish the separate regulation for the provision of financial
assistance for the acquisition of the company’s own shares. The risks linked to giving
financial assistance should instead be addressed by the fiduciary duties of directors who are
obliged to assess whether such a transaction is in the company’s interest or not and to check
whether the company, after giving financial assistance, is still in a position to meet the claims
of its creditors.

As the new provisions on financial assistance of the 2nd CLD have not been implemented in
the EU Member States, we have not been able to gather relevant cost data with companies on

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financial assistance. Therefore, we are not able to assess potential relief of burdens by further
liberalising the financial assistance by only referring to fiduciary duties of directors.

In order to achieve legal certainty, directors would have to take certain measures to ensure
that financial assistance is based on proper grounds. It remains to be seen how actual practice
would develop if such liberalisation took place.

Shareholder and creditor protection

Shareholders as well as creditors would suffer a reduced level of protection by a further

liberalisation of financial assistance because such assistance would be completely left in the
hands of the directors. A potential liability of directors will only help if it is certain that claims
against directors can actually be enforced.

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4.3.5 Conclusion on regimes proposed by literature

The four theoretical models discussed (High Level Group, Rickford Group, Lutter Group and
Dutch Group) show different levels of impact on the capital regime as currently embedded in
the 2nd CLD.

The main focus of all proposals lies on changes to the way distributions to shareholders are
restricted. All systems differ as to how this affects the overall set-up of the capital regime.
The Lutter Group proposal largely sticks to the current system of the 2nd CLD and only
changes provisions on the distribution of profits to accommodate the use of IFRS in the
individual financial statements. The remaining three theoretical models intend to
fundamentally change the current capital regime by abolishing the concept of legal capital in
favour of additional distribution testing by means of additional solvency/liquidity tests. The
latter goes hand-in-hand with the transition from a par-value concept of shares towards a true
no-par value share concept.

All four models are to certain extent incomplete in their suggestions on how to exactly
conduct changes to the 2nd CLD. The existing gaps in these models partly allow for a wide
interpretation and can immensely influence the associated burdens for the companies
concerned. One significant example is the impact of different designs of solvency/liquidity
tests.

The effects of the four models on the basic elements of capital regimes can be summarised as
follows:

Structure of capital and shares

Three of the four models foresee the abolishment of the concept of minimum legal capital and
the introduction of true no-par-value shares. One of the three, the High Level Group,
considers introducing the concept of a solvency margin. The Lutter Group Model does not
change the current approach of the 2nd CLD.

Overall, the cost implications of the administration of different structures of capital or shares
seem rather insignificant for the companies concerned. The abolition of par values as such
may lead to less complexity in the administration of shares. However, companies interviewed
assessed these simplifications to be rather insignificant. We have not been able to collect
reliable data or estimates to assess the associated costs in situations where companies apply
the no-par value concept.

Where the concept of minimum capital is abolished, shareholder and creditor protection suffer
from the loss of a distribution restriction to the extent that the minimum capital represents an
additional cushion that restricts distributions. This minimum capital protection is replaced by
the extended testing efforts concerning distributions (balance sheet plus an additional
solvency/liquidity test).

Capital increase

None of the four models significantly changes the concept of capital increases including pre-
emption rights. Thus, the basic compliance costs of today’s systems essentially remain. Three
of the four models foresee the abolition of the requirement of an expert opinion for
contributions in kind. However, there was no reliable data on the cost of such expert opinions.

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However, it can be assumed that the board of directors will seek some kind of reassurance
that the valuation is legally valid. Accordingly, we assume no significant change in the total
burdens associated with capital increases.

Shareholder protection is maintained by means of the approval of the general meeting of any
capital increase. With the exception of the Lutter Group proposal, expert opinions for
contributions in kind as an element of shareholder and creditor protection are given up.

Distribution

All four models basically aim at changing how distributions are legally restricted to allow for
capital maintenance. The Lutter Group only addresses an add-on for the situations where
IFRS are used for individual financial statements. This limits the number of companies where
these provisions have to be applied to IFRS users. Regardless of the effects of the accounting
concept on distributions, the three other models fundamentally change the approach to the
necessary testing as they abolish the concept of legal capital.

The core element that is added in all four models is solvency/liquidity tests. The High Level
Group favours current balance sheet ratios. The Rickford Group and the Lutter Group apply
cash flow projections. The Dutch Group does not specify the general approach to solvency
tests. However, none of the four models specifies in detail the design of these tests.
Accordingly, it seems impossible to estimate the cost impacts of these tests. Nevertheless, it is
clear that the actual design and the detail of the provisions will heavily influence the costs for
the companies when they substantially deviate from existing internal reporting rules of the
companies concerned.

The balance sheet tests remain important in all models, except for the Rickford Group where
there is a possibility to override the balance sheet test. The High Level Group explicitly offers
additional flexibility for companies by potentially allowing departures from the GAAP used
for financial reporting purposes. The other three models stick to the current accounting
framework based on the 4th CLD or IFRS.

Shareholder and creditor protection suffers from the fact that the distribution restrictions of
the legal capital are explicitly removed in three of the four models (exception: Lutter Group
model). Instead, the shareholder and creditors may receive comfort about the viability of a
company via the solvency/liquidity tests if the testing procedures are effective.

Repurchase of shares

Concerning the repurchasing of the company's shares, the fundamental processes remain
intact in all four models. This is especially true for the main compliance cost factors like the
shareholder approval with the preparation of proper proposals. Three of the four models
foresee the addition of a solvency/liquidity test. Here the same considerations concerning cost
aspects apply as for distribution processes.

Shareholder and creditor protection may benefit from the solvency/liquidity test for these
three models. However, especially under the Rickford proposal, but also in the other two
models which abolish the minimum legal capital, the net assets of a company would not be
protected.

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Capital reduction/withdrawal of shares

For capital reductions and withdrawals of shares, the authorisation of the general meeting,
which most likely represents the main cost factor, is still required. However, in our interviews
we have not been able to secure cost data on capital reductions as these are normally not used
in practice.

Three of the four models which foresee the abolition of legal capital ask for the performance
of an additional balance sheet/solvency test as used for distribution purposes. Therefore, the
cost considerations from the distribution process apply for this case as well for these three
models.

Shareholder and creditor protection may benefit from the additional solvency/liquidity test for
these three models. However, these three models also foresee the abolition of the right of
creditors to object to the capital reduction.

Financial assistance

On financial assistance, only two of the four models foresee explicit changes.

The Dutch Group wants to further liberalise financial assistance by resorting to fiduciary
duties of directors. Due to the lack of implementation of the provisions in EU Member States,
we were not able to get cost data on the impacts of newly introduced provisions. Accordingly,
it is not possible to estimate potential reliefs by further liberalisations.

The High Level Group explicitly adds the balance sheet/solvency test to the necessary
precautions for allowing financial assistance.

Shareholder and creditor protection may worsen if a further liberalisation of financial

assistance takes place in favour of fiduciary duties of directors. The addition of a balance
sheet/solvency test may benefit shareholders and creditors in helping them to assess the
viability of a company after financial assistance, if the testing procedure is effective.

Loss of subscribed capital

The Lutter Group is the only model which maintains the immanent preconditions for the
effectiveness of this alert function – the minimum legal capital. The other three models do not
touch explicitly on this issue. However, it could be assumed that this monitoring duty could
fall away in those three models where the minimum legal capital is abolished.

Nevertheless, from our interviews with EU companies, it has become clear that there is no
specific effort required for the monitoring of this provision. This is regularly monitored via
the internal reporting mechanisms of the companies which do not constitute any incremental
burden for the companies concerned.

Shareholder and creditor protection aspects of this alert function would vanish in those
systems where there is no legal capital required. Instead they may benefit from
solvency/liquidity tests to assess the viability of the company.

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Covenants/contractual self-protection

Covenants are not directly affected by any of the four models. It remains to be seen whether
the negotiation of covenants would be affected by the different models.

Shareholder and creditor protection remains unchanged.

Insolvency

Two of the four models foresee the creation of new EU wrongful trading rules. The cost
effects depend on the rigidity of the systems and how much effort companies have to invest in
order to achieve a satisfying level of legal certainty that the directors are not in breach of legal
duties in this regard.

Shareholder and creditor protection may benefit from an EU framework. However, the basic
question remains whether this could fit into national legal environments.

Incremental cost table for the alternative models

The previous analysis has made it evident that the main cost factors of the existing models
under the 2nd CLD will still remain, e.g. costs for the preparation of a shareholder assembly.
Concerning the question which additional significant costs will arise largely depends on the
design of solvency tests. As pointed out before, the costs cannot reliably determined as the
complete requirements are not clear. We also have not been able to make references to
experiences from the non-EU countries in this regard. Therefore, the following overview uses
the current average incremental cost of the five EU Member States as a starting point and lists
additional requirements on a factual basis.

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Figure 4.3.5 – 1: Estimated incremental burdens of theoretical models

EU High Level Rickford Lutter Dutch
Average Group Group Group Group
Capital €27.774 €27.774 €27.774 €27.774 €27.774
Plus: Plus: Plus: Plus:
Increase
• No • No • No change • No substantial
substantial substantial changes
changes changes
Distri- €15.596 €15.596 €15.596 €15.596 €15.596
Plus: Plus: Plus: Plus:
bution
• Solvency / • Solvency test • Solvency • Liquidity test
liquidity test • (solvency test • (solvency
• Solvency certificate) • (solvency declaration)
margin • Additional declaration)
• (solvency need to
certificate) consult
auditors
(possibly)
Acqui- €26.570 €26.570 €26.570 €26.570 €26.570
Plus: Plus: Plus: Plus:
sition of
• Similar • Similar • No change • Similar
own additional additional additional
shares testing testing testing
procedure as procedure as procedure as
applied for applied for applied for
distribution distribution distribution
Capital No data No data No data No data No data
Plus: Plus: Plus: Plus:
reduc-
• Application • Application • No change • Application of
tion of the same of the same the same
testing testing testing
procedures procedures procedures
Redemp- €750 €750 €750 €750 €750
Plus: Plus: Plus: Plus:
tion
• Application • Application • No change • No substantial
/With- of the same of he same changes
drawal testing testing proposed
of shares procedures procedures

Contrac- No data No data No data No data No data

Plus: Plus: Plus: Plus:
tual
• No change • No change • No change • No change
Self -
Protec-
tion

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4.4 Conclusions on comparative analysis

Concerning the five EU Member States, the 2nd CLD sets the guiding framework for capital
regimes in the European Union. Key features of the current capital regime of the European
Union are:

Concept of a legal capital - The subscribed capital is protected from distribution. The
concept of subscribed capital is also extended to the 2nd CLD’s approach to capital
maintenance, namely how the acquisition by a company of its own shares, capital reductions,
the withdrawal of shares and financial assistance are restricted.

Balance sheet test - Any distribution under the 2nd CLD is based on a balance sheet test. The
balance sheet profit is the profit realised for the financial year after setting off losses and
profits brought forward as well as sums in mandatory and optional reserves. The accounting
framework from which the realised profits are derived is either national GAAP harmonised to
a certain degree by the 4th CLD or IFRS.

Involvement of the general meeting - The decision making authority of the general meeting
concerns all matters relating to an amendment of the subscribed capital or fundamental
decisions concerning transactions linked to capital maintenance issues.

Deviations of importance also with respect to the costs were rather seldom and were found in
particular with respect to the use of IFRS and the question of what can be understood by
realised profits. The compliance cost concerning the 2nd CLD company law requirements are
generally low for companies interviewed throughout the five EU Member States; significant
costs rather arise outside the area of the core company law requirements, specifically with
regard to securities legislation (e.g. capital increases; acquisition of own shares).

For the individual EU Member States, our analysis of the incremental costs associated with
company law provisions delivered the following results for key processes:

Figure 4.4 – 1: Incremental costs in the five EU Member States

France Germany Poland Sweden UK EU
€ € € € € Average
€
Capital €12,260 to €8,500 to €55,634 No data €7,603 to €27,774
€16,750 €42,000 €23,806
Increase
Distribution €1,600 to €1,000 to €210 to €3,000 to €3,000 to €15,596
€2,700 €15,000 €5,443 €4,000 €120,000
Acquisition €53,300 to €50,300 to €2,800 to No data €1,200 to €26,570
€55,400 €50,500 €11,060 €12,000
of own
shares
Capital No data No data No data No data No data No data
reduction
Redemption/ No data €500 to €1,000 No data No data No data €750
Withdrawal
of shares
Contractual No data No data No data No data No data No data
Self
Protection

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The four non-EU countries show a mixture of alternatives to the capital regime used in the
EU. These systems have mainly abandoned the concept of legal capital or the importance of
legal capital is low. Instead, the emphasis has shifted to increased testing procedures for
dividend payments and other kinds of distributions like the repurchase of shares by means of
different kinds of solvency and balance sheet tests. In performing the balance sheet test, the
audited consolidated accounts are used in some of the jurisdictions due to legal or practical
considerations. The distribution decision regularly lies within the discretion of the board of
directors. The increased responsibility of the board in this regard translates into a fiduciary
duty or personal liability. Furthermore, fraudulent transfer legislation may come into play.

From a compliance cost perspective these non-EU systems are also not overly burdensome.

Figure 4.4 – 2: Incremental costs for the five non-EU jurisdictions

EU USA Del. USA Canada Australia New
Average Cal. Zealand
Capital €27.774 No data No data No data €2.000 €450
Increase
Distribution €15.596 €100 to €2.500 to €5.200 €650 to €1.600 to
€2.000 €5.000 €10.400 €2.500
Acquisition €26.570 €5.435 €50.000 No data €3.550 to No data
€32.500
of own
shares
Capital No data No data No data No data No data No data
reduction
Redemption/ €750 No data No data No data No data No data
Withdrawal
of shares
Contractual No data €8.000 €208.000 €46.800 No data No data
Self
Protection

A direct comparison of the averages of incremental compliance costs in EU and non-EU

jurisdictions re-emphasises the previous assessment:

Figure 4.4 – 3: Comparison of the average EU and non-EU incremental costs

EU Non-EU
Average Average
Capital €27.774 €1.225
Increase
Distribution €15.596 €3.515
Acquisition €26.570 €24.487
of own
shares
Capital No data No data
reduction
Redemption/ €750 No data
Withdrawal
of shares
Contractual No data €87.600
Self
Protection

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In considering these averages it needs to be kept in mind that the data was retrieved from
companies in good financial health. These figures may change one a company would enter
into more difficult financial situation. Especially with regard to a potential dividend
distribution, the non-EU burden may rise as more detailed considerations concerning their
financial position would have to take place; in the EU, the results from a balance sheet test is
rather easily determined.

The starting point of the four theoretical proposals in literature (High Level Group, Rickford
Group, Lutter Group, Dutch Group) are the potential changes to the way distributions to
shareholders are restricted. These proposals vary from partial to full scale reform of the 2nd
CLD capital regime. All systems differ as to how this affects the overall set-up of the capital
regime. The Lutter Group proposal largely sticks to the current system of the 2nd CLD and
only changes provisions on the distribution of profits to accommodate the use of IFRS in the
individual financial statements. The remaining three theoretical models (High Level Group,
Rickford Group, Dutch Group) discuss a fundamental change the current capital regime by
abolishing the concept of legal capital in favour of distribution testing by means of additional
solvency tests. The latter goes hand-in-hand with the transition from a par value concept of
shares towards a true no-par value share concept. The economic effects of these theoretical
models are not fully clear; the most burdensome incremental aspects of the 2nd CLD are still
intact. As the four models are in differing degrees incomplete in their suggestions on how to
exactly conduct changes to the 2nd CLD, the existing gaps in these models partly allow for a
wide interpretation and can immensely influence the associated burdens for the companies
concerned. One significant example is the impact of different designs of solvency tests.

A comparison of the incremental cost implications of the four theoretical models in literature
shows that the additional incremental burden to be expected will primarily stem from the
design of solvency tests. The starting point for the assessments is the current average
incremental cost of the five EU Member States:

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Figure 4.4 – 4: Comparison of the average EU incremental costs with estimated incremental burdens of theoretical models
EU High Level Rickford Lutter Dutch
Average Group Group Group Group
Capital €27.774 €27.774 €27.774 €27.774 €27.774
Plus: Plus: Plus: Plus:
Increase
• No • No • No change • No substantial
substantial substantial changes
changes changes
Distri- €15.596 €15.596 €15.596 €15.596 €15.596
Plus: Plus: Plus: Plus:
bution
• Solvency / • Solvency test • Solvency • Liquidity test
liquidity test • (solvency test • (solvency
• Solvency certificate) • (solvency declaration)
margin • Additional declaration)
• (solvency need to
certificate) consult
auditors
(possibly)
Acqui- €26.570 €26.570 €26.570 €26.570 €26.570
Plus: Plus: Plus: Plus:
sition of
• Similar • Similar • No change • Similar
own additional additional additional
shares testing testing testing
procedure as procedure as procedure as
applied for applied for applied for
distribution distribution distribution
Capital No data No data No data No data No data
Plus: Plus: Plus: Plus:
reduc-
• Application • Application • No change • Application of
tion of the same of the same the same
testing testing testing
procedures procedures procedures
Redemp- €750 €750 €750 €750 €750
Plus: Plus: Plus: Plus:
tion
• Application • Application • No change • No substantial
/With- of the same of he same changes
drawal testing testing proposed
of shares procedures procedures

Contrac- No data No data No data No data No data

Plus: Plus: Plus: Plus:
tual
• No change • No change • No change • No change
Self -
Protec-
tion

Overall, the cost analysis of the existing models in five EU Member States and four non-EU
countries has shown that the incremental burdens of company law in this regard for the
companies in all jurisdictions are not overly burdensome and, thus, cannot play a decisive role
in determining whether the transition to an alternative system would actually benefit EU
business by lowering administrative burdens. However, incremental burdens can be of
considerable relevance when considering the implementation of certain measures in a
jurisdiction. This is especially true of the design of solvency tests. Moreover, aspects of
shareholder and creditor protection have to be considered.

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5 Impacts of IFRS on profit distribution

5.1 Introduction

Profit and net assets are the current basis for determining the distributable amounts under
Article 15 of the 2nd CLD. Accordingly, accounting rules form the starting point for
determining such amounts. In the European Union, the accounting rules have been
harmonised to a certain degree by means of the 4th and 7th CLD for all limited liability
companies. In the year 2002, the European Union introduced the requirement for listed
companies to prepare their consolidated financial statements according to International
Financial Reporting Standards (Regulation 1606/2002). For group accounts of non-listed
companies and for the individual financial statements as a whole, the EU Member States have
been granted an option to permit or require the use of IFRS as accounting rules. Since annual
accounts are currently the basis for dividend distributions, the use of IFRS in individual
accounts may show significant impacts on distributable profits. Due to the fact that fair value
measurements increasingly play a role in the IASB standard setting, the question arises
whether the valuation of assets and liabilities at fair value should result in distributable
revaluation gains.

This analysis is split into two parts. The first part provides a brief overview of the current
situation on profit distribution for all 27 EU Member States. The second part covers a more
detailed analysis of certain accounting areas for the five EU Member States which form the
core part of our analysis.

Part I

Based on discussions with the European Commission, a questionnaire was designed and sent
to KPMG member firms in all 27 Member States of the European Union. This questionnaire
focuses on two fields of study:

¾ Determination of distributable profits and

¾ Specific areas of accounting.

Concerning the determination of distributable profits, this part of the study examines how far
IFRS are either optionally or mandatorily applied within the European Union. Furthermore,
the questionnaire aims at giving an overview of whether distributions are currently allowed
based on accounts prepared under IFRS and of whether these accounts have to be modified in
order to assess the distributable amounts.

The specific areas of accounting include:

o Investment Property,
o Post-employment Benefits, and
o Financial Instruments.

This selection was based on an initial assessment of accounting areas where significant
divergence between national accounting rules and IFRS could take place. Furthermore, these
areas contain fair value measurements or other measurement rules that may be relevant in
determining distributable amounts. This initial selection was supported by the European
Commission. The analysis of deviations between national accounting rules and IFRS has
reconfirmed the selection made.

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Reference model for all the analyses is the relevant IFRS. This indirectly provides a picture of
the state of harmonisation of accounting rules in Europe and directly makes it directly
possible to see whether a change from national accounting rules towards IFRS may lead to
differing distributable amounts.

Part II

In order to achieve a more detailed understanding of the “accounting mechanics” and the link
to distributable amounts, a more in-depth analysis was performed for the core five EU
Member States being subject to the study project.

The reader of this part of the study should be aware that the results only refer to the current
status of IFRS and national accounting rules. Future changes to IFRS and national accounting
rules may significantly change the conclusions drawn. Accordingly, this part of the study can
only give an insight into the current state of both accounting regimes.

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5.2 Overview on 27 EU Member States – part I

5.2.1 Introduction

For the accounting part of the study it was neither intended nor required to have a full analysis
of all differences in accounting regimes in the different countries. A stocktaking of the
implementation of IFRS in different countries was also not the major objective of the
questionnaires sent. The idea of the following analysis is to get an impression of how the
harmonisation of dividend distributions based on accounting results is proceeding. Realised
profits are one prerequisite for distributions according to the 2nd CLD as well as the net asset
position of companies. Other aspects of dividend distributions, such as mandatory legal
reserves, solvency requirements and any other impacts on distributable amounts are outside of
the scope of this part of the study.

Against the background of the requirements of the EU IAS-Regulation 1606/2002, it is

important to analyse whether (individual) IFRS financial statements may be the basis for
dividend distributions in different EU Member States. Closely connected to this question is
whether national (legal) requirements distinguish between accounting profits and “realised
profits” for distribution purposes.

The questionnaire tried to get a feel for the differences between the national accounting rules
and IFRS. If there were no major deviations, then the question whether IFRS or the national
accounting rules apply for determining profits would play no role at all. Since the total
amount of equity is also important in determining distributable amounts according to the 2nd
CLD, we also tried to get an idea of the impact of national accounting rules versus IFRS on
the net asset position of a company.

Then three other accounting topics were selected, which – based on the currently applicable
IFRS – are likely to have a major impact on financial statements. The measurement at fair
values and the related question of realisation of profits also guided the selection.

The sample areas include:

¾ Investment property
¾ Post-employment benefits, and
¾ Financial instruments.

A more in-depth analysis is provided in part II of this study section on IFRS impacts. Those
interested in a more detailed description of underlying accounting rules and deviations of
national accounting rules versus IFRS should therefore refer to this part of the study.

It must be noted that some issues in the questionnaire that were the basis for the following
analysis needed a high degree of subjective assessment. Furthermore, country-specific as well
as company-specific individual legal and economic requirements and conditions may impair
the comparability of the results of the country-specific answers. These caveats need to be
remembered when interpreting the results of this part I of the study section on IFRS impacts.

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5.2.2 Determination of distributable profits

5.2.2.1 Application of IFRS in the European Union

The first question raised dealt with the choice of implementing IFRS companies not directly
covered by the scope of the EU’s IAS-Regulation 1606/2002 and in individual financial
statements. This should give a first impression of how far IFRS are applicable within the
European Union. Since individual financial statements are currently the basis for dividend
distributions, the question of whether IFRS may be applied in the individual accounts shall be
of interest for the design of an alternative system of profit distribution.

The following table contains the percentages of EU Member States (based on a total number
of 27) that face one of the possibilities given. The results are based on the responses received
from KPMG member firms in the 27 EU Member States. A detailed analysis may lead to
much more complex results since the application of IFRS may depend on company sizes or
other criteria. Furthermore, some EU Member States apply IFRS as well as their national
accounting rules. Therefore, the percentages are simply an indication of the potential size of a
problem caused by the application of IFRS for distribution purposes.

In the legislation of some EU Member States, a distinction may be made between large and
small/medium-sized companies. Therefore for one segment of companies IFRS may be
allowed whereas for the other segment of companies it may be optional (e.g. in Bulgaria).

The numbers in the following table are rounded to full percentages.

Figure 5.2 – 1: Mandatory and permitted application of IFRS

Consolidated Accounts Annual Accounts
(individual financial statements)
National IFRS National IFRS
GAAP GAAP
Publicly Traded Companies The mandatory application of Required Required
IFRS is guided by Regulation 44% 41%
1606/2002. Allowed Allowed
37% 37%
Non-publicly Traded Required Required Required Required
Companies 22% 19% 52% 19%
Allowed Allowed Allowed Allowed
67% 78% 48% 56%

Especially relevant for the topics analysed in this study is the question of whether IFRS are
required or permitted for use in the individual financial statements. In a major part of EU
Member States, IFRS are optionally or mandatorily applicable in individual financial
statements (see list below). In all these countries, the determination of distributable profits
under IFRS is an issue or may be an issue.

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The following countries permit or require the application of IFRS in their individual financial
statements:

¾ Bulgaria
¾ Cyprus
¾ Czech Republic
¾ Denmark
¾ Estonia
¾ Finland
¾ Greece
¾ Ireland
¾ Italy
¾ Latvia
¾ Lithuania
¾ Malta
¾ Netherlands
¾ Poland
¾ Portugal
¾ Slovakia
¾ Slovenia
¾ United Kingdom

5.2.2.2 Determination of distributable profits based on IFRS

Furthermore, the IFRS questionnaire aimed at finding out whether it is actually permitted or
required to determine distributable amounts based on financial statements prepared under
IFRS. If it is permitted or required, it needed to be stated whether the amounts (net profit or
loss/net asset position) recorded in the IFRS financial statements are regarded as distributable
or whether modifications of these amounts are required. The question of whether
modifications are required may be perceived from different points of view. Therefore, the
corresponding explanation of that modification is stated further below when applicable.

Figure 5.2 – 2: Survey on 27 EU Member States: Profit distribution based on IFRS, modification requirements
Country Profit distribution based on IFRS- Modifications if IFRS-profit
financial statements required?
mandatory/possible?
Austria No N/A
Belgium No N/A
Bulgaria Yes No modification required.
Cyprus Yes No modification required.
Czech Republic Yes No modification required.
Denmark Yes Some form of “modification”
required. (see below)
Estonia Yes No modification required.
Finland Yes No modification required.
France No N/A
Germany No N/A
Greece Yes Some form of “modification”
required. (see below)
Hungary No N/A
Ireland Yes Some form of “modification”
required. (see below)
Italy Yes Some form of “modification”

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required. (see below)

Latvia Yes No modifications required.
Lithuania Yes No Modifications required. (see
below)
Luxembourg No N/A
Malta Yes Some form of “modification”
required. (see below)
Netherlands Yes Some form of “modification”
required. (see below)
Poland Yes No substantial form of
“modification” required. (see
below)
Portugal Yes No modifications required.
Romania No N/A
Slovakia Yes No modification required.
Slovenia Yes No modification required.
Spain No N/A
Sweden No N/A
United Kingdom Yes. Some form of “modification”
required. (see below)

In 17 of the 27 EU Member States a distribution based on IFRS is mandatory or permitted.

Only in some EU Member States, the IFRS amounts must be modified to determine
distributable profits; e.g. Ireland and the United Kingdom have developed a practice of
distinguishing between accounting profits and distributable profits (for details, please see the
table below). In other EU Member States, such as France and Germany, it is not permitted to
make dividend distribution based on IFRS accounting profits in individual financial
statements. Therefore, it can be concluded that there is currently broad divergence throughout
the European Union in how relevant profits are determined as the basis for dividend
distributions.

The following comments have been received from KPMG offices concerning the required
modifications:

Denmark
The distribution of profits is mainly determined by using the distributable reserves in the
annual accounts (which could be prepared in accordance with IFRS), though the financial
position at the group level should also be taken into consideration when determining the
acceptable level of dividend payments. If the annual accounts are prepared in accordance with
IFRS, the distributable reserves will be determined based on IFRS figures. There are though
some modifications based on the Danish legislation, primarily in the Danish Companies Act
and The Danish Financial Statement Act. Those modifications primarily relate to profits
related to non-realised revaluations to fair value. Those revaluations will not be distributable
until the underlying asset is realised. As an exemption, all fair value adjustments of financial
assets and liabilities will be a part of the distributable profit.

Greece
Under Greek company law, no modifications to accounting profits are required in determining
distributable profits. However, with the adoption of IFRS there were no changes in
determining distributable profits despite the fact that previous Greek GAAP, in general, did
not permit the recognition of ‘unrealised profits’. There is a view that in determining
distributable profits, unrealised gains should be deducted, but this is not binding.

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Ireland
The requirements under Irish company law in respect of distributable profits continue to apply
for companies preparing their financial statements under both Irish GAAP and IFRS. A
company’s profits available for distribution are defined by law (section 45(2) of Companies
(Amendment) Act 1983) as its accumulated, realised profits, so far as not previously utilised
by distribution or capitalisation, less its accumulated, realised losses, so far as not previously
written off in a reduction or reorganisation of capital duly made. Though the term ‘realised’ is
not defined by the Companies Acts, it is generally taken to mean profit is arising from
transactions where or other readily marketable assets is received by an entity. Irish companies
refer to interpretive guidance issued by the ICAEW in the UK where the definition of
distributable profits is identical. Specifically, the ICAEW have released two technical releases
on this topic, ‘Guidance on the determination of realised profits and losses in the context of
distributions under the Companies Act 1985’ (Tech 7/03) which has been finalised and
‘Distributable profits: Implications of IFRS’ (Tech 21/05) which has been exposed in draft
form for comment.

Italy
Modifications are required. Again, distribution of profits is regulated by articles 6 and 7 of the
Legislative Decree n. 38/2005. Briefly described, some FTA adjustments and some fair value
effects may not be distributed and should be classified in dedicated non distributable reserves.

Lithuania
The Lithuanian response formally answered “no” to the question “Is it permitted/required to
determine distributable profits based on financial statements prepared according to IFRS?”. In
this context, the following additional explanation was given: “Please note, however, that IFRS
is a statutory reporting framework for publicly traded companies, therefore their distributable
profits are based on IFRS financial statements (without further modifications).” For this
reason we changed the answer from a substance over form point of view.

Malta
In Malta, the starting point for the determination of distributable profits is the IFRS result.
Any profits not realised at the balance sheet date (and hence not available for distribution) are
transferred to a non distributable reserve.

Netherlands
There are modifications required in the Netherlands. Based on Dutch legal requirements, legal
reserves should be recorded. These result in a lower distributable profit compared to the net
profit according to IFRS.

Poland
There is only a limitation under the Polish Commercial Code that there should not be
uncovered losses from previous years.

United Kingdom
In the UK, the amounts of distributable profits are a matter of law. A distribution is justified
by reference to a set of accounts, the “relevant accounts” (Companies Act 1985 section 270).
Generally, the relevant accounts are the last annual accounts which were laid in respect of the
last preceding accounting reference period in respect of which accounts so prepared were laid.
The amount of a distribution that may be made is determined by reference to specified items
(i.e. profits, losses, assets, liabilities, provisions, share capital and reserves) as stated in those
relevant accounts. --- When a company elects to prepare its annual accounts in accordance

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with IFRS as adopted by the EU, it is the amounts stated in those accounts that are relevant
for the purpose of justifying a distribution. ---However, the net profit or loss in accordance
with IFRS (or UK GAAP) is only the starting point for the determination of distributable
profits. --- Instead, a company's profits available for distribution are defined as 'its
accumulated, realised profits, so far as not previously utilised by distribution or capitalisation,
less its accumulated, realised losses, so far as not previously written off in a reduction or
reorganisation of capital duly made' (CA 1985 section 263(3)). Realised profits and realised
losses are defined as 'such profits or losses of the company as fall to be treated as realised in
accordance with principles generally accepted, at the time when the accounts are prepared,
with respect to the determination for accounting purposes of realised profits or losses' (CA
1985 section 262(3) as applied by section 742(2). --- In the UK, a number of the 'principles
generally accepted' are set out in a series of Technical releases (Techs) issued by the UK's
Institute of Chartered Accountants in England and Wales (ICAEW) and the Institute of
Chartered Accountants in Scotland. These Techs give guidance on whether a gain or loss is
realised or unrealised as follows: --- Tech 07/03 (revised 2007) Guidance on the
Determination of Realised Profits and Losses in the Context of Distributions under the
Companies Act 1985 --- Tech 50/04 Guidance on the Effect of FRS 17 'Retirement Benefits'
and IAS 19 'Employee Benefits' on Realised Profits and Losses --- Tech 64/04 Guidance on
the Effect on Realised and Distributable Profits of Accounting for Employee Share Schemes
in Accordance with UITF Abstract 38 and Revised UITF Abstract 17 --- Tech 02/07
Distributable Profits: Implications of recent accounting changes --- This guidance is
considered to be authoritative and indicative of accepted practice. The guidance does not deal
with certain aspects of the requirements relating to investment companies. --- Consistent with
these principles generally accepted, gains and losses that are included in net profit or loss may
or may not be realised; gains and losses that are recognised elsewhere (i.e. in the statement of
recognised income and expense) may be realised and certain profits recognised directly in
equity may or may not also be realised. --- A UK public company (plc) is subject to an
additional 'net assets test' when making a distribution (CA 1985 section 264). A public
company may make a distribution at any time only if, at that time, the amount of its net assets
is not less than the aggregate of its called-up share capital and undistributable reserves and
then only if, and to the extent that, the distribution does not reduce the amount of the
company's net assets to below that aggregate. --- Additionally, there are fiduciary (eg
solvency) and common law requirements in the UK that additionally may apply to
distributions. --- Investment companies have the option of following the normal rules relating
to distributions (above) or of following the special rules for investment companies (CA 1985
section 265). For all practical purposes, the special rules apply only to listed investment trust
companies.

5.2.2.3 Deviations between national accounting rules and IFRS

The IFRS questionnaire also aims to identify the difference between national accounting rules
and IFRS. The purpose is the identification of major deviations when either IFRS or national
accounting rules are applied for determining profits/net assets.

Based on the different IFRS standards, the participants from KPMG offices in the 27 EU
Member States assessed the difference on a scale between 1 (similar) and 5 (dissimilar). The
assessment was intended to take the practical aspects of applying the different accounting
frameworks into account. The following tables present the average value of the responses per
country for the standards analysed as well as the total average of all EU Member States per
IFRS standard analysed. In interpreting the results, it must be remembered that the analysis
contains a portion of subjective assessment of the individual respondents and the responses

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could potentially differ between different respondents from the same jurisdiction. The
analysis is intended to give an informed estimate of the deviation between national accounting
rules and IFRS in accounting areas which have an impact on the determination of profit or
loss.

Figure 5.2 – 3: Survey on 27 Member States: average deviation of IFRS from national GAAP
Country Average deviation of IFRS from
national GAAP
Austria 3.6
Belgium 3.8
Bulgaria 1.0
Cyprus 1.0
Czech Republic 3.2
Denmark 2.4
Estonia 1.6
Finland 3.1
France 2.8
Germany 3.6
Greece 3.2
Hungary 3.1
Ireland 2.8
Italy 3.7
Latvia 3.1
Lithuania 1.1
Luxembourg 2.5
Malta 1.0
Netherlands 2.3
Poland 2.7
Portugal 2.7
Romania 3.3
Slovakia 2.3
Slovenia 1.0
Spain 3.3
Sweden 2.4
United Kingdom 2.0

The results of this analysis are twofold. Some EU Member States, such as Cyprus and Malta,
apply IFRS as their national GAAP and therefore a deviation is not identifiable; in all other
EU Member States the deviation ranges approximately between 1.6 and 3.8. This seems to
imply that in general IFRS are not really similar to national GAAP but that the deviations are
not very great.

Furthermore, it can be recognised that under IFRS the accounting results may deviate from
those determined under national accounting rules thus resulting in different distributable
amounts. The extent of the deviations cannot be generally determined since they depend on
the specific facts and circumstances of the companies affected. Furthermore, possible
(national) modifications of accounting profits and net assets would have to be considered as
well. Accordingly, it can only be stated that deviations of distributable amounts that were
determined under IFRS and under national accounting rules are likely to arise but the full
extent of this effect can only be determined in individual circumstances.

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Figure 5.2 – 4: Survey by IFRS standard: average deviation from national GAAP
Standard Analysed Average deviation from national GAAP
IAS 2 – Inventories 1.7
IAS 8 – Accounting Policies, Changes in 2.5
Accounting Estimates and Errors
IAS 11 – Construction Contracts 2.6
IAS 12 – Income Taxes 2.8
IAS 16 – Property, Plant and Equipment 2.2
IAS 17 – Leases 2.7
IAS 18 – Revenue 2.2
IAS 19 – Employee Benefits 2.9
IAS 20 – Accounting for Government Grants and 1.7
Disclosure of Government Assistance
IAS 21 – The Effects of Changes in Foreign 2.1
Exchange Rates
IAS 23 – Borrowing Costs 1.9
IAS 27 – Consolidated and Separate Financial 2.0
Statements
IAS 28 – Investments in Associates 1.9
IAS 29 – Reporting in Hyperinflationary 3.0
Economies
IAS 31 – Interests in Joint Ventures 2.1
IAS 36 – Impairment of Assets 2.4
IAS 37 – Provisions, Contingent Liabilities and 2.1
Contingent Assets
IAS 38 – Intangible Assets 2.6
IAS 39 – Financial Instruments: Recognition and 3.1
Measurement
IAS 40 – Investment Property 3.3
IFRS 2 - Share-based Payment 3.5
IFRS 3 – Business Combinations 3.2
IFRS 5 – Non-current Assets held for Sale and 3.4
Discontinued Operations

According to this analysis, the major deviations from national accounting rules arise in the
following areas.

¾ IAS 19 – Employee Benefits

¾ IAS 29 – Reporting in Hyperinflationary Economies
¾ IAS 39 – Financial Instruments
¾ IAS 40 – Investment Property
¾ IFRS 2 – Share-based payment
¾ IFRS 3 – Business Combinations
¾ IFRS 5 – Non-current Assets held for Sale and Discontinued Operations

This confirms the sample of accounting areas identified for a more detailed analysis in PART
II of this study section on IFRS impacts. This detailed analysis focuses on employee benefits,
investment property and financial instruments.

Furthermore, the participants were asked to identify whether the IFRS would have a tendency
to results into an increase or a decrease or have no impact on equity when compared to
national accounting rules. The following table summarises the responses received.

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Figure 5.2 – 5: Survey by IFRS standard: impact on equity

Standard Analysed Impact on Equity
(Information in %) Increase Decrease No impact
IAS 2 – Inventories 25.9 3.7 70.4
IAS 8 – Accounting Policies, Changes 0 0 100.0
in Accounting Estimates and Errors
IAS 11 – Construction Contracts 40.7 14.8 44.5
IAS 12 – Income Taxes 25.9 25.9 48.2
IAS 16 – Property, Plant and 40.7 7.4 51.9
Equipment
IAS 17 – Leases 22.2 11.1 66.7
IAS 18 – Revenue 11.1 14.8 74.1
IAS 19 – Employee Benefits 11.1 37.4 44.5
IAS 20 – Accounting for Government 0 3.7 96.3
Grants and Disclosure of Government
Assistance
IAS 21 – The Effects of Changes in 22.2 0 77.8
Foreign Exchange Rates
IAS 23 – Borrowing Costs 14.8 0 85.2
IAS 27 – Consolidated and Separate 11.1 3.7 77.8
Financial Statements
IAS 28 – Investments in Associates 14.8 3.7 74.1
IAS 29 – Reporting in 3.7 0 88.9
Hyperinflationary Economies
IAS 31 – Interests in Joint Ventures 7.4 0 88.9
IAS 36 – Impairment of Assets 0 44.4 55.6
IAS 37 – Provisions, Contingent 29.6 14.8 55.6
Liabilities and Contingent Assets
IAS 38 – Intangible Assets 55.6 11.1 33.3
IAS 39 – Financial Instruments: 33.3 7.4 44.4
Recognition and Measurement
IAS 40 – Investment Property 48.2 3.7 44.4
IFRS 2 - Share-based Payment 0 22.2 77.8
IFRS 3 – Business Combinations 51.9 3.7 33.3
IFRS 5 – Non-current Assets held for 18.5 3.7 77.8
Sale and Discontinued Operations

(Note: Not all lines add up to 100% since the respondents in some jurisdictions could not
indicate a tendency. The bases for the percentages are always 27 EU Member States.)

The overall assessment taking into account all IFRS standards results into an estimated
increase of equity of 21.3%. On the other hand, the assessment concerning a decrease in
equity amounts to 10.3%, and the assessment of no major impact amounts to 65.7%. This
result is remarkable as it obviously cannot be generally presumed that the total impact of the
application of IFRS automatically results in a “major increase” in profits or in equity.
However, it needs to be remembered that the number and size of such impacts is not
immediately measurable and that, in general, any impact on accounting profits in one period
will usually be reversed in another accounting period.

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5.2.3 Specific areas of accounting

5.2.3.1 Investment property

The initial question of the IFRS questionnaire on investment property concerned the issue
whether local GAAP distinguish between “investment property” and other (owner-occupied)
real property.

The following countries (48% of all EU Member States) make that specific distinction:

¾ Bulgaria
¾ Cyprus
¾ Denmark
¾ Estonia
¾ Ireland
¾ Latvia
¾ Lithuania
¾ Malta
¾ Netherlands
¾ Poland
¾ Slovenia
¾ Sweden
¾ United Kingdom

The number of EU Member States can just be seen as the identification of a specific
accounting problem. Such kinds of problems may be addressed in a number of ways, e.g. by
specific recognition rules or by disclosures in the notes. Therefore, this result has no direct
impact on the primary subject of this study section, the determination of distributable profits.
Nevertheless, it is an indication that this accounting problem is a relevant issue.

The specific relevance of this issue lies in the recognition of upward-revaluations to fair value
that may be regarded as unrealised profits for distribution purposes. In the 92.6% of all EU
Member States investment property must be or can be measured at depreciated cost.

A fair value measurement with an immediate impact on net profit is permitted or required in
the following nine EU Member States:

¾ Bulgaria
¾ Cyprus
¾ Denmark
¾ Estonia
¾ Latvia
¾ Lithuania
¾ Malta
¾ Netherlands
¾ Slovenia

A fair value measurement with an impact on net equity without any immediate impact on net
profit is either permitted or required in the following EU Member States:

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¾ Hungary
¾ Poland
¾ Romania

In Hungary, the following treatment is specified: “Investment property is not distinguished

from owner-occupied property. Generally, the cost model is required for all property, plant
and equipment. However, any excess of fair value over the carrying amount of an item of
property, plant and equipment can be recognised as a separate asset in the balance sheet
(called valuation adjustment) with a corresponding increase directly in the equity. Such
valuation adjustment is not depreciated and reassessed on a yearly basis against equity.”

For Poland, the situation can be described as follows: “A company has a choice of accounting
models. There are divergent views on whether recognition of revaluations in the income
statement is allowed/required, rather than directly in equity. In our view, this is not allowed.
The accounting law is however expected to change during 2007 to allow/require this.”

A fair value measurement with an impact on a specific performance statement is required in

Ireland.

In the United Kingdom the following specific accounting treatment applies: “Under UK
GAAP (SSAP 19) changes in the value of the investment property, other than permanent
diminutions, are credited or charged directly through the statement of total recognised gains
and losses (STRGL, the equivalent of the IFRS SORIE) to an investment revaluation reserve
within shareholders’ equity. Permanent diminutions are charged to the profit and loss
account.”

Based on the assessment that a fair value measurement could cause problems in determining
“realised profits” and equity for dividend distribution purposes, it becomes obvious that the
issue is not just relevant under IAS 40 “Investment Property”, which optionally allows the fair
value measurement of investment property, but that the issue also arises under national
accounting rules. A harmonisation in distinguishing investment property as well as the
measurement and recognition of gains or losses on re-measurement to fair value has so far not
been achieved in the European Union.

5.2.3.2 Post-employment benefits

A provision for all defined benefits plans is required in 63% of all EU Member States. The
following EU Member States installed some exceptions to this rule:

¾ Belgium
¾ Czech Republic
¾ Estonia
¾ Finland
¾ France
¾ Germany
¾ Greece
¾ Latvia
¾ Luxembourg
¾ Romania

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For some EU Member States, it was indicated to us that defined benefit plans are not common
or known and have not received specified answers in that section of the questionnaire. (The
EU Member States are Italy, Latvia and Romania). Nevertheless, the percentages in the
calculations below are based on 27 EU Member States.

The following statements were made on methods generally applied in determining the
obligation under a post employment benefit plan. The point of reference was the Projected
Unit Credit Method applied under IAS 19 “Employee Benefits”

Figure 5.2 – 6: Survey for 27 EU Member States: accounting method under a post employment benefit plan
Projected Unit Credit Not Specified / Free
Method Choice
Austria X
Belgium X
Bulgaria X
Cyprus X
Czech Republic X
Denmark X
Estonia X
Finland X
France X
Germany X
Greece X
Hungary X
Ireland X
Italy ---- ----
Latvia ---- ----
Lithuania X
Luxembourg X
Malta X
Netherlands X
Poland X
Portugal X
Romania ---- ----
Slovakia X
Slovenia X
Spain X
Sweden X
United Kingdom X
Number of Countries 9 15

When using the projected unit credit method as a point of reference, it becomes clear that
harmonisation has not yet been achieved in the EU in respect to how provisions for defined
employee-benefit plans are determined. Therefore, it is not feasible to determine the total
impact due to this lack of harmonisation. The impact can only be determined on an individual
company basis. But given the fact that the application of IAS 19, compared to national
accounting rules, is assessed to have a negative impact on equity in 33.3% of the countries
surveyed (please refer to the earlier analysis in this section of the report), it is likely that in
individual cases this issue may be of relevance in determining distributable amounts.

In 44.4% of the EU Member States it is permitted to offset plan assets with plan liabilities. In
33.3% of the EU Member States, it is allowed to measure plan assets at fair value. In the UK,
there is a similar measurement approach. Not all EU Member States have a concept or a
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practice of setting up plan assets. Whereas the presentation of plan assets is not immediately
relevant for determining distributable amounts, the fair value measurement of plan assets
may, however, again raise questions on how distributable amounts are determined.

The following table contains results of the IFRS questionnaire relating to the identification of
parameters which are generally taken into account to calculate the post-employment benefit
obligation.

Figure 5.2 – 7: Relevance of parameters to calculate a post-employment benefit obligation

Parameter Number of Percentage of Number of Countries
Countries Countries with answers No /
(based on 27 Free Choice /
countries) Optional
A market rate of interest is used 12 44.4 12
for discounting.
Mortality is taken into account. 15 55.6 8
Actual/expected return on plan 11 40.7 12
assets is taken into account.
Estimated future salary increases 12 44.4 11
are taken into account.
Future benefit increases are taken 11 40.7 12
into account.
Labour turnover rates are 13 48.2 10
mandatorily/optionally taken into
account.

The results generally show a separation between optional applications and a mandatory
application of parameters. Furthermore, some EU Member States do not address all specific
situations so that not all questions were answered by the participants of the study (i.e.
responses do not add up to 27 EU Member States). However, the results allow drawing a
picture concerning the current situation within the European Union. Again, it must be noted
that it is evident that there is a lack of harmonisation in the European Union concerning the
determination of pension liabilities. Even though the impact on the financial statements can
only be determined on a company-individual basis, general experience shows that the impact
of applying different parameters in actuarial calculations usually have a major impact on the
financial position of companies.

IAS 19 “Employee Benefits” contains a variety of ways of how actuarial gains and losses126
may be recognised. It is possible to apply the so-called corridor-approach under which
actuarial gains or losses are recognised in profit or loss over future periods according to
specific rules. Any spreading that is faster than the “standard solution” is possible as well.
Recently, a new option was added to IAS 19, i.e. it is possible to fully recognise actuarial
gains and losses directly in equity.

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“Actuarial gains and losses comprise:
(a) experience adjustments (the effects of differences between the previous actuarial assumptions and what
has actually occurred); and
(b) the effects of changes in actuarial assumptions.” (IAS 19.7)

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Actuarial gains or losses are recognised in the following ways throughout the European
Union:

Figure 5.2 – 8: Method of recognition of actuarial gains or losses

Method of recognition of actuarial gains or Number (percentage) of countries
losses
Immediately in profit or Loss 17 (63.0)
Traditional 10% Corridor Approach (like IAS 19) 10 (37.0)
Recognition in equity without recycling through 6 (22.2)
profit or loss (like IAS 19)
Other methods 7 (25.9)

In 6 EU Member States (which equals 22.2%), a special “statement of recognised income and
expense” is used to present actuarial gains or losses.

Unrecognised actuarial losses generally represent an “under-valuation” of liabilities and

therefore have an impact on equity and, if the effect is to be recognised through profit or loss,
on profits. Therefore especially unrecognised actuarial losses may have an impact on the
determination of distributable profits in a sense that the amounts determined may be
overstated. On the other hand unrecognised actuarial gains may, subject to an analysis of
individual situations, be regarded as an understatement of potentially distributable amounts.
The assessment of overstatement and understatement is based on the assumption that the
equity and profits form an immediate basis for the determination of distributable amounts.

Based on the considerations above, the issue of unrecognised actuarial gains and losses arose
in a significant number of EU Member States and could therefore be subject to further
harmonisation efforts.

5.2.3.3 Financial instruments

The responses received to the financial instruments question were diverse, and the KPMG
respondents from a considerable number of EU Member States saw the need to deviate from
question formulated in the IFRS questionnaire. Due to the diversity and complexity of
financial instruments accounting, it is only possible to specify the number of EU Member
States in which several standard accounting treatments for financial instruments are applied.
The following table indicates in how many EU Member States a specific accounting treatment
can be found. The accounting treatments only refer to non-derivative financial instruments:

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Figure 5.2 – 9: Accounting treatment for non-derivative financial instruments

Accounting Treatment Number of Countries Percentage of
Countries
Recognition of financial instruments at cost 16 59.3
Recognition of financial instruments at amortised 21 77.8
cost
Recognition of financial instruments at fair value 9 33.3
with immediate impact on profit and loss
Recognition of financial instruments at fair value 10 37.0
with immediate recognition of the effect in equity
– effect is later on recycled through profit and
loss
Recognition of financial instruments at fair value 1 3.7
with immediate recognition of the effect in equity
– effect is not recycled through profit and loss

If financial instruments are carried at fair value with an immediate impact on profit or loss, it
can be debated whether profits recognised in this manner could be regarded as realised for
distribution purposes. A similar discussion may ensue on the “realisation” of losses and the
potential understatement of distributable amounts. If a fair value measurement immediately
impacts on equity, this may have a similar impact on distributable profits. Based on the results
presented above, a major percentage of EU Member States face fair value measurements on
financial instruments. Therefore, it may be advisable to find a harmonised solution for the
European Union.

The following results were received on the recognition and measurement of derivative
financial instruments:

Figure 5.2 – 10: Recognition and measurement of derivative financial instruments

Recognition / Measurement Number of Countries Percentage of
Countries
Not recognised at all 2 7.4
Only recognised in case of a loss contract (i. e. no 8 29.6
assets recognised)
Recognised at Fair Value (with a gain or loss 15 55.6
impacting net income)
Recognised at Fair Value (with a gain or loss 3 11.1
impacting equity directly)
Otherwise 5 18.5

Note: Depending on the facts and circumstances in some EU Member States, more than one
option may be possible.

The findings concerning derivative financial instruments represent the divergence in practice
in recognising and measuring derivative financial instruments. But it is evident that the
recognition of derivatives at fair value is an accounting treatment applied in several
jurisdictions. This accounting treatment raises the same questions, as discussed above, for
non-derivative financial instruments.

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If derivative financial instruments are recognised at fair value, a special “statement of

recognised income and expenses” is used in presenting the recognition of these gains and
losses in five EU Member States.

Concerning the application of hedge accounting, the responses showed the following results.
However, it must be noted that any indication concerning the existence of a specific kind of
hedge accounting does not automatically translate into the application of the corresponding
IAS 39 - hedge accounting model.

Figure 5.2 – 11: Forms of hedge accounting

Forms of Hedge Accounting Number of Countries Percentage of
Countries
Fair Value Hedges 16 59.3
Cash Flow Hedges 16 59.3
Hedges of a Net Investment in a Foreign Entity 16 59.3
Other Models 10 37.0
No Hedge Accounting Permitted 2 7.4

Hedge accounting may immediately impact net income, similar to fair value hedge accounting
according to IAS 39, or may directly impact equity, similar to cash flow hedge accounting
according to IAS 39. In a majority of EU Member States hedge accounting models apply. The
results above indicate that a harmonisation in this area is currently not achieved. For more
accurate results, a more in-depth analysis would have to be conducted. But for the purposes of
this study, the results suffice in the way that it is evident that hedge accounting is a debatable
issue throughout the European Union. The magnitude of the problem can only be determined
on a case by case analysis.

5.2.4 Conclusion on overview of 27 EU Member States

Based on our analysis, it is evident that IFRS are not only applied in the European Union for
consolidated financial statements under EU Regulation 1606/2002. Several EU Member
States allow or require the application of IFRS in consolidated and/or single financial
statements. Some countries have even adopted IFRS as their national GAAP.

As the individual IFRS financial statements also serve for profit distribution under the 2nd
CLD, the questions arises whether the profits determined under this accounting framework
can be considered as “realised” for distribution purposes. Moreover, there is an issue
concerning the treatment of amounts immediately recognised in equity under IFRS for
dividend distribution purposes. The results of our analysis do not show a uniform picture for
the European Union in this regard.

In 17 EU Member States, it is permitted or required to distribute dividends based on

individual IFRS financial statements. Some Member States require modifications of the IFRS
financial statements in order to determine distributable amounts. Our analysis has shown that
there is a general lack of harmonisation in the European Union concerning the accounting
basis for dividend distributions. This also includes the question whether a modification of the
accounting profits is necessary.

With the exception of those EU Member States immediately applying IFRS, the measured
total deviations from national GAAPs to IFRS range around the mid-point of the scale defined

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for this study purpose. The IFRS for which deviations from national accounting rules have
been assessed as significant are as follows:

¾ IAS 19 – Employee Benefits

¾ IAS 29 – Reporting in Hyperinflationary Economies
¾ IAS 39 – Financial Instruments
¾ IAS 40 – Investment Property
¾ IFRS 2 – Share-based Payment
¾ IFRS 3 – Business Combinations
¾ IFRS 5 – Non-current Assets Held for Sale and Discontinued Operations

This has underpinned the selection of IFRS which have been subsequently analysed for all 27
EU Member States:

¾ Investment property
¾ Post-employment benefits
¾ Financial instruments

Investment property

The majority of EU Member States do not distinguish investment property from other real
estate under their local GAAPs. But the distinction itself has no immediate impact on
determining profits and distributable amounts. In 13 EU Member States, it is permitted or
required to revalue investment property to fair value. This may impact net profit or loss or
equity immediately. Concerning this revaluation, it is questionable whether for the purpose of
determining distributable these revaluation gains could be considered as “realised”. It equally
arises when gains are recognised either in the net profit or loss or, alternatively, in equity. A
similar discussion could take place concerning the “realisation” of losses.

It is evident that national accounting practices concerning the accounting for investment
property still differ throughout the European Union. There are in some cases deviations from
IAS 40 “Investment Property” which optionally allows a cost-based model as well as a fair
value model that has an immediate impact on profit or loss.

Post-employment benefits

In some EU Member States, defined benefit plans do not play an important role and therefore
do not create a problem. In several EU Member States, it is admitted to not recognise all
defined benefit pension schemes as liabilities. This raises the issue of whether distributable
amounts may currently be overstated in these EU Member States.

National accounting practices are not aligned concerning the measurement of defined benefit
liabilities and plan assets, the actuarial valuation methods applied as well as parameters that
are used in the actuarial calculations. Therefore, the impacts of defined benefits on
distributable amounts can only be assessed on a case by case basis.

A further area of significant deviation is the treatment of actuarial gains and losses which may
cause considerable changes in distributable profits under different accounting frameworks for
the field of defined benefit pension schemes. Under circumstances where actuarial losses are
not recorded, the distributable amounts may be overstated. When actuarial gains are not
recorded, an “understatement” of distributable amounts could be assumed.

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Financial instruments

The accounting treatment of derivative financial instruments as well as non-derivative

financial instruments is very complex. Based on our survey, national accounting practices still
significantly deviate throughout the European Union.

In a significant number of EU Member States, the measurement of financial instruments at

fair value is permitted or required. Like for investment property, a fair value measurement
also raises questions concerning the generation of distributable amounts. A similar assessment
can be made for hedge accounting since the accounting policies are perceived not to be
harmonised within European Union.

In total, it must be concluded that there is already a lack of harmonisation concerning a

consistent accounting basis for the determination of dividend distributions in the European
Union. The 4th CLD provides a minimum basis for harmonisation which does, however, not
address all significant accounting areas in order to achieve a consistent basis for profit
determination.

Concerning the impact of a transition to IFRS, our survey showed that it cannot be
automatically assumed that the application of IFRS will result into a major increase in profits
or in equity. However, the specific circumstances at a company prevail and situations may
arise where the transition may show major impacts. In the end, when comparing different
accounting frameworks any difference in the impact on the accounting profits in one period
will be reversed in another accounting period as total profits or losses over the lifetime of a
company will usually be the same under any accounting framework.

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5.3 Detailed country analysis - part II

5.3.1 France

5.3.1.1 Introduction

In France, individual financial statements must be prepared under French GAAP. This is also
the case for the individual financial statements of listed companies. Therefore any assumption
about the impact of the application of IFRSs on the distributable profit is purely hypothetical
under the current French situation. In France, distributable profit is defined as profit or loss
for the period in separate financial statements prepared under French GAAP plus or minus
profit or loss transferred from previous periods. The only limitation relates to the ‘legal
reserve: in France a company must allocate to such a reserve 5% of the profit for the period
until the amount of this reserve reaches at least 10% of the issued capital of the company.

Since this analysis focuses on distributable profits, disclosures and presentation issues are not
taken into account. The analysis focuses on major French GAAP areas of accounting
congruence or divergence for the following three accounting areas:

• Investments properties;
• Employee benefits; and
• Financial instruments, including hedging.

5.3.1.2 Investment property

The legal basis of the French accounting rules for investment properties can be found in the
French Commercial Code (C. com. art. D 7-1/2/3, C. com. L 123-18, C. com. art. D 7-5, C.
com. art. D 12, al. 4).

Briefly described, the most significant differences between French national accounting rules
and IFRS in the area of investment properties concern the following issues:

• Investment property is accounted for as property, plant and equipment.

• Investment property may be revalued only when all long-term financial instruments and
property plant and equipment are revalued.
• Any revaluation surplus is credited directly to equity.

Under French GAAP, there are no accounting rules similar to IFRS, and investment property
is accounted for as property, plant and equipment.

Accordingly, investment property generally is valued at depreciated cost except in the event
of a revaluation of all long-term financial instruments and property, plant and equipment of
the enterprise, in which case investment property is revalued to fair value. The revaluation
surplus is credited directly to equity. Such revaluations are not required to be updated
regularly.
For specialised enterprises disclosure is required of the fair value of property.

5.3.1.3 Employee benefits

The basis of the French accounting rules concerning employee benefits is as follows: C. com.
art. L 123-13, CRC 99-02 § 300, CU 00-A, R 03-1.

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The most significant difference between French national accounting rules and IFRS in the
area of employee benefits concerns the fact that under French GAAP it is not mandatory to
recognise a liability for post-employment employee benefits except in a business
combination.

In France most retirement plans are state-sponsored and supplementary benefits are offered to
a relatively small number of employees. Contributions in respect of state-sponsored plans are
set annually by the government and are expensed by an enterprise as incurred.

The preferred treatment in the consolidated financial statements is for the costs of
supplementary retirement and related benefits (e.g. severance payments, supplementary
retirement allowances, medical coverage, long-service recognition, sickness and provident
benefits) granted to both active and retired personnel and chargeable to the enterprise, to be
provided for systematically in the income statement over the working lives of the employees.
A recommendation has been issued by the French accounting standard setter CNC in 2003. It
is a translation of IAS 19 into French language as it was in force at that time.

However, it is not mandatory to recognise a liability for post-retirement employment benefits

and the Commercial Code gives companies the option of disclosing the liability in the notes
or providing for the amount either fully or partially in the financial statements. In this case
benefits are expensed as incurred.

Therefore, the French accounting practice in this area varies to a large extent.

Irrespective of whether the parent enterprise provides for post-employment retirement

benefits in its consolidated financial statements, in the event of a business combination the
liability relating to the retirement benefits of the acquired enterprise must be recognised.
However, there is no specific guidance on the method of valuation except for the guidance
included in the recommendation of the CNC.

5.3.1.4 Financial instruments, including hedging

The basis of the French accounting rules concerning employee benefits is as follows: CRC
99-03 art. 372-1, avis CNC n.29/86, avis CNC n.32/87, CU 98-B, D art. D 248-8-h.

The most significant difference between French national accounting rules and IFRS in the
area of employee benefits concerns the following issues:

• Transaction costs are recognised in the income statement as incurred.

• Financial instruments are not classified into the same categories as under IFRS, and are
not fair valued except in very limited circumstances.
• Generally only “permanent” impairments are recognised.
• A financial asset is derecognised only when legal title is transferred.
• Any liability discount or premium may be amortised on a straight-line basis.
• An issuer’s financial instruments may be classified on the basis of their legal form.
• Compound instruments are not split-accounted.
• A liability may be derecognised on the basis of in-substance debt defeasance.
• Derivatives usually are not shown in the balance sheet other than for the premiums paid
and received; only unrealised losses on derivatives are accounted for in the income
statement in the absence of hedge accounting.
• Hedge accounting is permitted more frequently than under IFRSs.

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Scope

Financial instruments as defined under IFRSs have no equivalent under French GAAP. The
French definition of financial items is restricted to shares, bonds, securities and futures
contracts.

Initial recognition

Different from IFRSs, financial items are recorded at cost.

However, transaction costs are recognised in the income statement when incurred rather than
being capitalised. There is no discussion under French GAAP of trade date versus settlement
date accounting, and practice varies.

Long-term investments

Long-term investments are those shares which the enterprise sees a benefit in holding for the
long term.

Investments in subsidiaries, jointly controlled entities and associates, which are not included
in the scope of consolidation, are classified as such.

Long-term investments are stated at depreciated cost.

Short-term investments

At the balance sheet date, investment securities should be valued at the lower of cost and
either the average price for the final month of the period if they are quoted, or their expected
realisable value if they are not quoted. Unrealised losses should be recognised in the income
statement.

Futures, options and other derivatives

Current accounting rules separate speculative transactions from hedges (see below) and
organised market transactions from other (over-the-counter) transactions.

Where speculative derivative transactions take place on organised markets and changes in
price are paid / received, the derivative is stated at market value and gains and losses are taken
to the income statement.

On over-the-counter speculative derivative transactions, realised losses and realised gains are
taken to the income statement. Unrealised losses are taken to the income statement on a
portfolio basis.

Unrealised gains are not recognised.

Impairment

In determining whether it is necessary to record an impairment loss against the carrying

amount of a long-term investment, reference should be made to the current market price (if
one exists), the investee`s net assets, profitability and prospects, the economic climate and any

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other factors that may be known. If it is felt that there is a permanent diminution in value, then
an impairment must be recorded with a corresponding charge to the income statement.
However, unrealised gains are not recognised, nor is it possible to offset gains and losses on
different investments.

Impairment losses on short-term investments are recognised automatically when any write-
down to market price or expected realisable value occurs (see above).

Impairment losses are reversed if circumstances change and the write-down is no longer
required.

De-recognition of financial assets

Unlike IFRSs an investment is de-recognised when legal title is transferred even if control is
retained by the transferor.

Liabilities

Financial liabilities are not defined precisely under French GAAP. They represent all external
resources provided to the enterprise in return for remuneration. They include long-term loans,
short-term bank borrowings such as overdrafts and accrued interest on loans.

The borrowing itself is recorded as a liability at its par value. In a difference from IFRSs, any
discount on issue or premium on repayment is recorded as a separate asset and is amortised
over the life of the loan either pro rata to interest payable (preferred method), or on a straight-
line basis.

Classification as a liability or equity

An option is available to classify an instrument according to its substance, i.e. as a liability

when it contains an obligation to transfer resources. However, in practice an instrument
usually is classified according to its legal form, which means that most shares are included in
equity. There are no provisions in French GAAP for split-accounting a financial instrument
between its liability and equity components.

Under the above-mentioned option to record an instrument based on its substance, when cash
is received under agreements where the lender cannot require repayment, such instrument is
recorded as either:

• equity where, in the event of insufficient earnings, no dividend or interest is due; or

• a separate category in liabilities, but outside financial debt, where a mandatory minimum
interest is due even in the event of insufficient earnings.

Debt with share purchase warrants

Debt with share purchase warrants, whether detachable or not, is accounted for entirely as
debt, which is different from IFRSs.

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Convertible debt

As noted above, split-accounting is not used in French GAAP. The classification of

convertible debt would follow the normal rules outlined above.

Extinguishments and restructurings of liabilities

A liability is extinguished following the same conditions as under IFRSs. However, unlike
IFRS, in-substance debt defeasance also results in the de-recognition of a financial liability
under the following conditions when securities are set aside in a separate legal entity to
provide for the repayment of a liability:

• The transfer of securities to a third party legal entity is irrevocable;

• The securities transferred:
- are assigned exclusively to servicing the debt payable;
- are risk-free with respect to their amount, term to maturity and payment of principal
and interest;
- are issued in the same currency as the debt payable; and
- have terms of maturity for principal and interest such that the cash flows service fully
• The debt payable; and the third party entity ensures exclusive assignment of the securities
received by it to redemption of the amount of debt payable.

Unlike IFRSs, where a liability is restructured or refinanced, whether terms are substantially
modified or not, it is accounted for as an extinguishment of the old debt, with a consequent
gain or loss; the new debt is recognised at its par value.

Troubled debt restructuring

The above rules on restructurings of liabilities apply even where the borrower is in financial
difficulties.

Hedging

To qualify as a hedge a financial instrument must have the following characteristics:

• contracts or options bought or sold have the effect of reducing the risk of change in value
affecting the hedged item;
• the hedged item may be an asset, a liability, an existing commitment or future transaction
as long as the transaction is precisely defined and likely to occur; and
• a correlation is established between changes in the value of the hedged item and the value
of the hedging contract or the underlying financial instrument where options are
concerned.

In practice many banks hedge a portion of their net exposure and assess the effectiveness of
hedges on this basis (“macro hedging”).

Written options qualify for hedge accounting only in exceptional cases.

Contracts that qualify for hedging are identified and treated for accounting purposes as such
from the outset, and retain this qualification until their maturity date or closure.

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All hedges, whether cash flow hedges or fair value hedges, are accounted for similarly.
Changes in the value of hedge contracts or options are not recognised immediately in the
income statement. The carrying amount of the hedged item is not adjusted for cumulative
gains or losses. Instead, any gains or losses first are recorded in a balance sheet account “short
term financial instruments”, then transferred to the income statement over the residual term of
the hedged item.

When the hedged item is realised, the hedging derivative must subsequently be accounted for
as a speculative transaction (see above).

A hedge of an investment in an autonomous subsidiary is accounted for similar to IFRSs.

Specialised industry guidance

There is specialised industry guidance in respect of financial instruments.

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5.3.2 Germany

5.3.2.1 Introduction

The following analysis is based on the assumption that any difference between an accounting
treatment according to local GAAP and IFRS that has a potential impact on net profit or loss
for the period does – at a specific point in time – change the distributable profit. The
consequence of this assumption is that generally any impact on profit or loss in one period
reverses in another period; i. e. over the life of an entity generally the cumulated profit does
not change because of different accounting treatments. So any impact assessment can be
given only for a specific point in time. Additionally it is assumed that any profit or loss
recognised directly in equity is not distributable unless explicitly stated otherwise.

The following analysis does not explicitly take the effects of deferred taxes into account.
Deferred taxes can reduce the primary impact effect of an accounting difference. This should
also be kept in mind. Furthermore the German government recently announced a modification
of the German Commercial Code that would be converging with IFRS in some areas. For
example, a fair value measurement of some financial assets is intended, and some
modifications of the rules for accounting for pension plans were announced. This proposal,
which has not been published as at October 21, 2007, has not been taken into account in the
following analysis.

In Germany the distributable profit is generally determined as the profit that is recognised in
the individual financial statements prepared according to the German Commercial Code
(“Handelsgesetzbuch”/HGB). This profit is modified or reduced in only a few cases when the
company recognises certain items as “assets” which do not fulfil the HGB definition of assets.
There is only a limited number of these items that are explicitly allowed, and they do not have
an immediate impact on the areas analysed in this paper. Therefore it can be said that
generally the accounting under HGB is the basis for determining distributable profits.
Furthermore some reserves have to be set up under certain circumstances; e. g. for the “offset”
of treasury shares. These legal rules are, in general, not immediately accounting related and
are therefore not to be taken into account.

Since this analysis focuses on distributable profits, note disclosures and presentation issues
have also not been not taken into account. Note that it is not necessary to analyse all
deviations between German GAAP and IFRS in detail. The analysis focuses on major areas of
accounting congruence or divergence.

5.3.2.2 Investment property

Separate identification of investment property

IAS 40 “Investment property” defines investment property as being land or a building — or

part of a building — or both held by the owner or by the lessee under a finance lease for the
purpose of earning rent or for capital appreciation or both, rather than for:
a) use in the production or supply of goods or services or for administrative purposes
[so called “owner-occupied property”]; or
b) sale in the ordinary course of business” (IAS 40.5).
IAS 40 contains a measurement option for investment property. A company may apply the
“fair value model” or the “cost model” for subsequent measurement. The cost model refers to
IAS 16 “Property, Plant and Equipment” and to IFRS 5 “Non-Current Assets Held for Sale

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and Discontinued Operations” (IAS 40.56). Owner-occupied property is accounted for

according to IAS 16.

The German Commercial Code does not distinguish between investment property and owner-
occupied property. Therefore the accounting treatment for both does not differ.

Measurement of investment property

Initial measurement

According to IFRS investment property is initially measured at cost including the transaction
cost (IAS 40.20 et. al.). “The cost of a purchased investment property comprises its purchase
price and any directly attributable expenditures” (IAS 40.21). The cost of a self-constructed
asset includes “any costs directly attributable to bringing the asset to the location and
condition necessary for it to be capable of operating in the manner intended by management”
(IAS 16.16(b)). This means that they also include “a systematic allocation of fixed and
variable production overheads” but not general and administration overheads (IAS 40.22/IAS
16.22/IAS 2.12 et. al.). This measurement will be called “full cost” in the following analysis.

Under the German Commercial Code, all real property is also initially measured at cost. There
is generally no major deviation in determining the cost of a purchased asset except in cases
where “the costs of dismantling and removing the item and restoring the site” form part of the
cost of an asset under IFRS. In these cases the obligation is generally recognised as an
expense spread over the useful life of the asset without any impact on the cost of the asset.
For self-constructed buildings there may be a difference. According to § 255 II HGB, it is
permitted to measure cost at direct material and production cost; consequently no material or
production overhead is allocated to the assets. This overhead may optionally be allocated to
the asset. Furthermore it is also permitted to recognise general administration overhead as part
of the cost of an asset. This means that on the one hand it is possible to measure buildings
below “full cost”; on the other hand it is permitted to measure buildings slightly above full
cost. In those cases where all “overhead” is immediately expensed under the German
Commercial Code, it is possible that during the construction periods the profits under IFRS
may exceed the profits under HGB. With reference to borrowing cost, § 255 III HGB has a
similar free choice as IAS 23 “Borrowing cost” has. It is optionally permitted to capitalise
“borrowing cost” when qualifying assets have been identified.

Comparison of national accounting rules with the “Cost Model”

Not taking the rules of IFRS 5 into account, investment property is – according to IAS 16 –
carried at cost less accumulated depreciation and accumulated impairment losses, if any (IAS
16.30). For depreciation purposes, the depreciation method “shall reflect the pattern in which
the asset’s future economic benefits are expected to be consumed by the entity” (IAS 16.60),
and the useful life represents “the period over which an asset is expected to be available for
use by an entity …” (IAS 16.6). Any impairment loss is determined under IAS 36
“Impairment of Assets”. Should a so-called “triggering event” arise, the carrying amount of
an asset is compared with its recoverable amount, i. e. the higher of the fair value less costs to
sell and the value in use (see IAS 36.6 et. al.).

Assets that are used for a longer period of time are classified as fixed assets according to §
247 II HGB. Real property that is classified as a fixed asset is carried at cost less depreciation
and write downs (§ 253 I + II HGB). The accounting treatment under German GAAP

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therefore resembles the cost model under IFRS. In practice there may be a couple of
deviations. The depreciation method as well as the useful lives of buildings may be derived
from tax rules and may be used for accounting purposes. This means that depreciation
methods and useful lives may differ from the methods and terms that have to be used under
IFRS. The impact on profit or loss can not be generally determined; but tax rules tend to lead
to a “faster” depreciation when compared with IFRS.

Furthermore companies have to write fixed assets down to a kind of “market value”
(“beizulegender Wert”) in such cases when impairment is permanent. The German
Commercial Code does not give any guidance on how to determine the “market value”. It
appears possible that the market value is similar to the fair value used under IAS 36 so that
the amount of impairment losses may be similar. In practice there may be differences, e. g.
when the “market value” is determined as replacement cost or when the value in use is
applied under IAS 36. Additionally the permanency of an impairment is irrelevant under
IFRS. No general effect on the profit or loss can be determined in this case. Since the
prudence principle is a very essential principle under the German Commercial Code, it may
be assumed that generally the impairment losses recognised under HGB exceed the losses
recognised under IFRS.

Comparison of national accounting rules with the “Fair Value Model”

As an alternative to the cost model, IAS 40 grants the option to measure all investment
property at fair value. The changes in fair value are recognised in profit or loss for the period
(IAS 40.33 et. al.).

A measurement at fair value is not on option under the German Commercial Code since assets
are not allowed to be measured above (depreciated) cost (§ 253 I HGB). However, if a loss is
deemed permanent, the fair value may be an indication of the “market value”. This means that
if fair values increase, the profits under IFRS may exceed the profits determined under the
German Commercial Code. If fair values decrease, the results under HGB and IFRS may be
similar if the loss is permanent, or if the losses recognised under IFRS may exceed the losses
recognised under HGB if the loss is not permanent.

Specific rules for determining distributable profits

There are no rules in Germany under which net income is modified to determine distributable
profits; i. e. net income according to the German Commercial Code represents the profit to be
distributed. There are no similar rules in IFRS.

Overall impact assessment on distributable profits

The impact on the net profit or loss arising from accounting deviations in the field of
investment property depends on several factors. One is the choice of options granted under
HGB and IFRS, and the second are market and valuation influences. On initial recognition, it
is permitted to recognise more expense in profit or loss under the German Commercial Code,
which results in reducing the distributable profits. The cost model under IFRS resembles the
HGB-model. Deviations generally stem from details, and a general statement on the effect on
distributable profits appears impossible. If the fair value model is chosen under IFRS and it is
assumed that all reductions in fair values are permanent, distributable profits under IFRS may
be higher than under the German Commercial Code since increases in fair values can only be
recognised under IFRS, whereas decreases may be recognised under both accounting regimes.

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5.3.2.3 Defined benefit plans (DBP)

Identification of DBP and the need to recognise a provision

Under IAS 19 “Employee benefits”, a company has to recognise a “liability” (or an ”asset”)
for all defined benefit plans127, no matter whether they are funded or unfunded and no matter
whether there is a legal or constructive obligation (IAS 19.49 et. al.).

Under the German Commercial Code, an entity has generally to provide for any third party
obligations (§ 249 I HGB), but there are two “exceptions” for pension benefits. Benefits
granted before January 1, 1987 are grandfathered, i. e. there is a free choice to provide for
these grants (Art. 28 I EG-HGB). Further the entity may opt to recognise any “indirect grant”,
i. e. generally a grant where the primary obligor is an external fund and the entity is
secondarily liable and other similar direct grants in its financial statements (Art. 28 II EG-
HGB). Should entities choose not to recognise a provision (liability), this generally increases
cumulated distributable profits in comparison to IFRS. Indirect grants are generally to be
accounted for under IAS 19; the assets of the fund may qualify as defined benefit plan assets.

Measurement of the (net) obligation

Valuation of the obligation

Under IFRS the relevant measure of the obligation is defined as being the “present value of a
defined benefit obligation” (DBO; IAS 19.6). This obligation is calculated by applying the so-
called “Projected Unit Credit Method” (IAS 19.64 et. al.). Furthermore several actuarial
assumptions – based on the market expectations at the balance sheet date – are needed to
calculate the DBO, for example (IAS 19.72 et. al):

Demographic assumptions
- Mortality
- Rates of employee turnover, disability and early retirement
The proportion of plan members with dependants who will be eligible for
benefits

Financial assumptions
- The discount rate (by reference to market yields at the balance sheet date on
high quality corporate bonds)
- Future salary and benefit levels (Medical benefits do not play a role in Germany
and are therefore not considered)

Under the German Commercial Code, there is no guideline on the measurement of the
obligation. Traditionally the majority of companies applied the guidance of the German Tax
Law to determine the obligation. Currently a method similar to IAS 19 may be regarded as
being appropriate as well. The tax model will be used as the point of reference in the
following analysis. According to German Tax Law, the method for determining obligation
and the current expense is called “Teilwertverfahren” (or going concern procedure). This
method is different from the Projected Unit Credit Method. Based only on this difference, it is
not clear whether the IFRS method or the German method lead to a higher calculated
obligation. This also depends on the age structure of the workforce.

127
For a definition of defined benefit plans cf. IAS 19.7.

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Both standards are similar in how they consider mortality rates and relevant dependants. But
under German Tax Law, employee turnover is not taken into account in determining the
liability. This effect may broadly be offset by the fact that under this law the earliest possible
age for the recognition of a provision is 28. No such limit exists under IFRS. The discount
rate in German Tax Law is set at 6% and not adjusted. For accounting purposes, different or
lower discount rates may be acceptable. The effect of this discount rate on the obligation in
comparison to that in IFRS depends on the discount rate for high quality corporate bonds. In
previous years this discount rate was below 6% and thus lead to an increase of the obligation
under IFRS with reference to this factor. For tax purposes as well as for accounting purposes
in Germany, it is generally not deemed acceptable to take future salary and benefit increases
into account. Since these increases are taken into account under IFRS, this may lead to
significantly higher calculated obligations under IFRS and consequently to a reduction in the
cumulated distributable profits.

The overall impact of the different methods in determining the obligation cannot be
generalised. But especially the analysis of the applied actuarial assumptions tends to lead to
higher obligations under IFRS. This could quite likely be underpinned with the experience
stemming from several IFRS conversions.

Treatment of plan assets

IAS 19.7 defines plan assets as being assets that are held by a long-term employee benefit
fund or qualifying insurance policies. The main characteristics are that the respective funds
can only be used to pay benefits, are not available to the companies’ creditors (even in
bankruptcy), and can generally not be returned to the entity. Plan assets are offset with the
“defined benefit obligation” (DBO; IAS 19.54). IAS 19 also refers to reimbursement rights
that cannot be offset with the DBO but are otherwise treated in the same way (IAS 19.104A
et. al.). Plan assets are measured at fair value (IAS 19.54 / IAS 19.102 et. al.).

Under the German Commercial Code, there is no definition for plan assets. For the indirect
grants described above, it is permitted to recognise the net obligation, generally under funded,
as a liability. The assets of the external fund are measured according to German GAAP. This
means that losses have to be anticipated whereas unrealised profits cannot be taken into
account (§ 252 I No. 4 HGB). This principle is supported by the rule that assets are not
allowed to be carried above (depreciated) cost. Permanent impairments of fixed assets and
both permanent and temporary impairments for current assets result in write downs of the
assets (§ 253 HGB). Based on further analysis, the fair value of the assets may be regarded as
a basis for determining the impairment loss in these cases. This means that if the fair value of
plan assets increases, a gain is recognised under IFRS which is not recognisable under HGB.
If the fair value of plan assets decreases, i. e. when a loss is recognised under IFRS, it does
not appear to be unlikely that a loss will also be recognised under the German Commercial
Code. The amount of the recognised loss, however, may slightly differ. This means that a
tendency towards earlier recognition of distributable profits under IFRS may be assumed.

Treatment of actuarial gains and losses

Under IFRS actuarial gains or losses may arise. Actuarial gains or losses comprise
“experience adjustments (the effects of differences between the previous actuarial
assumptions and what has actually occurred); and … the effects of changes in actuarial
assumptions” (IAS 19.7). These gains and losses do not have to be recognised immediately. It
is permitted to apply the so-called “corridor approach” meaning that the amount of cumulated

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actuarial gains and losses exceeding the greater of 10% of the DBO and 10% of the fair value
of the plan assets has to be spread over the remaining working lives of the employees. Any
method leading to a faster recognition of the gains/losses is acceptable as well (IAS 19.92 et.
al.). Recently the IASB has added an additional option for the recognition of the actuarial
gains and losses. Optionally it is allowed to recognise all actuarial gains and losses directly in
equity (retained earnings) immediately. No “recycling” of these gains and losses through
profit or loss in later periods is required or allowed (IAS 19.93A et. al.).

Under the German Commercial Code, it appears inappropriate not to recognise all actuarial
gains and losses immediately. This means that at year end the “full (net) obligation” is
recognised. Any adjustments made to the provisions have to be recognised in profit or loss for
the year, i. e. neither the corridor approach nor the immediate recognition of actuarial gains or
losses directly in equity are allowed under IFRS.

The immediate recognition of actuarial gains/losses is also an option under IAS 19. If this
option is used, no difference arises in this respect. Indeed if we assume that the adjustment of
retained earnings according to the new option under IFRS has an impact on distributable
profits, there is also no difference between the distribution potential according to the German
Commercial Code and IFRS in respect of actuarial gains and losses. If any other method
(corridor approach) of IAS 19 is applied, the general effect on distributable profits in
comparison to the German Commercial Code cannot be generalised. The effect depends on
the circumstances: Is there a cumulative actuarial gain or a cumulative actuarial loss? A gain
means a higher distribution potential under the German Commercial Code, a loss means less
distributable profits under the German Commercial Code.

Specific rules for determining distributable profits

There are no rules in Germany under which net income is modified to determine distributable
profits; i.e. net income according to the German Commercial Code represents the distributable
profit. There are no similar rules in IFRS.

Overall impact assessment on distributable profits

It is impossible to make a general statement on differences in the impact on cumulated

distributable profits between using the German Commercial Code and IFRS. There are
several tendencies that contradict in part. For example, the consideration of salary and benefit
increases leads on its own to higher liabilities under IFRS; thus resulting in a decrease in
cumulated distributable profits. On the other hand, the measurement of plan assets at fair
value tends to increase distributable profits under IFRS when compared with HGB.
Furthermore due to several factors, the impact on distributable profits depends on the
individual circumstances, e.g. the interest rate applied or the recognition of actuarial gains or
losses. Experience from several past HGB to IFRS conversion projects shows that in general,
the provisions for defined benefit plans do increase with a (theoretical) simultaneous decrease
in cumulated distributable profits.

5.3.2.4 Financial instruments

Identification and classification of financial instruments

Under IFRS there is a broad definition for financial instruments that includes financial assets
and financial liabilities. Financial instruments comprise debt as well as equity instruments (of

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other entities). Financial instruments also include derivative financial instruments (see IAS
32.11). According to IAS 39, financial instruments have to be classified into the following
categories with a consequential effect on their accounting treatment (see IAS 39.9):

⇒ Loans and receivables

⇒ Held-to-maturity Investments
⇒ Financial Instruments at Fair Value Through Profit or Loss
⇒ Available-for- ale Financial Instruments
⇒ Financial Liabilities

Amongst other exceptions, investments in subsidiaries, associates and joint ventures are not
within the scope of IAS 39 (IAS 39.2).

The most relevant distinction with relevance for measurement purposes under the German
Commercial Code is the distinction between fixed assets and current assets. Fixed assets are
assets that are intended to serve the business operations on the long term. All other assets are
current assets (§ 247 I + II HGB). Even though it is not permitted to match the IFRS financial
asset categories with the German distinction between fixed and current assets exactly, the
following assumptions can be made. Held-to-maturity investments correspond to fixed assets.
At Fair Value through Profit or Loss assets correspond to current assets. Loans and
receivables as well as available-for-sale financial assets can be classified as fixed or current
assets, based on the individual circumstances.

Under IAS 39 financial instruments are initially recognised at fair value (generally including
transaction costs; IAS 39.43). Under the German Commercial Code, financial assets are
initially recognised at cost and financial liabilities at their settlement amount (§ 253 HGB). In
practice this difference is unlikely to cause any major deviations.

Financial asset de-recognition

IAS 39 contains specific rules on financial asset de-recognition and financial liability de-
recognition (IAS 39.15 et. al.). Under the German Commercial Code there is no explicit
guidance on this issue. As a result there may be different accounting treatments in practice.
The major problem of financial asset de-recognition very often boils down to the question of
whether a financial asset should be replaced by liquid funds received or whether the financial
asset should not be derecognised and the receipt of liquid funds instead leads to an increase in
liabilities. This is mainly a presentation issue with no major impact on profit or loss (unless
for financial institutions). Therefore this area has not been analysed any further.

Subsequent measurement of financial instruments (excluding derivatives)

Loans and receivables

Loans and receivables are carried at amortised cost according to IAS 39.46. If there is any
objective evidence that such a financial asset or group of financial assets is impaired, “the
amount of the loss is measured as the difference between the asset’s carrying amount and the
present value of estimated future cash flows (excluding future credit losses that have not been
incurred) discounted at the financial asset’s original effective interest rate (i.e. the effective
interest rate computed at initial recognition; IAS 39.58/IAS 39.63 et. al.). Under IAS 39, the
assessment of impairments is done first “for financial assets that are individually significant,
and individually or collectively for financial assets that are not individually significant”. The

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grouping is based on credit risk characteristics (IAS 39.64). A subsequent reversal of the
impairment may be required (IAS 39.65).

Under the German Commercial Code, these assets are also carried at (amortised) cost.
However, the rules for impairment may differ. For a fixed asset, an impairment generally has
to be recognised if it is permanent. If it is only temporary, the company generally has an
option to recognise the impairment loss (§ 253 II HGB/§ 279 I HGB). The assets are written
down to a kind of “market value” (“beizulegender Wert”). The determination of this value is
not clearly defined (§ 253 II HGB). For current assets, an impairment loss has to be
recognised even for temporary impairments. The benchmark for determining an impairment
loss is generally also a “market value”; preferably derived from an active market.

In practice especially the impairment rules may result in differences. For example in Germany
accounts receivables are often reduced by individual allowances as well as general allowances
that may take interest effects into account. The groupings for general allowances may not be
based on credit risk. It can be assumed that the German impairments may be more
conservative. This is underpinned by the need to recognise impairment losses even for
temporary impairments. This means that distributable (net) profits may arise later under the
German Commercial Code.

Held-to-maturity investments

Held-to-maturity Investments are also carried at cost (IAS 39.46). Held-to-maturity

Investments are generally fixed assets under the German Commercial Code. The statements
made above covering fixed assets are also true for held-to-maturity investments.

Financial instruments at fair value through profit or loss (excluding derivatives)

There are two ways of classifying a financial instrument at fair value through profit or loss.
One way is holding the instrument for trading, i.e. normally short term profit making, or
designating the instrument into this class of assets at initial recognition (the possibilities of
designation are limited; IAS 39.9 et. al.). Financial instruments in this category are measured
at fair value with fair value changes recognised in profit or loss (IAS 39.46 et. al.).

Under German GAAP, financial assets are usually current assets. They are carried at the
lower of cost and “market value” as described above. It is not permitted to recognise
unrealised gains, i. e. it is not possible to measure assets above cost (§ 253 HGB). Therefore if
the fair value increases, gains are recognised under IFRS, which may not be booked under
German GAAP. For losses, an impairment loss has to be recognised under the German
Commercial Code – where applicable even for temporary losses (§ 253 II + III HGB). The
market value according to German law quite likely corresponds to the fair value according to
IAS 39. This means that the deviation is quite likely not a major issue for losses.

Liabilities are measured at the settlement amount under German GAAP (§ 253 I HGB). They
may not be measured at fair value. Accordingly, any changes in the fair value of liabilities
designated as at fair value through profit or loss according to IFRS are generally not
recognised under German GAAP. For example, this is also true for losses caused by a
decrease in the refinancing interest rate. Therefore the deviation in the area of liabilities
depends on the current circumstances.

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Available-for-sale financial assets

Available-for-sale financial assets are carried at fair value. Changes in the fair value are
recognised directly in equity. Upon the realisation of profits or losses, the gain or loss
recognised in equity is “recycled” through net profit or loss for the period (IAS 39.46 et. al.).
“When a decline in the fair value of an available-for-sale financial asset has been recognised
directly in equity and there is objective evidence that the asset is impaired …, the cumulative
loss that had been recognised directly in equity shall be removed from equity and recognised
in profit or loss …” (IAS 19.67 / for details see IAS 19.67 et. al.).

As described above, a measurement above cost is not permitted under German GAAP either
for fixed or for current assets. Where the gains recognised directly in equity are not
distributable, there is no impact on distributable profits. Under German GAAP, temporary
losses have to be recognised for current assets and may be recognised for fixed assets. For
permanent impairments, an impairment loss has also to be recognised for fixed assets. To
simplify a complex matter, it may be assumed that temporary impairments do not lead to the
recognition of decreases in fair values in profit or loss whereas permanent impairments do
under IFRS. This would mean that impairments recognised under IFRS are also always
recognised in profit or loss under German GAAP. But temporary impairments have to be
recognised in profit or loss under German GAAP and but not under IFRS. This leads to the
conclusion that the distribution potential under German GAAP tends to be lower than the
cumulated distributable profits under IFRS.

There are specific rules for reversals of impairments losses under IFRS. For debt instruments,
the reversals impact on profit or loss. For equity instruments the increase in fair value impacts
on equity (IAS 39.69 et. al.). Under the German Commercial Code, a reversal of impairments
losses is required and impacts on profit or loss in all cases (§ 280 I HGB).

Financial liabilities

Financial liabilities are generally recorded at amortised cost under IFRS. The effective interest
method is applied (IAS 19.47). German GAAP requires liabilities to be recognised at their
settlement amount (§ 253 I HGB). Sometimes liabilities are issued at a discount. This
discount may be expensed immediately or recognised as prepaid expenses and spread over the
term of the liability (§ 250 III HGB). The second option may be identical or at least similar to
the effective interest method. If the first option is used, this reduces distributable profits under
the German Commercial Code at the time of initial recognition.

Investments in subsidiaries, associates and joint ventures

IAS 27 applies to interests in subsidiaries, associates and joint ventures in, individual
financial statements. These may be carried at cost or according to IAS 39 (IAS 27.37). If they
are carried according to IAS 39, they are principally to be regarded as available-for-sale
financial assets. In this respect please see the analysis above. These investments may also be
carried at cost. This is similar to the accounting treatment under the German Commercial
Code.

There is an other “class” of financial assets as well that is carried at cost less impairment loss
under IAS 39: “…investments in equity instruments that do not have a quoted market price in
an active market and whose fair value cannot be reliably measured …” (IAS 39.46 et. al./IAS
39.AG80 et. al.). The accounting treatment is similar to the German Commercial Code as

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described above. But it may be possible for fixed assets or required for current assets to write
the assets down in case of a temporary impairment which may, subject to specific analyses,
not be appropriate under IFRS. Furthermore under the German Commercial Code, reversals
of write downs are required (§ 280 I HGB). But under IFRS reversals of write downs for these
specific assets are prohibited (IAS 39.66).

Accounting treatment of derivative financial instruments

Derivative financial instruments, as defined in IAS 39.9, are generally within the scope of
IAS 39. They are automatically classified as being traded and therefore accounted for “at fair
value through profit or loss”. As described above, this means that all derivative financial
instruments are recognised at fair value in an IFRS balance sheet, and any changes in the fair
value of those assets / liabilities are recognised within profit or loss for the period.

Under the German Commercial Code, there is a non-codified rule that executory contracts are
generally not recognised in the balance sheet. Normally derivative financial instruments have
to be identified as executory contracts. This means that derivatives are generally not
recognised according to German GAAP. This is supported by the fact that positive fair values
are regarded as unrealised gains that may not be anticipated (§ 252 I No. 4 HGB).
Nevertheless, onerous contracts have to be recognised according to the German Commercial
Code (§ 249 I HGB / § 252 I No. 4 HGB). An onerous derivative contract usually corresponds
with a negative fair value of the derivative. Therefore in cases of negative fair values of a
derivative, a provision is usually recognised under the German Commercial Code. The
measurement of the provision may slightly deviate from time to time from the negative fair
value, e.g. discounting is generally not allowed under HGB (§ 253 I HGB). This means that
losses / negative fair values tend to be recognised under German GAAP as well as under
IFRS. Gains may only be “anticipated” under IFRS. This shows a tendency that distributable
profits may be recognised earlier under IFRS.

Hedge accounting

IAS 39 distinguishes three kinds of hedging relationships: cash flow hedges, fair value hedges
and hedges of a net investment in a foreign operation128 (IAS 39.86). To be eligible to apply
hedge accounting, several required prerequisites have to be fulfilled (IAS 39.88 et. al.). Cash
flow hedges are used to hedge (potential) variations in future cash flows. Any gain or loss on
a (derivative) hedging instrument is recognised directly in equity until the hedged item affects
profit or loss, directly or in the form of a basis adjustment of the hedged item (see IAS 39.88 /
IAS 39. 95 et. al.). Fair value hedges are used to hedge the risk of changes in the fair value of
a recognised asset or liability or a firm commitment. The gain or loss of the (derivative)
hedging instrument is recognised in profit or loss. In addition the hedged item is revalued with
regard to the hedged risk as well, and any results of this revaluation are also recognised in
profit or loss. Ideally the gain/loss of the hedging instrument is fully offset by the loss/gain
from the revaluation of the hedged item (see IAS 39.88 et. al.).

Under the German Commercial Code, there is no guidance on hedge accounting. In practice
and in accounting literature it is possible to establish “units of account”. This means that the
hedged item and the hedging instrument are artificially linked to one unit that leads to
offsetting gains and losses. For example it is permitted to link a foreign currency receivable
and foreign currency forward to a “unit of account”. As a result, the foreign currency
128
Since cash flow hedges and fair value hedges are the most relevant kinds of hedging relationships in
individual financial statements in dividual financial statements only those will be analysed further.

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receivable is always translated at the forward rate, or it is permitted to link a liability with an
interest rate swap. As a result, the “cash flows” are recognised as incurred, i. e. neither the
liability nor the swap is revalued. The prerequisites for this kind of hedge accounting are also
not specified. Therefore it appears to be easier to be eligible for hedge accounting under the
German Commercial Code. A full analysis of hedge accounting under the German
Commercial Code appears impracticable due to divergence in practice.

The objective of hedge accounting under German GAAP is similar to the objective under
IFRS. The profit or loss should not be affected if two items are in substance closely linked but
would, due to “inappropriate” basic accounting rules, be treated differently. In Germany
unrealised losses have to be anticipated whereas unrealised gains cannot be recognised. If
hedge accounting were not applied, the loss of one item would affect net profit before the gain
of the other item could be realised; thus this would potentially impact the true and fair view of
the financial statements. Therefore hedge accounting is applied. Under IFRS the objective is
similar. The need for hedge accounting may even be increased by the fact that derivatives – in
general hedging items – are always measured at fair value. A detailed analysis of the impact
of the hedge accounting rules is almost impracticable. But since it is perhaps easier to be
eligible for hedge accounting under the German Commercial Code and given the analysis of
freestanding derivatives, the whole set of rules may tend towards an earlier recognition of
distributable profits under IFRS.

Specific rules for determining distributable profits

There are no rules in Germany under which net income is modified to determine distributable
profits; i.e. net income according to the German Commercial Code represents the distributable
profit. There are no similar rules in IFRS.

Overall assessment of the impact on distributable profits

It is difficult to assess the overall impact on distributable profits in the field of financial
instruments. Under IFRS fair value measurements are often applied. This is generally not
allowed under the German Commercial Code when fair values of assets exceed (amortised)
cost. On the other hand, a decrease in fair values to below cost leads in most cases to a write
down of assets under HGB. Therefore gains may not be “anticipated”, whereas potential
losses have to be anticipated. The prudence principle is the overarching major principle within
the accounting rules. In view of conservatism as a general rule, we could conclude that
German financial statements tend to recognise distributable profits later than IFRS financial
statements.

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5.3.3 Poland

5.3.3.1 Introduction

The following analysis is based on the assumption that any difference between an accounting
treatment according to local GAAP and IFRS that has a potential impact on net profit or loss
for the period does – for a specific point in time – change the distributable profit. In making
this assumption, one has to keep in mind that generally any impact on profit or loss in one
period reverses in another period; i.e. over the lifecycle of a company the accumulated profit
generally does not change because of different accounting treatments. Therefore, any impact
assessment can only refer to a specific point in time of this lifecycle. Moreover, it is assumed
that any profit or loss recognised directly in equity is not distributable unless explicitly stated
otherwise.

The following analysis does not explicitly take the effects of deferred taxes into account.
Deferred taxes can reduce the primary impact on an accounting difference.

In Poland the distributable profit is generally determined as the profit that is recognised in the
separate financial statements prepared according to the Polish Accounting Act dated 29
September 1994 (“the Act”) and to related bylaws. This profit, however, might not be fully
eligible for distribution. The rules are as follows:

- the amount eligible for distribution includes the entire profit for the current year and
retained profits;
- after deducting the value of treasury shares;
- after deducting amounts that, in accordance with laws and regulations or provisions of
the Company’s statutes need to be allocated to reserve capital, and;
- after covering accumulated losses.

The amount of retained earnings that, for joint-stock companies, needs to be allocated to
reserve capital based on the Commercial Companies’ Code is the equivalent of at least 8% of
the net profit for the year, until the reserve capital equals one third of the share capital. There
is no such requirement in relation to limited liability companies.

Since this analysis focuses on distributable profits, note disclosures and presentation issues
have not been not taken into account. Furthermore it is not necessary to analyse all deviations
between Polish GAAP and IFRS in detail. The analysis focuses on major areas of accounting
congruence or divergence.

5.3.3.2 Investment property

Separate identification of investment property

IAS 40 “Investment property” defines investment property as being land or a building, or

being part of a building or bothheld by the owner or by the lessee under a finance lease for the
purpose of earwing rent or for capital appreciation or both, rather than for:
c) use in the production or supply of goods or services or for administrative purposes
[so called “owner-occupied property”]; or
d) selling in the ordinary course of business” (IAS 40.5).
IAS 40 contains a measurement option for investment property. A company may apply the
“fair value model” or the “cost model” for subsequent measurement. The cost model refers to

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IAS 16 “Property, Plant and Equipment” and to IFRS 5 “Non-Current Assets Held-for-sale
and Discontinued Operations” (IAS 40.56). Owner-occupied property is accounted for
according to IAS 16.

The Polish Accounting Act does not differ significantly from IAS 40 with respect to the
identification of investment property, except for the fact that according to the Act, the
property needs to be “acquired” for the purpose of earning rent or for capital appreciation or
both. If this requirement is interpreted literally, an entity may not reclassify property, plant
and equipment when its usage changes.

Measurement methods are similar to ones offered by IAS 40 – cost model and fair value
model. There is no direct equivalent of IFRS 5 in the provisions of the Act.

Measurement of investment property

Initial measurement

According to IFRS, investment property is initially measured at cost including transaction

costs, (IAS 40.20 et. al.). “The cost of a purchased investment property comprises its purchase
price and any directly attributable expenditure.…” (IAS 40.21). The cost of a self-constructed
asset includes “any costs directly attributable to bringing the asset to the location and
condition necessary for it to be capable of operating in the manner intended by management”
(IAS 16.16(b)). This means that they also include “a systematic allocation of fixed and
variable production overheads” but no general and administration overheads (IAS 40.22/IAS
16.22/IAS 2.12 et. al.). This measurement will be called “full cost” in the following analysis.

Under the Act, the investment property is initially measured at cost. There is generally no
major deviation in determining the cost of a purchased asset, except for borrowing costs
capitalisation and except where “costs of dismantling and removing the item and restoring the
site” form part of the cost of an asset under IFRS. In these cases based on the Act, the
obligation is generally recognised as an expense over the useful life of the asset without an
impact on the cost of the asset.

With reference to borrowing costs, the Act requires capitalisation of all such costs incurred
during the period of construction, assembly, preparation or improvement. The borrowings
need to be obtained with the purpose of financing the construction; they may not be general
borrowings. In addition, any foreign exchange differences arising from the borrowings in the
period mentioned above, regardless of their amount and regardless of whether these are gains
or losses, are required to be capitalised. No general conclusion can be drawn as to the impact
of these differences. Other factors, such as the treatment adopted under IFRS (benchmark or
alternative), the type of financing used by the Company, as well as the type of assets (and
length of the “construction, assembly etc.” period), - can also have different an impacts on the
distributable profits; these may be either positive (an increase) or negative (a decrease).

Comparison of national accounting rules with the “Cost Model”

Despite the rules of IFRS 5, investment property is, according to IAS 16, carried at cost less
accumulated depreciation and accumulated impairment losses, if any (IAS 16.30). For
depreciation purposes, the depreciation method “shall reflect the pattern in which the asset’s
future economic benefits are expected to be consumed by the entity” (IAS 16.60) and the
useful life represents “the period over which an asset is expected to be available for use by an

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entity …” (IAS 16.6). Any impairment loss is determined under IAS 36 “Impairment of
Assets”, which states that should a so-called “triggering event” arise, the carrying amount of
an asset is compared with its recoverable amount, i. e. the higher of the fair value less costs to
sell and the value in use (see IAS 36.6 et. al.).

In accordance with article 28 of the Act, the investment property is carried either at cost less
depreciation and impairment charges or at fair value. The accounting treatment under Polish
GAAP therefore resembles the treatment under IFRS. In practice there may be several
deviations. The depreciation method under Polish GAAP once selected may not be altered.
Useful lives of the assets may not be changed during the accounting period; therefore any
adjustments to depreciation rates may be applied prospectively from the financial year
subsequent to the one, when the change of useful life took place. The impact on profit or loss
generally cannot be determined.

Furthermore, if impairment occurs (i.e. when “it is likely, that an asset controlled by an entity
will not bring, in whole or in part, expected economic benefits in the future”), companies have
to write fixed assets down to the net selling price or “otherwise determined fair value”. The
Act does not give any detailed guidance on how to determine the fair value, except for the
general definition that the fair value is “an amount for which a given asset could be
exchanged, and a liability settled, in an arm’s length transaction, between willing, well-
informed and non-related parties”. The Act makes reference to consideration of “value in use”
in determining the amount of impairment loss, as required under IFRS; however this term is
not defined. No general effect on the profit or loss can be determined in this case.

Comparison of national accounting rules with the “Fair Value Model”

As an alternative to the cost model, IAS 40 grants the option to measure all investment
property at fair value. The changes in fair value are recognised in profit or loss for the period
(IAS 40.33 et. al.).

A measurement at fair value is also an acceptable option under the Polish Accounting Act
based on article 28.1 point 1a). The changes in the fair value are recognised as follows (art.
35.4 of the Act):

- increases of fair value are recognised in a revaluation reserve in equity (see also below);
- decreases – up to an amount previously recognised in equity due to increases in fair value –
are recognised as a debit in the revaluation reserve. Other decreases are recognised in profit
or loss for the period;
- reversal of a decrease in fair value recognised in profit or loss is also recognised in profit or
loss.

It should be noted that changes proposed in the Polish Accounting Act and expected to be
effective as from 1 January 2008 are expected to be in line with the treatment under the IFRS
Fair Value Model.

Specific rules for determining distributable profits

Except for rules described in point 1 of the Introduction of this analysis, there are no other
rules in Poland under which net income is modified for determining distributable profits.
None of these rules relates to investment property.

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Overall impact assessment on distributable profits

The impact on the net profit or loss arising from accounting deviations in the field of
investment property depends on several factors. One is the choice of options granted under
the Act and IFRS, and the second is market and valuation influences.

Upon initial recognition, the differences might occur in relation to capitalizing borrowing,
dismantling, or restoration costs. However, the effect on distributable profits (a decrease or an
increase comparable to IFRS) depends on facts and circumstances, thus no general statement
can be made.

The cost model of subsequent measurement under Polish GAAP is similar to the one in IFRS.
However, differences impacting distributable profits may arise due to possibilities of changes
in the amortisation method under IFRS (not possible under Polish GAAP), moment of
changes in the useful lives of the investments, and differences in calculating impairment
losses under both reporting frameworks. In this regard it is also not possible to make a general
statement on the direction of differences between distributable profits under Polish GAAP and
IFRS.

The fair value model differences relate primarily as to how the change in fair value is
recognised – under IFRS P&L, under Polish GAAP – either in profit or loss or in equity,
depending on the direction of the changes and the history of the changes. The distributable
profits will therefore be lower under Polish GAAP in a situation of increases in fair value, and
may be higher in a situation of fair value decline.

5.3.3.3 Defined benefit plans (DBP)

Identification of DBP and the need to recognise a provision

Under IAS 19 “Employee Benefits”, a company has to recognise a “liability” (or an ”asset”)
for all defined benefit plans129; no matter whether they are funded or unfunded and no matter
whether there is a legal or constructive obligation (IAS 19.49 et. al.).

Under the Polish Accounting Act, an entity has generally to provide for any third-party
obligation (art. 35d.1). There are, however, no specific rules for calculating or recognising
defined benefit plan provisions. On that basis the entity may opt to choose an accounting
treatment as defined in IFRS although it has no obligation to do so.

Measurement of the (net) obligation

Valuation of the obligation

Under IFRS the relevant measure of the obligation is defined as the “present value of a
defined benefit obligation” (DBO; IAS 19.6). This obligation is calculated by applying the so-
called “Projected Unit Credit Method” (IAS 19.64 et. al.). Furthermore several actuarial
assumptions, based on the market expectations at the balance sheet date, are needed to
calculate the DBO, for example (IAS 19.72 et. al):

129
For a definition of defined benefit plans cf. IAS 19.7.

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Demographic assumptions
- Mortality
- Rates of employee turnover, disability and early retirement
- The proportion of plan members with dependants
who will be eligible for benefits

Financial assumptions
- The discount rate (by reference to market yields
at the balance sheet date on high quality corporate bonds)
- Future salary and benefit levels (Medical benefits do not play
a role in Poland and are therefore not considered).

Under the Polish Accounting Act, there is no guideline for measuring the obligation. The
obligation has simply to be measured “reliably” (art. 28.1 point 9 of the Act).

The overall impact of the differences between IFRS and Polish GAAP in relation to
determining the obligation cannot be generalised.

Treatment of plan assets

IAS 19.7 defines plan assets, which are assets that are held by a long-term employee benefit
fund or qualifying insurance policies. The main characteristics are that the respective funds
can only be used to pay benefits are not available to the companies’ creditors (even in
bankruptcy) and can generally not be returned to the entity. Plan assets are offset with the
DBO (IAS 19.54). IAS 19 also refers to reimbursement rights which cannot be offset with the
DBO but are otherwise treated in the same way (IAS 19.104A et. al.). Plan assets are
measured at fair value (IAS 19.54 / IAS 19.102 et. al.).

Under the Polish Accounting Act, there is no definition for plan assets. Entities may opt to
choose the accounting treatment as defined in IFRS; however they have no obligation to do
so.

Treatment of actuarial gains and losses

Under IFRS actuarial gains or losses may arise. Actuarial gains or losses comprise
“experience adjustments (the effects of differences between the previous actuarial
assumptions and what has actually occurred); and … the effects of changes in actuarial
assumptions” (IAS 19.7). These gains and losses do not have to be recognised immediately. It
is permitted to apply the so-called “corridor approach” meaning that the amount of cumulated
actuarial gains and losses exceeding the greater of 10% of the DBO and 10% of the fair value
of the plan assets has to be spread over the remaining working lives of the employees. Any
method leading to a faster recognition of the gains/losses is acceptable as well (IAS 19.92 et.
al.). Recently the IASB added an additional option for the recognition of the actuarial gains
and losses. Optionally it is allowed to recognise all actuarial gains and losses directly in
equity (retained earnings) immediately. No “recycling” of these gains and losses through
profit or loss in later periods is required or allowed (IAS 19.93A et. al.).

Under the Polish Accounting Act, it appears inappropriate not to recognise all actuarial gains
and losses immediately. This means that at year end the “full (net) obligation” is recognised.
Any adjustments made to the provisions have to be recognised in profit or loss for the year.

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Neither the corridor approach nor the immediate recognition of actuarial gains or losses
directly in equity is allowed under IFRS.

The immediate recognition of actuarial gains/losses is also an option under IAS 19. If this
option is used, no difference arises in this respect. Indeed if we assume that the adjustment of
retained earnings according to the new option under IFRS has an impact on distributable
profits, there is also no difference between the distribution potential according to the Polish
Accounting Act and IFRS in respect to actuarial gains and losses. If any other method
(corridor approach) of IAS 19 is applied, the general effect on distributable profits when
compared with the Polish Accounting Act cannot be generalised. The effect depends on the
circumstances: Is there a cumulative actuarial gain or a cumulative actuarial loss? A gain
means a higher distribution potential under the Polish Accounting Act; a loss means less
distributable profits under the Polish Accounting Act.

Specific rules on determining distributable profits

As mentioned above, except for some general rules described in the introductory paragraph of
this analysis, there are no rules in Poland under which net income is modified to determine
distributable profits.

Overall impact assessment on distributable profits

It is impossible to make a general statement about the differences between the Polish
Accounting Act and IFRS concerning the impact on accumulated distributable profits. There
are several tendencies that in part contradict each other, and there are several areas for which
no clear accounting rules exist under the Polish Accounting Act. The differences also cannot
be generalised because they are based on experience.

5.3.3.4 Financial instruments

Identification and classification of financial instruments

Under IFRS there is a broad definition for financial instruments. They include financial assets
and financial liabilities. Financial assets comprise debt as well as equity instruments (of other
entities). Financial instruments also include derivative financial instruments (see IAS 32.11).
According to IAS 39, financial instruments have to be classified into the following categories
with a consequential effect on their accounting treatment (see IAS 39.9):

⇒ Loans and receivables

⇒ Held-to-maturity Investments
⇒ Financial Instruments at Fair Value Through Profit or Loss
⇒ Available-for-sale Financial Instruments
⇒ Financial Liabilities

Amongst other exceptions, investments in subsidiaries, associates and joint ventures are not
within the scope of IAS 39 (IAS 39.2).

In Polish GAAP the presentation and the measurement of financial instruments are regulated
in detail in the Ministry of Finance Decree on recognition, measurement, presentation and
related disclosures of financial instruments, dated 12 December 2001 (“the decree”). The
decree was based on the versions of IAS 32 and IAS 39 applicable at that time, therefore the

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primary differences arising between Polish GAAP and IFRS in this respect results from
changes in IFRS that have been made since 2001.

Financial instruments are classified in one of the following categories:

- Financial assets or financial liabilities held for trading
- Loans granted and receivables
- Assets held to maturity
- Assets available for sale
- Other financial liabilities

Under IAS 39, financial instruments are initially recognised at fair value (generally including
transaction costs; IAS 39.43). Under Polish GAAP, financial assets are initially recognised at
cost and financial liabilities at fair value of the assets received (§ 13.1 of the Decree). In
practice this difference is unlikely to cause any major deviations.

Financial asset de-recognition

IAS 39 contains specific rules on financial asset de-recognition and financial liability de-
recognition (IAS 39.15 et. al.). Although the guidance on this issue is less comprehensive in
Polish GAAP than in IFRS, the same principles as in IFRS are followed. The asset is
derecognised when the entity no longer has control of it (§ 11 of the Decree). The Decree
includes almost the same de-recognition criteria as those in IFRS, and we do not expect any
differences having an impact on distributable profit in this regard.

Subsequent measurement of financial instruments (excluding derivatives)

Loans and receivables

Loans and receivables are carried at amortised cost according to IAS 39.46. If there is any
objective evidence that such a financial asset or group of financial assets is impaired, the
amount of the loss is measured as the difference between the asset’s carrying amount and the
present value of estimated future cash flows (excluding future credit losses that have not been
incurred) discounted at the financial asset’s original effective interest rate (i.e. the effective
interest rate computed at initial recognition; IAS 39.58/IAS 39.63 et. al.). Under IAS 39, the
assessment of impairments is done first “for financial assets that are individually significant,
and individually or collectively for financial assets that are not individually significant”. The
grouping is based on credit risk characteristics (IAS 39.64). A subsequent reversal of the
impairment may be required (IAS 39.65).

Under Polish GAAP, these assets are also carried at amortised cost (§16 of the Decree). There
are practically no differences between Polish GAAP and IFRS in this regard.

Held-to-maturity investments

Held-to-maturity Investments are also carried at amortised cost under IFRS (IAS 39.46) and
Polish GAAP (§16 of the Decree). The statements made under 4.3.1. are also true for held-to-
maturity investments.

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Financial instruments at fair value through profit or loss (excluding derivatives)

There are two ways of classifying a financial instrument. One is at fair value through profit or
loss and the other way is that the instrument is held for trading, i.e. normally short term profit
making, or the instrument is designated into this class of assets at initial recognition (the
possibilities of designation are limited; IAS 39.9 et. al.). Financial instruments in this category
are measured at fair value with fair value changes recognised in profit or loss (IAS 39.46 et.
al.).

Under Polish GAAP, there is no direct equivalent of “instruments at fair value through profit
or loss”. Only part of this category (instruments held for trading) is separated. There will be
no impact on distributable profits in relation to instruments held for trading. Other instruments
under Polish GAAP, which can be designated as fair value with changes through profit or loss
under IFRS, will need to be classified either as loans granted and receivables, held to
maturity, or assets available for sale.

Except for this presentation impact, the described difference between IFRS and Polish GAAP
will however impact distributable profits in relation to the valuation of items meeting the
definition of loans and receivables under Polish GAAP (and therefore measured as amortised
cost; refer to 4.3.1 above) or available-for-sale (and – although measured at fair values - the
changes in fair values may be accounted for directly in equity; refer to 4.3.4 below) that could
be designated through profit and loss under IFRS (i.e. measured at fair value, with changes
recognised in profit or loss).

Given the fact that the changes in fair value may either positively or adversely impact
distributable profits, no general statement can be made with regards to the direction of
differences between profits recognised under IFRS and under Polish GAAP in relation to
financial instruments classified as fair value through profit and loss.

Available-for-sale financial assets

Available-for-sale financial assets are carried at fair value. Changes in the fair value are
recognised directly in equity. Upon realisation of profits or losses, the gain or loss recognised
in equity is “recycled” through net profit or loss for the period (IAS 39.46 et. al.). “When a
decline in the fair value of an available-for-sale financial asset has been recognised directly in
equity and there is objective evidence that the asset is impaired …, the cumulative loss that
had been recognised directly in equity shall be removed from equity and recognised in profit
or loss …” (IAS 19.67 / for details see IAS 19.67 et. al.).

Under Polish GAAP, financial assets available for sale are also measured at fair value. Fair
value changes as at the year end may be recognised either in profit and loss or in the
revaluation reserve, depending on the accounting policy adopted by the entity (§ 21 of the
Decree).

There are specific rules for reversals of impairment losses under IFRS. For debt instruments,
the reversals impact profit or loss. For equity instruments, the increase in fair value impacts
equity (IAS 39.69 et. al.). Under Polish GAAP, a reversal of impairment loss is required and
is recognised in the profit and loss. The reversal of impairment loss may be made only up to
the value of financial assets at the date of the impairment loss reversal that would be used had
the impairment not taken place (§ 24.4 of the Decree).

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Financial liabilities

Financial liabilities are generally recorded at amortised cost under IFRS. The effective interest
method is applied (IAS 19.47). Financial liabilities, with the exception of those held for
trading (primarily derivative instruments), are recognised at amortised cost under Polish
GAAP (§ 18.1 of the Decree). Financial liabilities held for trading are measured at fair value,
as described above. The fair value option for financial liabilities other than those classified as
held for trading is not available under Polish GAAP.

Investments in subsidiaries, associates and joint ventures

IAS 27 applies to interests in subsidiaries, associates and joint ventures in individual financial
statements. These may be carried at cost or according to IAS 39 (IAS 27.37). If they are
carried according to IAS 39, they are principally to be regarded as available-for-sale financial
assets. In this respect please refer to 4.3.4. These investments may also be carried at cost.

Under Polish GAAP, interests in subsidiaries, associates and joint ventures are regulated
through the Accounting Act. Based on art. 28.1 of the Act, they are measured either at cost
less impairment losses, at fair value, or under the equity method, depending on the accounting
policy chosen and adopted by the entity.

There is an other “class” of financial assets as well which is carried at cost less impairment
loss under IAS 39: “investments in equity instruments that do not have a quoted market price
in an active market and whose fair value cannot be reliably measured …” (IAS 39.46 et.
al./IAS 39.AG80 et. al.). No such class of financial assets is mentioned under Polish GAAP.
However, given a broad range of accounting measurement methods allowable under Polish
GAAP (above), valuation of this item should not itself cause any differences between IFRS
and Polish GAAP, except for the issue of impairment losses and their reversals in relation to
this “class” of assets. Under IFRS reversal of any impairment loss recognised for this class of
assets is prohibited (IAS 39.66), while under Polish GAAP such an impairment loss may still
be reversed (the Act, art. 35c).

Accounting treatment of derivative financial instruments

Derivative financial instruments, as defined in IAS 39.9, are generally within the scope of
IAS 39. They are automatically classified as being traded and therewith as “at fair value
through profit or loss”. As described above, this mans that all derivative financial instruments
are recognised at fair value in an IFRS balance sheet and any change in the fair value of those
assets / liabilities is recognised within profit or loss for the period.

There will be no differences on the impacts on distributable profits between IFRS and Polish
GAAP in this regards since under Polish GAAP derivative financial instruments are classified
as financial assets/liabilities held for trading and measured at fair value, with fair value
changes recognised in profit or loss (§ 21 of the Decree).

Hedge accounting

IAS 39 distinguishes three kinds of hedging relationships: cash flow hedges, fair value hedges
and hedges of a net investment in a foreign operation130 (IAS 39.86). To be eligible to apply
130
Since cash flow hedges and fair value hedges are the most relevant kinds of hedging relationships in
individual financial statements only those will be analysed further.

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hedge accounting, several required prerequisites have to be fulfilled (IAS 39.88 et. al.). Under
Polish GAAP, the same hedging relationships are defined (§ 27 of the Decree).

Cash flow hedges are used to hedge potential variations in future cash flows. Any gain or loss
on a derivative hedging instrument is recognised directly in equity until the hedged item
affects profit or loss, directly or in the form of a basis adjustment of the hedged item (see IAS
39.88 / IAS 39.95 et. al.). Fair value hedges are used to hedge the risk of changes in the fair
value of a recognised asset or liability or a firm commitment. The gain or loss of the
derivative hedging instrument is recognised in profit or loss. In addition the hedged item is
revalued with respect to the hedged risk as well, and any results of this revaluation are also
recognised in profit or loss. Ideally the gain or loss of the hedging instrument is almost fully
offset by the loss or gain from the revaluation of the hedged item (see IAS 39.88 et. al.). The
hedge accounting requirements under Polish GAAP mirror the requirements of IAS 32 and
IAS 39 effective in 2001 and have not been updated since despite the evolution of these two
standards since that time. Accordingly, Polish GAAP, for example, does not allow fair value
hedges of firm commitments. In addition, the fair value option is not available in relation to
financial liabilities which may impact the application of hedge accounting in certain
circumstances. In addition, Polish GAAP does not address the use of hedge accounting from a
group perspective.

Given the nature of the IFRS / Polish GAAP differences and the optional application of hedge
accounting, no general statement can be made with regards to the direction of differences
between profits recognised under IFRS and under Polish GAAP in relation to hedge
accounting.

Specific rules on determining distributable profits

Specific rules on determining distributable profits are described in detail in point 1 of the
Introduction of this analysis.

Overall impact assessment on distributable profits

As mentioned above, a general statement on the impact on accumulated distributable profits

under Polish GAAP and IFRS with regard to financial instruments is impossible to make.
Generally there are no significant differences influencing the distributable profits, however it
is not possible to generalise the direction of the differences (i.e. whether the distributable
profits under Polish GAAP would be lower or higher than under IFRS due to the differences).

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5.3.4 Sweden

5.3.4.1 Introduction

The Companies Act (CA) provides rules for the maintenance of capital and the related matter
of profit distribution in Sweden. The main rule is that a company cannot return restricted
equity to its shareholders except by a reduction of capital sanctioned by the court. The CA
contains a number of restrictions for dividend distributions. A company may only distribute
unrestricted capital. A company is further restricted by the company’s capital requirements,
which are based on an assessment of the kind and scope of business. The distribution is also
restricted by the company’s liquidity, financial position and other aspects. A parent company
is also restricted by the group’s capital requirements, the group’s liquidity, financial position,
and other aspects.

What a company or group reports as unrestricted capital is governed by standards from

Redovisningsrådet (Swedish Financial Accounting Standards Council) or Bokföringsnämnden
(BFN, Swedish Accounting Standards Board) depending on the type of company it is.
Redovisningsrådet’s standards RR 1 – RR 29 must be applied by entities of such a size that
they attract public interest, but they are neither publicly listed nor do they voluntarily use
IFRS. The other unlisted companies must apply the standards according to BFN. Sometimes
the standards prescribe different rules for the separate or individual financial statements and
the consolidated financial statements. In addition, BFN’s standards sometimes prescribe
different rules for larger limited liability companies compared to smaller ones. Listed
companies and those applying IFRS voluntarily in the consolidated accounts must follow the
rules in RR 32 of the Redovisningsrådet in the individual financial statements. Subsidiaries
within a group applying IFRS in the consolidated financial statements may also apply RR 32
in the individual financial statements.

5.3.4.2 Investment property

Separate identification of investment property

RR 32 (for listed companies) refers to RR 24, which is Redovisningsrådet’s separate standard

for investment properties. However, companies applying Redovisningsrådet account for
investment properties in the same way as they do for owner-occupied properties. The
difference is simply the disclosures. BFN has no separate standard for investment properties.

Measurement of investment property

Initial measurement

Under Swedish GAAP, all property is initially measured at cost. There is generally no major
deviation in determining the cost of a purchased asset, except in cases where “costs of
dismantling and removing the item and restoring the site” form part of the cost of an asset
under IFRS. These costs are not included as costs of the asset according to Swedish GAAP
for separate or individual financial statements. With reference to borrowing costs, Swedish
GAAP has a free choice similar to that in IAS 23 “Borrowing cost” , where it is optionally
permitted to capitalise “borrowing costs” for qualifying assets. [A further analysis of this
subject appears to be of no further material merit.]

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Comparison of national accounting rules with the “Cost Model”

The cost model is the only alternative allowed according to Swedish GAAP. The component
approach is normally not applied as strictly as IFRS requires; normally the building is seen as
being only one component. (In the consolidated financial statements nearly all companies use
the fair value method.) The impact on profit and loss cannot be generally determined.

Redovisningsrådet has a standard on the impairment of assets, which is in agreement with

IAS 36. BFN has no standard on the impairment of assets.

BFN has issued an exposure draft on a range of accounting issues applicable to smaller
companies that might come into force as of the 1 January 2008. According to the draft, the
depreciation method, as well as the useful life of buildings, may be derived from tax rules and
in turn may be used for accounting purposes. This means that depreciation methods and the
useful life of an asset according to BFN may differ to those methods and terms that have to be
used under IFRS. The impact of the BFN method of accounting on profit or loss will mean
less profit than under IFRS.

By the end of June 2008, a governmental investigation will have been finished and may result
in a change in the tax and accounting rules that makes it possible for companies to apply the
fair value model in the separate or individual financial statements. However, that possibility
will only be a choice for publicly listed companies, for companies voluntarily applying IFRS
in their consolidated financial statements, and for subsidiaries of either of these types of
companies.

Comparison of national accounting rules with the “Fair Value Model”

As an alternative to the cost model, IAS 40 grants the option to measure all investment
property at fair value. The changes in fair value are recognised in profit or loss for the period
(IAS 40.33 et. al.).

A measurement at fair value is not an option under Swedish GAAP, see above. This means
that if fair values increase, the profit under IFRS exceeds the profit determined under Swedish
GAAP. If fair values decrease, the results under Swedish GAAP may be similar if the loss is
permanent (unlisted companies), or the losses recognised under IFRS may be the same
(companies following RR 32).

Specific rules on determining distributable profits

There are no rules in Sweden under which net income is modified in any predetermined way
in order to calculate how much the company can distribute to its shareholders. However, as
mentioned above, the company is not only restricted by the size of the unrestricted equity, but
also by the company’s capital requirements based on an assessment of the kind and scope of
business. The distribution is furthermore restricted by the company’s liquidity, financial
position and other aspects. A parent company is also restricted by the group’s capital
requirements, the group’s liquidity, financial position, and other aspects.

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Overall impact assessment on distributable profits

The impact on the net profit or loss arising from accounting deviations in the field of
investment property depends on several factors. The main factor is the change in fair value,
see above.

5.3.4.3 Defined benefit plans (DBP)

Identification of DBP and the need to recognise a provision

Under IAS 19 “Employee benefits”, a company has to recognise a “liability” (or an ”asset”)
for all defined benefit plans, no matter whether they are funded or unfunded and no matter
whether there is a legal or constructive obligation (IAS 19.49 et. al.).

Under the Swedish Annual Accounts Act (AAA), an entity has generally to provide for any
third-party obligations. However, AAA does not require an employer to account for its
pension liability. On the contrary, all significantly defined benefit pension plans (ITP and
similar) which are regulated by agreements between parties on the labour market, require the
employer to account for benefits on an accrual basis. Therefore, “pay-as-you-go” accounting
is available only to the extent that the employer has granted employees post-employment
benefits in excess of the nation-wide plans. Practice varies from company to company. If
accrual accounting is not applied, a contingent liability is disclosed. If entities do not
recognise a provision (liability), this generally increases the unrestricted equity. As stated
before, what a company can distribute is, however, also influenced by the company’s capital
requirements etc. The fact that the company has an obligation, even if it has not been
accounted for, has to be taken into consideration.

RR 32, dealing with accounting in the separate or individual financial statements for publicly
listed companies, refers to FAR SRS RedR4. This standard taken from FAR SRS is also
considered to be GAAP for unlisted companies. The standard states that the AAA does not
require accrual accounting, but the standard “strongly” recommends pension obligations to be
recognised.

Measurement of the (net) obligation

Valuation of the obligation

Under IFRS, the relevant measure of the obligation is defined as the “present value of a
defined benefit obligation” (DBO; IAS 19.6). This obligation is calculated by applying the so-
called “Projected Unit Credit Method” (IAS 19.64 et. al.). Furthermore several actuarial
assumptions – based on the market expectations at the balance sheet date – are needed to
calculate the DBO, for example (IAS 19.72 et. al):

Demographic assumptions
- Mortality
- Rates of employee turnover, disability and early retirement
- The proportion of plan members
with dependants who will be eligible for benefits

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Financial assumptions
- The discount rate (by reference to market yields at the
balance sheet date on high quality corporate bonds)
- Future salary and benefit levels (Medical benefits do not play a role in Sweden
and have therefore not been considered).

All Swedish companies are required to apply Tryggandelagen (a law about pensions) in the
separate or individual financial statements in order to gain tax deductions for their pension
costs. Tryggandelagen requires the present value of the defined benefit obligation to be
determined by assuming that at each balance sheet date the employee is entitled to a benefit
that can be established by pro-rating the years of actual service to the number of years from
vesting to retirement. This method is different from the Projected Unit Credit Method.

Unlike IFRS, specific actuarial assumptions to be used are stated in Tryggandelagen and also
in binding rules issued by the Swedish Financial Supervisory Authority (FI). The basis for
calculating the defined benefit obligation is the current level of salaries at the balance sheet
date, rather than also reflecting expected future salaries, as required by IAS 19. The actuarial
assumptions do not permit future salary increases to be taken into account.

The FI prescribes what discount rate is to be used. In previous years this discount rate was
below the discount rate for high quality corporate bonds, thus leading to a higher obligation
than under IFRS, when only referring to this factor.

The overall impacts of the different methods for determining the obligation cannot be
generalised.

Treatment of plan assets

IAS 19.7 defines plan assets as being assets that are held by a long-term employee benefit
fund or qualifying insurance policies. The main characteristics are that the respective funds
can only be used to pay benefits, that they are not available to the companies’ creditors (even
in bankruptcy), and that they generally cannot be returned to the entity. Plan assets are offset
with the DBO (IAS 19.54). IAS 19 also refers to reimbursement rights which cannot be offset
with the DBO but are otherwise treated in the same way (IAS 19.104A et. al.). Plan assets are
measured at fair value (IAS 19.54 / IAS 19.102 et. al.).

In Sweden, assets held by a pension fund can be returned to the employer only to reimburse
the employer for employee benefits already paid and only to the extent that they are in surplus
to what is required to meet the obligation to be paid by the fund. When determining to what
extent a surplus is available, assets are measured at fair value. Companies can have assets in a
pension fund in which the fair value of the assets is higher than the present value of the
pension liability. In these cases the company is not required to record this surplus as an asset
according to Swedish GAAP, even if they fulfil the requirements for doing so under IFRS.

Treatment of actuarial gains and losses

Under IFRS, actuarial gains or losses may arise. Actuarial gains or losses comprise
“experience adjustments (the effects of differences between the previous actuarial
assumptions and what has actually occurred); and … the effects of changes in actuarial
assumptions” (IAS 19.7). These gains and losses do not have to be recognised immediately. It
is permitted to apply the so-called “corridor approach”, which means that the amount of

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cumulated actuarial gains and losses exceeding the greater of 10% of the DBO and 10% of the
fair value of the plan assets has to be spread over the remaining working lives of the
employees. Any method leading to a faster recognition of the gains/losses is acceptable as
well (IAS 19.92 et. al.). Recently the IASB has added an additional option for the recognition
of the actuarial gains and losses. Optionally, it is allowed to recognise all actuarial gains and
losses immediately and directly in equity (retained earnings). No “recycling” of these gains
and losses through profit or loss in later periods is required or allowed (IAS 19.93A et. al.).

Unlike IFRS, Swedish GAAP does not defer recognition of actuarial gains and losses, as is
done for investment gains or losses by using a corridor or other deferred mechanism. This
means that any adjustments made to the provisions have to be recognised in profit or loss for
the year, i. e. neither the corridor approach nor the immediate recognition of actuarial gains or
losses directly in equity are allowed under Swedish GAAP.

If IFRS were to be applied in the separate or individual financial statements, then the effect on
distributable capital would depend on the circumstances: Is there a cumulative actuarial gain
or a cumulative actuarial loss? A gain means higher distributable capital under Swedish
GAAP. A change to IFRS and application of the corridor approach could lower the
distributable capital. However, as stated before, what a company can distribute is also
influenced by the company’s capital requirements, its liquidity, financial position, and other
aspects.

Specific rules for determining distributable profits

There are no rules in Sweden under which net income is modified in any predetermined way
to calculate how much the company can distribute to its shareholders. However, as mentioned
above, besides the size of the unrestricted equity the company is further restricted by the
company’s capital requirements based on an assessment of the kind and scope of business.
The distribution is also restricted by the company’s liquidity, financial position and other
aspects. A parent company is also restricted by the group’s capital requirements and the
group’s liquidity, financial position and other aspects.

Overall impact assessment on distributable profits

It is impossible to make a general statement on the impact on cumulated distributable profits

when comparing accounting treatments between Swedish GAAP and IFRS. There are several
– partly contradicting – tendencies. For example, the consideration of future salary and
benefit increases leads, on its own, to higher liabilities under IFRS; thus resulting in a
decrease in cumulated distributable profits. On the other hand, the recording of a surplus in
plan assets above the present value of the defined benefit obligation tends to increase
distributable profits under IFRS compared how they are accounted for under Swedish GAAP.
Furthermore, owing to several factors, the impact on distributable profits depends on the
individual circumstances, e.g. the discount rate applied or the method applied in recognising
actuarial gains or losses. Experience from several Swedish GAAP to IFRS conversion
projects in the past shows that it is impossible to say anything in general about the over all
effects.

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5.3.4.4 Financial instruments

Introduction to financial instruments

Swedish GAAP does not have a comprehensive accounting standard for financial instruments.
Publicly-listed-companies have to apply RR 32 in their separate or individual financial
statements. This means that they generally have to apply IAS 39, but there are exceptions due
to tax reasons and because the Annual Accounts Act (AAA) must be applied. This has the
result that a company can only measure a financial asset or a financial liability at fair value
through profit or loss under subparagraph b in IAS 39 paragraph 9 according to the
“Definition of Four Categories of Financial Instruments” if the AAA permits measurement of
a financial instrument at fair value. The AAA can also set restrictions on when to apply IAS
39 paragraph 11A.

According to the relationship between taxes and accounting, companies can choose not to
apply IAS 39 in some specific situations related to hedge accounting. If they decide not to
apply IAS 39 in these specific hedging situations, they have to apply Swedish GAAP and not
IAS 39 all kinds of financial instruments.

Non-listed companies, on the other hand, can choose between applying Swedish GAAP or an
option under the AAA, which is based on the version of IAS 39 that was issued in 2000. This
option means that companies can measure certain financial instruments at fair value. For some
financial instruments, fair value adjustments are recognised in profit or loss, and for other
financial instruments, those adjustments are recognised in equity with recycling. When
recognised in equity, they are included in unrestricted equity, which means that they are
distributable if the conditions for that have been fulfilled.

Identification and classification of financial instruments

Under IFRS, there is a broad definition for financial instruments. They include financial
assets and financial liabilities. Financial assets comprise debt as well as equity instruments (of
other entities). Financial instruments also include derivative financial instruments (see IAS
32.11). According to IAS 39, financial instruments have to be classified into the following
categories with a consequential effect on their accounting treatment (see IAS 39.9):

⇒ Loans and receivables

⇒ Held-to- maturity investments
⇒ Financial Instruments at fair value through profit or loss
⇒ Available-for-sale financial instruments
⇒ Financial liabilities

Amongst other exceptions, investments in subsidiaries, associates and joint ventures are not
within the scope of IAS 39 (IAS 39.2).

Under Swedish GAAP, measurement depends on classification. Swedish GAAP uses different
classification and measurement guidance than IFRS. Long-term investments are measured at
amortised cost. Financial assets classified as short-term investments are measured at the lower
of amortised cost or net realisable value. Financial liabilities generally are measured at
amortised cost. However, as mentioned above, the AAA includes an option to measure certain
financial instruments at fair value. For some financial instruments, fair value adjustments are

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recognised in profit or loss, and for other financial instruments, those adjustments are
recognised in equity.

Financial asset de-recognition

IAS 39 contains specific rules on financial asset de-recognition and financial liability de-
recognition (IAS 39.15 et. al.). Under Swedish GAAP, there is no specific guidance on this
issue.

Subsequent measurement of financial instruments (excluding derivatives)

Loans and receivables

Loans and receivables are carried at amortised cost according to IAS 39.46. If there is any
objective evidence that such a financial asset or group of financial assets is impaired, “the
amount of the loss is measured as the difference between the asset’s carrying amount and the
present value of estimated future cash flows (excluding future credit losses that have not been
incurred) discounted at the financial asset’s original effective interest rate (i.e. the effective
interest rate computed at initial recognition; IAS 39.58/IAS 39.63 et. al.). Under IAS 39, the
assessment of impairments is first done “for financial assets that are individually significant”,
and then “individually or collectively for financial assets that are not individually significant”.
The grouping is based on credit risk characteristics (IAS 39.64). A subsequent reversal of the
impairment may be required (IAS 39.65).

Under Swedish GAAP, loans and receivables that are classified as long-term investments
(fixed assets) are measured at amortised cost. If they are classified as short-term investments,
they are measured at the lower of amortised cost or net realisable value. For long-term
investments, impairment has to be recognised if it is permanent. The impairment test is to be
done item by item.

Loan receivables and receivables that are derived by the company and are not held for trading
are not covered by the option under the AAA, i.e. cannot be measured at fair value.

Held-to-maturity investments

Held-to-maturity Investments are also carried at cost (IAS 39.46).

Held-to-maturity Investments are generally fixed assets under Swedish GAAP, see above,
thus they cannot be measured at fair value.

Financial instruments that are held-to-maturity instruments and have not been designated as
hedging instruments are not covered by the option under the AAA, thus they cannot be
measured at fair value.

Financial instruments at fair value through profit or loss (excluding derivatives)

There are two ways of classifying a financial instrument at fair value through profit or loss.
One way is that the instrument is held for trading, i. e. normally short-term profit making, or
the instrument is designated into this class of assets at initial recognition (the possibilities of
designation are limited; IAS 39.9 et. al.). Financial instruments in this category are measured
at fair value with fair value changes recognised in profit or loss (IAS 39.46 et. al.).

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As mentioned above, the AAA includes an option for measuring certain financial instruments
at fair value. If the option is chosen, then it must be applied to all financial instruments
covered by the option. The option does not apply to financial liabilities unless they are held
for trading or are a derivative.

Available-for-sale financial assets

Available-for-sale financial assets are carried at fair value. Changes in the fair value are
recognised directly in equity. Upon realisation of profits or losses, the gain or loss recognised
in equity is “recycled” through net profit or loss for the period (IAS 39.46 et. al.). “When a
decline in the fair value of an available-for-sale financial asset has been recognised directly in
equity and there is objective evidence that the asset is impaired …, the cumulative loss that
had been recognised directly in equity shall be removed from equity and recognised in profit
or loss …” (IAS 19.67 / for details see IAS 19.67 et. al.). [It is assumed that the gains and
losses recognised in equity have no impact on distributable profits!]

Under Swedish GAAP, the measurement depends on whether it is a short-term or long-term

investment (see above). Regarding impairment, see above.

If the option to measure at fair value under the AAA is chosen, then companies can choose to
recognise the fair value adjustments either in profit or loss or in equity. The companies have
to be consistent in their choice.
When the fair value adjustments are recognised in equity, they are included in unrestricted
equity, which means that they are distributable if the conditions for that have been fulfilled.

Financial liabilities

Financial liabilities are generally recorded at amortised cost under IFRS. The effective interest
method is applied (IAS 39.47).

Under Swedish GAAP, financial liabilities are generally measured at amortised cost.

The option under the AAA to measure at fair value is not applicable to financial liabilities,
except for those liabilities that are included in a trading portfolio or are hedging instruments.

Investments in subsidiaries, associates and joint ventures

IAS 27 applies to interests in subsidiaries, associates and joint ventures in individual financial
statements. These may be carried at cost or according to IAS 39 (IAS 27.37). If so, they are
principally to be regarded as available-for-sale financial assets.

Under Swedish GAAP, interests in subsidiaries, associates and joint ventures are carried at
cost. The option under the AAA to measure at fair value is not applicable. In addition publicly
listed companies that apply RR 32 have to carry these kinds of investments at cost.

Accounting treatment of derivative financial instruments

Derivative financial instruments, as defined in IAS 39.9, are generally within the scope of
IAS 39. They are automatically classified as being traded and thus are accounted for “at fair
value through profit or loss”. As described above, this means that all derivative financial

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instruments are recognised at fair value in an IFRS balance sheet, and any change in the fair
value of those assets / liabilities is recognised within profit or loss for the period.

Under Swedish GAAP, all derivatives other than those designated as hedges are recognised in
the balance sheet and measured at the lower of cost or at net realisable value. The lower of
cost or net realisable value concept may be applied on a portfolio basis for marketable
securities.

However, the AAA includes an option for measuring derivatives at fair value. The changes in
fair value are to be recognised in profit or loss.

Hedge accounting

IAS 39 distinguishes three kinds of hedging relationships: cash flow hedges, fair value hedges
and hedges of a net investment in a foreign operation131 (IAS 39.86). To be eligible to apply
hedge accounting, several strict prerequisites have to be fulfilled (IAS 39.88 et. al.). Cash
flow hedges are used to hedge (potential) variations in future cash flows. Any gain or loss on
a (derivative) hedging instrument is recognised directly in equity until the hedged item affects
profit or loss. When this happens, the gain or loss of the hedging instrument is accounted for
either directly in profit or loss or in the form of a basis adjustment of the hedged item (see
IAS 39.88 / IAS 39.95 et. al.).

Fair value hedges are used to hedge the risk of changes in the fair value of a recognised asset
or liability or a firm commitment. The gain or loss of the (derivative) hedging instrument is
recognised in profit or loss. In addition, the hedged item is revalued with respect to the
hedged risk as well, and any results of this revaluation are also recognised in profit or loss.
Ideally the gain/loss of the hedging instrument is (almost) fully offset by the loss/gain made
by revaluing the hedged item (see IAS 39.88 et. al.).

Under Swedish GAAP, fair value hedges, cash flow hedges and hedges of a net investment in
a foreign entity are applicable. Guidance on hedge accounting is limited, and there are no
explicit rules for documenting and testing hedge effectiveness. Therefore some hedges that
qualify for hedge accounting under Swedish GAAP but may not qualify under IFRS. Just as
in IFRS, the type of hedge accounting applied depends on whether the hedged exposure is a
fair value exposure, a cash flow exposure or a currency exposure on a net investment in a
foreign operation. However, hedge accounting is applied differently under Swedish GAAP,
and hedges of future transactions are generally off the balance sheet until the hedged
transaction occurs.

Specific rules for determining distributable profits

There are no rules in Sweden under which net income is modified in any predetermined way
for calculating how much the company can distribute to its shareholders. However, as has
already been mentioned (see Introduction), the company is not only restricted by the size of
the unrestricted equity, but also by the company’s capital requirements based on an
assessment of the kind and scope of business. The distribution is also restricted by the
company’s liquidity, financial position, and other aspects. A parent company is also restricted
by the group’s capital requirements, the group’s liquidity, financial position, and other
aspects.
131
Since cash flow hedges and fair value hedges are the most relevant kinds of hedging relationships in single
financial statements only those will be analysed further.

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When fair value adjustments are recognised in equity, they are included in unrestricted equity,
which means that they are distributable if the conditions for that have been fulfilled.

Overall assessment of the impact on distributable Profits

The impact on distributable profits arising from deviations in the field of financial instruments
depends, amongst other things, on whether a company applies the option under the AAA or
not. If the option is applied, the impact on distributable profits compared to IFRS is not as
huge as when the option is not applied. To sum up, it is not possible to make a general
statement on the impact on distributable profits between the differing accounting treatments
according to either Swedish GAAP or to IFRS.

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5.3.5 United Kingdom

5.3.5.1 Overview of UK legal position on distributable profits

Before considering the impact of accounting under UK GAAP and IFRS in the three selected
areas on distributable profits, it is necessary to outline, in broad terms, the legal framework
which is used within the UK in order to determine what constitutes distributable profits.

The earned surplus test

UK companies legislation, in section 263(3) of the Companies Act 1985 (or s830(2) of the
Companies Act 2006 when it is implemented to replace the Companies Act 1985), defines a
company’s profits available for distribution as “its accumulated, realised profits, so far as not
previously utilised by distribution or capitalisation, less its accumulated, realised losses so far
as not previously written off in a reduction or reorganisation of capital duly made”. Realised
profits and losses are defined as “such profits or losses of the company as fall to be treated as
realised in accordance with principles generally accepted, at the time when the accounts are
prepared, with respect to the determination for accounting purposes of realised profits or
losses”.

Section 270 of the Companies Act 1985 (s836 of the Companies Act 2006) requires a
company’s individual accounts to be used as the basis for determining the amount of a
distribution which can be made, but is only the starting point.

Under UK Companies legislation, there is only a requirement for the consolidated accounts of
listed companies to be prepared using IFRSs adopted by the EU. There is an option, but not a
requirement, to prepare other accounts, including individual accounts, using IFRSs adopted
by the EU, subject to certain provisions regarding the consistency of framework used for
individual accounts within a group.

A number of key points should be noted as arising from the legal requirements:

• The starting point for the determination of distributable profits is taken as being
the published accounts.
• This encompasses those companies which prepare their individual accounts under
IFRS as well as those applying UK GAAP (including those UK GAAP preparers
which have been required to, or have taken the option, to apply FRS 26 (the UK
Accounting Standard which largely mirrors IAS 39). It should also be noted that
some profits are specifically considered to arise in law, even though they are not
recognised as such in accounting (e.g. capital contributions).
• There are some accounting profits or losses which are not considered to be profits
or losses in law (e.g. interest on share capital which is considered as debt under
IAS 32)
• Not all profits are necessarily realised.

It is apparent from the words “falls to be treated as realised” (rather than simply “realised”)
that the concept of a realised profit is intended to be dynamic.

The Institute of Chartered Accountants in England and Wales (ICAEW) and the Institute of
Chartered Accountants of Scotland (ICAS) jointly issue guidance, in the form of technical
releases, regarding what constitutes distributable profits and the interpretation of “realised

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profits”. Such Guidance is regarded as authoritative as to how principles referred to in the Act
should be interpreted at the current time. Current ICAEW/ICAS Technical Releases in issue
in respect of distributable profits are as follows:

ƒ Tech 02/07 – Distributable Profits: Implications of recent accounting changes

ƒ Tech 64/04 – Guidance on the effect on realised and Distributable Profits of
Accounting for Employee Share Schemes in Accordance with UITF Abstract 38
and Revised UITF Abstract 17
ƒ Tech 50/04 – Guidance on the effect of FRS 17 ‘Retirement Benefits’ and IAS 19
‘Employee Benefits’ on realised profits and losses.
ƒ Tech 07/03 (revised 2007) – Guidance on the determination of realised profits and
losses in the context of distributions under the Companies Acts 1985

Under UK common law, a company cannot lawfully make a distribution out of capital. In
addition, directors are subject to fiduciary duties in exercise of the powers conferred on them.
The directors must therefore consider, amongst other things, whether the company will still be
solvent following a proposed distribution. The directors should therefore consider both the
immediate cash flow implications of a distribution and the continuing ability of a company to
pay its debts as they fall due.

It should be noted that although distributable profits are based upon published accounts, the
legal requirement for distributable profits to be “realised” is making the use of accounting as
the basis for determining distributable profits increasingly problematic, as accounting under
both UK GAAP and IFRS is moving away from the concept of realisation as a recognition
test.

It should also be appreciated that the legal requirement to base distributable profits on those
which are realised in response to the original EU 2nd and 4th CLD (77/91/EEC and
77/660/EC). Article 15 of the 2nd CLD contains the requirement that distributions to
shareholders may not exceed the amount of “profits” at the end of the last financial year end
plus any profits brought forward and sums drawn from reserves available for the purpose, less
any losses brought forward and sums placed to reserve in accordance with law or statutes.
With regard to defining what constitutes “profits” in this context, reference is made to Article
31, paragraph 1 (c) of the 4th CLD which only permits “profits made” to be reflected in the
asset valuations that flow through the profit and loss account, and reference to the original
French text, makes it clear that “profits made” in this context are meant to be “realised
profits”. This is further referred to by Article 33, paragraph 2(c) of the 4th CLD which makes
it clear that no part of a revaluation reserve may be distributed, either directly or indirectly,
unless it represents gains actually realised. Taking all of this together, a distinction has been
drawn between the different types of profits/gains made, viz those that are realised and
available for distribution and those that are not.

The net assets test

A further restriction is placed on distributions by public companies under section 264 of the
Companies Act 1985 (section 831 of Companies Act 2006), reflecting the requirements of the
2nd CLD. A public company is only allowed to make distributions if after the distribution has
taken place, the amount of its net assets is not less than the aggregate of its called up share
capital and undistributable reserves as shown in its accounts.

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The following are undistributable reserves:

- share premium account;

- capital redemption reserve;
- the excess of accumulated unrealised profits, so far as not previously utilised by
capitalisation, over the accumulated unrealised losses, so far as not previously written
off in a reduction or reorganisation of its share capital; and
- any other reserve which the company is prohibited from distributing by any
enactment, or by its memorandum or statutes (or equivalent).

This means that, in calculating the amount available for distributions, a public company must
deduct from the amount of its net realised profits the amount of its net unrealised losses.

Once again, the basis – or starting point – for the application of this test is amounts as stated
in the individual accounts (section 270 of Companies Act 1985, section 836 of the Companies
Act 2006).

Realised profits - the general principles

The basic principle as to what constitutes realised profits is set out in Paragraph 10 of Tech
07/03 and is in turn based upon the UK Accounting Standard FRS 18: Accounting policies,
which sets out the generally accepted principle that profits are only realised when in the form
of “cash or other assets the ultimate cash realisation of which can be assessed with reasonable
certainty”. FRS 18 also states that in this context “realised may also encompass profits
relating to assets that are “readily realisable”.

Based upon this general principle, Tech 07/03 (as revised in 2007) details a number of
specific circumstances in which it considers profits to be realised.

- a transaction where the consideration received by the company is 'qualifying

consideration', or
- the recognition in the financial statements of a change in fair value, in those cases
where fair value has been determined in accordance with the fair value measurement
guidance in the relevant accounting standards, and to the extent that the change is
‘readily convertible to cash’.
- the translation of:
- a monetary asset which comprises qualifying consideration, or
- a liability
denominated in a foreign currency, or
- the reversal of a loss previously regarded as realised, or
- a profit previously regarded as unrealised (such as amounts taken to a revaluation
reserve, merger reserve or other similar reserve) becoming realised as a result of:
- consideration previously received by the company becoming 'qualifying
consideration', or
- the related asset being disposed of in a transaction where the consideration received
by the company is 'qualifying consideration', or
- a realised loss being recognised on the scrapping or disposal of the related asset, or
- a realised loss being recognised on the write-down for depreciation, amortisation,
diminution in value or impairment of the related asset,

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- the distribution in specie of the asset to which the unrealised profit relates, in which
case the appropriate proportion of the related unrealised profit becomes a realised
profit; or
- the receipt of a dividend in the form of qualifying consideration when no profit is
recognised because the dividend is deducted from the book value of the related
investment (e.g. as required by IAS 27 in the case of dividends out of the pre-
acquisition profits of subsidiaries)

The above criteria for the recognition of realised profits apply irrespective of whether the
accounts are prepared under UK GAAP or IFRS (Para 11 of Tech 7/03).

It should be noted that the guidance considers that “realised profits” may arise irrespective of
whether they have been recognised through the profit and loss account or directly in reserves.
This is of particular relevance when considering fair value accounting when fair value gains
may be directly recognised in the available for sale or similar reserves.

Qualifying consideration

As can be seen, a key concept underlying realised profits is that of “qualifying consideration”.
For this purpose “qualifying consideration” is defined as comprising:

- cash, or
- an asset that is readily convertible to cash (see definition below), or
- the release, or the settlement or assumption by another party, of all or part of a
liability of the company, unless
- the liability arose from the purchase of an asset that does not meet the definition of
qualifying consideration and has not been disposed of for qualifying consideration,
and
- the purchase and release are part of a group or series of transactions or arrangements
that fall within Paragraph 12(*) of this guidance; or
- an amount receivable in any of the above forms of consideration where:
- the debtor is capable of settling the receivable within a reasonable period of time;
and
- there is a reasonable certainty that the debtor will be capable of settling when called
upon to do so; and
- there is an expectation that the receivable will be settled.

(Paragraph 18, Tech 07/03)

*This requires that when assessing whether a company has a realised profit, transactions and
arrangements should not be looked at in isolation. A realised profit will only arise where the
overall commercial effect on the company satisfies the definition of a realised profit set out in
the guidance. Thus a group or series of transactions or arrangements should be viewed as a
whole, particularly if they are artificial, linked (whether legally or otherwise) or circular. The
aim of this provision is to ensure that profits which are in reality ‘unrealised’ are not treated
as ‘realised’. This ‘anti-avoidance’ provision is in practice, likely to be of application more in
the case of intra-group transactions.

In situations, where an asset is sold partly for qualifying consideration and partly for other
consideration (for example, a mixed consideration of cash and a freehold property), any profit
arising is a realised profit to the extent that the fair value of the consideration received is in

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the form of qualifying consideration. This approach is sometimes referred to as 'top-slicing'.

(Example: fair value of consideration received is 10, of which 4 is cash and 6 is freehold
property. If the depreciated historical cost of the asset sold is 5, the total gain is 5 but the
realised profit is limited to 4.)

Readily convertible to cash

As can be seen from the above, it is particularly important when considering whether changes
in fair value give rise to realised profits to determine if the change recognised is “readily
convertible to cash”. For this purpose “readily convertible to cash” is defined as follows:

An asset, or change in the fair value of an asset or liability, is considered to be “readily

convertible to cash” if:

- a value can be determined at which a transaction in the asset or liability could occur, at
the date of determination, in its state at that date, without negotiation and/or
marketing, to either convert the asset, liability or change in fair value into cash, or to
close out the asset, liability or change in fair value; and

- in determining the value, information such as prices, rates or other factors that market
participants would consider in setting a price is observable; and

- the company’s circumstances must not prevent immediate conversion to cash or close
out of the asset, liability or change in fair value; for example, the company must be
able to dispose of, or close out the asset, liability or the change in fair value, without
any intention or need to liquidate, to curtail materially the scale of its operations, or to
undertake a transaction on adverse terms.

(Paragraph 19, Tech 07/03)

Realised losses

Accounting losses should be regarded as realised losses except to the extent that the law,
accounting standards, or the provisions of Tech 07/03 provide otherwise.

A loss that represents the reversal of an unrealised profit does not lead to a reduction of
cumulative realised profits. Even if the loss is treated as a realised loss, for example because it
represents an impairment, the unrealised profit will become realised in such situations.

Cumulative net losses arising on fair value accounting are considered to be unrealised only if
both the profits on remeasurement of the same asset or liability would be unrealised and the
losses would not have been recorded other than pursuant to fair value accounting.

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Amounts recognised as realised profits as a matter of law

There are certain amounts which may, as a matter of law, be regarded as profits even though
they would not necessarily be reflected as accounting profits. Such profits then need to be
tested as to whether they are realised. These include the following:

• Gratuitous contributions of assets from the owners in their capacity as such , which
as they represent transactions with shareholders in their capacity as such do not
constitute profits under either the UK GAAP or IFRS accounting frameworks. Any
contribution received would need to be tested to ensure that it meets the definition
of “qualifying consideration” before it could be considered as a realised profit.
• Amounts that are taken to a so-called “merger reserve” reflecting the extent that
relief is obtained under sections 131 or 132 of the Companies Act 1985 from the
requirement to recognise a share premium account. Under UK companies’
legislation, when share for share transactions are used for acquiring at least 90% of
the equity share capital of a non group company or for group reorganisation, then
it is possible, in some circumstances, to allocate part of the amount recorded for
the new equity issued to a “merger reserve” rather than to the share premium
account (which would be non-distributable). The amounts initially recognised in
the “merger reserve” will initially represent an unrealised profit and therefore are
not to be available for distribution. They will however be considered as being
subsequently realised if for example the original investment acquired is disposed
of for qualifying consideration, a realised loss is recognised as a result of the
investment being impaired or if a dividend is received which is paid of the pre-
acquisition profits of the investee.
• (*)A reduction or cancellation of capital (ie, share capital, share premium account
or capital redemption reserve) which results in a credit to reserves where the
reduction or cancellation is confirmed by the court, except to the extent that, and
for as long as, the company has undertaken that it will not treat the reserve arising
as a realised profit, or where the court has directed that it shall not be treated as a
realised profit, or
• (*)A reduction or cancellation of capital (ie, share capital, share premium account
or capital redemption reserve) which is undertaken by an unlimited company
without confirmation by the court and which results in a credit to reserves, in
which case the amount so credited represents a realised profit to the extent that the
consideration received for the capital:

• was qualifying consideration; or

• has subsequently become qualifying consideration; or
• has subsequently been written off (for example, by way of depreciation) and the
loss arising has been treated as realised; or
• was originally paid up either by a capitalisation of realised profits or by a
capitalisation of unrealised profits or reserves which, had they not been
capitalised, would subsequently have become realised.

(*) Expected to be changed when the Companies Act 2006 and related statutory instruments
all come into force; it is expected that the instruments will provide that all reserves arising
from capital reductions are, as a matter of statute law, to be regarded as realised profits
(unless, e.g. the court orders otherwise).

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Linked transactions

As noted above, when considering qualifying consideration, it is important to emphasise that

when looking at transactions and arrangements which are linked, (which may often be the
case with intra-group transactions but is not confined to such transactions) the approach
adopted when considering whether any gains or losses arising are realised is to assess the
overall impact of the linked transactions, rather than looking at separate transactions in
isolation.

We will now consider how the general requirements and further specific guidance set out in
Technical releases is applied to determine the impact on UK distributable profits of
accounting for investment properties, defined benefit pension schemes and fair value
accounting. In each case, there will also be a short assessment of how the accounting
requirements of UK GAAP and IFRS differ in each area, followed by an analysis as to the
extent of such profits and losses being realised.

5.3.5.2 Investment property

How UK GAAP (SSAP 19) differs from IAS 40

The UK GAAP standard relating to Investment Properties, SSAP 19, has a number of
differences from IAS 40: Investment Properties, of which the most significant is that IAS 40
allows a choice between using either a fair value through profit and loss or a cost model,
while SSAP 19 requires investment properties to be carried at open market value, with no
depreciation charged (except for short leases). Under SSAP 19, in contrast to IAS 40, no
changes in the value of the investment property, other than permanent diminutions, are
reflected though profit and loss but are instead credited or charged directly through the
statement of total recognised gains and losses (STRGL, the equivalent of the IFRS SORIE) to
an investment revaluation reserve within shareholders’ equity. Under UK GAAP, permanent
diminutions are charged through the profit and loss account.

Other areas where UK GAAP differs significantly from IAS 40 include the following:

• Although the definition of an investment property is similar to IAS 40, it is also

necessary that any rental income be negotiated on an arm’s length basis.
• Property leased within a group cannot be investment property in either the single
entity or group accounts. IAS 40 would require the property to be treated as an
investment property in the single entity accounts but as owner occupied in the
consolidated accounts.
• Leasehold property that meets the definition of an investment property is treated as
such under SSAP 19. There are no specific additional requirements for such
properties. Under IAS 40, if a property is held by a lessee under an operating lease,
it may be classified as an investment property if the rest of the definition of
investment property is met and if the lessee measures all its investment properties
at fair value.
• Under UK practice, a portion of a dual-use property need not be capable of
separate disposal to be classified as an investment property, as is required under
IAS 40 subject to the portion of the property used for own use being insignificant.
• Investment properties are not depreciated under SSAP 19, except that investment
properties held on leases may be depreciated and must be depreciated if the
unexpired term of the lease is 20 years or less. Under IAS 40, depreciation is only

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permitted when using the cost model, and in such cases is determined in
accordance with IAS 16.

Guidance on realised profits/losses

Recognised gains on investment properties are not considered as realised profits regardless of
whether they are recognised in the income statement in accordance with IAS 40 or through
the STRGL in accordance with SSAP 19. The ICAEW/ICAS Guidance permits changes in the
fair value of assets determined in accordance with fair value measurement guidance in
relevant accounting standards to be treated as realised profits, subject to the condition that the
change recognised is readily convertible to cash. However, in the case of investment property
any increase in the fair value of investment property would not, in nearly all circumstances,
be considered as readily convertible to cash since a period of marketing and/or negotiation
would be required to dispose of the property, and therefore it would not be considered as
being readily convertible to cash at the date of determination. The exception to this principle
would be in rare cases when the process of marketing and negotiation is complete at the date
of determination and legal completion of the disposal occurs shortly afterwards.

Under both UK GAAP and IFRSs, any write down or impairment of an investment property
below the amount recognised initially would be considered to be a realised loss, and any
subsequent reversal of such a write down or impairment would be considered as a realised
profit to the extent that it did not exceed cumulative realised losses already recognised on the
property.

The only situation where IFRS and UK GAAP will give rise to a different level of realised
profits in respect of investment properties, will be where a company preparing IFRS accounts
adopts the cost model and the property is therefore subject to depreciation, which is
considered to be a realised loss which reduces the level of realised profits. Under UK GAAP,
depreciation is not ordinarily charged on investment property, and hence there would be no
resulting reduction in the level of realised profits. Overlaid over this, however, is the point
that in some cases IFRS will classify more properties as investment property and in some
cases fewer properties.

5.3.5.3 Defined benefit schemes

How UK GAAP (FRS 17) differs from IAS 19

The UK standard relating to the accounting for defined benefit pension schemes, FRS 17
Retirement benefits, is consistent with IAS 19 in most respects. The significant differences
are as follows:

• FRS 17 requires actuarial gains and losses to be recognised immediately, in full, in the
STRGL. IAS 19 allows a similar treatment with actuarial gains/losses being
recognised in SORIE, but also permits an option for actuarial gains/losses which
exceed a “corridor” to be recognised in profit or loss over the average remaining
working life of the employees in the plan, with faster recognition being allowed on a
systematic basis.
• Plan assets that are quoted securities are valued at mid market price under FRS 17.
This contrasts with the practice under IFRSs that the fair value of quoted securities
after initial recognition should be based on bid price. With effect from periods

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commencing on or after 6 April 2007, FRS 17 is to be amended so that quoted

securities are required to be valued on the same basis as IAS 19.
• A wider multi-employer exemption is permitted under FRS 17 than under IAS 19.
Multi-employer plans are plans that pool the assets contributed by various entities to
provide benefits to employees of more than one entity. In addition to the exemption
under IAS 19, which allows employers participating in multi-employer defined benefit
schemes to use defined contribution accounting where there is insufficient information
to allow the employer to identify its share of the underlying assets and liabilities in the
scheme, FRS 17 also allows such accounting when the individual employers’
contributions are set in relation to the current service period only, i.e. they are not
affected by any surplus or deficit in the scheme relating to past service of its own
employees or any other members of the scheme.
• In situations where there is a contractual agreement between a multi-employer plan
and its participants that determines how the surplus in the plan will be distributed (or
the deficit funded), IAS 19 requires that participants which account for the plan on a
defined contribution basis are also required to recognise the asset or liability that
arises from the contractual agreement and the resulting income or expense in profit
and loss. There is no equivalent provision within FRS 17.
• Under IAS 19, unlike FRS 17, employer defined benefit schemes which cover
members of the same group, or other entities under common control, cannot be
considered to be multi-employer schemes. In the case of such common control
schemes, it is still possible for individual group members to use defined contribution
accounting in their accounts if certain conditions are met, but in such situations the
group company that is legally the sponsoring employer for the plan would be required
to reflect the defined benefit cost for the entire scheme (net of any contributions
receivable) and to reflect the overall scheme surplus/deficit on its balance sheet. Thus
in the UK it is possible that no individual company in a group adopts defined benefit
account, but under IFRS one of them must do so. As will be seen, this is likely to have
a significant impact on the level of realised profits of that particular company.
• There is no equivalent to IFRIC 14 under UK GAAP. Under IAS 19, scheme surpluses
may only be recognised to the extent that it is possible to recover a surplus either
through reduced contributions in the future or through refunds from the scheme.
Under IFRIC 14, the recognition of a surplus in a scheme is restricted to the extent
that there is an unconditional right to a refund from the scheme and/or a reduction in
future contributions. UK schemes will not necessarily have an unrestricted right to a
refund and/or a reduction in future contributions because the agreement of the scheme
trustees may be required beforehand. In the cases where there are minimum funding
requirements, such as might be imposed in the UK by the pensions regulator, IFRIC
14 might also give rise to the requirement to recognise an additional liability, akin to
an onerous contract, which would be above and beyond the liability which would be
required to be recognised under IAS 19.

Guidance on realised profits/losses

In order to establish the impact that a defined benefit scheme surplus or deficit has on a
company’s realised profits under both FRS 17 and IAS 19, it is necessary to:
1) Establish the extent to which a cumulative net debit or credit taken to reserves in respect
of a pension scheme is realised or unrealised; and
2) Identify the cumulative net gain or loss taken to reserves in respect of the pension surplus
or deficit.

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Status of a net cumulative debit or credit

A cumulative net debit in reserves in respect of a pension scheme is considered to be a

realised loss as it results from the creation of, or increase in, a provision for a liability or loss
resulting in an overall reduction in net assets. A cumulative net credit in reserves in respect of
a pension scheme only constitutes a realised profit to the extent that it is represented by an
asset agreed to be recoverable by agreed refunds and that the refunds will take the form of
qualifying consideration. To the extent that a cumulative net credit to reserves exceeds any
such agreed refunds, it is unrealised, but it becomes realised in future periods to the extent
that it offsets subsequent net debits to reserves being recognised as realised losses in respect
of the pension scheme (i.e. as the cumulative net credit reduces).

Determining the amount of the cumulative debit or credit

Although the various elements making up the change in the overall defined benefit asset or
liability are disclosed separately and in different performance statements, it is the net cost that
is taken to represent the cost to the company of its pension promise. Thus it is the cumulative
net gain or loss taken to reserves that falls to be classified as realised or unrealised. There is
no need to distinguish that cumulative balance between amounts charged or credited to profit
and loss and those recognised in the STRGL/SORIE (dependent on the framework being
used). This is demonstrated by the following example in respect of a scheme set up at the start
of the year.

For simplicity, current and deferred tax is ignored. The scheme has a surplus of 4 at the end of
the year that would be reported on the company's balance sheet as an asset, BUT there has
been a cumulative charge of 16 to reserves that would fall to be treated as realised.

Figure 5.3 -1: Example deferred taxes (UK)

Increase/ (Reduction) in Amount debited/
(decrease) in cash balance (credited) to
pension asset reserves

B/F 0
Debited to profit and loss (20) 20
account
Credited to STRGL 4 (4)
Contributions paid 20 (20) -
C/F 4 (20) 16

The net effect on the balance sheet in the above example is:

DR CR
Debit
Pension asset 4
Debit Reserves 16
Credit Cash 20

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It is the cumulative loss of 16 in the above example that has been debited to reserves in
respect of the pension scheme that falls to be assessed as realised or unrealised, rather than
any notional "credit" relating to the asset of 4.

The cumulative net gain or loss taken to reserves, and which needs to be considered in
determining realised profits/losses, will differ from the balance sheet asset/liability recognised
as a result of any contributions paid to, or more rarely refunds from, the scheme and any
scheme asset/liability introduced to the company as a result of a business acquisition/scheme
transfer. A consequence of this is where there is a surplus on a scheme, it is not readily
possible to identify how much of the surplus can be considered as representing realised or
unrealised profits.

It should also be noted that for companies applying IFRS that the cumulative net gain or loss
taken to reserve will need to take into account the affect of any adjustments required by
IFRIC 14, and hence may result in the recognition of a smaller cumulative net gain or a larger
cumulative loss than might be the case under UK GAAP.

In practice, it can be difficult to identify past cumulative contributions paid to the scheme
and/or the impact of business acquisitions especially in the case of long standing company
pension schemes. This is particularly the case since the accounting required by FRS 17/IAS
19 is a relatively recent introduction within the UK, and hence it is often not practical to
identify how much of a scheme surplus/deficit recognised on implementation of FRS 17/IAS
19 could be considered to represent realised profits/losses arising from the cumulative impact
of net gains or losses taken to reserves determined on the basis of FRS 17/IAS 19. In order to
address this problem, the ICAEW/ICAS Guidance permits an alternative approach, whereby
the cumulative net credit or debit in reserves for a pension scheme at the transition date to
FRS 17/IAS 19 is taken as being equal to the amount of the surplus or deficit recognised
before taking account of deferred tax, adjusted for:

- Identified cumulative net contributions less any refunds (which it is assumed will
always be identifiable given their rare occurrence); and
- In the rare cases in which the company has recognised a pension asset or liability in its
individual accounts (e.g. on the acquisition of an unincorporated business or a scheme
transfer), the amount initially recognised.

The alternative approach is prudent in that its effect will be to understate realised losses (or to
overstate unrealised profits) on the adoption of FRS 17/IAS 19, when compared with the
precise effect (see example below). If the estimate of realised losses is understated, compared
with the precise effect, then this has the effect on restricting the amount of realised profits that
may be recognised in the future on the basis that they represent a reversal of previously
realised losses.

For example, in its December 2005 financial statements, a company adopts IAS 19 in full. It
wishes to determine its realised or unrealised reserves as at that date of switching from the
previous UK standard to IAS 19. Its total net contributions made to the scheme since it started
were 90. The scheme has an IAS 19 surplus of 20 at 30 June 2005, and there is no ceiling on
the company's ability to recognise this amount as an asset.
If the company is able to identify the entire 90 of contributions, under the precise approach
the effect of IAS 19 on the company's reserves can be calculated as follows:

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IAS 19 asset 20
Net contributions (90)
Precise net (loss) in reserves (70)
This loss will be a realised loss. As a result, the first 70 of net gains that the company reports
on its pension scheme after adoption of IAS 19 as at 30 June 2005 will reduce the cumulative
net loss in reserves and therefore effectively be treated as realised gains.
Say that the company could identify only (i) 20; or (ii) 65 of the contributions made prior to
30 June 2005. Under the alternative approach, the effect of IAS 19 on reserves would be as
follows:

Identify Identify
20 65
IAS 19 asset 20 20
Contributions identified (20) (65)
Estimated net (loss) in
reserves 0 (45)
(i)Since the cumulative effect on reserves as at 30 June 2005 is estimated to be nil, any net
gains that the company reports thereafter will lead to a net cumulative gain which will be
unrealised. The net cumulative gain will therefore have to be deducted from total reserves as
part of the company's calculation of the amount of realised reserves available for distribution.
(ii)More of the total contributions made prior to 30 June 2005 can be identified in this case
and the estimated net loss at that date is 45. Therefore, the first 45 of net future gains will
have the effect of reducing the cumulative net loss in reserves, and no adjustment in respect of
pensions will be needed to total reserves in arriving at realised reserves. If the cumulative
amount of future gains exceeds 45, the excess would be a cumulative net gain in reserves,
which would be unrealised. At that time, the company may wish to investigate whether it can
identify more contributions made prior to 30 June 2005 (up to the ceiling of 90). If it can, the
estimated effect of adopting FRS 19 can be recalculated.

5.3.5.4 Financial instruments

Principal differences between UK GAAP and IFRS

The presentation requirements contained in IAS 32 in respect of the debt/equity classification

of financial instruments and the off-setting of financial assets and liabilities are applied in UK
GAAP through FRS 25 to all entities other than those applying the Financial Reporting
Standard for Smaller Entities (FRSSE). The FRRSE can only be applied to small companies
or small groups as defined by Companies Acts, or entities that would qualify as such if they
had been incorporated under companies legislation (excluding building societies, which are
authorised mutual credit institutions); we do not comment on the position of entities within
the FRSSE.

Over and above those companies that choose to adopt IFRS in their individual accounts, the
recognition and measurement requirements contained in IAS 39 are applied in UK GAAP
through FRS 26 which is applicable to the following entities:

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• Any individual company only accounts of any listed entity, or

• Other entities which prepare their accounts in accordance with the fair value rules
which were incorporated into the Companies Act 1985 (Section D of Schedule 4)
to implement the EU Fair Value Directive.

Under the fair value accounting rules, UK Companies which prepare their accounts under UK
GAAP are permitted to value certain financial instruments, including derivatives, at fair value
with the gains/losses arising being accounted for on a consistent basis with that required under
IAS 39 (i.e. fair value through the profit and loss accounting, available for sale accounting or
hedge accounting). However, due to the legal constraints of the 4th Directive, the fair value
accounting rules of the Companies Act place a number of restrictions as to when fair value
accounting is permitted by the Companies Act even though such accounting would be
permitted by FRS 26 (and thus IAS 39), in certain circumstances. In particular, it is not
permitted to apply fair value accounting in respect of the following (i.e., the legal rules
prevent certain of the FRS 26 choices being taken):

• Any financial liabilities, other than those that are held as part of a trading portfolio
or which are derivatives;
• Loans and receivables originated by the company and not held for trading
purposes;
• Interests in subsidiary undertakings, associated undertaking and joint ventures
(IAS 27.37, IAS 28.35 and IAS 31.46 all contain options that permit valuation in
accordance with IAS 39)
• Contracts for contingent consideration in a business combination (while IAS
39.2(f) excludes contracts for contingent consideration from its scope for the
acquirer they are within the scope of IAS 39 for the seller, and hence the seller
could designate such contracts to be accounted for at fair value under IAS 39/FRS
26)

If an entity does not elect to apply fair value accounting, and hence does not apply FRS 26,
then it will usually carry financial instruments at cost and generally only recognise any fair
value losses which are considered permanent. Any such losses will be considered as realised
losses for distributable profits purposes.

Under the “alternative accounting rules” of paragraphs 31 to 34 of Schedule 4 of the

Companies Act 1985 , it is permitted to revalue fixed asset investments and current asset
investments, with the valuation being on the basis of market value determined at the last
valuation date or a valuation determined on any basis which appears to the directors to be
appropriate in the circumstances of the company, in respect of fixed asset investments, or at
current cost (i.e. replacement cost) in respect of current asset investments. Any cumulative
gains arising on revaluation are required to be reflected directly though a revaluation reserve
and not through the profit and loss account. When considering whether the gains arising on
the revaluation reserves represent distributable profits, the same considerations need to be
applied as when considering whether gains arising from fair value accounting represent
realised profits (see below).

“Fixed asset investments” under the Companies Act 1985 include shares in group
undertakings, loans to group undertakings, participating interests, loans to undertakings in
which a company has a participating interest, other investments other than loans and other
loans. “Current asset investments” include shares in group undertakings, other investments
and own shares.

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A “participating interest” means an interest held by an undertaking in the shares of another

undertaking which it holds on a long-term basis for the purpose of securing a contribution to
its activities by the exercise of control or influence arising from or related to that interest. A
holding of 20 per cent or more of the shares of an undertaking is presumed to be a
participating interest unless the contrary is shown.

Guidance on realised profits

Fair value accounting

In determining whether gains arising from fair value accounting are realised profits, particular
attention needs to be paid to whether the gains can be considered as “readily convertible to
cash” as defined by paragraph 19 of Tech 07/03. The general position – setting aside hedging
for the moment - is fair value gains on financial instruments will usually be considered as
representing realised profits in circumstances where the fair value is based on readily
available prices in a liquid market and there are no restrictions, specific to the company
concerned, which would prevent it from disposing of the financial instrument. However,
outside of these circumstances, differences may be thrown up as between profits recognised in
the accounts and as a sub-set of that, realised profits.

The manner in which a fair value gain is reflected in the financial statements e.g. as fair value
through profit and loss, or directly to equity as in the case of available-for-sale financial assets
and cash flow hedges, has no bearing on whether the gains are considered to represent
realised profits.

The overview section, above, defines “readily convertible to cash”, but Tech 07/03 provides
more detailed guidance on application of the definition of “readily convertible to cash” in
specific situations where fair value is used, the key features of which are summarised below.

Valuation of the financial instrument

Where financial instrument is traded in an active market, it is usually likely that it will be
possible to enter into a transaction, at prices assessed in active markets, to convert the change
in value to cash at short notice without any period of marketing and/or negotiation, and hence
the gain arising can be considered as “readily convertible to cash” and hence, as a realised
profit, subject to the general test in paragraph 19 (c ) of TECH 7/03 that the company’s
current circumstances do not prevent immediate conversion to cash or close out of the asset,
liability or change in fair value, without any intention or need to liquidate, to curtail
materially the scale of its operations or to undertake a transaction on adverse. If for example,
an entity was required to retain a certain financial asset for regulatory purposes, then this
might lead to a restriction on the ability to consider any fair value gains on such an asset as
representing realised profits.

Close out

A financial asset, financial liability or change in the fair value of a financial asset or liability
may be capable of being readily convertible to cash for the purposes of applying condition (a)
of paragraph 19 of revised TECH 07/03 if it could be immediately closed out i.e. the relevant
contract or underlying market risk position is capable of being immediately offset in the
market and normal market practice would be to close out a position in this way. For example

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risks in a derivative may be eliminated by taking out other financial instruments, including
derivative contracts, with an offsetting risk profile.

While the above addresses the ability to close out a transaction, it is still necessary to address
whether the valuation of the close out instrument is based on observable market data, whether
the company’s circumstances would prevent close out (i.e. are conditions b) and c) of para 19
of revised TECH 07/03 being satisfied) and whether the cash flows from the close out
instrument meet the definition of qualifying consideration (in particular para 18(d) of TECH
07/03 re the settlement of any debtor balances.)

Embedded derivatives

Where there is bifurcation, and the embedded derivative is fair valued separately from the
host contract, profits arising from changes in fair value of the embedded derivative only
constitute a realised profit if the derivative component can be closed out so as to meet the
readily convertible to cash tests, described above, or if the host contract and embedded
derivative together meet the tests.

Unquoted equity investments

Increases in fair value of unquoted equity investments will not generally meet the “readily
convertible to cash test” since, for example, a period of marketing and negotiation would
generally be required to dispose of such investments.
Strategic investments

Where companies hold investments for strategic purposes, they are not readily disposable in
the sense to meet condition c) of the definition of “readily convertible to cash” test of
paragraph of TECH 7/03, as a company’s strategy cannot be readily changed so as to allow
the investment to be realised immediately at the date of determination. Hence any gains on
such investments would not be considered as realised profits. For example, such investments
would include investments which qualify to be accounted for as joint ventures and associates
but where the company has elected under IAS 28/31 to account for the investment at fair
value under IAS 39.

A similar analysis would apply to other holdings of investments that are held to meet
regulatory requirements, since a company cannot readily change its regulatory compliance to
allow realisation at the date of determination.

Own credit

When liabilities (eg bank debt or bond issues) and over-the-counter derivative contracts are
measured at fair value, their value may be affected by the reporting company’s own credit
worthiness. Consequently, a profit may arise where a company’s own credit worthiness is
deteriorating, that is, the fair value of the liability is decreasing. In such cases, it is necessary
to consider whether the company would be able to realise the profit by settling the liability at
its fair value. This may not be possible, particularly if the company is experiencing financial
difficulties, and the relevant profit will therefore not be a realised profit. However, in most
circumstances where a company is not in financial difficulties and it would be able to settle
the debt at fair value, there will be no need to analyse the fair value changes between the
amount attributable to marginal changes in the creditworthiness of the liability and changes
due to movements in interest rates and other market factors.

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It should be noted, however, that the tests set out in paragraph 19 of Tech 7/03 are wider than
solely the ability to settle at fair value and must all be met. For example, the company must be
able to settle on the date of determination without negotiation or marketing. Thus where a
large volume of debt is under consideration, this is akin to a question of whether the company
could refinance that large volume of debt on that date without negotiation, which would often
not be the case.

Block discounts for securities traded in an active market

FRS 26 and IAS 39 require certain financial instruments to be valued on a basis that does not
take account of the size of the holding. That is to say that the valuation included in the
accounts uses the published price quotation in an active market as the best estimate of fair
value and does not reflect any “block discount” that might apply if the entire holding was
disposed of at the date of determination. In the case of assets (e.g. investments) that are traded
on an active market, it may be possible to dispose of the entire holding at the date of
determination, but it is necessary to recognise that the proceeds may be less than the value
recognised in the balance sheet in accordance with FRS 26/IAS 39, and as a consequence the
amount of any “block discount” reflected in the carrying valuation of the investment would
need to be considered as representing an unrealised profit.

Holdings in financial assets traded in an active market that might be regarded as relatively
small (e.g. less than 1% of a company’s share capital) may nevertheless be large in relation to
the volume of business done in that company’s shares on a typical day in the market. For
example, some such investments held by investment companies and other financial
institutions fall into this category. Such investments are rarely, if ever, disposed of in a single
block but are instead disposed of in a number of smaller blocks either all on the same day or
over a short period of time, in accordance with normal market practice, to reduce or eliminate
the effect of any block discount. In these limited circumstances, the effect of any block
discount on realised profits may be calculated on such a basis rather than on the assumption
that the entire holding is disposed of in a single block on the date of determination. This is a
limited departure from the principle established in paragraph 19(a) above.

Losses

The general principal is that all losses should be regarded as realised except to the extent that
the law, accounting standards, or the guidance provides otherwise (para 17 of Tech 7/03).
Accordingly, losses arriving from fair value accounting should be treated as realised losses,
where profits on the remeasurement of the same financial asset/liability would be treated as
realised profits in accordance with the guidance issued by the ICAEW/ICAS.

A loss that represents the reversal of an unrealised profit will not reduce cumulative realised
profits. Even if the loss is treated as a realised loss, for example because it represents an
impairment, the previously unrealised profit will become realised.

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When cumulative net losses arise on an asset through fair value accounting, these will
generally be realised. However, such losses on assets will be unrealised losses where both of
the following apply:

- profits on remeasurement of the same asset would be unrealised; and

- the losses would not have been recorded had the asset been measured on the basis
of historical/amortised cost less impairment provisions.

Similarly, cumulative fair value losses on a liability will be unrealised if both:

- profits on the same liability would be unrealised, and

- the losses would not have been recorded otherwise than on a fair value basis (e.g.
would not have been recorded either on an amortised cost basis under IAS 39 or as
an onerous contract liability under IAS 37).

It is expected that situations where cumulative net losses on assets and liabilities measured at
fair value do not give rise to a realised losses are likely to be relatively rare, but such
unrealised losses might, for example, arise in a situation where a financial asset carried at fair
value, is carried at a value less than historical/amortised cost less impairment provisions,
because the diminution in the fair value of the asset is not considered to be permanent and
hence is not reflected in the amount of the impairment provision. The Guidance makes it clear
that all such cases should be considered on their merits, and where there is doubt, losses
should be treated as realised.

Hedge accounting

The general principle contained within the Guidance (paragraph 33 of TECH 07/03) is that
where hedge accounting is undertaken in accordance with relevant accounting standards
(including IAS 39 and FRS 26, as well as existing UK GAAP) then it is necessary to consider
the combined effect of both sides of the hedging relationship to determine whether there is a
realised profit or loss. The application of this principle to different types of hedge accounting
is described below.

Fair value hedge accounting

In the case of fair value hedges under IAS 39/FRS 26, the gross profits and losses on
remeasuring the hedging instrument and the hedged item for the hedged risk are both
recognised in profit or loss. In many instances both the profit on one and the loss on the other
will be realised by reference to the readily convertible to cash and other criteria. In such cases,
no special consideration of hedging aspects is required (including hedge effectiveness or
ineffectiveness).

In some cases, however, the profit on either the hedged item or the hedging instrument may,
absent consideration of the hedging aspect, be unrealised (e.g. if a fair value movement is not
readily convertible to cash). The following paragraphs explain how the general principle set
out in respect of hedge accounting should be applied in circumstances where the profit is not
realised.

Where the hedge accounting relationship results in a net loss, this amount will generally be
treated as a realised loss. For example, consider the situation where there is an unrealised
profit on the hedged item of £90 and a realised loss on the hedging instrument of £100. The

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net loss of £10, which arises from hedge ineffectiveness, is recognised in the profit and loss
account and is treated as a realised loss. Due to the hedge accounting relationship, the
remaining £90 of the gross loss on the hedging instrument is not treated as a realised loss and
is set off against the unrealised profit on the hedged item.

Where there is a net profit, it will be necessary to consider whether that profit is a realised
profit. This will depend on the relationship between the gross components. For example, if
there is an unrealised profit of £100 and a realised loss of £90, only the net profit of £10 will
be treated as unrealised.

This approach applies irrespective of whether the profits or losses in question arise from
changes in fair value of open contracts or from settled transactions. For example, the hedge
accounting policy may designate a series of rolling derivatives as the hedging instrument,
some of which have already been settled in cash, whereas there have been no past settlements
in respect of the hedged item.

Cash flow hedge accounting

In the case of cash flow hedges under IAS 39/FRS26, the portion of the profit or loss on the
hedging instrument that is determined to be an effective hedge is recognised directly in equity
through the statement of changes in equity/statement of recognised gains and losses. Such
profits and losses are unrealised and become realised only when the hedged transaction affects
profit or loss (or IAS 39 otherwise requires the gain or loss to be recycled through profit or
loss). This is based on the principle, set out above, that it is necessary to have regard to the
combined effect of both sides of the hedge accounting relationship to determine whether there
is a realised profit or loss. To the extent that the profit or loss is recognised directly in equity
(or, later on, added to the cost of a non-financial asset) in accordance with IAS 39, it must
arise in connection with a valid hedge accounting relationship. It would therefore be
inappropriate to consider this profit or loss in isolation from the hedged item. To the extent
that any ineffective element of the profit or loss on the hedging instrument is recognised in
profit or loss, that element should be assessed as to whether it is realised in accordance with
normal principles (e.g. the “readily convertible to cash” test).

The hedging principle above applies irrespective of whether the profits or losses in question
arise from changes in fair value of open contracts or from settled transactions. The amounts
taken direct to equity may, for example, include profits or losses on short-term derivative
contracts that form part of a rolling-hedge strategy but which have matured. Such profits and
losses should be treated as unrealised provided that IAS 39 requires them still to be deferred
in equity as part of a cash flow hedge accounting relationship.

Net investment hedge accounting

Under IAS 39/FRS 26, net investment hedge accounting policies will generally arise only in
the context of consolidated financial statements. Those financial statements are not relevant
for the purposes of justifying distributions. However, it is possible that in some instances, in
accordance with IAS 21(of FRS 23 the UK GAAP equivalent for companies subject to FRS
26), a branch may be treated as a foreign operation in the individual accounts of a company.
In this case, net investment hedge accounting may be relevant to the individual accounts of a
company. A net investment hedge under IAS 39 is accounted for similarly to a cash flow
hedge.

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In such cases whether the hedged item (i.e. the branch assets and liabilities reflected in the
company’s balance sheet) gives rise to realised profits needs to be determined by an analysis
according to the nature of the assets and liabilities on which the translation difference arises
and taking into account the changes in the composition of assets during the period.

Amortised cost accounting

Although differences exist in the methodologies required under IAS 39/FRS 26 and pre-
existing UK GAAP, which applies to non FRS 26 adopters, in respect of the determination of
amortised cost, which largely apply to the calculation of impairment provisions and the
amortisation of premiums and discounts, it is not considered that these have an impact on
realised profits and losses. Under both frameworks all impairment/bad debt provisions would
be considered as representing realised losses and any amortisation of premiums and discounts
would give rise to realised profits or losses.

Issues arising from IAS 32 (and its equivalent FRS 25)

Under both IFRS and UK GAAP, since the introduction of FRS 25, financial instruments are
presented according to the substance of the contractual arrangement determined by the rules
in IAS 32/FRS 25. This may differ from their legal form.

Prior to 1 January 2005, under UK financial instruments, which met the statutory definition of
share capital, were previously accounted for according to their legal form. As a general
principle, it is still the legal form of share capital which is of relevance in considering what
constitutes realised profits and losses and needs to be considered in relation to ensuring
compliance with any legal requirements in respect of distributions.

The accounting for certain capital instruments as debt under IAS 32/FRS 25, rather than on
the basis of their legal form, creates a number of complications when considering the impact
of such instruments on realised profits and restrictions on the distribution of realised profits.
The latter is particularly the case for public companies which in addition to the general
restriction applying to all companies “that a company’s profits available for distribution are
limited to its cumulative realised profits, less its accumulated realised losses, so far as not
previously written off in a reduction or reorganisation of capital duly made” (Section 263(3)
of the Companies Act 1985 or section 830 (2) of the Companies Act 2006), also have to
comply with Section 264 of the Companies Act 1985 which states that a company may only
make a distribution at any time:

• if at that time the amount of its net assets is not less than the aggregate of its
called-up share capital and undistributable reserves; and

• if, and to the extent that, the distribution does not reduce the amount of those
assets to less than that aggregate.

TECH 02/07 provided detailed guidance, and examples, as to issues arising from
IAS 32. Although the guidance is complex, it is largely driven by the following
two main principles:

• Distributions or capital repayments on instruments which have the legal form of

share capital are not as a matter of law a loss, notwithstanding that they may be
presented for accounting purposes as an interest charge, and consequently they

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should be considered as a distribution at the time that they actually occur rather
than as a reduction of realised profits at the time the amount is booked (which may
be earlier); and

• When public companies consider the net asset test of Section 264 of the
Companies Act 1985 (Section 831 of Companies Act 2006), it should be noted that
each of net assets and share capital (and defined, undistributable reserves) is
determined as presented in the accounts, which might for example show shares as
a debt payable or show a commitment to buy-back shares as a debt payable.

The latter point can mean, for example, where there is a debit to equity arising from the
advanced recognition of a future distribution or capital repayment in respect of equity shares,
and the recognition of a corresponding financial liability (say a commitment to buy-back own
shares), the application of the above principle restricts the amount of profits available for
distribution by public companies in accordance with Section 264 of the Companies Act 1985
(Section 831 of Companies Act 2006). That is net assets are reduced but share capital (and
defined, undistributable reserves) are not reduced (the debit to equity is not part of share
capital and defined, undistributable reserves).

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5.3.6 Conclusions on detailed analysis for selected EU Member States

The 2nd CLD contains the following rules in Article 15 for distributions:

“1. (a) Except for cases of reductions of subscribed capital, no distribution to

shareholders may be made when on the closing date of the last financial year the net
assets as set out in the company's annual accounts are, or following such a distribution
would become, lower than the amount of the subscribed capital plus those reserves
which may not be distributed under the law or the statutes.
(b) …
(c) The amount of a distribution to shareholders may not exceed the amount of the
profits at the end of the last financial year plus any profits brought forward and sums
drawn from reserves available for this purpose, less any losses brought forward and
sums placed to reserve in accordance with the law or the statutes.
(d) The expression "distribution" used in subparagraphs (a) and (c) includes in
particular the payment of dividends and of interest relating to shares.
2. … “

This current regime of distributions refers to the annual financial statements of companies.
The rules for these financial statements are harmonised to a certain degree based on the 4th
CLD. Furthermore, as described above, it is also possible under Regulation 1606/2002 for EU
Member States to require or to permit that annual financial statements are prepared according
to IFRS. The following discussions are based on the assumption that the current distribution
arrangement in the European Union is maintained and that the distribution regime under
Article 15 of the 2nd CLD has not been altered towards another system of determining
distributable amounts, e.g. a solvency test.

The above description of the situation in the different EU Member States can only be a
“snapshot” of the current status concerning accounting rules and local law. Both, the IASB as
well as national standard-setters and legislators continue to develop the accounting
frameworks that companies are operating in. Therefore, any conclusions are just accurate as
of the current date, and the situations may significantly change over time.

The answers received show a diverse picture of how the companies have to determine profits
according to national accounting frameworks as compared to IFRS. Furthermore, several
approaches can be noted under which “realised” profits/losses are determined as the basis for
dividend distributions.

In Germany, for example, the profits determined under the German Commercial Code are
regarded as “realised” and distributable. No distinction is made between accounting profits
and distributable profits. On the other hand, there is much (at least theoretical) effort spent in
the United Kingdom to distinguish accounting profits from realised profits. This is true for
UK GAAP profits as well as for IFRS profits since UK companies are allowed to apply IFRS
in their annual accounts. The discussion makes it evident that there is an issue in
differentiating between accounting profits and distributable profits for distribution purposes.
For example, when comparing the German accounting rules with the UK accounting
approach, two different solutions to the same problem may be seen. In Germany, the prudence
principle is seen as a dominating principle in accounting. Based on this principle, Germany
conceptually tries to already eliminate “unrealised profits” at the level of the single financial
statements. In the UK, the “elimination” of “unrealised profits” for distribution purposes is
performed in a separate step after preparing the single financial statements. The determination

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of “realised profits” for distribution purposes is only one issue in determining distributable
amounts. As, for example, described for Poland, some “reserves” may have to be set up to
represent non-distributable amounts. However, these rules are not part of the accounting
analysis. Other considerations may also have to be taken into account when distributable
amounts are determined. For Sweden, the following applies: “The Companies Act contains a
number of restrictions for dividend distributions. A company may only distribute unrestricted
capital. A company is further restricted by the company’s capital requirements, which are
based on an assessment of the kind and scope of business. The distribution is also restricted
by the company’s liquidity, financial position and other aspects (“prudence rule”). A parent
company is also restricted by the group’s capital requirements, the group’s liquidity, financial
position, and other aspects.” These rules, generally, also go well beyond a simple
consideration of accounting rules and are embedded in company law.

Overall, in the current system in the 2nd CLD, the determination of distributable profits is
based on accounting rules. A balancing element which allows for a cautious assessment of
distributions is introduced into this determination at different levels. In Germany, prudence is
introduced at the financial statement level by means of an emphasis on prudence in the basic
accounting principles, i. e. the generally distributable accounting profits are determined on a
prudent basis. In the United Kingdom, the realised profits are determined as another layer
subsequent to the determination of accounting profits. In Sweden, additional considerations
by management based on the economic viability of the company and on the related group of
companies come into play after the determination of accounting profits. Therefore, different
approaches toward a cautious determination of distributable amounts by management exist in
some way. There is currently no harmonised approach to introduce an element of caution into
the process. This is true for local accounting rules as well as for IFRS, where applicable.

It can be seen from the descriptions above that the use of fair values in accounting may, at
least, be one of the major points of discussion with respect to “realised profits”. Fair values
were traditionally used in some jurisdictions just to determine the need for unscheduled write
downs of assets and similar situations. This is simply a conservative way of using fair value.
But in some countries it is possible or required to apply fair values in both directions and to
recognise a gain on the re-measurement of balance sheet items. In practice a tendency towards
fair value measurements can also be found within IFRS. The areas of study, for example,
focus on some of the issues involving an increased use of fair values. For investment
property, it is possible to measure property at fair value (according to IAS 40) and to
recognise losses as well as gains in net profit for the period. In the area of financial
instruments, many fair value measurements are required according to IAS 39. All derivative
financial instruments as well as many non-derivative financial instruments are recorded at fair
value. Gains and losses are recognised in profit or loss immediately or are to be recorded first
in equity – as the case may be. With respect to pension accounting, no immediate fair value
measurement is possible, but IAS 19 tries to include a wide variety of parameters for
determining the defined benefit liability. It has to be mentioned that some of the so-called
actuarial gains and losses are not to be recorded within profit or loss for the year.

IFRSs as published by the International Accounting Standards Board are not designed for
determining distributable profits. The primary focus of the IASB is to set up accounting
standards that lead to financial statements that are useful to their users in making economic
decisions. Consequently, the objective of the IASB is to gain information about the economic
situation of a company. The Preface of the IFRS explicitly states: “IFRSs apply to all general
purpose financial statements. Such financial statements are directed towards the common
information needs of a wide range of users, for example, shareholders, creditors, employees

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and the public at large. The objective of financial statements is to provide information about
the financial position, performance and cash flows of an entity that is useful to those users in
making economic decisions.” Even though the Framework for the Preparation and
Presentation of Financial Statements lists the determination of distributable profits and
dividends as being one economic decision that is based on financial statements, this is not to
be regarded as being the general purpose of financial statements and thus the IASB cannot
focus on this specifically. Prudence or conservatism itself is not and cannot therefore be a
virtue for the Board.

With the recognition of gains on the measurement of assets or liabilities at fair value or the
lack of immediate recognition of actuarial losses, it is evident that an element of caution and
consequently the prevention of “unrealised losses” are at least not specifically set forth in
IFRS at the individual financial statement level. Therefore, since IFRS can potentially form
the basis for distributions in any EU Member State, a discussion similar to the UK may be
indicated as to the way to deal with “unrealised” IFRS accounting profits in order to allow for
a certain degree of harmonisation concerning the distribution regime throughout the European
Union.

Many accounting areas, which could be discussed from a realisation point of view, may not
even impact the distributable amounts of certain companies. The impact of accounting rules
on the accounting profits of companies depends on the individual facts and circumstances of
that company. A general conclusion on the impact of accounting rules cannot be drawn. This
has become evident through all of the detailed analyses above. In addition, fair value
measurement does not always lead to the recognition of gains; losses may have to be
recognised as well. That means that the impact on distributable amounts can finally only be
determined in the context of a specific situation under consideration. Nevertheless, if the
current distribution model of the 2nd CLD which is exclusively based on a balance sheet test is
to be maintained, there needs to be a solution for significant differences between accounting
profits under IFRS and the “realised” profits/losses for distribution purposes.

It has to be borne in mind that the determination of the realisation of a profit or loss is a
matter of judgement. There is no red thread in making that determination as the different
solutions presented above evidence. Ultimately, a profit realisation can only be determined
upon the termination and liquidation of a company. However, this over-conservative approach
would seem to be inappropriate towards the interests of the shareholders. It should also be
noted that Poland, for example, faces a situation that accounting rules for investment property
and financial instruments are very similar to IFRS and that no modification of the profits has
to be made for determining distributable amounts. This system is obviously operational as
well.

Possible remedies for potential differences between IFRS accounting profits and realised
profits could be twofold. A first option is to maintain the current distribution model of the 2nd
CLD and to determine realised profits/losses in the context of the IFRS accounting
framework. The description of the UK approach makes it evident that distinguishing
accounting profits from distributable profits may become in certain situations very complex.
For the interview experience with UK companies please refer to section 4.1.5. A second
option is to amend or completely change the current distribution model of the 2nd CLD, i.e. to
introduce a solvency test which could at least form a corrective element to the balance sheet
test or could lead to a situation where a distribution regime did not substantially rely on the
IFRS accounting framework.

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6 Introduction of a new regime

6.1 Introduction

As part of this study project, we have been specifically asked to explain concrete effects of the
introduction of a new regime. This section is therefore intended to show the European
Commission an array of options how the system of the 2nd CLD could be adjusted in order to
introduce an alternative to the current regime of the 2nd CLD.

The previous analysis of the existing models in five EU Member States and five non-EU
jurisdictions has shown that the incremental burdens of company law for the companies in all
jurisdictions are not overly burdensome and, thus, do not play a decisive role in determining
whether an alternative system is needed. However, incremental burdens can be of high
relevance when considering the implementation of certain measures in a jurisdiction. One
specific example which has been discussed for the theoretical models proposed is the issue of
the design of solvency tests.

The introduction of IFRS as a potential basis for profit distribution poses a definite challenge
for the European Union as a legislator and it can be questioned whether the 2nd CLD in its
current format is sufficiently prepared for this challenge. The analysis conducted in this study
whether IFRS can be used under the current capital and distribution regime only provides a
snapshot of IFRS, as IFRS are still developing and this specifically in the direction of an
increased use of fair value measurements. However, it is absolutely clear that the objectives
under which the IFRS are developed are not intended to produce standards which mainly
serve as a basis for a prudent distribution policy which aims at warranting the future viability
of a company. It may therefore be argued that the use of IFRS, at least under the current
distribution regime, must accommodate a higher degree of flexibility for companies to
determine their level of dividends. Such flexibility could help companies to address specific
situations in which a certain accounting framework like IFRS may deliver accounting profits
that are not adequate in view of a cautious assessment of distributable profits.

The focal point of the following analysis is therefore the question in which ways the current
capital regime of the 2nd CLD can be transformed in order to achieve this flexibility for the
companies. To this end, it is intended to show the different degrees of reform to the current
2nd CLD by structuring these into various dimensions. A discussion of these dimensions may
help to develop a sensible approach to a possible alternative that will not be overly
burdensome for companies. These dimensions are

- amendments to the basic model of legal capital of the 2nd CLD

- distributions from a group perspective
- design of solvency tests
- introduction of true “no-par value” shares

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6.2 Legal Capital

6.2.1 Amendments to the 2nd CLD’s basic model of legal capital

6.2.1.1 Overview

With a view to allowing more flexibility to EU companies concerning possible effects of

different accounting standards on their distribution possibilities, we have analysed in chapter
4 of this study report different existing and theoretical models that offer alternatives to the
current capital regime of the 2nd CLD. The analysis covered four non-EU countries which
have chosen different approaches to restricting excessive dividend payments and maintaining
a company’s capital. Similar approaches can also be found in the four theoretical models
presented by the High Level Group, the Rickford Group, the Lutter Group and the Dutch
Group. Also these models show in differing degrees, how to transform the current 2nd CLD
capital regime in order to allow for more flexibility. But also the actual practice in the five EU
Member States shows certain possibilities to reform the 2nd CLD.

We have grouped possible approaches into five main categories with specific regard to the
degree of change to the 2nd CLD. The range of models starts with adjustments to the
distribution model in Article 15 of the 2nd CLD and ends with a full scale reform of the 2nd
CLD.

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The following table provides an overview of the five basic approaches to adjust the legal
capital system which will be subsequently explained in more detail:

Figure 6.2 – 1: Five Approaches for amendments to the basic model of the 2nd CLD
Model Main Features Legal changes Scope; time

Legal Balance Solvency

capital sheet test
test
1A – Companies decide Remains Deviation Necessary Adaptation of distribution Voluntary;
on deviations from from provision 2 years
„Company audited accounts; GAAP or
option“ definition of allowed interpretation of „realised
“realised profit” profit“
[PLUS: solvency
test]
1B - Regulators decide Remains Deviation Not Adaptation of distribution Companies using
on deviations from from necessary provision „regulated acc.
„Regulator audited accounts; GAAP or treatments“;
option“ definition of allowed interpretation of „realised 5 years
“realised profit” profit“
2– Additional Remains No Necessary Adaptation of distribution Individual IFRS
solvency test for deviation for IFRS provision; introduction accounts;
„IFRS IFRS individual from individual solvency test and certificate; 9 years
solvency accounts GAAP accounts review by an auditor; sanctions
add-on“ allowed

3– Combination of Abolished No Necessary Adaptation of distribution All companies;

solvency and / solvency deviation provision; introduction of two 10 years
„On equal balance sheet test; margin from stage distribution test and
terms“ both have to be GAAP certificate, possibly
met /solvency introduction of solvency
margin margin; own shares,
redemption of shares;
sanctions; no-par value shares;
raising capital; financial
assistance; wrongful trading
4– Combination of Abolished No Necessary Adaptation of distribution All companies;
solvency and deviation and pre- provision; introduction of two 12 years
„Solvency balance sheet test; from dominant stage distribution test and
test pre- finally, only GAAP; certificate; probably review by
dominance“ solvency test needs test is an auditor; own shares;
to be met submerged redemption of shares;
reduction of capital; sanctions;
no-par value shares; raising
capital; financial assistance;
wrongful trading

6.2.1.2 Model 1A- „Company option”

Under the “Company option” approach, the companies could continue to use their balance
sheets prepared under their national GAAP or IFRS. The board of directors could decide
whether the balance sheet prepared under either accounting standard is adequate to present the
basis for distribution. If deemed necessary, the board of directors would be entitled to adjust
individual balance sheet items in order to determine the realised profits to be used for
distributions. In order to protect shareholders and creditors, the company’s directors would
need to be subject to a fiduciary duty to be established in company law in this regard. This
fiduciary duty could also include an assessment whether the current and/or prospective cash
flow situation of the company allows for the distribution.

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The question of whether the accounting standards currently used by the companies in the five
EU Member States under consideration are sufficiently tailored to determine the level of
distributions asked in a a CFO questionnaire sent to companies in the five EU countries listed
on the main indices produced the following results:

Figure 6.2 – 2: CFO survey results: accounting framework and profit distribution

Balance-sheet-oriented distributions test:

"Are in your opinion the accounting
standards applied by your com pany
sufficiently tailored to adequately determ ine
the level of profit distributions?"

1%

19% Yes
No
NA
80%

Source: CFO Questionnaire, September 2007

Our interviews conducted in Poland, where IFRS have already been introduced for individual
accounts, have not pointed to specific problems with the use of IFRS for distributions. In
general, however, specific problems with IFRS may specifically arise where companies
heavily use fair value based standards.

A similar approach is taken in the current practice of Delaware corporations in this regard.
Even though not bound to specific accounting rules, Delaware corporations regularly refer to
their audited consolidated accounts under US GAAP and would only deviate from these
audited accounts in very few exceptional circumstances. One specific reason why deviations
are not popular is potential liability exposure for directors. The companies we have
interviewed did not make changes to their audited accounts to justify their distribution
assessment. Furthermore, based on jurisprudence, the Delaware companies are obliged to
perform a solvency test. As the solvency test is not bound to specific requirements, the
companies mainly referred to current balance sheet ratios to justify their decision. However,
depending on the specific circumstances of the company, the documentation for this purpose
could have differed.

Another European jurisdiction where a similar concept of fiduciary duty has been recently
enacted is Sweden. Sweden has introduced, in its new Companies Act 2006, the concept of
value transfer. With regard to distributions also, Swedish boards of directors must apply a
“prudence rule” whereby they have to assess whether the dividend based on the balance sheet
test is justifiable bearing in mind the type and size of the business and the risks involved.

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Necessary legal changes

Two ways of adapting the 2nd CLD may be considered:

As a first alternative (“legal solution”), the distribution provisions in Article 15 could be

amended so that a fiduciary duty on the board of directors to prudently review the financial
statements as to whether they can be used for distributions purposes is introduced. If deemed
necessary, adjustments could be made to the results of the financial statements based on
business judgment taking into account solvency aspects. The legislative process for such an
amendment of the 2nd CLD takes at least two years. The introduction of a new fiduciary duty
may also result in subsequent jurisprudence depending on the legal preciseness of the
requirement.

As a second alternative (“interpretation”), a reference to the UK experience, which has shown

that from a practical point of view a distinction between accounting profits and realised
profits may be a way forward, could be made. Based on this interpretation, companies could
be offered the possibility to individually determine “realised profits”. To ensure that the
directors act in the best interests of shareholders, a fiduciary duty must be foreseen, again
with an obligation to take into account solvency aspects. Individual Member State laws may
implicitly already provide a fiduciary duty for directors to act in this regard. If not, either the
European or national legislator would need to introduce such a fiduciary duty.

Impact on companies

It would be up to the board of directors to act on this requirement. For a company with a good
earnings and cash position, this requirement would not require a high effort, as compliance
could be considered as a given. The experience with Delaware companies underpins this. In
exceptional cases, especially with regard to a heavy reliance on IFRS fair value
measurements, the additional burdens could become significant in individual cases.

6.2.1.3 Model 1B – “Regulator option”

For the “regulator option”, it would be necessary that a central authority at EU or Member
State level would introduce, for distribution purposes, mandatory adjustments for certain
accounting treatments under IFRS. The centrally determined adjustments would need to
identify IFRS accounting treatments which were considered as producing “unrealised
profits/losses” for distribution purposes. The central authority at EU or Member State would
need to ensure on a continuous basis that all relevant IFRS accounting treatments will be
subject to mandatory adjustments.

This approach is currently followed in the United Kingdom. For UK GAAP, the Institute of
Chartered Accountants in England and Wales (ICAEW) and the Institute of Chartered
Accountants in Scotland (ICAS) have issued various pieces of authoritative accounting
guidance in relation to determining what profits are realised. Interviews with UK companies
have shown that this practice can, in some cases, result in significant administrative burdens.
Other UK companies are not affected as they do not use adjustable accounting practices or
have a comfortable earnings/cash position.

However, we have been made aware that the ICAEW itself would rather prefer to break the
link between accounting profits and dividends. The argument for this opinion is the increasing
use of fair values in modern accounting. Therefore, a fundamental reform of the 2nd CLD is

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considered favourably by the ICAEW in order to reduce or remove the necessity of a central
authority constantly updating the necessary adjustments.

Necessary legal changes

In his context, adaptation of distribution provisions in Article 15 which clarify that there
needs to be a central authority either at EU or Member State level to determine adjustments to
certain IFRS accounting treatments for distribution purposes, could be considered. The
legislative process for such an amendment of the 2nd CLD takes at least two years. The
implementation of the amended provisions of the 2nd CLD and the development of central
guidance may, altogether, take up to three years..

Alternatively, current UK practice could be followed and the term „realised profit“ be
interpreted in a way that such central guidance was necessary. Accordingly, it would be a
matter of discussion between the EU and Member State level how such central guidance was
organised.

Impact on companies

All companies using IFRS for individual accounts could be affected. For a company with no
or very limited use of IFRS fair value measurements, this requirement would not require a
high effort as compliance could be considered as a given. In exceptional cases, especially with
regard to a heavy reliance on IFRS fair value measurements, the additional burdens could
become significant in individual cases. The experience with UK companies interviewed
underpins this and can be referred to concerning cost implications.

6.2.1.4 Model 2 – „IFRS solvency add-on“

Another approach for a limited amendment of the 2nd CLD is to maintain the 2nd CLD in its
current format and to introduce an additional solvency test for IFRS individual accounts. This
obligation does not generally concern other individual accounts prepared under national
GAAP and the 4th CLD, respectively. However, based on our conclusion concerning the lack
of harmonisation of the realisation principle of the 4th CLD, this could also be considered for
companies reporting under the 4th CLD.

The solvency test needs a formal certification by the board of directors. The management
should be liable for the test. The certification could be reviewed by an auditor.

Necessary legal changes

For the introduction of the solvency test and the necessary certification by the board, Article
15 concerning the distribution provisions needs to be changed. The legislative process for
such an amendment of the 2nd CLD takes at least two years. The implementation of the
amended provisions of the 2nd CLD and the development of new jurisprudence may take up to
seven years, altogether, however, depending on the design of the solvency test and the clarity
of the newly established legal provisions.

Impact on companies

All companies using IFRS for individual accounts could be affected. The burdens associated
with the approach are closely linked to the actual practice of performing the solvency test.

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The requirements will result from the format of the solvency certificate. The intensity of this
burden depends on how detailed the prescribed calculation methods are and how much they
deviate from internal practices at the companies concerned. Accordingly, the way the
calculation is conducted will heavily influence the workload associated with this test.

6.2.1.5 Model 3 – „On equal terms“

The “On equal terms” model requires a full scale reform of the 2nd CLD abolishing the current
concept of legal capital. Under this approach, a two-stage distribution test consists of a
balance sheet test and a solvency test which both have the same importance. Such an
approach has been suggested by the High Level Group and the Dutch Group. Furthermore, a
certain solvency margin could be introduced in order to reinforce the balance sheet test as
proposed by the High Level Group.

Both tests constitute substantive restrictions on distributions: company assets may only be
distributed to shareholders if the distribution complies with both tests. Hence, in cases in
which the balance sheet test indicates that the proposed distribution is not covered by net
assets whereas, according to the solvency test, the company is solvent, a distribution may not
take place. In cases in which the two-stage distribution test has been performed on the basis of
accounts which have not been drawn up in accordance with generally accepted accounting
methods and have not been audited, a distribution is prohibited if the audited accounts of the
company indicate that the proposed distribution does not comply with the two-stage
distribution test.

A solvency margin would ensure that the assets, after the proposed distribution, exceed the
liabilities by a certain margin and/or current assets, after the distribution, exceed current
liabilities by a certain margin. The US State of California has the only solvency margin
actually existing. This solvency margin only comes into play when the California
incorporated company does not meet the first stage of the distribution test. Accordingly, we
have not encountered any California company that had practical experience in applying the
solvency margin. It is therefore important to consider how high such a solvency margin
should be and how it should be exactly calculated. A high solvency margin may impede
potential distributions and cause additional incremental efforts for the companies concerned
to mobilise sufficient profits and cash from subsidiaries to allow for distributions. To this
extent, the actual impact of solvency margins on companies is not clear.

The board of directors is responsible for performing the two-stage distribution test. The board
members are required, on the basis of the tests, to issue a solvency certificate in which they
explicitly confirm that the proposed distribution meets the two-stage distribution test.

Necessary legal changes

This approach requires a full scale reform of the 2nd CLD. The central part is the two-stage
distribution test which serves as a means to determine the maximum amount available for
distributions to shareholders and a solvency certificate for which the board is responsible.
This test is required for dividend payments and other forms of distributions to shareholders,
including share buy-backs and – if the concept of a reserve for share capital which is not
distributable is retained - capital reductions. As a consequence, the substantive restrictions on
dividend payments (Art. 15), share buy-backs (Art. 19), redemption of shares (Art. 39) and
possibly reductions in capital (Art. 32) will be repealed. Furthermore, the prohibition on the
issue of true no-par value shares (Art. 8 (1)) should be abandoned and a comprehensive

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system of sanctions with respect to the board members responsible for the solvency certificate
should be introduced. In addition, the introduction of a solvency margin is discussed.

Furthermore, the High Level Group recommends, for example, that the provisions concerning
the raising of capital (Art. 7, 10), be repealed and that an alternative regime on financial
assistance (Art. 23) and a European framework on wrongful trading, be introduced. Beyond
this, the High Level Group proposes that the minimum capital requirement (Art. 6) as well as
the pre-emption rights (Art. 29) be retained.

The legislative process for such an amendment of the 2nd CLD takes at least two years. The
implementation of the amended provisions of the 2nd CLD and the development of new
jurisprudence may take up to eight years or longer, as it is a full scale reform.

Impact on companies

All EU companies falling under the 2nd CLD would be concerned. Again, the burdens
associated with this approach for the companies are closely linked to the actual practice of
performing the solvency test. The requirements will result from the format of the solvency
certificate. The intensity of this burden depends on how detailed the prescribed calculation
methods are and how much they deviate from internal practices at the companies concerned.
Accordingly, how the calculation is conducted will heavily influence the workload associated
with this test.

6.2.1.6 Model 4 – „Solvency test predominance“

The “Solvency test predominance” approach constitutes the most far reaching reform of the
current 2nd CLD model. The Rickford Group proposes this approach. However, we have not
encountered a similar approach in any of the existing jurisdictions under consideration.

In this scenario, a two-stage distribution test serves as a means of determining the maximum
amount available for distribution. It also applies to all forms of distributions to shareholders,
that is dividends, share buy-backs and distributions as part of a capital reduction. The two-
stage distribution test consists of a solvency test and a complementing balance sheet test.
Company assets may be distributed provided that a distribution complies with the solvency
test. The balance sheet test does not, by contrast, constitute a substantive restriction on
distributions but prescribes additional disclosure and specification requirements. If, according
to the balance sheet test, the distribution is not covered by net assets, the management board
may still make a distribution provided it states the reasons why it is of the opinion that a
distribution is nevertheless justified. The management board is required to provide and
publish a solvency certificate in which it declares that in its assessment, after an enquiry into
the affairs and the prospects of the company proper for the purpose, the distribution complies
with the requirements. A mandatory auditor’s certificate is not required.

Necessary legal changes

This approach requires a full scale reform of the 2nd CLD. The central part is the two-stage
distribution test which serves as a means to determine the maximum amount available for
distributions to shareholders (the balance sheet net assets test does not constitute a substantive
restriction on distributions) and a solvency certificate for which the board is responsible and
which could be reviewed by an auditor. This test is required for dividend payments and other
forms of distributions to shareholders, including share buy-backs and, if still applicable,

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capital reductions. As a consequence, the substantive restrictions on dividend payments (Art.

15), share buy-backs (Art. 19) and reductions in capital (Art. 32) will be repealed.
Furthermore, the subscribed capital, the mandatory reserves and the prohibition on the issue
of true no-par value shares (Art. 8 (1)) should be abandoned and a comprehensive system of
sanctions with respect to the board members who are responsible for the solvency certificate
should be introduced.

Furthermore, the Rickford Group recommends several further amendments. It recommends,

for example, that the provisions dealing with the raising of capital (Art. 7, 10) and the
financial assistance (Art. 23), be repealed. In addition, a European framework on wrongful
trading is recommended, and the retention of the resolutions of the general meeting on share
buy backs, share issues and the exclusion of pre-emption rights, is proposed.

The legislative process for such an amendment of the 2nd CLD takes at least two years. The
implementation of the amended provisions of the 2nd CLD and the development of new
jurisprudence may take up to ten years or longer, as it is a full scale reform and the
jurisprudence with the inclusion of the predominance of the solvency test may take longer to
develop as the distribution concept is fundamentally changed.

Impact on companies

All EU companies falling under the 2nd CLD would be concerned. Again, the burdens
associated with the approach for the companies are closely linked to the actual practice of
performing the solvency test. The requirements will result from the format of the solvency
certificate. The intensity of this burden depends on how detailed the prescribed calculation
methods are and how much they deviate from internal practices at the companies concerned.
Accordingly, how the calculation is conducted will heavily influence the workload associated
with this test.

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6.2.2 Capital maintenance in groups of companies

6.2.2.1 Overview

One interesting result of the interviews conducted with companies in the EU and outside the
EU is the fact that companies mainly referred to their consolidated accounts as a starting point
for the determination of dividends. Necessary cash flow considerations have also been
conducted at group level, i.e. decisions are taken from a group perspective, not the individual
legal entity. Subsequent to these assessments, dividend levels are subject to a “political
decision” by the company’s management with a view to its share price. This includes aspects
such as dividend continuity or giving certain signals to the capital market.

The results of a CFO questionnaire sent to the companies listed in the main stock exchange
indices of the five EU Member States reconfirm these experiences:

Figure 6.2 – 3: CFO survey results: Determinants for dividend distributions by holding companies

"What are the determ inants for the distribution of dividends by your holding
com pany?"

5
Fin. perf ormance (group accounts)

4 Financial perf ormance (individual accounts of

Importance

t he parent company)
Dividend continuit y
3
Signalling device
2
Credit rat ing considerations

1 Tax rules
F r ance Ger many Po l and Swed en UK EU
A ver ag e

Source: CFO Questionnaire, September 2007

Due to the fact that individual legal entities are decisive for aspects like dividend payments or
taxation, companies have to take further measures. To bring the parent company’s financial
situation in line with the group perspective, the companies interviewed in nearly all cases
steer the profits and cash flow situation of the parent company. This is mostly done in a
structured planning process over several years, mainly to achieve tax optimisation for intra-
group distributions. Some UK companies, in particular, have pointed to high expenditures in
this regard.

A potential reappraisal may therefore give regard to the consolidated view applied in the
determination of distributable profits.

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To this end, the following three alternatives may be considered:

Figure 6.2 - 4: Three approaches concerning dividend distributions in groups of companies

Model Action Comment Legal changes

1 – „Do nothing“ None Single legal entities are No change

decisive.

2 – „Add-on“ Creation of additional Current approach of Additional elements in

element single legal entity the distribution process.
complemented by group
dimension.

3– Fundamental change of Radical change to Fundamental legal

approach consolidated figures for reform; not only
„Pure the whole group. company law but also
consolidated insolvency and tax law.
view“

6.2.2.2 Model 1 – “Do nothing”

As already mentioned, under the current 2nd CLD, profit distribution and capital maintenance
are conducted from a single legal entity perspective. The legal framework in which this
happens is consistent, as responsibilities in other regards (e.g. insolvency legislation or tax
law) are also mainly directed towards this single legal entity. It could therefore be argued
from a legal point of view that further reflections concerning a group relationship are not as
such necessary.

6.2.2.3 Model 2 – “Add-on”

To reflect the economic reality, the group situation may be taken into account in a way to
additionally test the economic situation of a group when making a dividend distribution
decision. The current testing model based on the individual accounts could be extended by an
additional formal test of the consolidated accounts

A specific example where the consolidated view is already taken up in such a way is Sweden.
Sweden has integrated this in its current legislation. For groups of companies, the
distributable amount for dividend payment is determined as the lesser of distributable
amounts available at the parent company’s level or the distributable amount of the group
accounts. Moreover, the group view seems to be embedded in the “prudence rule” for the
board of directors when assessing the financial position of the company, especially in view of
cash flows.

Furthermore, a similar suggestion to take the group view into account has come from
individual members of the Lutter Group, Pellens/Sellhorn132.

6.2.2.4 Model 3 – “Pure consolidated view”

The most daring approach is the transition of the distribution scheme from the perspective of
the individual legal entity to the group perspective. However, this approach would neglect the

132
Cf. Pellens/Sellhorn, in: Lutter (Ed.), Legal capital in Europe, ECFR Special Volume 1, p. 364-393.

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individual legal entity in its existence and would rather protect the company solely from a
group perspective. For this reason, a legal solution that would only focus on profit distribution
is not sufficient to solve the remaining legal problems caused by the fact that it is the single
legal entity which is subject to legal requirements, not the group. Significant examples are the
question of insolvency law and group taxation and the issue of the limitation of the liability to
a single legal entity. Both issues need to be resolved before a comprehensive group view
could be taken on the issues of profit distribution and capital maintenance. Another significant
barrier may come into play for all groups operating outside the European Union. Even if a
harmonised solution is found for the European Union, a lack of convergence with other non-
EU jurisdictions may prevent an effective approach to a group view.

One specific jurisdiction where the group perspective is used in legislation is the US State of
California. However, the requirements only refer to the use of group financial statements and
group’s cash flows which is an expression of how the consolidated accounts of the group are
perceived – as the financial statements of the parent company. The individual financial
statements are only relevant at subsidiary level. Even though the group perspective is used
with regard to the assessment of the financial position of the parent company, the California
legislation does not basically change the legal obligations for directors as they are still
directed towards the single legal entity.

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6.2.3 Design of the solvency test

6.2.3.1 Overview

One essential element of alternative capital regimes already used in other non-EU
jurisdictions as well as in the theoretical models are so called “solvency tests” that aim at
ensuring the liquidity of companies after a dividend distribution. Solvency tests may also be
employed in other situations where company assets are transferred, e.g. repurchase of shares,
capital reductions.

Experience from our interviews conducted in EU and non-EU jurisdictions showed that cash
flow considerations play a decisive role. It is a matter of diligent behaviour of the company’s
management to assess, with the help of the corporate treasury function, whether dividends can
actually be paid from the current cash flows of the company/group. Furthermore, longer term
cash flow prognosis may be needed if certain levels of dividends should be paid on a
sustainable basis; mostly, a cut in dividends is considered a bad signal to capital markets.

A typical internal monitoring effort in the corporate treasury regularly shows the following
pattern: detailed cash flow forecasting is performed for a period of at least one year; this is
followed by a mid-term cash flow planning spanning 3 years, at maximum 5 years. The mid-
term period is already less detailed and the basis for the prognosis is considered to be less
reliable due to uncertainties concerning the actual development of the business of a company.
In some cases, cash flow planning is conducted even over longer periods, of up to ten years.
Whether such planning makes sense depends on the nature of the business and whether this
allows for a reliable projection of cash flow and revenue/expense streams.

Concerning the question whether companies in the five EU Member States see the use of
solvency tests as an effective means to determine their ability to pay dividends, the CFO
questionnaire sent to listed companies on the main stock indices in the five EU Member
States delivered the following results:

Figure 6.2 – 5: CFO survey results: use of liquidity tests

Liquidity-oriented/solvency tests: "Is the ability to pay dividends better

determ ined via liquidity tests that take into account projected future cash
flow s?"

100%
90%
80%
70%
Percentage

60% Yes
50% No
40%
NA
30%
20%
10%
0%
F r ance Ger many Po land Sw ed en UK EU A ver ag e

Source: CFO questionnaire, September 2007

Except for Germany, there is always at least a slight majority of CFOs of listed companies
who believe that a solvency test is better positioned to determine the level of dividends. A
solvency test in this sense refers to projected future cash flows.

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From a legal point of view, the requirements regarding a solvency tests are to be set out in
law. This can be done in a more or less precise manner. A starting point could be the wording
of a solvency certificate to be signed by the company’s management. In the course of our
interviews, we found in New Zealand a framework in which the companies set up their own
wording. In Canada, solvency certificates are subject to provincial laws which could differ in
detail but cause companies concerned to seek interpretation of the exact meaning of legal
terms. In essence, experience has shown that the clearer the legal terminology, the more there
is legal certainty for companies concerned which have to prepare the relevant documentation.
On the other hand, business judgement in the interpretation may help to find workable
solutions to find an adequate cost benefit ratio for legal compliance. For example in Canada,
the lack of clearness of certain legal terms allows the documentation already prepared for the
purpose of bank covenants to be used in one case.

To this end, the following basic options may be used to determine an adequate design of such
solvency tests:

Figure 6.2 – 6: Four approaches concerning the design of solvency tests

Model Method Predictability Burden

1– No intervention (best Depends on model chosen Depends on model

practice) by company chosen by company
„Leave it to the
companies“
2– Liquidity assessment No projection required; Rather insignificant
based on current balance „certain“
„Current ratios“ sheet ratios
3– Cash flow projection for Medium level of certainty Depends on deviation
one year (plus known from current practice
„Short-term future payments)
projection“
4– Cash flow projection High level of uncertainty Depends on deviation
from two to five years from current practice
„Mid-term (plus known future
projection“ payments)

6.2.3.2 Model 1 – “Leave it to the companies”

Under a “Leave it to the companies” approach, the legislator could introduce a specific
fiduciary duty of the management board to ensure that the company justifies the distribution
from a cash flow perspective without exactly prescribing the contents of such a liquidity test.
Such a fiduciary duty could be required via a solvency certificate which sets out the exact
requirements of the test.

In such a situation, a company could decide which instruments it intends to use to document
its decision in this regard. Experiences from the interviews have shown that companies can
flexibly adapt their documentation. For the Delaware companies interviewed, the
documentation referred to current balance sheet ratios as the companies obviously had
sufficient cash at hand to make distributions. In New Zealand, the companies individually
prepared their wording of a solvency test. In Canada, one company, for the solvency
certificate prescribed by provincial law, used the documentation already prepared for the bank
covenants. In this way, the incremental efforts of these companies were minimised and could
be adapted to their individual financial situation.

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6.2.3.3 Model 2 – “Current ratios”

The “current ratio” approach refers to the current situation of a company which could be
determined by a comparison of current assets to current liabilities based on the audited
financial statements of a company. This is also foreseen by the High Level Group proposal.
Such an approach could be easily complied with and convey a high level of legal certainty to
those who were charged with performing the test. However, such an approach would neither
look into the short-term nor medium to long-term future. Therefore, substantial known future
developments could be intentionally ignored.

6.2.3.4 Model 3 – “Short-term projection”

An approach where a short term projection would be the basis of the solvency test is another
alternative. A short term projection would cover the next 12 months of a company’s life and
could be attested via a solvency certificate. The Rickford Group proposes such a design for
the next year; the Lutter Group for the next one to two year period. This corresponds to the
actual practice of companies where the most detailed and reliable projection takes place for
the next financial year. This is our experience from the interviews with companies inside and
outside the EU. However, it depends on the exact format prescribed whether such a
requirement would require a substantial effort by the companies concerned to comply with the
requirement. The closer the required format to the actual company practice, the easier the
compliance. However, such a prognosis always requires a subjective assessment by those who
are charged with the preparation and the format of the certificate would need to take this
uncertainty into account. In the case of a one year projection, the projection is more certain
than over a longer projection period.

Another important element of such an approach would be the inclusion of long term
commitments already foreseeable at the time of the preparation of the projection. This
element ensures that known future developments are not ignored. Such an element can also be
found in the proposals of the Rickford and Lutter Groups.

6.2.3.5 Model 4 – “Mid-term projection”

A “Mid-term projection” would cover the next three to five years of a company’s life and
could also be attested via a solvency certificate. From our experience with the companies
interviewed inside and outside the EU, the length of the projection period stretches to the
boundaries of the companies’ practices and ability to project cash flows in most cases. Again,
it depends on the exact format prescribed whether such a requirement would require
substantial effort by the companies concerned to comply with the requirement. The closer the
required format to the actual company practice, the easier the compliance. Especially in this
case, the prognosis requires a subjective assessment by those who are charged with the
preparation and the format of the certificate would need to take this uncertainty into account.
In the case of a mid term projection the degree of subjectivity is very high and less reliable
than a short term projection over one year.

Another important element of such an approach would be the inclusion of long term
commitments already foreseeable at the time of the preparation of the projection. This
element ensures that known future developments are not ignored. Such an element can also be
found in the proposals of the Rickford and Lutter Groups.

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6.3 True no-par value shares

The question of whether and to what extent the introduction of shares without any reference
to either nominal or fractional value would constitute a significant change in the system of the
2nd CLD is examined below.

6.3.1 Introduction

The 2nd CLD at present recognises only par value shares and shares with an accountable par
("pseudo no-par value shares"). While the 2nd CLD does not expressly provide for the
admission of no-par value shares, it can be concluded from an overall view of various
provisions of the 2nd CLD that true no-par value shares conflict with the current concept of the
2nd CLD, because all shares are linked back to the subscribed capital.

While the 2nd CLD in Art. 3 c admits the subscription of shares without stating the nominal
value, it also prescribes that companies must have subscribed capital (Art. 2 c) and also uses
at various places (for example in the description of the minimum issue price in Art. 8 ss. 1 and
the minimum contribution for shares in Art. 9 ss. 1) the term accountable par which
corresponds to the nominal value, meaning the amount of the subscribed capital attributable to
each single share.

Par value shares are characterised by direct reference of the shares to the subscribed capital of
the company. Each share is stated to represent an amount in Euro, the sum of which makes up
the entire subscribed capital. In the case of pseudo no-par value shares, a mathematical
amount of the subscribed capital can be attributed to each share by way of division. Because
the subscribed capital is protected against distributions, it remains in place so that the par
value can also remain. Changes to these items are possible only by formal procedures, for
example by capital increases, in which additional income leads to an increase in subscribed
capital, the increased amount being again divided into nominal value.

In the case of true no-par value shares, this reference to the subscribed capital is absent. The
systems in which they exist, do not provide for any subscribed capital or there is no
connection between subscribed capital and number of shares issued. The question of no-par
value shares therefore is always connected to the question how the proceeds from a share
issue are handled if not included in the subscribed capital. In this connection reference is to be
made to the fact that the par value has nothing to do with the real value of the shares.

Accordingly, the question of the introduction of true no-par value shares depends on how the
basic set-up of the capital regime in which the no-par value shares are to be included, is
designed in detail. It must be distinguished between models in which the current capital
regime differentiating between subscribed capital and premiums is replaced by a similar
system which abolishes this distinction, and such models which either partially or wholly
reject the association of the capital or the proceeds from the issues of the shares.133

133
cf. special edition of the European Company and Financial Law Review (2006) „Legal Capital in Europe“
recently published by Marcus Lutter.

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6.3.2 Concepts for the introduction of true no-par value shares

As has already been stated, there is no definitive overall system for the introduction of true
no-par value shares, but a number of models come under consideration. They are
distinguished initially mostly according to the extent the proceeds from the issue of the shares
are protected against distribution. The lesser the protection in this context the greater the need
for adjustment in relation to the provisions of the 2nd CLD, which relate precisely to the
protection of these proceeds and, based thereon, pursue the nominal capital concept. As to be
shown in detail, various models can be considered. Model 1 maintains as far as possible the
provisions of the 2nd CLD and places all proceeds from the issue of shares under protection
similar to that applicable to subscribed capital. Model 2 assumes variable capital. According
to Model 3, the proceeds from the share issue are used initially to make up the amount of
subscribed capital and then reserves, so that there is a mixture of uses involved. Models 4 and
5 protect the proceeds of the share issue not by the prevention of distributions but by
admitting its distribution under certain conditions, namely a balance sheet and/or solvency
test or solvency margins.

6.3.2.1 Model 1: Protection of all proceeds from share issues

True no-par value shares can firstly be introduced without repealing the existing provisions on
capital contributions and capital maintenance by introducing instruments comparable to those
of the subscribed capital system. A specific working group on European Company Law also
headed by the German Professor Lutter supports the view in this respect that, with the
introduction of true no-par value shares, the concept of legal capital need not necessarily be
given up but its implementation can be ensured in a different technical manner.134 A similar
model is also investigated by Böckli135 and discussed by Rickford.136 The details of such a
system might be as follows:

Replacement of subscribed capital by equity capital

In this model137 “subscribed capital”, the fixed nominal capital (subscribed capital) is given-
up. An “equity capital” position remains on the balance sheet, but is no longer divided
between subscribed capital and premiums but contains a statement that the company has
achieved certain proceeds.138 A uniform balance sheet item in “equity capital” therefore arises
as “contributed capital” which is made up of the total of capital contributions received i.e. the
present subscribed capital and the premium, and serves as a reference dimension. In this
model, access to the subscribed capital by distributions is replaced by a prohibition against
repayment of contributions as they are stated in the balance sheet.139

In this connection it is to be seen that EU law contains no prohibition on the distribution of

premiums but of subscribed capital in the 4th CLD, that the premiums are to be entered as
equity capital with the further consequence that the premiums in various jurisdictions –
unlike, for example in the UK - are subject to a less restrictive bond than the subscribed
capital. For example, premiums in Germany and Poland where they ought to be shown as
134
copied in ZIP (2002), pp. 1310, 1317.
135
Böckli in Festschrift Druey (2002), pp. 331, 341 et seq.
136
Rickford, Reforming capital , 15 EBLR (2004), p. 930.
137
cf. opinion of the European Company Law working group of March 2003 on the final report of the High
Level Group, ZIP (2003), pp. 863, 872.
138
Böckli in Festschrift Druey (2002), pp. 331, 341 et seq.
139
cf. also Weiß, Aktionärs- und Gläubigerschutz im System der echten nennwertlosen (Stück-)Aktie, Diss.
2007, pp. 186 et seq. in connection with the English proposal.

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capital reserves can be used under certain conditions to make up annual losses or losses
carried or for conversion into subscribed capital. They are usually bound for the protection of
present and future shareholders against agiotage. On the contrary, they can, in France and
Sweden, be distributed to shareholders140. If now however the entire contribution capital
(contributions plus premiums) are bound, this possibility is lost because the entire amounts
contributed are bound. This model therefore results in improved protection for creditors by
binding the assets more strictly.

On the other hand, it should be noted that the interest of the shareholders in profit is affected
by this change. It is – as already stated above - admissible for example in Germany and
Poland that premiums be used to cover losses and the reserves subsequently gradually rebuilt,
with corresponding influence on the distribution of profit. If premiums were bound under the
new item “equity capital”, this possibility would be lost. This applies all the more for France
and Sweden where premiums are not protected and can be distributed. The introduction of a
uniform "equity capital" would, in the states without full premium protection, therefore lead
to a more strict block on distributions and ultimately to less capacity for distributing profits.

No-par value shares

In this model, it is proposed to introduce true no-par value shares representing a quota of the
company’s equity. The share issue price should be fixed by the board according to its fair
value, possibly by reference to the quotation of the share price on a stock exchange.141
Consequently, the shareholder no longer pays in the nominal value and the premium
separately, but a single specified issue price for the share which is to be entered under the
protected item “equity capital”. In this case a connection between the protected item
“contributed capital” and the proceeds from the share issue remains, because both are to be
entered completely as equity capital.

Abolition of below-par issues

The prohibition of below-par issues (non discount rule, Art. 8) would no longer arise because
of the no-par value shares but rather the issue price would be specified by the general meeting
or in the case of authorised capital by the board or management board and supervisory board
according to the true value (relying on the stock exchange price, as the case may be). This has
advantages in particular if a reconstruction is concerned. A company in need of restructuring,
the stock exchange or market value of which is below-par (stock exchange price or market
value is lower than the nominal value of the subscribed capital), must issue new shares at their
nominal value if the prohibition on below-par issues applies. The financing and therefore the
restructuring can in this case therefore be more difficult, because shares would have to be
acquired for a price higher than their value. By the issue of the no-par value shares, this
problem would be excluded from the outset. It is to be noted however, that there is a process
to some extent in the Member States that the prohibition on below-par issues is counteracted
by a capital reduction with subsequent capital increase being conducted. In Germany for
example it is admissible that capital in this case (other cases are excluded) is reduced to zero
in order then to be increased to a reasonable amount.

140
details regulated in German law by § 150 Stock Corporation Act.
141
Böckli in Festschrift Druey (2002), pp. 331, 347.

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Bonus shares

It is also pointed out that with the abolition of the direct link between the number of shares
and the subscribed capital, further capital measures which are linked to the division of the
subscribed capital into shares could also disappear while participation in the company would
be specified by the true value of the company. As an example, the issue of bonus shares as a
price correction is quoted. Bonus shares are shares from a capital increase from company
funds which – expressed briefly – can be described as a transfer in the books from reserves to
equity capital. Shares from a capital increase out of company funds142 are issued to existing
shareholders without the contribution of fresh capital so that the price of the shares is reduced
because of the higher number of shares resulting from the capital increase. Such a bonus issue
can be significant if the shares are traded at a high price. It is, however, seen in practice that a
price correction can also be carried out by share splitting (division of one share into several
shares). In case shares with an accountable par are used, no change to the par value is needed.

Share splitting

It is also argued that the no-par value shares could resolve the problem that a par value share
issued at the minimum amount can no longer be split. This absence of splitting is seen as a
disadvantage if the price of the par value share has risen so strongly that at least small
shareholders refrain from purchasing such “heavy” shares.143 However, such minimum
nominal amounts do not arise from the 2nd CLD but from national law – if this problem is at
all today of practical relevance. In Germany, which has such a minimum nominal amount,
this problem has been resolved with the introduction of the statutory minimum par value of
one Euro.

Simpler management

It is also pointed out that in the case of true no-par value shares, the number of shares can be
changed without changing the par value of each shareholder by a greater number of new
shares (share splitting, cf. above) taking the place of a smaller number of shares (merger of
shares). Technically, therefore, this provides a simplification of procedure because no change
to the par value is needed. However, it should be pointed out that this advantage can be
achieved even today with shares with an accountable par.

Capital increases and reductions

If new shares are issued, the replacement of subscribed capital by equity capital can remain in
this model in the case of a capital increase (Art. 25), because the item “equity capital” is
necessarily increased in a new issue of shares by the resulting proceeds. It could therefore be
considered that conceptually, reference be made to an increase in the number of shares. No
material change would, however, balance this because, in this model, with the issue of new
shares and the inflow of the proceeds, equity capital must also be increased so that the terms
“equity increase” or “equity capital increase” could remain. Furthermore, in this model, the
pre-emption rights (Art. 29) and the capital reduction process (Art. 30) can remain because a
protected equity capital exists which can be reduced.

142
with respect to the comparable problem of capital reductions cf. Münchener Kommentar-AktG/Heider, 8
marg. note 103.
143
Münchener Kommentar-AktG/Heider, 8 marg. note 34.

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Other provisions which refer to capital

In the context of this model, the other provisions which are characterised by the reference to
capital can, in principle, remain, because another protected item – contributed capital – would
exist. This applies, for example, to the publication of equity capital, the minimum
contribution, the contribution regulations, subsequent formation, the obligation to call a
general meeting in the case of serious loss of capital, the acquisition by the company of its
own shares, capital increases and reductions (see below) and distributions. The situation is
different in the case of some regulations which refer to subscribed capital as reference for
certain rights and obligations (e.g. dependent on a certain percentage of subscribed capital)
both in relation to the provisions of the 2nd CLD (see below) and also under national law (see
below).

Subsequent adjustment due to change of the reference

With the change of system dealt with, here from subscribed capital to equity capital, various
consequent changes must be made. These changes refer to cases in which a certain proportion
of subscribed capital or the subscribed capital as such is used as reference, because as already
stated, equity capital would, after the change in system, be greater than the previous
subscribed capital because of the addition of the former nominal values and premiums. In this
respect, distinction is firstly to be made between the situations in which the 2nd CLD refers to
a single percentage of subscribed capital and those in which it refers to subscribed capital as a
whole and this leads to further consequences such as a barrier to distributions in the case of
dividends.

Reference to a certain proportion of the subscribed capital.

If the 2nd CLD refers to a single percentage of subscribed capital, the question of whether an
adjustment of this percentage to the new item of equity capital is necessary or instead the
number of shares is to be relied on, arises, and, in this respect, distinction between European
law and national law has to be made.

Adjustment of the percentage in equity capital

European Law

Capital contribution

In the case of capital contribution, it is questionable to what extent the existing provisions of
the Directive according to which, in the case of cash contributions, 25% of the nominal value
at the time of formation and the premium in full must be paid-up (Artt. 9, 26), needs to be
amended. Because of the addition of the par value and premiums necessitated by the system
change from subscribed capital to equity capital, payment of the total issue price will
sometimes be required144. A compromise solution (e.g. 50% or 75% of the total amount) or
retention of the existing amount could be considered.

144
This has been repeatedly suggested by the English Company Law Reform Steering Group cf. Modern
Company Law – For a Competitive Economy – Company Formation and Capital Maintenance – A Consultation
Document (URN 99/1145), October 1999, p. 31, 3.19.

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Subsequent formation

In the case of subsequent formation (Art. 11), the extent to which the acquisition of an asset in
return for 1/10th of the subscribed capital should be relied on for the application of the
subsequent formation provision, is to be examined. In the case of a system change, the
threshold would be higher than under the present law.

Repurchase of shares

In relation to the repurchase by the company of its own shares, the extent to which Art. 19 (1)
c) of the 2nd CLD, according to which the par value or accountable part of the shares acquired
may not be more than 10% of the subscribed amount, should be amended, has to be clarified
(cf. Directive 2006/68/EC of 6 September 2006, which allows Member States to delete the
current rule of the 2nd CLD that allows an acquisition of a company’s own shares only up to a
proportion of 10% of the subscribed capital).

Alarm function

The 2nd CLD provides (Art. 17) that the EU Member States may not set the amount which is
to be specified as a serious loss of subscribed capital at more than half. In the models
examined, this provision could be retained. However, since the equity capital would include
the entire proceeds (including premiums) and would therefore be greater than the capital
subscribed so far, the question of adjusting this reference dimension arises. Maintaining the
present dimension, would increase shareholder and creditor protection.

Consequent amendments in national law

In a change of system from “subscribed capital” to “equity capital”, the effects on national
law and the associated consequent likely comprehensive amendments would also have to be
considered.
The various national laws rely at present in various areas on a specific proportion of
subscribed capital. In Germany, this relates to the right to require that a general meeting be
called or to have certain items placed on the agenda of a general meeting, the making of
compensation claims of the company against members of the management and/or supervisory
boards, the waiver of claims of the company against those and certain other persons, the rules
of procedure for the general meeting, approval of amendments to the statutes and capital
measures and inter-company agreements, the exclusion of pre-emption rights, the
continuation of the company, terminations, various special resolutions and objections,
integration, exclusion and transformation processes.

Amendment of the percentage by calculation in number of shares

As mentioned at the outset, there is also the possibility, instead of the reference figure which
relies on a percentage amount of the protected proceeds from the share issue, to invoke the
number of shares as reference.145

145
So Böckli in Festschrift Druey (2002), p. 331 (341, 343).

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Subscribed capital as barrier

In this context, cases in which the entire subscribed capital item results in certain further
consequences, in particular as a barrier to distributions, are also to be seen.

Distributions

The provisions of Art. 15 of the 2nd CLD, according to which distributions may only take
place if the net assets exceed the subscribed capital plus the reserves, the distribution of which
is forbidden by law or the statutes, are significant. As already shown a stronger barrier to
distributions would be created in many Member States by the combination of subscribed
capital and premiums, and this would lead to a reduction in dividends. The extent to which
reliance on the equity capital as a barrier to distributions is justified, or whether it would lead
to a considerable reduction in distributions, must be examined.

Repurchase of shares, financial assistance

The same questions arise in the case of the repurchase by the company of its own shares, in
that under the existing provision of Art. 19, 1 of the 2nd CLD, the repurchase of shares may
not lead to the net assets being impinged (cf. the amended provision of Directive 2006/68 EC
of 6 September 2006, which also relies on the net assets). The combination of capital and
premium could lead to less assets as hitherto under the 2nd CLD remaining for the repurchase
of the company’s own shares. The same considerations apply to the new regulation of
financial assistance in Directive 2006/68 EC of 6 September 2006, which relies, inter alia, on
the financial assistance not impinging on the net assets.

Editorial amendments

The introduction of such a protected item "equity capital" would lead to changes in the 2nd
CLD to the effect that the term "subscribed capital" would have to be replaced in various
places by “equity capital”. The following provisions, in particular, would have to be so
amended:

ƒ in the recitals, “capital” would have to be replaced by “equity capital” (so that “equity
capital increase” would replace “capital increase”) and the “composition of the company’s
capital” would become “the amount of equity capital”,
ƒ in Art. 2 c), the amount of equity capital must replace the amount of subscribed
capital,
ƒ in Art. 6 a minimum equity capital or an equity capital fixed by the statutes146 would
be necessary,
ƒ in Art. 7 the contributed capital may consist only of assets the monetary value of
which is ascertainable,
ƒ in Art. 15 ss. 1 as the central distribution provision, the uniform "contributed capital"
must replace "the amount of subscribed capital plus reserves"; the other sub-sections must
also be reformulated accordingly,
ƒ all other provisions dealing with „subscribed capital“ (cf. Arts.11, 17, 19, 20, 23, 25,
27 – 40 Capital Directive) must also be amended accordingly.

146
For a proposal to rather refer to the most recent financial statements, see Böckli in Festschrift Druey (2002),
pp. 331, 347.

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Amendments to the 4th CLD would also be required in the case of the balance sheet items
(Art. 19 of the 2nd CLD).

The change of system to no-par value shares – as here investigated – would also involve the
repeal of those provisions which reflect the par value system, i.e. by referring to a nominal
capital value or a nominal share value. An example would be the new wording of Art. 3 of the
2nd CLD, which would then have to prescribe that the total number of shares and the
contributed capital is to be disclosed and no longer the nominal amounts. Just as “capital”
must be replaced by “contributed capital”, the „nominal value of the shares“ must be replaced
by „share in the contributed capital“ or „contribution amount“, so that, for example, according
to Art. 10 ss. 2 of the 2nd CLD, the report on contributions in kind must state whether the
value actually corresponds to the contributed amount.

In addition, Art. 8 of the 2nd CLD – as already described above – must be repealed and
instead, the value (true value) at which the shares should be issued must be determined.
Finally, the extent to which the consequent amendments described above, which result from
the change to the reference dimension, should be implemented must be reviewed. They affect,
in particular, Arts. 9, 11, 15, 17, 19 and 26 of the 2nd CLD.

Consequences

With the approach of introducing no-par value shares while retaining the capital system, in
that all proceeds of the share issue are contributed to a protected capital amount, hardly any
principle changes to the present system of the 2nd CLD arise. However, beyond the necessary
abolition of the prohibition on below par issues many consequent amendments would be
required because of the total binding of the proceeds from the share issues. This applies, in
particular, to those provisions in which the 2nd CLD refers to subscribed capital items, or in
which a special function is attributed to the subscribed capital (e.g. as a barrier to
distributions). This would also continue into national law.

The advantage in that system lies mainly in the disappearance of the prohibition on below par
issues which can be of particular significance in connection with restructurings. As shown
however, in practice – at least in certain EU Member States – methods of dealing otherwise
with the related questions have emerged. In connection with the issue of bonus shares and
share splitting or merger of shares also, certain advantages are referred to, which are,
however, in practice hardly significant or which can also be achieved by pseudo no-par value
shares.

However, it should be noted that such a system change would, with regard to the binding of
the total proceeds in an item "equity capital", in some EU Member States represent a
considerably more onerous solution than the present one, which could affect the dividend
interests of the shareholders.

6.3.2.2 Model 2: Variable capital

The second possible model, in which the no-par value shares could be included, is
characterised by the fact that the proceeds of the share issue are not completely contributed to
a protected equity capital item – as is the subscribed capital – but to an only partially
protected reserve.

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Reserve

For this case, a model in which there is no item „subscribed capital“ and instead the proceeds
of the share issue on the formation and capital increase are entered as a reserve which can be
used only under certain conditions, such as making up losses or losses carried forward, could
be considered. The proceeds of the share issue would, in that case, be only partially protected.
Even if in this model, the catch-up principle - i.e. the rebuilding (possibly in stages) of these
reserves after their reduction or loss - applied, the use of the reserve to make up losses would
result in a reduction of the item (variable reserve).

No-par value shares, below par issues

The consequence of this model would be, in the case of the availability of no-par value shares,
the dissolution of the connection between shares and entry values in which the proceeds of the
issue are entered, if this item would be reduced when used to cover losses. The shares could
continue unchanged, because their value would, according to the proportionate participation,
be determined by the actual value of the company. In this model, the prohibition on below par
issues would – as above described - disappear (for consequences see above). The above
comments can also be referred to in connection with the issue of bonus shares, share splitting
and the merger of shares.

Capital increases

In this model also, the reserves would increase by the proceeds of the issue of new no-par
value shares. The concept of capital increase could therefore be maintained or the term
"increase in reserves" used in that context (cf. the concept of increasing the number of shares
above).

Capital reduction

A formal procedure of reduction of the reserve item in which the share proceeds are entered
appears to be appropriate in this model, because the limited possibility of dissolving the
reserves (suggested only to cover losses) permits situations in which the company would wish
to reduce the reserves. The capital reduction provisions may be used as a precedent.

Consequent amendments

With regard to capital procurement, the same problem arises as in Model 1, because here the
items subscribed capital and premium used on the 2nd CLD are combined in one item, namely
the reserves. However, in this model, it also arises that the reserves, into which the
contributions are to be paid, could be reduced to zero if used to cover losses, so that the items
in the 2nd CLD, which have hitherto related to subscribed capital, would have to be
reconsidered (cf. various considerations above). In the course of such a transition to reserves,
which could even be reduced to zero, reference to that figure is completely excluded and there
remains only the reference to the number of shares (which admittedly is only partially
possible).

In addition, in this model many consequent amendments in national law would be required
(cf. above).

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Conclusions

The reserves model has the same advantages as the Model 1 (in particular the avoidance of
below par issues). The reduced protection for shareholders and creditors is characteristic of
this model because the reserves for example in the case of an annual loss can be reduced to
zero. The inviolable cushion of the subscribed capital of the 2nd CLD would not be available.
In addition, this model would require many consequent amendments in European and national
law.

6.3.2.3 Model 3: Mixed model

No-par value shares could also be introduced in the context of a mixed model proposed by
Jahr and Stützel as early as 1963 for German company law (“Saarbrücken Proposal”)147. This
model provides for the retention of subscribed capital in spite of the introduction of no-par
value shares.

Subscribed capital –reserve

According to this model, subscribed capital is formed on the establishment of the company,
and the proceeds of the share issue are entered as such, until the minimum capital or a higher
amount prescribed by the statutes is reached. Above that figure, the issue proceeds are no
longer treated as subscribed capital but are entered as reserves. The reserves have a degree of
protection because, according to the proposal, they can be used only to make up losses or
losses carried forward or to increase the subscribed capital. In the event of later capital
procurement measures, the proceeds can be added either to the subscribed capital or to the
reserves and the proposal provides for various procedures in this respect – increasing capital
or increasing the number of shares.

Introduction of no-par value shares – no below par issues

It is proposed in this model that true no-par value shares be introduced. Each no-par value
share carries the same rights. The prohibition on below par issues no longer applies in this
model (cf. above). The comments above can also be referred to in connection with bonus
issues, share splitting and share mergers.

Capital increases and reductions

Two procedures have to be distinguished in this model in relation to the acquisition of new
capital, depending on whether the proceeds of the share issue are intended to be attributed to
the subscribed capital or to the reserves148. In both cases, a qualified general meeting
resolution is required. If the proceeds are attributed to the reserves, the proposal refers to the
issue of new shares. It also provides that a minimum amount below which the shares may not
be issued, be fixed. If the proceeds are attributed to the subscribed capital, it is provided that
the maximum increase in the subscribed capital is the total issue amount of the new shares.
The protection of shareholders against dilution in the case of share issues without a capital
increase is, in this model, intended to be provided by the amount of the issue having to be
selected so that the reduction in the proportion of shares is balanced out by the increase in net
assets.

147
Jahr and Stützel: no-par value shares (1963).
148
Cf. Overview in Weiß, Aktionärs- und Gläubigerschutz im System der echten nennwertlosen (Stück-)Aktie,
Diss. 2007, pp. 196 et seq.

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The proposal also provides for a special procedure for capital reduction and the reduction in
the number of shares (withdrawal of shares).

Other provisions which refer to capital

In this model, the other provisions which are characterised in that they refer to subscribed
capital are retained by virtue of the continued existence of subscribed capital. Certain
amendments are nevertheless required:

Consequent amendments

With the disappearance of the obligation to increase the subscribed capital with every capital
procurement measure, the question of necessary amendments arises, because the subscribed
capital no longer necessarily increases with the issue of new shares. The relevant comments
made above and, in relation to editorial amendments, on the proposal of Jahr/Stützel are
referred to149.

Conclusion

The Jahr/Stützel mixed model leads firstly to deviations from the existing par value system,
with the removal of the prohibition on below par issues (cf. above). However, it should be
noted that the necessity to have various procedures in place depending on whether the
proceeds of the share issue are attributed to, or should be removed from, the subscribed
capital or the reserves, leads to increased costs.

It is also clear that the proposed model would lead to changes in the binding of the proceeds
of the share issue. While it is already possible according to the 2nd CLD to attribute the
proceeds of a share issue to the subscribed capital or the reserves, if the premium is resorted
to, the difference that, under the 2nd CLD, a certain amount must be added to the subscribed
capital remains. Accordingly, in this model, less of the proceeds could flow to the subscribed
capital than under the 2nd CLD. This would then result in a certain reduction in protection.
Under this model also, many consequent amendments in European and national law would
become necessary.

6.3.2.4 Model 4: Solvency test

A further model in which the introduction of no-par value shares can be integrated is a model
in which legal capital as it exists at present is totally abolished. This model can invoke third
states, for example New Zealand. This model would lead to considerable amendments to the
2nd CLD and would require the introduction of additional protection instruments such as
solvency tests, which are not, however, linked to the introduction of no-par value shares as
such.

Removal of protection for share issue proceeds

In this model, the proceeds from the issue of shares on formation and on capital increases are
no longer protected against distribution (cf. the situation in New Zealand and Delaware).150 In

149
Jahr and Stützel: no-par value shares (1963).
150
See also the models existing in Canada and Australia where the proceeds from share issues cannot be
distributed. Also these models use true no-par value shares.

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fact, the proceeds are to be entered as a constituent of equity capital (e.g. profit reserve) which
can be distributed unless this is prevented by additional tests to be conducted (e.g. balance
sheet test and solvency test).

Introduction of no-par value shares

Due to the abolition of subscribed capital and the possibility that share issue proceeds can, in
principle, be distributed, no-par value shares must be introduced in this model. These no-par
value shares would designate the value of shares purely by reference to the shareholder's
proportionate share in the value of the company. By the introduction of no-par value shares,
the shareholder would have to pay-in an equal amount per share as a specified issue price151.
In addition, the prohibition of below par issues would also be removed by the introduction of
no-par value shares (cf. above) and the results described above would arise on the merger or
splitting of shares (on bonus shares see also above).

Capital increases and reductions

In later capital procurements, in this model the proceeds of the share issues are to be entered
as equity capital in the same manner as the contributions received on formation. This process
is sometimes described as an increase in the number of shares152 but sometimes the term
capital increase continues to be used153. The requirements for the resolution and the pre-
emption rights of shareholders, which can also be retained in this system, are to be seen
independently thereof154 (cf. the California provisions according to which pre-emption rights
are not retained per se but may be granted in the statutes). Capital reductions as such would
no longer be necessary, because the receipts from the share issue can be distributed in any
event155.

Cancellation of other regulations which refer to capital

In this model, the other regulations of the 2nd CLD which refer to capital, would have to be
reviewed. Publication of equity capital would no longer be necessary because it can, in any
event, be amended at any time. Apart from the capital reduction provisions, the obligation to
call a general meeting in the case of serious loss of capital would no longer be necessary. At
first sight, it can also be asked whether the provisions on capital procurement (in particular,
the eligibility of services as a contribution and the valuation of contributions in kind by an
auditor) make any sense in a no-par value system. As, however, they serve the precautionary
purpose of ensuring measurable and valuable contributions, they are not, as such, contra-
indicated in the no-par value system.

Although it is intended in this model to apply solvency tests with respect to distributions, it
should be pointed out that the change to the solvency system in regard to distributions and the
repurchase of the company's own shares – and capital contribution - is not necessarily the
result of the introduction of no-par value shares, because even with no-par value shares the
existing distribution model of the 2nd CLD can be retained with certain amendments (cf.
above).

151
Cf. the various proposals of the High Level Group and Rickford Group.
152
This is the case in New Zealand; cf. also the proposal of the Rickford Group.
153
This is the case in Delaware.
154
Cf. the proposals of the High Level Group and the Rickford Group.
155
Cf. however, the proposal of the Rickford Group.

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Conclusions

This model would lead to a wide reaching system change, going far beyond the consequences
linked to the introduction of no-par value shares, as such. As has been shown, the introduction
of no-par value shares in this model is a necessary step due to the abolition of subscribed
capital. The benefits of the introduction of no-par value shares as such would only have the
advantages stated in respect of the Model 1.

The question of whether and in what form regulations on distributions, the repurchase by the
company of its own shares or proper contribution should be framed and what advantages can
be thereby derived, does not depend on the question of the introduction of no-par value
shares. The advantage to be gained from such regulations are described above.

6.3.2.5 Model 5: Solvency margin

The Model 4 described above can be seen as the basis for the introduction of a solvency
margin as for example under the law of California. In this model, the proceeds of a share issue
are not per se protected – as is the case in the capital regime of the 2nd CLD – by being
entered as a non-distributable item. There would, on the contrary, be a variable barrier.

Legal capital, as provided in the 2nd CLD, would, in this model, be cancelled. The proceeds of
a share issue would be entered as a constituent of equity capital. For a distribution according
to the Californian model, it would firstly depend on whether profits were available. If not, two
further tests must be passed. Firstly, the assets after the distribution, must be at least 125% of
the liabilities (i.e. an equity ratio of 20% must be exceeded, for details see the legal annex
California). Secondly, the short-term assets must cover the short-term liabilities.

In this model, a variable barrier to distributions, which can lead, in the case of adequately
high equity capital, to distribution of the proceeds of a share issue, is provided. Because of the
abolition of the intrinsically protected equity capital item, this model – like the Model 4 –
must be linked to no-par value shares.

The same questions as arose with regard to the Model 4 also arise here and reference is
therefore made to the comments above. It is also to be stated that the introduction of the
solvency margin does not, as such, result from the introduction of no-par value shares.

6.3.2.6 Conclusion

The introduction of true no-par value shares is possible within the framework of the 2nd CLD.
Abandoning the par value concept by the introduction of true no-par value shares could be
conducted in the context of various models. Distinction is made between those which rely as
closely as possible on the current concept of the 2nd CLD (Models 1 to 3) and those based on
other forms of capital regimes as can be found in the four non-EU countries (Models 4 and 5).

In all of these models, the introduction of true no-par value shares would be linked to the
abolition of below par issues. This can be helpful in company restructuring, although some
EU Member States have already found solutions which cushion the prohibition on below par
issues and which may be less burdensome than the introduction of no-par value shares for this
purpose.

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Less significant, on the contrary, is the fact that no-par value shares provide the possibility of
changing the number of shares so that without changing the nominal value of the shares of
each shareholder, a smaller number of new shares (merger of shares) can take the place of a
greater number of new shares (share splitting), because this advantage is diminished by the
fact that even today under the 2nd CLD by means of pseudo no-par value shares, the same
result can be substantially achieved (par value shares).

Here also the advantage that, with no-par value shares, share splitting would no longer be
prevented by a minimum par value is also reduced by the fact that the 2nd CLD does not
specify any such minimum par value.

Model 1 assumes an item similar to subscribed capital in which the entire proceeds of the
share issue (subscribed capital and reserves) would be entered. Model 2 is characterised by
the proceeds being entered in a less well protected reserve. Model 3 assumes a proportionate
entry under subscribed capital and reserves, only the reserves being available for use after the
subscribed capital has been achieved. Because of the different treatment of the proceeds from
the shares, depending on the model, either enhanced or reduced protection of the proceeds
from the shares compared to the present situation can result.

Amendments would be required by the above models because of the amended entry of the
proceeds from the share issues and because of the necessary abolition of the prohibition on
below par issues. In addition, because of the differentiated protection of the proceeds against
distributions, other necessary amendments to the 2nd CLD would be required. This applies, in
particular, to those provisions in which the 2nd CLD refers to subscribed capital items, or in
which a special function is attributed to the subscribed capital (e.g. as a barrier to
distributions). This would also continue into national law. The other provisions which are
characterised by their reference to the capital can, on the contrary, be retained in principle.
That applies for example to the publication of the capital, the minimum contribution, the
contribution regulations, subsequent formation, the obligation to call the general meeting in
the case of serious loss of capital, the acquisition by the company of its own shares, capital
increases and reductions and distributions.

With the introduction of no-par value shares into a model which gives up legal capital
(Models 4 and 5), also waiving the protection of the share issue proceeds provided in the 2nd
CLD and relying instead on e.g. solvency tests or a solvency margin, the advantages of the
introduction of such a type of share remain as above described. As, in this model, no-par
value shares would be in a completely different environment, a comprehensive revision of the
2nd CLD would be necessary in practice, although this would not be due to the introduction of
no-par value shares as such.

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To summarise, the following models could be envisaged to introduce true no-par value shares:

True no-par value shares

Model 1 "Protection of all proceeds from share issues" – This model maintains, as far as
possible, the provisions of the 2nd CLD and places all proceeds from the issuance of shares
under protection under a new balance sheet item “equity capital” similar to that applicable to
subscribed capital. Amendments would be necessary apart from the abolition of the
prohibition on below par issues in particular because of the total binding of the proceeds from
the share issues. However, it should be noted that this solution would, in some EU Member
States, represent a considerably more onerous solution than the present one. The reason is that
it is admissible in certain EU Member States that premiums be used to cover losses. This
possibility would be lost if premiums were bound under the item “equity capital”.

Model 2 "Variable capital" - This model is characterised by the fact that the proceeds of the
share issue are not completely contributed to a protected equity capital item but to an only
partially protected reserve. In this model most of the provisions of the 2nd CLD could remain
intact. Amendments apart from the abolition of the prohibition on below par issues would be
necessary in particular because of the different binding of the proceeds from the share issues.
Furthermore, it should be noted that the reserves can be – under certain circumstances -
reduced to zero.

Model 3 "Mixed model" - According to the mixed model, subscribed capital is formed on the
foundation of the company, and the proceeds of the share issue are entered as such, until the
minimum capital or a higher amount prescribed by the statutes is reached. Above that figure,
the issue proceeds are no longer treated as subscribed capital but can be entered as reserves.
This model leads to the necessity to have various procedures in place depending on whether
the proceeds of the share issue are attributed to, or should be removed from, the subscribed
capital or the reserves. Amendments to the 2nd CLD are – in addition to the introduction of the
abovementioned different procedures and the abolition of the prohibition on below par issues
– necessary as also this model leads to changes in the binding of the proceeds of the share
issue. Furthermore, it should be noted that in this model less of the proceeds could flow to the
subscribed capital than under the 2nd CLD.

Models 4 and 5 "Total abolition of legal capital" – These two models protect the proceeds of
the share issue not by the prevention of distributions but by admitting its distribution under
certain conditions, namely a balance sheet and/or solvency test or solvency margins. As, in
this model, no-par value shares would be in a completely different environment, a full
revision of the 2nd CLD would be necessary in practice, although this would not be due to the
introduction of no-par value shares as such.

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