When is a company prohibited from paying out money to its shareholders?
Risks connected with shareholders’ receipt of money from a limited-liability company out of the assets necessary to cover the share capital.
The Polish Commercial Companies Code contains a number of provisions governing the rules for paying in the share capital of a limited-liability company and for receipt by the shareholders of payments from the company in connection with the shares they hold. These include Art. 189 §1, which provides that during the existence of the company, contributions may not be returned to the shareholders in whole or in part, unless otherwise provided by specific regulations in the chapter on limited-liability companies. Art. 189 §2 provides that the shareholders of a limited-liability company may not receive payments on any basis out of the assets of the company necessary to fully cover the share capital of the company.
There was a provision analogous to Art. 189 §1 in the former Commercial Code. It codifies one of the main principles of stability and protection of the share capital in a limited-liability company, and stresses the distinction between the assets of the company and the assets of the shareholders.
Art. 189 §2, introduced by the Commercial Companies Code, provides an additional instrument designed to limit the disposal of the assets of a company in dealings with shareholders if it would threaten the coverage of the share capital. This solution is intended to protect creditors of the company who are not shareholders.
This article discusses selected risks associated with violation of the prohibition on payments out of the assets of the company leading to depletion of the share capital, that is, situations that are inconsistent with Art. 189 §2. But to understand §2 properly, it should be interpreted in connection with the general prohibition in §1 against returning contributions to shareholders (with specific exceptions).
The prohibition in §1 should be understood as a denial of permission to create any legal basis—by contract or disposition—which would result in return of shareholder contributions. With respect to the rule in §2 prohibiting payments causing a depletion in coverage of the share capital, the subject of the prohibition is dispositive acts resulting in a lack of full coverage of the share capital or deepening a situation in which the share capital is already not covered completely.1
Dealings are often encountered in practice between a limited-liability company and its shareholders which may result in payments being made, or other consideration provided, by the company to the shareholders. In such instances, it should be examined whether these dealings violate the prohibitions set forth in Commercial Companies Code Art. 189. Based on observations drawn from transactional due diligence, including the legal analysis of corporate documentation and contracts, it appears that companies and shareholders more often remember, or better understand, the prohibition on return of contributions to the company than they do the prohibition on receiving payments that would result in incomplete coverage of the share capital. It seems particularly problematic for management boards and shareholders to determine the scope of the prohibition against making payments depleting the coverage of the share capital, in connection with the phrase “on any basis” used in Art. 189 §2. Admittedly, the legal interpretations of this provision also vary.
It should be pointed out that the code does not distinguish between payments arising out of the corporate relationship and those arising out of contractual relationships between the company and its shareholders. The statement in Art. 189 §2 that shareholders may not receive payments “on any basis” from the assets necessary to fully cover the share capital requires that the rule be interpreted broadly. It does not provide for any exceptions.
Problems in interpretation may arise, however, in situations where the company makes a payment to a shareholder on a basis such as payment for services rendered, work performed or goods supplied, or repayment of a loan, distribution of an approved dividend, or repayment of surcharges. Some of the grounds are contractual, while others (such as distribution of dividends or repayment of surcharges) are connected with the corporate relationship between the company and the shareholders.
In practice, documentation is often encountered involving a company’s payment obligations to shareholders arising out of effectively concluded agreements, under which the company receives property or other consideration from the shareholder for which payment is a normal and expected element of the economic relationship. Nonetheless, given the categorical wording of Art. 189 §2, it should be examined whether performance of the contract with the shareholder creates a risk of violating the prohibition against making payments to shareholders which could cause (or worsen) non-coverage of the share capital.
Shareholders of a limited-liability company who are also suppliers of goods or services, lenders, or lessors of real estate to the company, or provide other contractual consideration to the company, must bear in mind that because there is also a corporate relationship between them and the company, their legal situation may differ from other parties to contracts with the company who are not shareholders, when it comes to their ability to obtain payment pursuant to their contracts, e.g. if the payment would violate Commercial Companies Code Art. 189 §2. The interpretation that the limitation set forth in Art. 189 §2 applies to various forms of transactions with the company and may limit contractual (non-corporate) payments appears justified.2
It may be accepted that a state in which the share capital is covered exists when the net assets of the company, i.e. the assets after deduction of obligations (broadly understood), is equal to or greater than the amount of the share capital.
It is stated in the legal literature that the prohibition against payments to shareholders out of the assets of the company necessary to maintain a state of coverage of the share capital may be asserted not only against obligations arising out of commercial contracts with the shareholders, such as loan agreements, but also contractual relationships that are governed by employment law. If payment of salary to a shareholder for work performed would cause depletion of the assets necessary to cover the share capital, the salary should not be paid to the shareholder.3
In analysing the scope of application of Art. 189 §2, attention should be drawn to the purpose which the drafters of the code sought to achieve when introducing this provision. It should be recognised that the purpose is to protect the assets of the company against constructions, including contractual arrangements, which would cause assets to be shifted to the shareholders in a situation where there is a threat of a loss or a loss has already occurred, and also to provide increased protection for creditors who are not shareholders and thus do not have corporate instruments at their disposal to influence the company’s economic condition and do not have a right of inspection or other privileges connected with equity participation in the company. For this reason, there are arguments in favour of the broad interpretation referred to above of the prohibition set forth in Art. 189 §2, extending the application of this provision to include situations in which the company receives equivalent consideration from the shareholder in exchange for the payment in question.4 It might be assumed, for example, that acquisition of goods from a shareholder in exchange for payment to the shareholder will not alter the net assets of the company, because tangible property enters the company in place of the funds paid out, but this does not fully meet the purpose of Art. 189 §2. Such a rule of equivalence would result only in analysis of the changes in balance sheet items and would not account for many specific situations, for example where products acquired from a shareholder are of no use to the company (e.g. if the shareholder sells its inventory to the company even though the company already has a sufficient supply of the products on hand).
Violation of the prohibition against payments to the shareholders out of the assets of the company necessary to fully cover the share capital gives rise to an obligation to return the payments to the company. Moreover, members of the authorities of the company responsible for the payment are jointly and severally liable with the recipient for return of the payment to the company. This issue is governed by Commercial Companies Code Art. 198. Indeed, the set of persons who may be liable for return of payments to a shareholder in violation of the rule of full coverage of the share capital is even broader. If return of the payment cannot be obtained from the recipient or the authorities responsible for making the payment to the detriment of the company’s assets necessary to fully cover the share capital, the shareholders are liable to make up the shortfall in proportion to their shares. Amounts which cannot be executed against specific shareholders are allocated among the other shareholders in proportion to their shares. This is a far-reaching consequence of violation of Commercial Companies Code Art. 189 §2 and constitutes a significant risk for all shareholders of a company from which payments have been made depleting the coverage of the share capital.
Jacek Bondarewski, Corporate Law, Corporate Restructuring and Commercial Contracts Practice, Wardyński & Partners
See also K. Ziemnicka & J. Bondarewski, “Negative Equity in Corporate Balance Sheets,” in P. Ciećwierz & I. Zielińska-Barłożek (ed.), Legal Risks in M&A Transactions, Warsaw 2013, pp. 115 and following (in Polish).
1 A. Opalski, Kapitał zakładowy. Zysk. Umorzenie (Share Capital, Profit, Redemption) (LexisNexis, Warsaw 2002, Lex Polonica No. 214737).
2 But see W. Jurcewicz, “W sprawie interpretacji art. 14 § 3 i art. 189 § 2 k.s.h.” (“On Interpretation of Commercial Companies Code Art. 14 §3 and Art. 189 §2”), Przegląd Prawa Handlowego, July 2003, p. 25.
3 S. Sołtysiński, A. Szajkowski, A. Szumański & J. Szwaja, Kodeks spółek handlowych. Komentarz (Commercial Companies Code: Commentary) (3rd ed. Warsaw 2005), vol. 2, comments in Part III on Art. 189.
4 But see A. Opalski, supra.