Expert Opinion (#09 September 2018)

Corporate Risks under the Law on Companies

by Maxim Oleksiyuk, Victoriia Minets

The Law of Ukraine On Limited and Subsidiary Liability Companies (Law On Companies), which has been in effect since 17 June 2018, established new rules for the most common type of legal entities in Ukraine (LLC) and entails new risks and opportunities.

1. Changes in shareholders' powers

The new law cancelled the requirement for a quorum of the general meeting of shareholders in the amount of 60%+1vote. Now the power of the general meeting to make decisions is determined solely by the availability of the necessary number of votes to resolve the issue. For most issues, a simple majority (50%+1vote) of the total number of shareholders of the company is sufficient. While earlier a share stake of 40% could block the holding of any general meeting of the company, now it is possible to hold it without such a shareholder. This significantly diminishes the value of the share package in the Ukrainian LLCs in the range of 40%-50% 1 share. It crushes the balance of power established in numerous companies.

On the other side, minor shareholders obtained powers to block some specific decisions, which under the new law should be decided at the general meeting only by an unanimous decision of all the companys shareholders. In particular, full consensus is required to approve the monetary valuation of a proprietary contribution into the share capital, to make changes in the realization of the preemptive right of the shareholders, to establish necessity of the shareholders' consent on alienation or pledge of the share, as well as in some other cases.

What is more, a shareholder with a share of less than 50% may leave the company at any time, without giving advance notice or the consent of other shareholders, while the company is obliged to compensate for the respective shares (Article 24 of the
Law On Companies). It should be noted that the exit of a shareholder with a significant stake may lead to serious negative consequences. In the widespread situation, when the company's assets are mostly in non-monetary form, and funds are in circulation and cannot be withdrawn at the first request, so such exit may ruin the whole business and force the company to sell the asset at liquidation value, i.e. lower than market one. An unpredictable significant reduction in the companys assets may lead to a collapse of the business, devaluation of shares of other shareholders and even bankruptcy. Such right of withdrawal could be used by a minor shareholder to blackmail a company.

2. Risk of losing control over affiliated companies

The other legal novel is an irrevocable power of attorney, which may be issued for fulfilling or ensuring the fulfillment of the obligations of the parties to the shareholders' corporate agreement (Article 8 of the Law On Companies). Such obligations may include participation on behalf of the shareholder in general meetings with decision-making powers, as well as realization of other shareholders powers in respect to the company. And the irrevocable power of attorney cannot be canceled without the consent of authorized person or can be canceled only in cases provided in the power of attorney.

It should be noted that the irrevocability of a power of attorney contradicts the general principle of fiduciary relations (from the Latin "fiducia", which means trust), based on the trust between the principal and the attorney. Whereas the principal is responsible for actions committed on his behalf by such an attorney, it is logical that the power of attorney can be terminated any moment when the principal loses his trust in the attorney. Irrevocability means preserving the powers of the attorney even during a conflict with the principal, which is contrary to the very nature of these relations based on trust.

As to individual shareholders, they may simply decide whether they take respective risks and issue an irrevocable power of attorney. However, in holding structures (when the shareholder in LLC is a legal entity itself) such a "decision" may pass over the beneficiaries. Today, the right of a director to issue a power of attorney is usually not limited under the charter or other corporate documents of a company. And the corporate agreement may also not fall under the charter threshold of transaction (if any exists) for which the director must obtain the approval of a general meeting. The unfair use of this mechanism creates the risk of seizing control in affiliated companies via irrevocable powers of attorney, which would be extremely difficult to cancel, even after removal of the director who had issued such power of attorney.

To eliminate the risk of losing control over affiliated companies, the company is recommended to introduce into its charter limitations on a director to issue an irrevocable power of attorney and/or conclude a corporate agreement without the prior consent of the companys general meeting. These limitations should be also indicated in the Unified State Register of Legal Entities (in order to give notice to third parties on directors limited authority).

3. Risk of "null and void" agreements

According to the Law On Companies any significant transaction exceeding 50% of the net assets of the company must be approved by the end of the previous quarter by the companys general meeting. Additional criteria for significant transactions to be agreed by the general meeting or the supervisory board may be provided for by the company's charter. Without the approval a significant transaction does not create any binding obligations for the company (para1 Article 46 of the Law On Companies). These consequences are equal to the effects of "null and void" agreements (Article216 of the Civil Code of Ukraine).

It is hardly practical to check the balance sheets and charters of all counterparts (LLCs) on a quarterly basis, to control the total value of typical supplies or other transactions under framework agreements (which may be together treated as one significant transaction according to part 4, Article 44 of the Law On Companies), or to demand respective decisions to be adopted by the general meeting for almost all agreements in any case. And even a decision obtained from the general meeting does not guarantee the validity of the approval, because common procedural violations (absence of prior written notice on the general meeting in 30 days before its holding, lack of actual meeting of the shareholders who signed the decision, unless it was formalized as one held by a vote or by absentee voting, etc.) may entail additional risks for transactions. So, it is also feasible to verify proper authorization of the representatives and compliance with the procedures during the general meetings of the counterparts, although one usually has no means to carry out such verification. As a result, provisions on significant transactions place disproportionate responsibility on the company for its counterparts and can become the basis for manipulation by dishonest debtors, which directly contradicts the interests of protecting the rights of creditors.

What is more, the rules on significant transactions are extremely inconvenient for those companies with small net assets. The mentioned provision obliges the directors of such companies to obtain the approval of the general meeting to almost any agreement. A possible solution would be to provide the director with a prior approval to enter into ordinary transactions for the year ahead. In some other cases, instead of a limited liability company, it is advisable to choose the form of a private enterprise (that could be established by one legal entity, or by one or several individuals), which is not subject to restrictions on significant transactions.

A similar situation arises with the contract, which was concluded by its party in violation of the shareholders' corporate agreement. According to part 6, Article 7 of the Law On Companies such contract is directly called "null and void" (i.e. invalid under the law). This is literally the first case when Ukrainian legislation has established the nullity of the contract based on its non-compliance with another contract. This provision creates wide opportunities for abuse, when unfair shareholders will be able to waive their obligations under contracts with third parties, referring to their nullity due to violation of their corporate agreement. This risk is intensified by the fact that the shareholders' corporate agreement may be concluded in a simple written form, without any notarization or registration (which enables manipulations with "backdating" it).

The consequences of "null and void" agreements are quite serious. The most important is that the law establishes the nullity of the mentioned agreements, which makes unnecessary their recognition as void by a judicial decision. The seller under such "null and void" agreements may face refusal of the unfair purchaser (who may intentionally cause the defects) to pay for the supply. As for those who in good faith purchased under such "null and void" agreements, there are even more dramatic risks. The tax authorities may not recognize the respective VAT credit or deductible expenses. Tax fines would also be applicable. We should underline that provisions on "null and void" agreements are the easiest instrument for tax inspectors, who would only need to refer to the nullity of the transaction, without the need to prove the violation of the rules of taxation, find defects in the accounting, or carefully study the primary documentation. Thus, the risk exists that the tax authorities will restore their infamous practice on void transactions.

4. Additional risks for the company's management

On the coming into force of the Law On Companies, officials of the company will be considered as "members of the executive body, supervisory board, as well as other persons stipulated by the charter of the company". Therefore, to ensure avoiding concentration of all responsibility on the director of the company, it is appropriate to introduce a specific definition of "officials" into a companys charter.

In any case, the liability of the directors and other officials of a company was significantly increased (stipulated joint and several liability for obligations owed to the company or even under obligations of the company itself). First, those responsible for violations in the entering into significant transactions or interest party transactions bear joint and several liability for any losses caused to the company (para 5, Article 44, para. 4, Article 45 of the Law On Companies). Second, the managers who misled the shareholders on the financial status of the company via the production of corporate documents with incorrect data, which caused unlawful payments (dividends), bear joint and several responsibilities (jointly with the shareholders) in respect to the return of such payments to the company (para 5, Article 26 of the Law On Companies).

Also, the directors may hold joint and several liability under the companys obligations in case they fail to initiate the general meeting in a timely way, after the value of net assets of the company decreased by more than 50% compared with the end of the previous year, and within three years from such a decrease the company bankrupt (para 3, 4, Article 31 of the Law On Companies).

Considering the mentioned provisions, the companys managers should carefully execute their respective duties and keep (even after dismissal) all respective documentary proof (e.g. correspondence with shareholders, notices on convening general meetings with respective agenda, etc.).

In conclusion it is important to note that some of the serious risks that have emerged (like restoring tax practice on null and void transactions) cannot be eliminated without amendments to the Law On Companies.

Maxim Oleksiyuk, partner at KM Partners

Victoriia Minets, senior adviser at KM Partners

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