In M&A, one of the key elements of due diligence prior to conducting a share deal is verifying legal title to the company’s shares. Any irregularities discovered in this respect can represent a significant risk for the potential acquirer of the shares. Can a merger or change in corporate form eliminate this risk?
A decision to acquire shares in a limited-liability company is typically preceded by a legal review of the company. In the case of a share deal involving a Polish company, it is fundamentally important to verify the legal title to the shares, particularly in terms of proper creation and initial taking up of the shares, and then proper acquisition of the shares by subsequent shareholders. The most commonly encountered irregularities include conclusion of share sale agreements in improper form, previous sales of the shares without obtaining required approvals, or errors in transferring shares between companies as an in-kind contribution. Discovery of such legal defects imposes a serious risk on the investor, as its title to the shares obtained in the transaction could later be disputed.
Before entering into the transaction, it is in the interest of the current shareholder and the prospective buyer to cure any legal defects in the shares or at least minimise the risk connected with acquisition of the shares. Investors often wonder whether merging the target into a company they already control, or converting the limited-liability company (sp. z o.o.) in question into a joint-stock company (SA), will protect against challenges to their ownership of the shares. Indeed, merger or conversion of the target may reduce this risk, but not eliminate it. And conducting such measures by shareholders whose title is defective can also generate additional problems.
Disputing reorganisation procedures
Either a merger or a conversion of corporate form is a time-consuming and costly process. It is conducted on the basis of a resolution of the shareholders’ meeting in which the shareholders consent to reorganisation of the company. The law permits challenges to such a resolution, and in consequence undermining of the process conducted pursuant to the resolution. Considering the scale of the undertaking and its legal consequences, the Commercial Companies Code specifies a period when litigation may be commenced to set aside a merger or conversion. The legislative intent was to protect the economic interests of companies participating in transformative processes and to ensure certainty in commerce. In reality, due to the absence of a comprehensive set of regulations in this area, permitting challenges to the resolutions under which such a reorganisation is conducted increases the risk inherent in the merger or conversion of a limited-liability company.
An action to set aside or invalidate a corporate merger resolution may be commenced no later than one month after adoption of the resolution. In the case of a resolution on conversion of the corporate form, the application must be filed within one month after the applicant learns of the resolution, but no later than three months after adoption of the resolution.
The persons and bodies with standing to commence such actions include:
- The management board, the supervisory board and the audit committee, and their individual members
- Shareholders who voted against the resolution and after adoption of the resolution demanded that their objection be recorded in the minutes
- Shareholders improperly excluded from the shareholders’ meeting
- Shareholders who were not present at the shareholders’ meeting, if the meeting was convened improperly or the resolution was not included in the agenda.
It should be pointed out that the law provides time limitations only on the permissibility of commencing a proceeding to set aside or invalidate a resolution. No period is specified in which the court must issue a ruling setting aside or invalidating a resolution on merger or conversion of a company. This means that a merger or conversion may be overturned even many years later. Thus if the application is filed on time, the proceeding before the court may be pursued without time restrictions, even after the merger or conversion is registered. The need to wind back to the status prior to the merger or conversion many years later can carry negative commercial and legal consequences, for both the participants in the merger or conversion and their shareholders.
Recognising the imperfection of these regulations, the Supreme Court of Poland held in its judgment of 7 December 2012 (Case II CSK 77/12) that a resolution on merger of companies cannot be set aside once six months has passed after registration of the merger. Under this view, when this period expires the court proceeding becomes moot and cannot be continued. However, this ruling does not apply to the process of conversion of the company’s corporate form. This view by the Supreme Court has also been widely criticised in the legal literature because the period indicated by the court is not grounded in any relevant provisions of law.
For these reasons, in consideration of commercial certainty, there are calls for introduction of a period after which a ruling cannot be issued setting aside or invalidating a resolution on merger or conversion of a limited-liability company. A similar solution has been adopted for the process of cross-border merger, where registration of the merger prevents setting aside or invalidation of the merger resolution.
The problem of non-existent resolutions
The risk discussed above may also materialise in the case of merger or conversion of a company after its shares have been acquired by an unauthorised person. The level of this risk depends on whether the investor has acquired all of the shares in the company’s capital.
In the case of acquisition of only a portion of the shares in the company, the other shareholders can effectively thwart the investor’s plans and block the merger or conversion of the company by challenging the shareholders’ resolution under the rules discussed above.
After the investor acquires 100% of the shares in the company and appoints its own members to the company’s boards, the risk that the resolution will be effectively set aside or invalidated is negligible. In that situation, there are no persons or entities with standing or an interest in challenging the resolution on merger or conversion of the company. This is because the resolution will be adopted unanimously, and the management board members will have no reason for challenging the resolution.
But a doubt arises in this case whether the resolution truly exists and exerts the legal consequences provided for in the resolution. Given the lack of unequivocal regulations the issue of “non-existent resolutions” is one of the most controversial in the corporate case law and literature. On one hand, it is argued that actions seeking declaratory relief holding a resolution to be non-existent are inadmissible. On the other hand, however, such claims are sometimes filed in practice, and there the claimant may allege that adoption of the resolution by the entity that acquired the shares from an unauthorised person could not result in the effective merger or conversion of the company, because the acquirer did not obtain the status of a shareholder and could not exercise the right to vote at the shareholders’ meeting on the resolution in question. This risk is increased by the fact that a claim seeking a finding of the non-existence of a resolution may be filed at any time, so long as the claimant succeeds in demonstrating that it has a legal interest in issuance of such a ruling. The person who holds true title to the shares and has been excluded from the process of deciding on the reorganisation of the company clearly has a legal interest in obtaining such relief. But the Commercial Companies Code provides that the registry court’s deletion of constitutive entries in the commercial register made in connection with a merger is possible when the merger resolution has been set aside or invalidated. Consequently, the results of a declaratory judgment holding that the merger resolution is non-existent are doubtful, because it is not known whether the registry court is empowered to delete the entry of the corporate merger on the basis of such a declaratory judgment.
For these reasons, a merger or conversion of the company does not eliminate but only limits the risk connected with acquisition of defective shares in the company. If legal defects in the shares are identified during due diligence, the first recommendation is to cure the defects, if possible, before carrying out the transaction. After acquisition of defective shares by the investor, adoption of resolutions by the investor, including resolutions on merger or conversion, will carry a substantial risk. This risk is greater considering that apart from the legal measures provided for in the Commercial Companies Code discussed above, the persons holding true title to the shares may also pursue other available instruments, such as seeking to reopen the registry court proceedings.
Marta Rybacka, Łukasz Śliwiński, M&A and Corporate practice, Wardyński & Partners