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Leveraged buy-outs

In the last ten years, the phenomenon of private equity has assumed previously unknown dimensions and importance for the Italian economy. But when considering a leveraged buy-out in Italy, one of the most important issues for investors must be the legal hurdles particular to the Italian market. Annapaola Negri-Clementi and Paolo Montironi of NCTM Negri-Clementi Toffoletto Montironi & Soci, Milan, consider the options.

The leveraged buy-out (LBO) is a technique to acquire the entire or the controlling shareholding of a company (target), having recourse to the capital of third parties. The peculiarity is that the debt, which is contracted for the acquisition of the target, is paid after the acquisition with the cash flow generated by the target. The latter remains with a debt/equity ratio higher than it was before the acquisition. (According to statistics, in Italy the medium indebtedness level of LBOs has been around a coefficient of 1:3, that is one-third equity and two-thirds debt.)

In an LBO, articles 2,357 and 2,357 quarter and 2,358 of the Italian civil code (CC), and for listed companies article 132 of Consolidation Act on Financial Matters, must be considered. The most widespread form of LBO is the merger LBO.

Scholars' opinion
The most relevant legal issues are seen in merger LBOs. While there is no doubt (or, at least, there was no doubt before law No 366/2001), according to the majority of leading scholars, that LBO operations carried out without recourse to merger are illegitimate, due to the direct breach of article 2,358 CC (since the guarantees are given by the target) the lawfulness of LBO operations concluded with the merger between the Newco purchaser and the target is being discussed (or, at least, it was under discussion until law No 366/2001).

Scholars seeing merger LBOs as illegitimate operations
Article 2,358 CC does not prevent a company from releasing guarantees unless they have the aim of allowing the purchase of target's own shares. It was said that the ratio of article 2,358 CC is the protection of the corporate assets, and not only the protection of the corporate capital integrity. In fact, if the legislator only wanted to protect the corporate capital, the same could have dictated a parallel and corresponding rule to that of the purchase of its own shares, allowing the company to grant loans or to give guarantees within the limits of distributable profits and of the available reserves.

The detractors of the lawfulness of merger LBOs argue that the legislator would have ascribed a typical scope to the merger, consisting of the concentration of enterprises supported by a suitable industrial plan. Where the merger does not have such a typical purpose, the operation would have a fraudulent nature.

Again, to support the unlawfulness of merger LBOs, other scholars took a hint from article 2,357 CC to conclude that even the legislator would deem that the merger could actually be an elusive procedure. Article 2,357 bis CC allows to purchase company's own shares, should the purchase be the effect of universal succession or merger. This provision has been interpreted so that the less severe regulation would apply when the purchase of one's own shares is a mere possible and accidental consequence of the merger. So, if the merger were aimed solely and exclusively at the acquisition of one's own shares, it would not comply with the rules and regulations governing special cases of purchase of one's own shares, and the merger procedure should be considered, for the purposes of article 1,344 CC, as planned to avoid the application of the rule.

Scholars seeing merger LBOs as legitimate operations
In favour of the lawfulness of merger LBOs, firstly, there is no issue of a guarantee released by the target:

·     because there is no taking over of the debt for the acquisition by the target, since this occurs when the company is dissolved; there is no taking over because this would occur only after the annulment of the shares following the merger; and
·     furthermore, since the given guarantee is not a specific one but a generic one, under article 2,740 CC there would be no issue of guarantee relevant for the purposes of article 2,358 CC.

Therefore, according to the opinion of the supporters of the lawfulness of merger LBOs, this construction would be admitted without limitations.

To support the lawfulness of the LBO, it has been observed that in order to configure the deceit of the law, all the various steps of a merger LBO should be construed as one sole structure. This assumption, however, in the generality of the LBO, is to be excluded. An index of the legitimacy of the LBO is the regularity of the operation under the tax profile, in particular with reference to the Consolidation Act of Income Tax (TUIR), which considers the merger as a tax neutral operation.

The prohibition against issuing guarantees under article 2,358 CC cannot be extended by analogy. In fact its breach is sanctioned by article 2,360 CC, which is a criminal law provision that, according to the criminal code, cannot be extended by analogy.

Such limited application of article 2,358 CC excludes that the most common statement, ie the financial institution that grants the loan relying on the assets of the target to be sanctioned under article 2,630 CC, is correct.

The merger concluding the LBO involves the combining of the companies' capital, and the legislator has provided corporate creditors with protection instruments in consideration of the serious prejudice which they could suffer. According to Article 2,503 CC, mergers can be implemented only after two months from the registration in the Company Registry. Within the mentioned term, creditors can file an opposition to safeguard their credits.

In merger LBOs, there would be no detriment to creditors if the value of the company resulting from the merger is not lower than the value of the incorporated company. Even in the opposite case, it is not easy to determine the kind of prejudiced credit interest. The interest of the creditors is not in the maximization of the value of the shares or of the property of the company, but in the timely repayment of their credit, which will be certain only in the case of non-insolvency of the company. The negative effect of the company indebtedness must be set against the positive effects deriving from the factors influencing the profitability and solvency of the company, which could be prevailing even in case of partial loss of the corporate capital.

In substance, through the merger, the target does not privilege the reimbursement of some creditors of the vehicle compared to others, not even compared to its own original creditors. There is only an addition of new creditors with the same rights as the others on the property of the target. The obligation of the target to satisfy the creditors of the corporate vehicle is determined by the full confusion of the vehicle and target assets and liabilities situation.

Until now the danger of direct or indirect breach of article 2,358 CC was solved by making recourse to the following structure: a foreign company (Holdco) is set up with equity and debt (sourced by the financing by a bank or financial institution). Through Holdco a new company (Italco) is set up in Italy, fully capitalised with low nominal capital and high share premium. Italco purchases from the seller the shareholdings of the target, which is subsequently merged. Following the merger, Italco enters into a loan agreement by means of which the share premium is paid back to Holdco, which then reimburses its loan to the lenders.

Until now, before the reversal under the law 366/01, some leading scholars deemed the construction at issue to be compliant with the applicable laws.

Civil and criminal case law
Case law dealt with LBOs in 1992, on the occasion of the Farmitalia case and, with two first instance sentences, a civil one, and a criminal one, the same issue has been solved and argued in opposite ways. The civil judge stated, even obiter, the inexistence of a direct or indirect breach of article 2,358 CC, since the merger cannot be a transaction in deceit of the law.

The criminal judge instead, considered the case at issue as a purchase of the company's own shares under article 2,357 CC, though carried out by a third party, in breach of article 2,630 CC.

In the past case law sometimes deemed, with different motivations, that merger LBOs represent a breach of article 2,358 CC, and at other times that the prohibitions provided for by article 2,358 CC are not breached. In 2000, the Supreme Court stated that LBOs have to be considered illegitimate in Italy since the same is in contrast with the regulation prohibiting the company from guaranteeing the purchase of their own shares. On other occasions the relevant case law considered LBOs to be legitimate, but that they can originate a transaction in deceit of the law when it is used as an instrument to avoid the prohibition to guarantee the purchase of shares.

Still under the criminal profile, particular attention is to be given to bankruptcy law and to the possible configuration of bankruptcy crimes under article 217 of the Italian bankruptcy law. It should, first of all, exclude the possible applicability of other criminal cases provided for by the bankruptcy law; so it should be possible to:

·     exclude fraudulent bankruptcy provided for in article 216 of the Italian bankruptcy law, which does not refer to LBOs, considering that an entrepreneur implementing a merger LBO is not wasting the company property to create a detriment to the creditors, and therefore there is no criminal intent; and 
·     exclude the crime provided for in article 218 of the Italian bankruptcy law, which applies sanctions against the abusive recourse to credit. The recourse to external financing by the company that takes advantage of the financial lever running into relevant debt, is not carried out concealing the financial difficulty. In fact, it is the negative outcome of the merger LBO operation that determines the insolvency, which, normally, does not exist at the time of the recourse to the financing.

Going back to article 217 of the Italian bankruptcy law, the recourse to a merger LBO cannot be considered as incautious behaviour, since incautious is only the operation from which any judicious operator is expecting a negative result.

However, the bankruptcy events are relevant only to the extent that they occurred in a period of financial difficulty for the company. If the financial difficulty exists when making recourse to the lever, it is likely that, still today, notwithstanding the provision of law No 366/01, a configuration of bankruptcy crimes will be possible.

The recent law No 366/01 excludes that the recourse to LBO represents a breach of articles 2,357 and 2,358 CC - thus in our opinion it has definitely eliminated the risk for the company's directors to be charged with the torts provided for in article 2,630 CC - but it did not have any influence whatsoever on the danger connected with the LBO operations involved in the recourse to a strong indebtedness. Such indebtedness can determine an insolvency status and, therefore, the bankruptcy of the company, which is no longer in the position to duly comply with its obligations.

Recent law no 366/2001
Law No 366/2001, which delegates the amendment of corporate law to the government, in article 7 explains, with a regulation we consider interpretative, that merger LBOs do not represent a breach of article 2,357, of article 2,357 quarter in addition to article 2,358 CC.

It is worth noticing that such a law has only a formal efficacy, which consists in mandating the government to issue the relevant rules according to the principles set out by the law, therefore it should not have the direct effect which is typical of the laws.

Under the criminal profile, no direct breach of article 2,358 CC can be seen in merger LBOs. Therefore, the crime under article 2,630 CC cannot be asserted.

It might occur that, in addition to sentences already passed by courts, Article 7 of Law No 366/01 applies, on the basis of the following arguments: (i) that the reasons for excluding the tortuousness can be found in the entire legal system (and therefore even in Law no. 366/01); (ii) that Article 2 of the Italian criminal code provides that ‘nobody can be punished for a fact that, according to a subsequent law, does not represent a crime and if a sentence exists the execution and the criminal effect of the same shall cease'.

Under a civil profile, the regulation at issue should theoretically not be applicable because of its nature of source on the production of laws; but the clearly interpretative nature of such law produce effects for the proceedings still pending. The interpretative nature of such law is confirmed by the fact that the ‘preparatory works' of any law, which are of the ‘lowest' binding nature, may be taken into consideration as hermeneutical criteria of the law itself.

It is therefore certainly possible to make recourse to Article 7 of law No 366/01, as the instrument for interpretation, and therefore to exclude merger LBOs from the area of civil tort.

This article was first published in the International Financial Law Review Private Equity & Venture Capital guide 2002.

The law firm NCTM (Negri-Clementi, Toffoletto, Montironi & Soci) is the result of the merger between two long-established and highly-reputed Italian law firms: the law firm Negri-Clementi, Montironi & Soci, whose practice focused on commercial and financial law, and the law firm Toffoletto e Associati, whose practice focused on employment, company and antitrust law. Negri-Clementi, Toffoletto, Montironi & Soci, Studio Legale Associato, Via Agnello, 12, 20121 Milan, Italy, tel +39-02 72551 1, fax +39-02 72551 501, email info@nctm.it, or visit our website at www.nctm.it (Main Office).

© IFLR 2002