Negative Equity and Quasi-Negative Equity in Italian Companies
Unlike those established in many other jurisdictions, Italian companies are subject to specific rules on negative equity and quasi-negative equity. These rules have become quite a hot topic for investors in a pre-restructuring or a pre-insolvency scenario. Riccardo Sallustio of Bonelli Erede Pappalardo LLP explores the treatment of net loss under the Italian Civil Code.
Riccardo Sallustio
Generally negative equity and quasi-negative equity occur when a company is required to reduce its share capital as a consequence of losses. In this respect Italian law specifically considers two scenarios, which however may be regarded as the same situation albeit with different degrees of seriousness: (i) under the first scenario, the incurrence of losses causing the net worth of the company to fall below one third of its subscribed share capital triggers certain duties for directors, while (ii) under the second scenario, the incurrence of losses not only causing the net worth of the company to fall below one third of its subscribed share capital but also resulting in the share capital falling below the minimum required by law triggers certain further duties and actions by directors, statutory auditors and shareholders.
Under Italian law, “net worth” includes subscribed share capital, reserves, any equity injection to be converted into share capital, and any existing profits, while the minimum capital required by law for example for a joint stock company is equal to €120,000 (less in the case of a company limited by quota). The losses that may determine a reduction of the share capital are referred often to as “net losses” to indicate that such losses are in excess of the part of the net worth not including the subscribed share capital.
ARTICLE 2446 OF THE ITALIAN CIVIL CODE
Article 2446 of the Italian Civil Code contemplates the situation whereby the losses reduce a company’s net worth so that it becomes lower than the subscribed share capital by more than one third. Therefore from a reversed perspective, the situation contemplated by article 2446 could be regarded as the situation when, as a consequence of losses, the company’s net worth falls below two thirds of its subscribed share capital.
An example would be helpful to clarify when such situation occurs. Considering a company whose subscribed share capital is equal to €120,000 and its reserves amount to €400,000 and the scenario whereby losses (at any given moment) are:
• €380,000: this case does not entail a reduction of the share capital, as such losses are completely absorbed by the reserves. This situation is not caught by the scope of article 2446 of the Italian Civil Code;
• €420,000: in such scenario the losses exceed the reserves, the “net” losses (which are equal to €20,000) entail a reduction of the subscribed share capital, however they do not exceed one third of the subscribed share capital itself. Therefore, also this situation is not caught by article 2446 of the Italian Civil Code;
• €480,000: in this case the losses exceed the reserves and the “net” losses are higher than one third of the subscribed share capital. This situation is caught by the provisions of article 2446 of the Italian Civil Code.
In the above situation, the board of directors must convene without delay an extraordinary general meeting of the shareholders to take “appropriate measures” and must provide the shareholders with a directors’ report on the financial situation of the company (substantially an updated balance sheet) together with the remarks of the board of statutory auditors.
Although the reference in article 2446 of the Italian Civil Code to “appropriate measures” is still debated among scholars on account of the broad spectrum of potential actions that the shareholders might be called to resolve upon, shareholders’ meetings have been substantially consistent in adopting one of the resolutions further described under the bulleted points below.
In relation to the directors’ report, it has to be noted that, as to companies whose shares are listed in a regulated market, article 74 of the Regulation No. 11971 of 1999 issued by the Italian stock exchange commission (CONSOB) provides that such directors’ report on the financial situation of the company together with the remarks of the board of statutory auditors shall be made available to the market at least 21 calendar days before the date of the shareholders meeting, also through the company’s website, and shall include information in relation to, inter alia, the prospected measures to be adopted aiming at reducing the losses; in relation to the potential capital increase; and in relation to the maintenance of the conditions for the continuity of the business. Where a restructuring plan has been, or is going to be, approved, the directors’ report should also provide details of such plan and the prospective effects on the business of the company.
At the convened shareholders’ meeting, the shareholders may therefore resolve upon:
• taking immediate remedial actions (eg, by covering the losses through a reduction of the share capital of the company); or
• postponing any decision on such remedial actions until the end of the following financial year, explaining the reasons underlying such a resolution (this frequently occurs when the shareholders are confident that the losses - or part of them - may be covered within one year).
In such a case, if by the end of the following financial year the losses have not been reduced so as to bring the net worth of the company over two third of the subscribed share capital, the shareholders’ meeting must resolve a reduction of the share capital to an amount sufficient to cover all the losses that have been generated. Should the shareholders’ meeting fail to adopt such a resolution, the board of directors and the statutory auditors must seek for the intervention of the competent court, applying for a decree enforcing such capital reduction.
It has to be noted further that the company is neither allowed to increase its share capital nor to distribute any dividend if there are uncovered losses outstanding.
ARTICLE 2337 OF THE ITALIAN CIVIL CODE
Article 2447 of the Italian Civil Code considers the situation whereby losses reduce the company’s net worth below two thirds of its subscribed share capital and the value of such net worth falls below €120,000 (this amount representing the minimum share capital required under Italian law for the setting up of a company in the type of “società per azioni”, which is the most common type of company provided for by Italian law). Such occurrence would entail the same rules described in paragraph 1 above to apply, although it leads to more drastic consequences than the article 2446 scenario: the shareholders’ meeting is rather bound to either resolve:
• to wipe the company’s share capital out and simultaneously increase it to at least €120,000 (after having covered all losses);
• to transform the company in either a partnership or a company limited by quota, if the relevant share capital requirements are met; or
• the dissolution of the company.
Under article 2484, first paragraph, number 4), of the Italian Civil Code, failure to wipe out and simultaneously increase the company’s share capital, or to transform the company, entails the immediate and automatic dissolution and subsequent liquidation of the company.
It may be noted that this provision would seem to leave a grey area in respect of those situations where losses would not reduce the company’s share capital by more than one third, yet would be able to determine a reduction of such company’s share capital below the minimum amount required by the law. Such occurrence is indeed still untested before the Italian Supreme Court, and no conclusive guidance might be drawn by the legal doctrine: Indeed, it is still debated among scholars whether in this scenario, on account of the peculiar case represented by the provisions of article 2447 of the Italian Civil Code to the general provisions concerning the reduction of the share capital by one third, it would be possible to apply those rules in the absence of any such situation, notwithstanding the share capital having fallen below the minimum required by the law.
Again, an example would be helpful to clarify such process. Considering a company:
• whose subscribed share capital is equal to €500,000;
• its “net” losses amount to €400,000; and
• the minimum share capital amount required by the law is equal to €120,000.
The concerned company is bound to wipe €400,000 of its share capital out and simultaneously resolve upon a share capital increase, which shall be equal to at least €20,000.
DIRECTOR'S LIABILITY
Directors that fail to convene, without delay, the shareholders’ meeting in the circumstances described above (or, it may also be argued, fail to detect without delay the losses contemplated by above) incur liability vis-à-vis the company and, in certain circumstances, the shareholders and the creditors of the company; under certain further circumstances they may also be held liable for administrative fines.