New legislation reduces effectiveness of pledges over project company shares

In an attempt to improve the collection of taxes in Slovakia, the legislator has imposed additional restrictions on the sale of shares in private limited liability companies.

The restrictions enable the management of a defaulting company to frustrate the enforcement of a security interest over its shares, thus potentially reducing the protection for banks.

Most project companies (SPVs) in Slovakia are structured as private limited liability companies which are easier to incorporate and run than the more heavily regulated jointstock companies. In project finance, a standard security granted to banks, in addition to pledges over the project company's assets (most importantly, its real property), is also a pledge over the shares in the project company.

Whilst pledges over the project company's assets are the primary security relied on by the banks, there are situations when it is impractical or impossible to enforce against these assets. For example, where a financially distressed company enters formal restructuring proceedings, all security interests over its assets are subject to a moratorium. In such a case, a bank's most effective remedy may be to enforce its pledge over shares in the project company in a forced sale and to satisfy itself from the proceeds of such sale. Under Slovak law, such enforcement was generally possible without having to rely on cooperation from the project company or its shareholders.

In late 2012, as part of a broader amendment to VAT legislation, the Slovak legislator also amended conditions for the sale of shares in private limited liability companies. More specifically, pursuant to the amended Section 115 of the Commercial Code, the sale of a majority stake only becomes effective upon registration of the sale with the Companies Registry (and not upon execution of the share purchase agreement, as before the amendment). Such registration is subject to the company producing a confirmation from the tax authority that neither its shareholders not the acquirer have fallen into arrears with their tax payments.

However, the legislation does not appear to address the implications of such change on forced sales in enforcing security interests and to what extent the additional requirements will also be applicable in that context. It is more than likely that the shareholder of a financially distressed project company may have trouble meeting its tax obligations. It is also likely that the management of such project company will not be particularly forthcoming in providing the tax confirmation and thus assisting the bank in the forced sale.

If the company does not request the confirmation from the tax authority or if such confirmation is not issued because the shareholder has failed to pay its due taxes, any forced sale of a majority stake in the company will not be registered with the Companies Registry and will thus not become legally effective. The risk of not being able to complete the acquisition will make potential buyers reticent to bid for the shares.

Previously, there has been at least a theoretical chance to argue that the requirements discussed above do not apply to forced sales in the context of enforcing security interests. The situation has become more complicated with an additional amendment made on 1 December 2013. In an attempt to clarify the situation, the legislator has added a transitional provision stipulating that the requirements do not apply to the enforcement of security interests registered before 1 December 2013, thus indirectly confirming that they do apply to all security interests registered thereafter.

Comment

The new regulation effectively enables the management of a project company and its shareholder to obstruct and potentially even to frustrate the enforcement of a security interest over the majority stake in the project company. Thus, it essentially deprives financing banks of the comfort granted by a central part of a standard security package.

It seems that despite its declared good intentions of improving tax collection, the Slovak legislator has inadvertently upset a well-established and functioning system of standard security packages in project financing.

There are ways to mitigate the impact of the new legislation. Project companies may be structured as joint-stock companies or as foreign vehicles. Similarly, the regulation does not apply where the shareholder and the acquirer are foreign entities. Banks may also require the debtor to grant a power of attorney for requesting the tax confirmation (although powers of attorney may always be revoked, as a matter of Slovak law). However, none of these alternative mechanisms is entirely bulletproof and all of them will bring about increased transaction costs and complexity.