Suspension of Mandatory Capital Reduction and Liquidation in the event of Capital Loss

1. Introduction

The Argentine economy is in the middle of a deep recession. Furthermore, many local companies have been strongly impacted by the recent devaluation of the peso provided by Law Nº 25,561. As a result, in addition to the losses generally associated with business risk per se, local companies are suffering significant losses derived from: the recession, which brings about a decrease of their income; the discontinuance of the payments chain, which forces them to write-off bad debt, and, finally, the devaluation, which in most cases causes a negative impact on the economic and financial position of companies. In its preamble, the Decree mentions the first two causes but does not refer directly to the severe impact of the devaluation on the business of Argentine companies.

This critical situation reflects on company financial statements, placing many companies at risk of falling under the provisions requiring mandatory capital reduction (Section 206 of Companies Law) or even mandatory liquidation due to loss of capital (Section 94 par. 5 of Companies Law).

This is not the first time that such a measure has been taken. The effectiveness of Sections 206 and 94 para. 5 of Companies Law was also suspended from September 1989 to September 1991 as a result of the economic emergency that existed at the time .

2. Mandatory capital reduction

Section 206 of Companies Law provides that “Reduction shall be mandatory when losses absorb reserves and fifty per cent of the share capital.”

Under Argentine legislation, companies recording losses on their balance sheets must absorb them by charging them: i) to retained earnings, ii) voluntary reserves, iii) statutory reserves and, iv) legal reserves. If, once absorption has been made in the order indicated, there remains a balance of loss to be absorbed totaling 50% or more of the share capital, then companies are required to reduce their capital.

For the purposes of this provision contained in the Companies Law, the National Securities Commission (CNV) calculates share capital as nominal capital plus irrevocable capital contributions (aportes irrevocables) and share issuance premiums (primas de emisión), with their corresponding adjustments. The Public Registry of Commerce adopts the same criterion, but considering irrevocable capital contributions as retained earnings, that is to say, computing them at 100% of their value.

Once losses the existence of losses have been determined, either when preparing the fiscal year balance sheet or from accounting documentation evidencing the losses incurred, the Board of directors must summon an extraordinary shareholders’ meeting to approve the mandatory reduction. The Companies Law does not set any limit on the reduction. As a result, the shareholders’ meeting must resolve the terms of the reduction as it deems appropriate. Nothing prevents the capital from being reduced to zero and then later increased until it reaches the legal minimum.

The Companies Law does not provide any penalty if the company should fail to make the mandatory reduction, but it does impose the burden of responsibility on directors, statutory auditors ("síndicos") and members of the supervisory board (“consejo de vigilancia”), authorizing legal actions to be brought against them.

3. Winding up due to losses

Section 94, para. 5 of Companies Law provides that “The company is to be dissolved (...) following loss of share capital ...”.

As to the interpretation of the concept of “share capital ”, there are those who consider that in spite of the terminology used, the Companies Law refers to “corporate assets”. In this regard, they point out that the nominal capital amount -which can only be altered by means of procedures of capital increase and/or reduction- cannot be the legal reference for the event we are considering, particularly if we are to take into consideration the inflationary background. Others, however, consider that in effect the Companies Law is referring to the capital subscribed by the shareholders. They consider that the scope of the provision of the Companies Law refers to those cases in which the liabilities due would result in the loss of the share capital in its entirety. It seems reasonable to consider that the law is referring to situations of companies in which there is a negative net worth situation.

It is also not easy to determine the loss. The existence of an inflationary context makes it necessary to appraise corporate assets before any analysis is performed. In other words, to adjust the balance sheet values to reflect real values, calculating third party liabilities and allocating the debts against the various reserves -the legal reserve, the legal technical appraisal reserve and finally against the subscribed capital. The Decree has reestablished the obligation to prepare annual financial statements and statements for interim periods in constant units of currency, as provided under Section 62 in fine of the Companies Law.

The ideal instrument for determining the existence of a total loss of share capital is also an issue to consider. As it is not specified by the Companies Law, it would be possible to accept any accounting document that duly reflects the status of the company’s net worth. However, majority opinion leans towards the use of the financial statements for the fiscal year as the appropriate document for evaluating the matter. It is important to underline that the loss should be definite in nature and not merely circumstantial.

Once the existence of the mandatory capital reduction situation has been determined, the administrators are obliged to confirm it and notify the situation to the shareholders, under penalty of compromising their own liability. However, winding up and liquidation shall only occur upon a resolution of the shareholders. The shareholders can chose alternatives other than liquidation, such as restoring the capital or increasing it by means of new capital contributions or the capitalization of credits (Section 96 of Companies Law). Even though the Companies Law does not provide a term within which the shareholders should cure the situation, it is generally considered that they should act immediately upon determination of the loss, adopting any of the alternatives provided by the Companies Law.

Directors and statutory auditors of companies qualifying for liquidation due to the loss of their capital must adopt the measures required to initiate the winding up and liquidation and cease corporate activities unless the shareholders approve either a capital refund or increase. If this does not occur and the company continues to operate, the directors and statutory auditors would be severally liable, without limit, to third parties and shareholders, notwithstanding the responsibility of the latter (Section 99 of the Companies Law).

4. Concluding comments

The Decree eliminates the risk of liquidation faced by companies with negative net worth or mandatory capital reduction, and preserves the veracity of their financial statements. It avoids the need for companies to resort to dubious accounting recourses such as the capitalization of exchange differences (losses) which are in reality illusory and end up distorting the results and net worth of the companies.

From a practical perspective, the Decree allows company balance sheets to be approved and filed even with negative net equity or in mandatory capital reduction situations, and also allows companies to continue to operate without generating any responsibility for directors and statutory auditors for doing so. This is a temporary remedy based on the extreme urgency of the situation, in the hope of an eventual recovery of the economy.