Arcticle: The problems of JSCs consolidation through merger

The problems of JSCs consolidation through merger

 Alzhan Stamkulov
LLM, University of East Anglia, 2005
Partner, Synergy Partners Law Firm

In practice, there are situations when it is necessary to consolidate two JSCs into one. JSCs consolidation can be made through merger or acquisition. Our law firm has recently performed merger, and, judging from our practical experience, unfortunately, consolidating JSCs this way is far from perfect. Kazakhstan legislation creates a lot of difficulties for beneficiaries of the corporate legal relationship. As one of the cutting-edge law firms, we want to clarify and explain in this article legal challenges, imperfection of the legislation, and suggest some improvements for the benefit of our society.

Merger. Merger of two JSCs normally takes place without any difficulties, if these JSCs have one shareholder. But what do we do if JSCs merger undergoes by the will of two or more shareholders? Article 82 of the Law of the Republic of Kazakhstan on JSCs orders, due to being clearly imperative, that merger of two or more JSCs results in creating a new JSC. Basically, new Business Identification Number (BIN) is created, and all the previous BINs are liquidated; property, rights and liability are transferred from the liquidated JSCs to the new JSC by the transfer deed. The old JSCs are liquidated.

Difficulties for the shareholders emerge in two aspects. First comes from the fact that when a new JSC is created through merger, the old JSCs are closing down. For example, if three Kazakhstan banks are consolidated through merger, the creation of a new bank will not allow to receive all the licenses for carrying out banking activities from the National Bank of Kazakhstan at once. As a minimum, new JSC will have to re-register the licenses of the liquidated JSCs [2], apart from the time that the liquidated JSCs will have to waste in order to notify all the creditors and clients of the bank about the merger. Of course, we are not forgetting to mention that some of the treaty obligations of the consolidated financial institutions require the approval of their creditors, bond holders, and other beneficiaries for the amalgamation of banks. As you can see, creating a new JSC does not consequence in suspension of the banking activities, but it can cause some technical and transactional difficulties for the creditors and clients of the bank before the merger and termination of the activities of current JSCs.

Even if we disregard the licenses and approvals issue, as well as the need to resolve the treaty obligations and prohibition issues, the shareholders of the consolidated JSCs can encounter another more important obstacle – how do they distribute the shares of the new JSC between each other in the result of merger?

Normally this threshold question is managed by the board of directors. The board of directors of each JSC, of course, will not make the final decision, but it will present a plan of the JSCs consolidation for the approval of the general shareholders meeting of each JSC. The trick here is that the Law orders that (1) the number of new JSC shares announced is equal to the consolidated JSC’s equity, and these shares are allocated between the shareholders proportionally with the equity of the consolidated JSCs [3], and (2) without any remains, all the shares of the new JSC are distributed to the shareholders of the consolidated JSC accordingly to the proportion of number of shares they owned in the consolidated JSC to the number of all shares in the created JSC [4].

Legislator established an ambiguous approach. According to the legislator’s opinion, JSCs merger should be performed on the base of integrating all the equities. This approach is fair only if the equity of the consolidated JSCs is equal to the market or assessed value of these JSCs. However, in practice, equities of different JSCs are not the same, since one JSC can be bigger, while other can be smaller. Besides that, in practice, equity never equals the market price.

With this approach, each shareholder of the consolidated JSCs gets stock of shares in the new JSC. The value of this stock of shares of the shareholder in the new JSC should measure up to the value of the previous stock of shares this shareholder owned in the reorganized JSCs. Let’s look into the matter of this article carefully. For example, JSC-1 has equity of 18 million tenge and 9 million of shares outstanding, while JSC-2 has equity of 27 million tenge and only 1 000 shares outstanding. Following the logic of the legislator, the shareholders of the JSC-1 will receive 40% in the new JSC, and shareholders of the JSC-2 will receive 60%, irrespective of the numbers of shares outstanding. We want to highlight that each shareholder, whether coming from JSC-1 or JSC-2, will receive his/her shares proportionally with the number of owned shares in the corresponding reorganized JSC, meaning the inner proportion of shares in JSC-1 and JSC-2.

This article is imperative, which means that it does not give any freedom of choice for the free distribution of shares between the shareholders under any agreements. To consolidate businesses, we can only recommend the shareholders of each JSC to buy shares through subscription in other JSCs by mutual debt disbursements, in order to reach the desired proportion, equalize the disproportions, and make the merger acceptable for all the parties. Sometimes it can be difficult to do, because there are risks of market manipulation, capital diffusion, tax risks of synthetic transactions, and other issues.

However, in reality, according to our experience, the board of directors of each of the consolidated JSC will look into the merger bargain from the position of market value of each company. Law requires each member of board of directors to act in the interest of the company and all the shareholders of their JSC [5]. But how do we specify what is the interest or the value of this merger for the consolidated JSC and shareholders?

For example, let’s imagine that JSC-1 costs 15 000 tenge, even if it has equity of 10 000 tenge and net cash flow of 1 000 tenge a year. JSC-2 costs 8 000 tenge, with the equity of 20 000 tenge and net cash flow of 300 tenge. If the assessment of market value of JSC-1 and JSC-2 will be accepted by shareholders, then the new JSC will cost 23 000 tenge, and the proportion of shares will be 65,2% for JSC-1 shareholders, and only 34,8% of shares for JSC-2 shareholders.

The problem is that the board of directors can use different approach to the assessment of the market value of each company. In practice, a company can be assessed by parties using the income method, meaning how much profit does this company make. In this case, usually such indicator as the earnings before interest, taxes, depreciation and amortization (EBITDA) is taken into consideration. Some make assessments based on cost plus pricing, meaning how much it will cost to start this business from scratch. Some make assessment based on the liquidation value or using the net assets method, meaning how much money you can make by selling all the assets minus liabilities.

We will not describe all the methods of assessment and their variations. What we want to say is that usually shareholders themselves decide on whether to accept the assessment of market value or not, decide on the size of shares given to each shareholder, define the concessions on the size of shares for each other, if besides major shareholders, each JSC also has minority shareholders or shareholders with passive membership, who do not take active participation in the JSC’s management.

Of course, in the M&A world most often net cash flow is taken as the basis and multiplied by 1:6 or 1:20, because the net cash flow allows to forecast the return on investment. As a consequence, the higher the ability of the company to generate net cash flows, as the more expensive this company will be assessed by investors. For example, let’s imagine that JSC-1 has equity of 10 000 tenge, and its net cash flow a year is about 1 000 tenge. JSC-2 has equity of 20 000 tenge, and a net cash flow a year about 300 tenge. In the situation of this two JSCs merger, shareholders of JSC-1 will ask for 76%, if we are based on the 1 300 tenge net cash flow, and equity is not taken into consideration. But if we use the assessing net assets method, the shareholders of JSC-2 will want 66% of the new JSC, taking into consideration the merged equity of the new JSC, which will equal 30 000 tenge.

As discussed above, consolidation through merger always undergoes through some type of JSC-1 and JSC-2 market value assessment, which can be based on different assessment methods. However, as mentioned before, current legislation is attached to the merged equity of reorganized JSCs. On the one hand, for State JSCs this legislation simplifies a lot of procedures, ignoring the market interest by taking away the right of the freedom of contract, but, nevertheless, leaves the questions of which is the best way to conduct the merger, which method of assessment should be used towards each of the merging companies, which proportion to suggest the other party, while still acting in the interest of your company to the board of directors.

We noticed that the initial version of the Article 82 of the Law of the Republic of Kazakhstan on JSCs of 2003 fully complied with the requirements of civil circulation, because JSCs merger was happening of free will, following the freedom of contract. In particular, parties had the right to decide on which acceptable for their shareholders conditions the merger would be performed, and what should be the merger plan approved by both parties. In 2003 the Article 82 of the Law was focused on: (1) transferring the property, rights and liabilities of the liquidated JSCs according to the transfer deeds, (2) merger was conducted based on the merger contract, which is a legal and constitutive act, meanwhile this constitutive act was brought by (3) the board of directors of each company participating in the merger at the general shareholders meeting, where they were also faced with the questions of reorganization in the form of merger, establishing the transferring deeds and the merger agreement, (4) general shareholders meeting of each JSC participating in the merger decided by a qualified majority about the reorganization through merger, the establishment of transferring act and merger agreement, and also chose the people designated to sign the merger agreement and transferring acts. The JSCs merger agreement should contain the information about the name, location of each company taking part in the merger, information about their balance sheets, and also consider the procedure and the conditions of merger, especially the exchange order of the shares of merging JSCs to the shares of the created company.

In our opinion, the very first, initial version of the Article 82 of the Law of the Republic of Kazakhstan on JSCs (2003) meets most of the beneficiaries’ and shareholders’ expectations and will help to revive bargains in the mergers and acquisitions field, making JSC a more attractive form of business in Kazakhstan.

[1] Article 82.1 of the Law of the Republic of Kazakhstan on JSCs
[2] Article 33 of the Law of the Republic of Kazakhstan on permissions and notifications
[3] Article 82.3.1. of the Law of the Republic of Kazakhstan on JSCs
[4] Article 82.3.2. of the Law of the Republic of Kazakhstan on JSCs
[5] Article 62.1.1. of the Law of the Republic of Kazakhstan on JSCs