Financial distress and its consequences are regulated by Article 376/3 of the Commercial Code (6102). Pursuant to Article 376/3, where there are signs which create the impression that a company is in financial distress, its board of directors should prepare an interim balance sheet. If the balance sheet verifies that the company is in financial distress, the board should notify the first-instance commercial court where the company is headquartered and request a bankruptcy declaration. If the board fails to follow the steps set out in Article 376/3, it could result in civil and/or criminal liability for the directors.
The main reason for imposing such an obligation on boards is to protect creditors. If a company in financial distress continues to operate, it may incur new debts or dispose of its assets. As a result, creditors may be unable to collect their receivables and suffer losses.
Under Article 376/3, financial distress occurs when a company's assets are insufficient to cover its debts. In order to determine whether a company is in financial distress, its due and undue debts and total value of assets are taken into account rather than its due debts and cash flow. According to this calculation, if the total value of a company's assets is insufficient to cover its due and undue debts, it is accepted that the company is in financial distress and a bankruptcy declaration should be requested from the relevant court.
Boards must prepare an interim balance sheet when the signs that a company is in financial distress appear. The content of these signs is not specified by law. However, even if these cannot be observed from the company's balance sheet, there may be other signs (eg, the cancellation of a crucial licence, the termination of a fiscally important agreement, the inability to collect a significant receivable at the end of an execution proceeding, an important decrease in probability or fluctuations of foreign currency rates) which create the impression that the company is in financial distress.
There is no specific timeframe under the Commercial Code for the preparation of interim balance sheets. Boards must prevent potential financial distress (eg, through negotiations with creditors or by requesting capital injection from shareholders) and decide which of these precautions should be applied during the interim balance sheet preparation process. However, Article 369 sets out that board members should act with the attention of cautious managers and look out for the company's benefits in good faith. Therefore, board members should not wait for the completion of these precautions to prepare an interim balance sheet.
Article 376/3 requires interim balance sheets to be static balance sheets that show the value of a company's assets and debts as of a specific moment rather than dynamic balance sheets which show the company's performance within a specific time period (eg, a fiscal year). In this regard, two interim balance sheets should be prepared: one based on the fair market value and the other on the continuity assumption.
However, the Commercial Code offers no guidance about which balance sheet should be considered if a company is in financial distress in one but not in the other. Some scholars think that in order to apply to the court for a bankruptcy declaration, companies should be in financial distress in both balance sheets, while others argue that it is sufficient to apply to the court if the company is in financial distress in one balance sheet.
The Commercial Code sets out no specific timeframe regarding court applications for bankruptcy declarations. Waiting on the results of precautions (eg, negotiations with creditors) after the determination of financial distress does not remove the liability of board members. According to the Commercial Code, boards should notify the courts as soon as possible and precautions that could remedy financial distress should be undertaken simultaneously with the litigation process of bankruptcy. However, pursuant to Article 377 of the code, it is also possible to apply for a konkordato (bankruptcy certificate) together with the bankruptcy application or during the bankruptcy litigation process. Therefore, if an interim balance sheet reveals that a company is in financial distress, its board should notify the courts immediately and request a declaration of bankruptcy. The board should also take the necessary precautions to remedy the financial distress during the litigation process and if necessary, it should apply to start the konkordato process. The notification of financial distress to the courts is irrevocable. Therefore, if the conditions of financial distress are not removed during the litigation process, the notification made by the board cannot be taken back and the company's bankruptcy cannot be prevented.
If a board does not request a declaration of bankruptcy from the courts, it may be held liable for damages that the company, shareholders or creditors incur.
The following conditions must be met to hold a board liable for damages:
- Contradiction of the law – this condition is met if a board fails to request a bankruptcy declaration from the courts pursuant to Article 376/3 of the Commercial Code
- Fault – if a board fails to notify the courts of bankruptcy in spite of the balance sheet stating that a company is in financial distress, this violation is deemed to be its fault. If there are signs to indicate that a company may be in financial distress and the board does not prepare an interim balance sheet, it is accepted that such obligation has been violated through negligence.
- Damage – the company, shareholders and/or creditors should have incurred damages due to the board's negligence or failure to act.
- Causation – there should be a causal connection between the damage incurred and a board's negligence or failure to act. For example, if a board does not request a bankruptcy declaration and the company continues its business, incurs additional liabilities and debts or makes payments to some of its creditors resulting in other creditors being unable to collect their receivables from the company's assets before the date on which the company should have been declared bankrupt, these creditors could claim damages from the board for not applying to the court for bankruptcy and causing more damages.
Where there are signs that a company is in financial distress (as set out in Article 376/3 of the Commercial Code), the board should prepare an interim balance sheet. If pursuant to the interim balance sheet it is determined that the company's assets are insufficient to cover its debts, the board should request that the court declare the company bankrupt.
Failure by the board to notify the court of the company's financial distress is a criminal offence under the Code of Enforcement and Bankruptcy 2004 and may result in criminal liability of the directors if such a complaint is filed.
Such complaints must be made within three months from the date on which the plaintiff became aware of the financial distress and one year from the date on which the board failed to notify the court of the financial distress. The penalty for such an offence is 10 days' to three months' imprisonment.
Since such imprisonment is defined as 'short term' under the Criminal Code (5237), the courts shall convert penalties to judicial fines or other judicial measures regulated under the Criminal Code, for the penalty of imprisonment for more than 10 days but less than 30 days. This conversion will be subject to the courts' discretion if the penalty of imprisonment has been decided for a period of 30 days to three months.
For further information please contact Baris Ertekin or Canset Birgül at Selvi & Ertekin by telephone (+90 212 236 12 12) or email ([email protected] or [email protected]). The Selvi & Ertekin website can be accessed at www.selviertekin.com.
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