^[1]By: Virginia Kalis Letayf

Much has been said and written about the adjustments and eliminations needed in order for groups to present their consolidated financial information, that is, “as if they were one company”. However, there is a problem that goes way back, since it is first necessary to identify whether or not you have control of the companies in which you participate, which is not necessarily transparent in all cases.

Before, control was identified by stock ownership in most situations. However, it is now a matter of identifying who has the right to manage the important activities of the entity.

According to the International Financial Reporting Standards 10 (IFRS 10), Consolidated Financial Statements, an investor will determine whether he/she has control over the investee company, provided that each of the following conditions is met:

1. Power over the investee company.
2. Exposure or rights to variable returns from its involvement with the investee company.
3. The ability to use its power over the investee company to affect the amount of the investor’s returns.

Power refers to the authority to direct the relevant activities of the investee company and is exercised on the basis of rights, which may be as follows:

• Voting rights, that is, derived from the shareholding.
• Rights arising from agreements between shareholders.
• Rights to appoint and remove key managerial personnel, provided that this employee is the one who directs the relevant activities.

As mentioned above, in many cases the rights granted through shareholding are not a strong or significant indication of the exercise of power. In principle, these rights must be on the majority of the shares with the right to vote and even so, it is essential to review the agreements between shareholders and other rights they have to identify if having the majority of the stocks gives control of the company to its shareholder.

In addition, those potential voting rights must be substantive rather than protective. What is understood by substantive right is to have the capacity to exercise power, that is, that there are no barriers preventing the exercise of that power. Possible voting rights are substantive provided that they have a favorable exercise price, that is, that their exercise price is lower than the market price.

By saying that they should not be protective, the rule is that rights should not be designed to protect any party. Normally, these rights are granted to the non-controlling interest, formerly known as minority interest, that is, they protect the interests of minority shareholders. Therefore, if the rights were protective, regardless of the percentage of shareholding participation, they would not give their shareholder control of the company.

There is also no control when deciding only on one or some, but not all relevant business activities. In such a case, it would be treated as a joint control. Therefore, great care must be taken in drafting shareholder agreements, such as those related to resolution of disputes, as well as conscientiously reviewing the clauses of the contracts, in order to determine whether the mechanism that is used is a substantive right.

In the case of joint ventures, normally the agreements include deadlock clauses, which apply when there is a dispute regarding the management of the company. This corporate deadlock is due to the inability of the partners to reach an agreement and put an end to the conflict. Therefore, these clauses are equivalent to a “pact among partners” and are designed to resolve differences, but, as such, they become a barrier to exercise control.

Among the most common deadlock clauses are the following:

• Establish options to buy or sell the shares of any of the parties. They entitle the shareholders who agree on the same solution to the dispute to buy the shares of other shareholders at an agreed upon price. But they also give the other shareholders the power to buy them out at the same price. If no one agrees to sell at this price, counteroffers are allowed, until a suitable price is reached. This solution typically forces the exit of one or more shareholders and favors those who are in a better financial situation.
• Submit the dispute to arbitration and decision of an independent expert appointed beforehand, who has the power to impose a solution and make a decision that breaks the deadlock.
• Give one of the shareholders the right to become the chairperson, in the event of a situation of conflict.
• Liquidate the partnership if the problem persists for a significant period of time. Logically, this clause is only suitable in serious situations.
• Empower one of the shareholders to find a buyer for 100% of the shares. If the designated shareholder fails to secure a buyer, this authority is moved to another shareholder and continues until all shareholders have had a chance or a buyer is found.

For example, company X belongs to shareholders A and B, each of which holds 50% of the voting rights. But shareholder A also has the right to appoint the chairman of the board, who has the casting vote in the event that shareholders A and B do not reach an agreement. Thus, shareholder A exercises control of X. However, if the chairman of the board does not have a casting vote, even when shareholder A has the right to appoint him, that does not give him control of the entity.

It may be the case that, despite these agreements, one of the parties refuses to comply. That is why other clauses are included that impose the obligation to pay compensation to the other party if it breaches the pact. Thus, the compliant partner may demand that the noncompliant partner must comply with the payment of the compensation established in the pact.

Let us take another example. Shareholders A and B each have 50% of the voting rights of company X. What would happen in the case of a dispute between them and they did not reach an agreement? To know who has control it is necessary to review the agreements established between the two.

If the agreement says that in case that no agreement is reached, shareholder A is obliged to buy all the shares of shareholder B, who has the obligation to sell them to A, would it seem that shareholder A has control? Before the reader makes a decision, there are other aspects to consider.

If shareholder A has the resources to buy all the shares of B and gets some benefit for doing so, it can be said that shareholder A’s right is substantive and, therefore, he has the control. But, what would happen if shareholder A were not interested in acquiring B’s shares? Logically, he would not be willing to enter into a dispute with shareholder B, because he knows that, if they do not reach an agreement, he would be forced (by the agreement) to buy them. In this case, it would seem that shareholder B would have control. However, in reality it is a joint control, since shareholder A’s right is not substantive, since there is a barrier to exercising it.

Several problems may be presented over time. The first is the difficulty to lay down the criteria for establishing the deadlock clauses. Another problem may be to detect that a conflict situation has occurred and that it is necessary to apply the corresponding clauses.

Perhaps one may think it is most appropriate to appoint a third party to resolve the conflict. However, for this it is necessary that the designated person not favor one of the parties, so that his appointment is far from simple.

In conclusion, having more than 50% of the voting rights is the easiest way to avoid situations of conflict and the need to establish deadlock clauses. However, there are more and more joint ventures. Due to the above, the lawyers of the company are a key piece in the wording and explanation of the agreements and contracts, as well as of all the derived implications.

Referencias

• IASB. 2016. IFRS 10: Consolidated Financial Statements, in: http://www.checkpointmexico.com/maf/app/document?endChunk=1&startChunk. ^[2]Consulted on December 5, 2016.
• Hanrahan, Gavin. What types of deadlock clauses are used in shareholder agreements?, en: http://www.turnbullhill.com.au/articles/what-types-of-deadlock-clauses-are-used-in-shareholder-agreements-.html ^[3]. Consulted on December 5, 2016
• González, Antonio. El bloqueo societario y los pactos de socios, en: http://www.gonzalezasturiano.com/el-bloqueo-societario-y-los-pactos-de-socios/ ^[4]. Consulted on December 7, 2016.
• Fernández, J. Raúl. Evita el bloqueo societario con un pacto de socios, en: http://www.jraulfernandez.es/evita-el-bloqueo-societario-con-un-pacto-de-socios/ ^[5]. Consulted on December 7, 2016