Board Members’ Financial Rights in the Context of Disguised Profit Transfers

Introduction

The concept of disguised profit transfer in joint stock companies, in its broadest meaning, covers the transfer of company assets to related parties and may occur in different ways. This concept is regulated in detail under capital markets legislation (both at the level of the law and in the secondary legislation). It is also the subject of many judicial decisions both under the scope of the good faith principle and the capital maintenance principle in the context of the general assembly resolutions of private joint stock companies.

In the decision of approval of the 11^th Civil Chamber of the Court of Cassation dated November 2021, the Court found that the financial rights granted to the members of the board of directors, who were also the majority shareholders, were contrary to the rule of good faith, and the relevant general assembly resolution was annulled. This Newsletter will focus on whether or when the financial rights of the members of the board of directors constitute a disguised profit transfer in closed joint stock companies by focusing on Court of Cassation rulings.

It should be noted that this Newsletter article will explore the concept of disguised profit transfer from the perspective of company law, and no examination or evaluation will be made regarding tax law.

Board Members’ Financial Rights

Article 394 of the Turkish Commercial Code numbered 6102 (“TCC”), regarding the financial rights of the members of the board of directors, states that “Members of the board of directors may be paid attendance fees, wages, bonuses, premiums^[1] and a share from the annual profit, provided that the amount is determined by the articles of association or the decision of the general assembly”. More than one type of financial right might be determined for the members of the board.^[2]

The wording of Article 394 of the TCC contains two important differences, when compared to Article 333 of the repealed Commercial Code numbered 6762 (“Repealed Code”). The first of these is, while only a fee per meeting (attendance fee) was mentioned as financial right in the Repealed Code, Article 394 of the TCC lists different forms of financial rights. Secondly, pursuant to the Repealed Code, the attendance fee will be paid unless otherwise agreed in the articles of association, whereas under the TCC, a provision in the articles of association or a general assembly resolution is required for any financial right to be granted.

It is explicitly stated under Article 408(2)(b) of the TCC that the determination of financial rights is the exclusive authority of the general assembly. As a result of general assembly’s exclusive authority, financial rights may not be determined by the board of directors itself,^[3] but must be determined by the decision of the general assembly.^[4]

TCC Principles on Disguised Profit Transfer

The basic regulation on disguised profit transfer is Article 21 of the Capital Markets Law numbered 6362 (“CML”), which reads:

“Publicly held corporations and collective investment schemes and their subsidiaries and associates are prohibited from transferring income to real persons or legal entities with whom they have a direct or indirect relationship in terms of management, audit or capital by decreasing their profits or their assets or by preventing the increase of their profits or their assets via performing transactions such as making contracts or commercial practices containing different prices, fees, costs or conditions or producing a trading volume in violation of the conformity with market practices and comparability to similar transactions, prudence and honesty principles of commercial life.”

The scope of application of Article 21 of the CML covers publicly held partnerships and the affiliates and subsidiaries thereof. The TCC, which regulates private joint stock companies, does not contain an explicit regulation on disguised profit transfer. However, in order to understand whether the TCC contains the principles and mechanisms that will result in the prohibition of disguised profit transfer, the ratio legis of Article 21 of the CML should be examined. The aim of prohibiting the disguised profit transfer has been defined by scholars as preventing the transfer of company assets to a related party.^[5]

It should be noted that disguised profit transfer is a concept that applies for shareholders, managers or other related third parties.^[6] Beyond its appearance in the financial rights granted to the board of directors, disguised profit transfer might be examined at a wide spectrum, especially in the veiled payments and asymmetric legal transactions. Therefore, it may be argued that it is related to a number of provisions and principles under the TCC. However, since the main subject of this Newsletter article is whether the financial rights of the board members may constitute a disguised profit transfer, the capital maintenance principle and the principle of equal treatment will be discussed briefly.

The principle of capital maintenance,^[7] which is among the founding principles of the TCC’s company law, may entail legal protection similar to what is aimed at by the prohibition of disguised profit transfer. The principle of capital maintenance, which also prohibits to return the paid in capital as regulated under Article 480(3) of the TCC, aims to prevent profit distribution made through veiled payments.

A precedent from comparative law perspective on such veiled payments is the Michigan Court of Appeals’ decision in Erdman v. Yolles. The court decided that the distribution of the cash obtained by the sale of company’s assets, to shareholders who were working in the company, was a veiled profit distribution even if the company referred to it as a “salary increase” rather than a profit distribution.^[8]

Another key principle regarding the financial rights of board members who are also the majority shareholders, is the principle of equal treatment as regulated under Article 357 of the TCC.^[9] This principle requires that the shareholders on equal terms be subjected to equal conditions. Although right to equal treatment is mainly discussed when a person is a party to a transaction not as a third-party but as a “shareholder”, it would also be applied in cases where dividend distributions (either implicitly or directly) were not made on pro rata basis (whether the capital contribution or any privilege on profit).^[10]

Finally, the good-faith principle as a general principle in Article 2 of Turkish Civil Code numbered 4721, is a ground for annulment of general assembly resolutions under Article 445 of the TCC. Accordingly, general assembly resolutions that are contrary to the rule of good faith may be subject to an annulment sanction, in addition to resolutions that are contrary to the law or the articles of association of the company.

Court of Cassation’s Decision Dated 16.11.2021

By its decision dated 16.11.2021 and numbered E. 2020/5842, K. 2021/6256, 11^th Civil Chamber of the Court of Cassation approved of the decision of the Istanbul 14^th Regional Court of Appeal (“Court”) dated 17.06.2020 and numbered E. 2020/567, K. 2020/593 (“Decision”).^[11] In this decision, the Court held that the financial rights determined to the members of the board of directors were contrary to the principle of good faith, since they constituted a disguised profit transfer. As a result, the annulment claim for the relevant general assembly decision was accepted.

The facts of the Decision are as follows: the plaintiff is the shareholder of a family owned company and was not elected to the new board of directors. At the subsequent general assembly meeting on 16.01.2015, a monthly fee of TRT 75,000 was determined for two board members, who also held the majority shares. The plaintiff claimed that the determined amount was excessive and that it would serve as a personal benefit to the majority shareholders, to the detriment of the minority shareholders, and, thus, was contrary to good faith.

The Court accepted the claims of the plaintiff and found the decision of the general assembly resulted in a disguised profit transfer contrary to the principle of good faith. In its examination, the Court referred to the case law of the Court of Cassation,^[12] which sets out the criteria for determining the financial rights of board members. These are: (i) financial rights should be proportional to the effort and time spent by a member, (ii) amounts should be in line with the amounts in peer companies, (iii) decisions should comply with the financial situation and past practices of the company, and (iv) the right to dividend of the shareholders should not be violated.

The Court first examined the financial structure of the company. It referred to the fact that the company has been operating for almost fifteen years until the date of the general assembly, but during this period, it was decided to pay the attendance fee for less than two years. Furthermore, the company decided not to pay any attendance fee between 2009 and 2015. Therefore, the Court determined that the decision regarding the attendance fee was not in line with the past practices of the company.

The second observation was that the company was not conducting its main activity, was only generating non-operating income, and had closed the previous financial year with a loss. In the light of these findings, the Court concluded that the relevant general assembly decision did not comply with the financial situation of the company.

Finally, since the amount was found to be higher than the amounts at peer companies and there were no extraordinary effort was required for board members, the Court decided that the determined amount was in the nature of a disguised profit transfer, contrary to the principle of good faith.

Conclusion

Disguised profit transfer, although not explicitly regulated under the TCC, may be the subject of disputes with the alleged breach of capital maintenance principle the good faith principle. The principle of capital maintenance and the principle of equal treatment may shed light on whether a decision constitutes a transfer of the company’s assets to related parties, veiled as the financial rights of the board members. The Court of Cassation, in its case law, has determined the criteria regarding the determination of financial rights as the proportionality of the amount with the effort and time to be spent, similarity with the amounts at peer companies, and compliance with the financial structure and past practices of the company.