Legal Due Diligence and Corporate Restructuring in the Preparation of Groups of Companies for an IPO

14 12 2010

This article will describe the practice of legal due diligence and corporate restructuring in the preparation of companies for an ІРО. It will, in particular, deal with the offerings abroad by Ukrainian issuers.

The IPO consists of several main stages where the legal advisers practicing Ukrainian law are involved. This is, in particular, the legal due diligence of companies and assets, corporate restructuring, and participation in preparing an offering circular in respect of Ukrainian law issues.

The lawyers of Vasil Kisil & Partners were involved as legal counsels for companies operating in various sectors including machine-building, media, real estate and others and dealt with the issues of global depositary receipts. In addition, we handled the share issue projects involving both initial and secondary public offerings, in particular, on the London Stock Exchange, the Frankfurt Stock Exchange, and the Tel-Aviv Stock Exchange.

The purpose of the due diligence is to identify and subsequently minimize any legal risks, which may affect the interest of potential investors from the standpoint of the value of assets and the existence of any other business risks. Due diligence is also an essential tool in terms of guarantees to be provided by directors in relation to the companies within the respective group. The basic areas of the legal due diligence are to thoroughly examine the corporate ownership structure of a group and its formation history, corporate governance (to identify exactly what changes are needed to achieve IPO purposes), to inspect basic titles to assets, real estate, intellectual property, basic contract obligations, issuer’s group financing, regulatory approval of business activities (licenses, permits, approvals, etc.), and any pending litigation or arbitration involving the issuer’s group.

Due diligence is conducted in several jurisdictions. This is usually due to the fact that groups’ holding companies often have their registered offices outside Ukraine and legal due diligence is actually required for companies/assets in at least two jurisdictions. Thus, Ukrainian lawyers conduct the legal due diligence and provide their opinion in respect of Ukrainian companies and assets.

What is important is a format of due diligence reports. Two options are used by the issuers in practice: a full report or a limited report on identified risks only. The report mainly describes identified legal risks and recommendations on their mitigation and outlines the practice of law enforcement and legal regulation in the specific industry in which the respective business group is operating. The report is used to prepare an offering circular, i.e. to disclose the information on the issuer-specific risks and risks specific to the jurisdiction in which the issuer is operating.

Speaking about the corporate restructuring, its purpose is to optimize the group’s corporate structure and build an adequate corporate governance system in compliance with the rules of the jurisdiction in which an IPO is pursued. Here is a material overlap with the rules of the stock exchange that establishes its specific requirements in the respective stock market. This, in particular, concerns the creation of the independent directors’ institute, which is still an uncommon practice for Ukrainian companies that prepare for initial public offerings.

One of the most important elements of the corporate restructuring is the implementation of the recommendations provided by company’s legal counsel in the legal due diligence process. Based on the practical experience, the corporate restructuring of a group may take up to three to four months. The process generally depends on the scope of required actions, including regulatory approvals (in particular, one or several merger clearances from the Antimonopoly Committee of Ukraine). The time usually depends on how many companies are within the group and how the group was formed. In preparing for an IPO, one may need to make a significant redistribution of assets or participation interests in companies or to exclude some companies from the transaction.

The next important stage is to add a foreign holding company to the group’s structure. For many projects, this is a mandatory requirement dictated by the restrictions set by applicable Ukrainian laws (an exception is made for projects involving the issue of global depositary receipts for shares in Ukrainian companies). An absolute majority of Ukrainian issuers use the most popular foreign jurisdictions, such as Cyprus, the Netherlands, Luxembourg, and the Isle of Man, to set up their holdings. The corporate restructuring process usually includes a split-off of non-liquid or non-core assets of the issuer’s group of companies to avoid a potential undervaluation of its business during the evaluation stage. Such split-off is also done at a stage preceding the offering of shares (depositary receipts).

A separate mention should be made of certain tax aspects of the restructuring procedure, which are particularly relevant in the context of the new Tax Code. When building up a multilevel holding structure as mandated by applicable laws, particular attention should be given to the new concepts envisaged under the Tax Code. In particular, one should take into account the concept of a beneficial owner for the purposes of making payments to non-residents and the concept of a reasonable business purpose of entering into agreements. These concepts can affect the corporate structures used by companies for the offering of their securities on international capital markets. One should also consider some new rules, such as tougher regulation of the inclusion of royalties in gross expenses. As to interest payments, restrictions continue to apply when non-residents hold over 50% of shares / participation interests in a respective Ukrainian taxpayer company. Certain positive developments are taking place in the context of dividends. Thus, for example, advance corporate income tax exemption is granted to fixed agricultural tax payers.

Imposing limitations on expenses associated with unproductive capital outflows is quite a progressive idea aimed at curtailing the withdrawal of cash from the Ukrainian market. These new limitations will have to be further implemented under a series of subordinate regulations. A rather tough monitoring procedure will be introduced for disclosures of information about Ukrainian issuers on the stock market, which can generally be viewed as a positive development.

As to the restructuring in Ukraine, the Tax Code offers clearer rules and confirms the neutral status of reorganizations in the context of both the corporate income tax and the value added tax. The only question that remains open is the VAT credit transfer procedure, except in the context of transformations. The rest of the new tax rules will have a lesser impact on the procedure for entering the IPO market.

The due diligence report is updated following both the restructuring process completion and any material changes in the issuer’s business. In particular, such updating is done when a considerable period of time elapses between the due diligence completion date and the day when the final updated offering circular is prepared. Such updated offering circular must also be published after the expiry of a financial year or following any material amendments to the laws that apply to the issuer’s business.

As legal advisers, we would naturally like to see better growth dynamics – first of all, on the Ukrainian stock market. The current progress observed in the introduction of the Law on Joint Stock Companies, in particular its corporate governance provisions, is likely to facilitate the process. Hopefully, the initiatives, which are now getting much attention from the Securities and Stock Market State Commission of Ukraine and from many Ukrainian stock market experts, will get the same attention from the National Bank of Ukraine, and exchange control regulations will be further liberalized. Only coordinated and consistent efforts of regulators can secure, in a mid- and long-term perspective, an improvement in the liquidity of Ukraine’s domestic stock market and the launch of full-scale Ukrainian securities offerings with the participation of a large number of investors, including foreign investors.
Ukraine Business Review, # 52-53, December 9, 2010
Author: Denis Lysenko