When optimizing your business structure, you may consider demerging certain (non-core) activities. While this may improve your balance sheet and financial performance of your (core) business, it is important to be aware that demerging and demerged companies both remain cross-liable for past burdens. A demerging company remains cross-liable (i.e. it becomes a statutory guarantor) to the company from which it demerges and vice versa for all debts (including latent ones) that existed as of the completion of the demerger.
Therefore, a diligent legal structuring of the demerger or a thorough legal review of a company that was subject to the demerger, could have a significant impact on the future company´s operation and business.
Cross-liability of companies
Generally, demerger means that a specific part of the business and assets of a company is transferred to another (often newly incorporated) company. The company that is demerging continues to exist without that part of its business or assets.
We may often see frequent demergers in the hotel and leisure sector. A company operating a hotel business also owns real estate – the hotel. Due to high demand in the real estate sector, the company decides to sell its real estate. Instead of selling the whole business, which purchasers are not interested in, the company (OpCo) will decide to demerge the real estate to a new company (PropCo), which will be subject to the sale. OpCo continues operating the hotel business, usually based on a new lease agreement concluded with PropCo.
Under Czech law, OpCo (as a demerged company) is cross-liable for all debts that were transferred to PropCo (as the demerging company) up to the amount of its own capital as listed in the financial documents. On the other hand, PropCo is cross-liable for the debts that remain with OpCo up to the amount of the demerged net asset evaluated by an expert or alternatively up to the amount of it changed own capital as a result of the demerger. In case of the plurality of PropCos, the law establishes a joint and several cross-liability of PropCos towards OpCo and also between all the demerging PropCos companies.
If the OpCo's own capital, as displayed in the financial documents, is lower that its registered capital, the registered capital needs to be decreased or the shareholders will provide the contribution beyond the registered capital. Breach of this obligation could force the company into liquidation.
Protection of creditors
The demerger could significantly affect the position of the creditors. Beyond the cross-liability, if the recoverability of the creditor´s claim is significantly decreased due to the demerger, the creditor may ask the debtor participating in the demerger for the provision of additional security. Such security can be sought up to six months after the completion of the demerger. As per the Highest court ruling, the additional security can be, for example, the establishment of pledge, a guarantee or a security assignment.
If the additional security is not provided, the creditor can initiate a court proceeding for the provision of the additional security.
Limits of demerger, impact on business
The legal and practical points that that should to be considered prior to the demerger of a company include:
- The demerger should not cause the insolvency of the participating companies.
- A state authority approval can be required as a prerequisite in the demerger of a regulated entity.
- The demerger project should precisely specify the assets and liabilities being demerged. Otherwise, it will be assumed that the item in question remains with the demerged company.
- The debts being demerged need to be accompanied by adequate assets.
- A prior thorough revision of contracts being demerged would be recommended as some of them may contain change of control clauses with an additional contractual penalty in case of breach.
- Cross-liability of companies can be beneficial for creditors in case the debtor subject to the demerger is not in a position to fulfil its duties.
- In terms of a transaction, the appearance of the demerger and, in particular, the high cross-liability of a company that is being acquired can materially impact the negotiation in cases where the buyer is seeking the relevant specific indemnity from the seller for the period after the completion of the acquisition.