Annex B. Reducing founding and operation costs and facilitating modern forms of business and finance in Latvia
Reducing founding and operation costs
Mandatory minimum share capital requirements reconsidered
Mandatory share capital requirements for private and public companies have an influence on the level of entrepreneurial activity. The higher the capital figure required for founders to raise when commencing business in the form of a limited liability company, the less entrepreneurial activity is to be expected. While a mandatory share capital was quite common in the 20th century in many European company laws, recent times saw many countries giving up a mandatory capital figure for private companies and lower it for public companies. Mandatory minimum capital requirements lost ground, because such a figure is arbitrary and would be either too high or too low in the large majority of cases. Where the figure is too high, it stifles business and increases the costs of founding one. Where the figure is too low, it does not have a relevant regulatory effect for creditors. In addition, research showed that offering limited liability with lower capital requirements increases the number of enterprises founded. In line with these developments in regulatory practice and science, most stakeholders interviewed in the OECD missions felt that a mandatory minimum share capital for private companies in Latvia is not necessary. In addition, the suggestion was made to reduce the capital figure for public companies.
Latvian law currently requires a minimum amount of equity capital of EUR 2 800 for private limited liability companies (Section 185 of the Commercial Law). Under specific circumstances, the equity capital can be lower than this figure (described in Section 186 of the Commercial Law). In essence, such a company may have a maximum of five members, all of them need to be natural persons, the directors may only be persons who are members of the company at the same time and each member is only associated with one such type of company. For public companies, the minimum capital figure is set at EUR 35 000 (Section 225 of the Commercial Law).
For the reasons named above, Latvia might be interested in analysing the approaches of other jurisdictions that have abolished the minimum share capital requirement entirely for private companies. In English company law, for example, private limited companies can be founded without a minimum share capital requirement. European law does not require any minimum figure for private companies as the relevant directive rules only apply to public companies. Article 45 of Directive 2017/1132 requires a minimum share capital of EUR 25 000 only for public companies in Latvia. Hence, the relevant figure in Section 225 of the Commercial Law could be reduced from EUR 35 000 to EUR 25 000. While the current English Companies Act 2006 requires a minimum share capital of GBP 50 000, only 25% – i.e. GBP 12 500 – have to be paid up (Sections 586, 761, 763 of the Companies Act 2006).
Model articles by ministerial order
Model articles for private and public companies offer a reduction of the costs of founding a company, while at the same time maintaining legal certainty. As a result, entrepreneurs can have access to companies as an organisational form for businesses without the need for costly advice on their articles. English law has used this approach for many decades and other OECD jurisdictions, such as Germany, have followed this best practice. In essence, English law offers model articles for founders of private and public companies. These model articles are established by ministerial order and reflect the standard articles that the majority of founders would choose. Model articles are based on a ministerial order instead of statutory law to provide an easy mechanism to adapt them to changing business needs. An act of parliament is not required; rather the relevant company law empowers the minister accordingly. Further, a section in the company law provides that the model articles apply unless they are not excluded or amended by the members of the company. This makes the model articles automatic, but optional. Founders and shareholders can opt out and amend them, if they prefer different rules. However, if founders do not amend them, they get a reliable standard set of articles for free.
Section 20 of the English Companies Act 2006 reads as follows:
“Default application of model articles:
(1) On the formation of a limited company;
(a) if articles are not registered, or
(b) if articles are registered, in so far as they do not exclude or modify the relevant model articles.
The relevant model articles (as far as applicable) form part of the company’s articles in the same manner and to the same extent as if articles in the form of those articles had been duly registered.
(2) The “relevant model articles” means the model articles prescribed for a company of that description as in force at the date on which the company is registered.”
For more information on model articles under English law, see www.gov.uk/guidance/model-articles-of-association-for-limited-companies.
Latvian law currently does not provide for such a combined mechanism in the Commercial Law and by way of ministerial order. The Enterprise Registry seems to offer standard articles on its website. However, they neither have the effect of a ministerial order, nor are they equipped with automatic application by a section in the Commercial Law. In particular, small and medium-sized enterprises (SMEs) are potential beneficiaries of model articles that apply automatically by force of law if not excluded or amended. Model articles based on a default provision in the Commercial Law would have the advantage of clear legal status. Such articles may, in particular, fill gaps where SMEs do not have or are not willing to spend the relevant funds for tailored legal advice.
Modern management structures and responsibilities
Latvian public companies are currently required to have a two-tier board structure, i.e. a board of directors and a supervisory council. Private companies need to have a board of directors, but have the choice whether to establish a supervisory council or not. Consideration might be given to the request of some stakeholders to allow for choice between one-tier and two-tier board structures. In a one tier-board, the board of directors has the power to both manage and supervise the management of the company. Usually, executive directors exert the management function while non-executive directors supervise management. In the two-tier board-structure currently prescribed in Latvia, the board is charged with managing the business and the supervisory council controls the board. Allowing choice between the one-tier and the two-tier board structure could provide businesses with the opportunity to select the corporate governance model that fits their needs. Both models could be designed in a robust way to ensure the desired level of management supervision. The option to choose between one- and two-tier board structures is already part of Latvian law for the Societas Europaea. Many European member states offer a choice between one- and two-tier boards, for instance in France, Italy, Lithuania and the Netherlands.
A further area for consideration is the optimal level of loyalty, care and risk taking by directors of private and public companies in Latvia. Currently, Section 169 of the Commercial Law provides only a short description of the loyalty and care required from directors. The law refers to the “duties of an honest and careful manager” and leaves it to the courts to develop further details by way of interpretation. The stakeholder interviews revealed some indication that the reference to the “honest and careful manager” might create both over- and under-regulation at the same time. The provision might over-regulate by preventing desired risk taking and under-regulate by failing to capture wrongdoers. It might make sense to discuss whether moving to a model that combines directors’ duties regulated in more detail with a business judgement rule that encourages desired risk taking. Regulatory examples include English law for the more detailed regulation of directors’ duties. For more than a decade, directors’ duties are laid down in a higher level of detail in Sections 170 and following in the English Companies Act 2006. German law introduced a business judgement rule in § 93 of the German Law for Public Companies (Aktiengesetz) following the US-American model. In essence, a director is not liable under the business judgement rule if he or she took a business decision adequately well-informed and in good faith in the interests of the company.
Closely connected to the duties of directors is the enforcement of liability if such duties are breached. When considering whether boards show the optimal level of care, loyalty and risk taking, enforcement mechanisms such as Section 172 of the Commercial Law might be considered together with substantive law rules. If the result is that the enforcement of director liability is wanting, the introduction of wider powers of minority shareholders to bring claims on behalf of the company might be an option. The introduction of the power for shareholders to bring derivate claims under certain conditions in the English Companies Act 2006, Sections 260 to 264, is generally considered successful. A core element of the English model is the introduction of a procedural vetting process in which the court filters whether an action has potential merit and may continue or whether it seems wrongly constructed and should not further burden the company.
Section 173 of the Latvian Commercial Law allows the shareholders to release members of the board of directors or the supervisory council from liability for breaches of duties. In its current wording, this rule seems to provide the shareholders with the power to release from liability even in those cases in which the company cannot satisfy all creditors’ claims. This might create incentives for shareholders to ratify breaches – possibly by themselves in their function as director – when companies are in financial distress to the detriment of creditors. If this is considered as unhelpful practice, inserting a limiting wording into Section 173 preventing such ratifications might be a way forward.
Broadening the view to private sector activities, helpful facts may be revealed by an observation of the market for directors and officers insurance (D&O insurance). Stakeholders indicated that D&O insurance is not very common in Latvia, but is slowly emerging. Further, stakeholders reported that D&O insurance products are offered by European and international insurers rather than by local insurance companies. At least two things might require attention. First, it might be helpful to find out why the local insurance market is not offering D&O insurance or why local products are not competitively priced. Second, if D&O insurance products become more prevalent, attention should be given to whether or not they are undermining the ex ante behavioural effects of directors’ duties. If directors are not worried any longer, whether they might be held liable for breaches because they are insured, then directors’ duties might lose their disciplinary effect. Other jurisdictions have reacted to such a development by limiting the company’s contribution to the costs of D&O insurance and by setting minimum liability figures that cannot be insured. Moving ahead, Latvia may consider various options in this regard, taking into account a number of factors and how they may best be adapted to the particular circumstances in Latvia. Amongst these factors are the deterrence effect of liability on the willingness to be a director, the amount of remuneration directors receive and how effectively reputational concerns may already serve as an incentive for directors to take their duties seriously.
A sophisticated framework for mergers and divisions
All stakeholders spoke with one voice when evaluating the rules applying to mergers, divisions and restructurings. The common evaluation is that these rules provide a basic framework, but are in need of improvement. Stakeholders made the following suggestions to either introduce possibilities or clarify the existing rules to reduce uncertainty:
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introduce rules on spin-off restructurings
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simplify the reorganisation of a private company as a public company
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simplify the merger of two subsidiary companies
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introduce a straightforward possibility to transfer a local branch to another local company
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clarify the exact point in time when a reconstruction becomes effective
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reconsider whether the announcement of registering a merger is necessary as the stakeholders are informed anyway
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simplify the rules on informing creditors about a merger
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simplify share conversions
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facilitate squeeze-outs for private and non-listed public companies.
Reforming the law of mergers and divisions needs to take account of the requirements of Title II of Directive 2017/1132 on mergers and divisions of limited liability companies. This would require a decision on whether the mandatory EU requirements for public companies shall also apply to private companies. Generally, it seems to be preferred practice to reduce the administrative burden for private companies as far as shareholder and creditor interests allow. In other words, split rules for public and private companies are used to avoid over-regulation of private companies. Similarly, many EU member countries make intensive use of the options and possibilities provided by the directive to reduce the administrative burden for mergers and divisions involving public companies.
Formal coherence
Several stakeholders mentioned unease concerning the inconsistent registration of shares in public companies and indicated that thought should be given to including private companies by way of optional share registration. Currently registration of share ownership is not mandatory for all joint stock companies. A number of stakeholders felt that this often can provide a way for some shareholders in public companies to hide (for the wrong purposes). The depository registration is currently only optional. The necessity to set up a register for the beneficial ownership of shares should be considered for reform in this area of the law. In particular, it provides an opportunity to harmonise registration requirements regarding public companies.
If shares in a private company are registered, then the transfer of such shares could be freed from having public notaries involved, which would further reduce costs. In a less radical approach, this would, however, only be an optional registration. If the register was not used, the prime responsibility would remain with the company. Some stakeholders went even further and argued that private companies should have their shares mandatorily registered with a central entity because the boards were not always efficient in managing the share register.
Facilitating modern forms of business and finance
A modern corporate finance law as the backbone of innovative finance
As the European Union’s Capital Market Union Action Plan1 puts forward, deeper and integrated capital markets promise to provide businesses with a greater choice of funding at lower cost and offer new investment opportunities for investors. Law has an important role to play in expanding investment choice and in minimising the cost of finance. This concerns both equity and debt finance. The role of the law in corporate finance is two-fold. First, it can enable financial arrangements that parties would have trouble creating based only on freedom of contract. An example is the provision of different classes of shares by company law. Second, it can contribute to reducing the cost of business finance. An example is finding the right balance between creditor protection and flexibility for shareholders in capital restructurings. If creditors are prone to expropriation, the cost of debt finance will rise. At the same time, overly limiting shareholder flexibility will make equity finance more costly. The latter shows that legal reform should keep in mind that market actors will react to the corporate finance framework they find. If the law does not create the optimal balance, equity and/or debt investors will charge a premium for the finance provided. As a consequence, fewer projects and businesses would be financed. Hence, the ultimate goal should be to minimise the average cost of both equity and debt finance.
The stakeholder interviews in Latvia revealed a general consensus that updating core provisions of classic corporate finance law would be beneficial to support business finance. Providing investors and managers with finance options and clarity of law would put them in a position to develop innovative solutions. Hence, the starting point for an innovative finance practice can be high-quality core provisions of business finance law. In this regard, the Latvian Commercial Law already provides a stable basis. Stakeholders suggested to further broaden the range of finance options available and provide businesses with more certainty.
A minor, but potential helpful change called for by stakeholders is to allow the nominal value of shares to be determined in cents. Currently, Section 186(1) of the Latvian Commercial Law requires the nominal value of equity capital of a private company to be expressed in whole euros. Consequently, a nominal value of one cent or ten cents is prohibited for private companies. The nominal value of a share in a public company may not be less than ten cents according to Section 230(2) of the Latvian Commercial Law. These restrictions for private and public companies may complicate certain forms of sophisticated business participation. Lower amounts may become necessary after incorporation, for example to implement the introduction of new classes of shares or capital restructurings. Allowing one-cent shares for both private and public companies in Latvia - as a possibility - could increase the flexibility for businesses to arrange their finance structure, as there seems to be low risk this would lead to costs or further problems in legal reality.
A further basic feature of shares that might be discussed is the introduction of no par value shares, i.e. shares without a nominal value. The shares of both private and public companies are required to have a fixed nominal (or par) value, according to Section 186(1) of the Latvian Commercial Law. There is a trend in many countries to move away from a mandatory nominal value of shares as they are often associated with complications in share capital adjustments and could lead to confusion for market participants. Countries that allow no par value shares are, for example, Australia, Germany, Portugal and South Africa. While non par value shares may be attractive for businesses and their investors, they require careful drafting when reforming the law. One of the options to consider for Latvia is to offer businesses a choice between nominal (par) and no par value shares. This is the approach that the German Aktiengesetz currently takes.
Another possibility asked for by stakeholders is to facilitate the creation of classes of shares in private companies. The Latvian Commercial Law recognises the possibility of creating different classes of shares in Section 227. This provision, however, is to be found in the rules for public companies. As a result, the question arose whether different classes of shares can be created for private companies. While the Latvian Commercial Law does not contain a prohibition to create different share classes in private companies, the uncertainty regarding class rights created by the current law is often reported to create problems for private companies. Similar to some OECD countries (e.g., Germany, United States and the United Kingdom), Latvia may encourage the freedom for businesses and their equity investors to create different classes of shares, with different classes allowing the possibility to offer different equity participation to different types of investors. As there are different types of investors with different types of investment interests and profiles in the market, more flexibility in terms of share classes may encourage more equity investment at lower cost. The rise of start-up finance and private equity finance in the United States and the United Kingdom was – among other things – based on the ability of their legal systems to provide different share classes in private companies.
The logic that class rights are a means to satisfy the investment interests of different types of equity investors with the expectation that this will lead to more equity finance offered at lower cost may also call for a reconsideration of the regulation of class rights for public companies. The rules on class rights in Section 227 of the Latvian Commercial Law currently seem to limit the type of class rights that can be created. This section only mentions different rights with respect to: 1) receiving dividends; 2) receiving a liquidation quota; and 3) voting rights at a meeting of stockholders. Consequently, it seems that all other types of class rights are not recognised by Latvian law. However, investors and companies may have good reasons to provide certain shares with other types of administrative, financial or information rights. The occasion of looking into the issue of class rights for private companies might be combined with reconsidering a more liberal approach to the definition of classes of shares. One solution might be to do away with the enumeration of different types of class rights and instead only define what constitutes a class of shares. It would then be left to the businesses and their investors to negotiate the types of class rights that fit their needs. This approach is currently taken both by English and German company law.
Similar considerations concern the regulation of preference shares. Preference shares are regulated in Sections 231 to 234 of the Latvian Commercial Law. Further provisions concern the position of preference shareholders, in particular in reorganisation. First, the fact that Sections 231 and following of the Latvian Commercial Law only apply to public companies raised the concern of several stakeholders that preference shares might be considered unavailable to private companies. At the least, even if registers and courts accept preference shares in private companies, their position is fraught with uncertainty, which increases the cost of capital. Second, a number of stakeholders suggested deregulating the rules on preference shares. Section 232(1) of the Latvian Commercial Law leaves it to the articles of association to determine the rights of preference shares. However, stakeholders felt that the following subsections limit the freedom to create preference shares that fit their needs. In particular, subsection (3) determines that preferences with special dividend rights acquire voting rights only if dividends are not paid for two successive accounting years. It was suggested to consider deregulation of the law on preference shares and generally allow the shareholders to determine the rights associated with preference shares. In addition, stakeholders felt that there is scope to simplify the currently drawn-out procedure for voiding preference shares.
A further related issue is the facilitation of employee share schemes. The Latvian Commercial Law provides rules on employee shares only for public companies in Section 255. Stakeholders have expressed that this creates uncertainty on whether employee shares can be used in private companies. Employee shares can play a useful role for private companies, in particular to provide equity-based incentives. Going beyond the reduced applicability of Section 255 of the Latvian Commercial Law, thought might be given to equipping employee shares in general with further benefits. English law, for example, provides the following benefits for employee share schemes: 1) as a default position, directors do not require specific authority to allot employee shares; 2) pre-emption rights do not apply to employee shares; 3) a public company is not prevented from giving financial assistance for the acquisition of shares for an employee share scheme; 4) the rules on share buy-backs are less strict for employee shares. As a related side note, stakeholders also suggested the general relaxation of the rules on share buy-backs.
Moving on to exit options, it might be worthwhile discussing the costs and benefits of the right of first refusal in Section 189 of the Latvian Commercial Law. This area of law has been the focus of recent reform. According to section 189 of the Latvian Commercial Law, the other shareholders have a right of first refusal if a shareholder in a private company sells his or her shares. While such a rule can found in some cases, it might reduce the attraction of being a shareholder in a private company. The obligation to offer shares to the other shareholders after entering into a purchase agreement may create uncertainty for the original share purchase agreements and make the sale of shares in a private company a lengthy process. As a result, shareholders interested in exiting private companies will find it more difficult to find a buyer willing to incur the costs for a share purchase that might not happen in the end. This in turn may add further difficulties to the already reduced exit options regarding private companies. If investors know that exit is difficult, they might refrain from investing in the first place. Therefore, equity finance for private companies can become more costly and scarce. In English and German law a right of first refusal does not exist as a default position in private company law. The shareholders are always free to negotiate such a right for their company and establish it in the articles of association. Latvia might benefit from monitoring how the practice as regards the right of first refusal develops over time and consider adjustments, if this seems beneficial.
A final brief point concerns tax law although it is generally not within the ambit of this report. It might be interesting to note, though, that stakeholders asked to reconsider the point in time at which profit accrues in terms of tax law for share options. Choosing the point in time when they are exercised rather than when they are issued might make them more attractive in practice.
Supporting recent trends in business finance
Stakeholders reported a recent initiative in the FinTech market driven by remarkable consensus. This is encouraging as it offers opportunities for fruitful discussions on how law can support FinTech and other initiatives related to blockchains and initial coin offerings (ICO). One issue particularly emphasised in the stakeholder interviews was crowdfunding. From the point of view of the legislature, crowdfunding is particularly challenging. It is a relatively new phenomenon and it sits somewhat uneasily between issues of consumer law and capital markets law. Internationally, different approaches to regulating crowdfunding can be discerned. While crowdfunding is considered as possibly offering a useful source of finance and deserving support, careful consideration should be given to ensure that consumers are not lured into deceptive investments. There is certainly no one-size-fits-all approach to regulating crowdfunding and the particularities of the Latvian capital market need to be respected.
In this regard, consideration might be given to facilitating share pledges. Some shareholders thought it might be helpful to offer a solution for those cases, where a large number of share pledges needs to be registered.
A balanced capital markets law initiative
A number of stakeholders called for a better connection between the Commercial Law (including the company law elements) and the Financial Instruments Law. Stakeholders feel that the Commercial Law is not always written with public finance markets in mind, which might also be explained by the history and development of the Commercial Law. While it could be a major undertaking, it may be worthwhile, though, and could support the development of deeper capital markets in Latvia. In addition, it could be tied into the European Union’s Capital Market Union Action Plan initiative and thus gain further momentum. Such a regulatory analysis and initiative may, however, not lose sight of small companies and their needs. Innovative solutions can be found to develop a more integrated approach to company and capital markets law while at the same time maintaining a focus on small and medium-sized companies and their regulatory interests.
Share registration
A further issue for consideration might be the registration of shares. Stakeholders mentioned three issues with regard to reordering the law on shareholder registration. First, there seems to be a need to achieve a consistent framework for the registration of shares in public companies. Currently, not all shareholders of public companies are listed. Second, the registration of beneficial owners of shares can be considered in the interest of fraud avoidance. Third, there appears to be a need for discussion on whether an (optional) registration shall be offered for shareholders in private companies. The background to these issues are reports from some stakeholders that directors sometimes make registration mistakes or even collude with certain shareholders. In the past, this led to, for example, 145% shareholders’ presence in a general meeting. Similarly, in the past there were illegal takeovers of companies using manipulations of shareholders’ lists. Furthermore, stakeholders reported problems of finding shareholders, which had negative consequences for company reorganisations, as their involvement was required.
The issue of extending shareholder registration may raise the following two issues: 1) which institution is best suited to manage the registration process; 2) which institution is the point of contact for outsiders who want to obtain information on registered shares. For the particular situation of Latvia, two possible institutions were mentioned by shareholders to manage registrations: the Enterprise Registry or the Central Depository. Here, choice requires a balancing act considering existing competences and structures and the future benefits of economies of scale through the centralisation of registration competences. In any case, however, the information on share ownership should be available from one central entity for outsiders requiring information. External data fragmentation should be avoided in the interest of providing a one-stop data provision institution.