20.2 Conversion of profits and reserves into shares

A method for converting profits and reserves into shares is not provided by law. The law does dictate that certain reserves can be transferred into share capital. The transfer of profits or reserves into share capital is also referred to as ‘conversion.’ Conversion assumes an issuance of shares. For an issuance of shares to take place there needs to be a resolution to issue shares from the authorised corporate body and an agreement with the party taking up the shares, as well as a deed of issuance. There are numerous reasons for a conversion of reserves into shares. It can be desirable at the shareholders level to effect a shift in the right to profits or in the control within the general meeting by issuing shares without that resulting in the strengthening of the capital of the company. In the context of an employee participation plan it may be desirable that shares can be issued without the participating employees having to make a financial contribution. There may also be tax reasons. This summary is not finite. A company may also prefer to distribute a dividend in the form of shares, rather than as cash, because this contributes to the strengthening of its liquidity and solvency.

Every existing theory which attempts to define in legal terms the transfer of a dividend or reserves into shares falls short in one aspect or another. My conclusion is that we need to distinguish between two different sorts of issuance: (i) those where the starting point is that the shareholder provides assets to the company and this leads to a mutation both on the ‘assets side’ of the balance sheet (an increase in money and/or goods) and on the ‘liabilities side’ (increase in the share capital of the company) and (ii) those where the intention is not that the shareholder contributes assets to the company and therefore that the balance total remains unaffected. This second variation, the conversion of reserves into shares, does not fit into either of the legally defined ’contribution of money‘ or ’contribution in kind’. This sort of issuance implies a different form of contribution for shares which is recognised in law but which is not further legally defined. Conversion of reserves is essentially a reclassifying of a company’s own equity whereby the company neither loses nor gains and which therefore affects neither the shareholders nor the creditors. In my opinion, therefore, conversion of reserves does not raise questions as to whether or not there is enough distribution capacity for the necessary issuance.

A stock dividend is a distribution to the shareholders of the profit the company has achieved in the previous book year which is made in the form of shares in the capital of the company. This distribution is made when the profits are allocated. In effect the distribution of a stock dividend is similar to reserving profit, but takes this one step further: from the moment that a stock dividend is distributed a portion of the amount of profit which is then kept on account, namely the sum total of the nominal value of all the shares distributed as stock dividend, comes under the bracket of retained capital and therefore reduces the possibility of further distributions. Most of the shares in NV’s which are distributed as stock dividends are current. The shareholder faces the risk of a fall in prices from the moment of distribution to the moment the shares are sold. I believe, therefore, that the NV cannot decide to make a distribution in the form of a stock dividend without a provision for this in the articles. For the distribution of a stock dividend by either an NV or a BV in addition to a resolution to reserve profit there also needs to be a resolution to issue shares from the relevant corporate body within the company. A decision to discount the value of the shares to be distributed as a stock dividend is in my opinion permissible provided it is within the bounds of reasonableness.

An NV may only make a distribution from its premium or profit reserve to the extent that the assets of the company are greater than the amount of the contributed and claimed capital plus the reserves which must be maintained in accordance with the applicable law or the articles (article 2:105 paragraph 2 of the Dutch Civil Code). The conversion of reserves into share capital is not covered by the second EEG-directive and should not be seen as a distribution in the sense of Article 2:105 paragraph 2 of the Dutch Civil Code. In addition, the law does not restrict the conversion of reserves in the sense that before this can be done a distribution test is prescribed. This means the conversion of reserves into capital is simply a reclassification of liabilities. No assets leave the company. Capital protection does not play a role here. Both the NV and the BV can convert premium or profit reserves, even if the company has negative equity.

Mandatory reserves based upon the articles (‘mandatory reserves’) can differ both in nature and form. The articles of a company may require a certain amount to be maintained, possibly for a set period of time or for a specified purpose. The articles determine the form, the maintenance and the use of the reserve. Provisions in the articles may require certain reserves to be attached to different types of shares, like profit reserves or share premium reserves. These are reserves provided for in the articles but are no mandatory reserves. Mandatory reserves may not be distributed according to Articles 2:105 paragraph 2 and 2:216 paragraph 1 of the Dutch Civil Code. Distribution here means a transfer of assets in the form of money or goods to those entitled to profits and distributions. Conversion itself is not a distribution, which could bring about a transfer of a mandatory reserve into capital. For an NV this is the case. The distribution capacity of the NV is not affected by this. Whether a mandatory reserve of a BV can be converted into capital depends upon the wording of the articles. Conversion of a mandatory reserve into shares by a BV does have an impact on the distribution capacity. If the BV does not have any legal or mandatory reserves then in principle its distribution capacity knows no restrictions and any limitation will only come about if the ability of the company to meet all its liabilities becomes uncertain due to distribution (Article 2:216 paragraph 1 Dutch Civil Code). If the BV does have a mandatory reserve then its equity may not be reduced below the threshold set in the articles for such a reserve as a consequence of a distribution. Where a mandatory reserve can be converted into shares the limitation of the distribution capacity is lost entirely in one go where a conversion of all of the mandatory reserves into shares takes place. Since a mandatory reserve is a provision explicitly chosen or maintained by the shareholders, I have reservations about the convertibility of mandatory reserves by a BV. If the BV’s articles do not make provision for a conversion then conversion of a mandatory reserve cannot take place without the articles being amended in this regard. Where a foundation is converted into a BV or an NV then on the basis of case-law I regard the reserve thereby formed as a mandatory reserve by requirement of law.

Article 2:373 paragraph 4 of the Dutch Civil Code defines legal reserves as reserves that must be maintained as a consequence of Articles 2:67a paragraphs 2 and 3 of the Dutch Civil Code (negative crediting reserve and non-distributable reserve for redenomination of the nominal value of the shares from guilders into euros), Article 2:94a paragraph 6 subparagraph f of the Dutch Civil Code (the reserve for contributions where no statement or description from an auditor is required), Article 2:98c paragraph 4 of the Dutch Civil Code (reserve for providing loans for the taking up of or gaining shares in the capital of the company), Article 2:365 paragraph 2 of the Dutch Civil Code (reserve for capitalised costs), Article 2:389 paragraph 6 of the Dutch Civil Code (reserve participation interest), Article 2:389 paragraph 8 of the Dutch Civil Code (translation differences reserve for participating interests), Article 2:390 paragraph 1 (revaluation reserve), Article 2:401 paragraph 2 (translation reserve investments) and Article 2:423 paragraph 4 of the Dutch Civil Code (translation reserve for valuation of fixed assets). With regards to the reserve for participating interests (2:389 paragraph 6) and the revaluation reserve (2:390 paragraph 2) the law essentially states these can be converted into capital. I am of the opinion that conversion of the translation differences reserve for participating interests (Article 2:389 para 8) similarly allows this, even though this is not explicitly stated in the Code. The law also fails to state anything with regards to whether or not the reserve for capitalised costs (2:365 paragraph 2) may be converted into capital. I believe that this reserve can be converted into capital. Article 2:423 paragraph 4 of the Dutch Civil Code states that differences arising from a translation of assets and liabilities should be accounted for on the profit and loss account. To the extent these differences relate to fixed assets or to forward transactions to cover such assets, they may be booked in favour or in detriment of a non-distributable reserve. The reserve against which the relevant differences have been booked may be considered for conversion into capital. The reserve for conversion of amounts into euros as provided for in Article 2:67a paragraph 2, as an exception, does seem to be suitable for conversion into capital. Equally, such reserve as determined by Article 2:94a paragraph 6 can be argued to be available for conversion into capital. In the case of a BV, an argument against possible conversion of this reserve is that this legal reserve is thereby cancelled whilst under Article 2:94a paragraph 6 of the Civil Code it must be maintained for a certain period of time. It is possible to argue that this is a rule for protection of capital of an NV that has come to be applied at the level of BV’s. However I believe that the convertibility of this reserve is also simply inherent in the current rules for capital protection for a BV.

For an NV there is in principle nothing beforehand to prevent the conversion of a legal reserve into share capital since share capital limits/restricts distribution capacity just as much as the legal reserve. If the share capital is increased by the same amount as any reduction in the legal reserves then there is no impact on the distribution capacity. If, however, after the conversion of a legal reserve the share capital is reduced, the distribution capacity is larger due to this capital reduction than it was prior to conversion of the legal reserve into capital. That does not mean that conversion of this reserve is impossible. When an NV converts a legal reserve into capital and thereafter a capital reduction takes place whereby the NV experiences difficulties with meeting its liabilities, that problem was not caused by the conversion of the reserve into shares but by the capital reduction. The capital reduction procedure provides security to protect the interests of creditors through the possibility of creditor objection (2:100 Civil Code). Cooperation of the board of directors with a conversion which is immediately followed by a repayment on shares is not without risk for the directors.

Even though for a BV, as opposed to an NV, the distribution capacity increases after conversion of a legal reserve, this does not mean that conversion of the BV’s legal reserves is not possible. The law states both the reserve for participating interests (Article 2:389 paragraph 6 Dutch Civil Code) and the revaluation reserve (Article 2:390 paragraph 1) can be converted into capital. No exception is made for BV’s. It is not the conversion which undermines the capital standing of the BV but the distribution which follows the conversion. All of this is the consequence of changes to the legal system whereby the capital protection for BV’s has not been removed altogether. The legislator argued that the choice to keep this part of the capital protections rules comes from obligations under the Fourth EEG-directive, whereas actually under this directive the formation and maintenance of a reserve is only required under certain specified circumstances and therefore allows room for the conversion into capital. Whether or not a distribution can be made which would draw on the capital of the company is not dealt with by the directive. Parliamentary history expressly recognises the fact that legal reserves can be converted into share capital and that the distribution capacity of a company is thereby increased. I am therefore of the opinion that Article 2:216 of the Dutch Civil Code actually only should apply to a single type of reserve which may limit the distribution capacity: the mandatory reserve. The flexible character of a BV and the autonomy of share-holders to agree articles which suit their own wishes and requirements necessarily includes the possibility for those shareholders to limit the distribution capacity of the BV in its articles.

Under ‘other reserves’ as mentioned in Article 2:373 paragraph 1, subparagraph f of the Dutch Civil Code come the reserves which are not included as legal reserves in Article 2:373 paragraph 4 of the Dutch Civil Code and which also do not fall under mandatory or premium reserves. These reserves are distributable and, as is also in principle the case with all reserves, can be converted into capital. ‘Not distributed profits’ (Article 2:373 paragraph 1, subparagraph g of the Dutch Civil Code) covers the total profit from the previous years, for so far as not paid out and not added to the reserves plus the results after tax from the last financial year, supposing the balance is made up before the allocation of profits. These can be converted into share capital by the distribution of a stock dividend.

Supposing the entire profit is distributed in the form of a stock dividend, then in reality the entire profit is reserved. Should the distribution be made in cash then the shareholders would be entitled to this in proportion to their respective shareholdings, taking into account any special provisions in the articles regarding entitlement to distributions. The shareholders can agree to a deviation from these proportions. The decision to issue shares follows a different path to the decision to make a distribution, i.e., in accordance with certain legal requirements and the articles of the company which dictate the decision process for the issuance of shares. In many cases the only requirement is a resolution of the general meeting which is passed by a majority of the votes cast without there being any requirement for a given quorum. It may also be that another corporate body of the company can take the decision to issue shares and to override any pre-emptive rights. Given a conversion of profit into shares, i.e., a distribution in the form of a stock dividend in reality involves reserving profit, case-law indicates that the company or the majority share-holder when taking the decision to reserve must show the necessary care towards the interests of the (minority)shareholders. A majority shareholder may of course vote in accordance with his/her own best interests but his/her behaviour is limited by the requirements of fairness and reasonableness under Article 2:8 paragraph 1 of the Dutch Civil Code.

The main rule is that when shares are issued every shareholder has a pre-emptive right to new shares in proportion to the amount of his/her current shareholding (Article 2:96a/206a Dutch Civil Code). Holders of shares in an NV do not have such pre-emptive rights to shares issued for consideration other than cash, unless the articles provide otherwise. I am of the opinion that issuance as a dividend or from a reserve cannot be treated as a contribution in cash but also not as a contribution in kind as intended by the Code. No contribution is made. An issuance of shares from reserves does not therefore fall under the exception from Article 2:96a paragraph 1 of the Dutch Civil Code. With respect to such an issuance, holders of shares in an NV do have a pre-emptive right, unless such pre-emptive right has been expressly excluded. Holders of shares in a BV also have a pre-emptive right on shares issued from a reserve unless the articles state otherwise. The corporate body which has the authority to issue shares can decide to make a disproportionate issuance of shares (which may include the issuance of shares to just a few and not all shareholders) from a reserve. In this way not only are pre-emptive rights ignored to the benefit of only a few shareholders but reserves are used to which all shareholders, whether directly or indirectly, are entitled, and therefore to the disadvantage of other shareholders. A particular example of such a disproportionate issuance is the issuance from reserves to non-shareholders. Under Article 2:92/201 paragraph 1 of the Dutch Civil Code all shareholders have equal rights and obligations in proportion to their holding. And under Article 2:92/201 paragraph 2 the shareholders and holders of depositary receipts must be treated in the same manner in comparable circumstances. A disproportionate issuance from profits or a reserve is in principle contrary to these requirements. Deviation from the requirement for equal treatment can be made on three grounds: (a) if this is allowed by the law or the articles, (b) if the shareholders cannot be said to be in comparable circumstances, (c) if the result of the unequal treatment is fair and reasonable. In principle an issuance of shares should be treated in the same way as a distribution of money and therefore all shareholders are entitled in the same proportions as they are entitled to a distribution of money. It is possible that the articles contain a provision with respect to an issuance of shares to non-share-holders from a reserve. So, for example, there are provisions in articles on the basis of which a company maintains a mandatory reserve so that this can be used on an ongoing basis to issue shares to a foundation which has as its object the continuity of the company. Even if such a provision is not included in the articles this does not mean that a decision to make a disproportionate issuance, or an issuance to a third party, is always contrary to the requirement for fairness and reasonableness. Share capital can be converted directly into a premium reserve by a capital reduction. This can be included in the resolution to reduce the capital as a way of the execution as in Article 2:99/208 paragraph 1 of the Dutch Civil Code.

Reserves of the company itself cannot by their very nature be subject to a limited right such as a right of pledge or usufruct. They form part of the capital of the company and as such the company cannot dispose of them. A legal person can dispose of its own assets but not of its liabilities.

Bonus shares, shares that are issued out of company reserves, are not ‘fruits’. Similarly, a claim is not a fruit. A bonus share is granted to a shareholder. At the establishment of the usufruct it may be determined that bonus shares will fall under the usufruct (Article 3:216 Dutch Civil Code). A dividend is a fruit. Both a cash dividend and a stock dividend therefore belong to the usufructuary. Other distributions and advantages that go with distributions of profits are part of the entitle-ment of the main proprietor of the share. These advantages are in general seen as ‘advantages derived in the course of the usufruct from an encumbered asset other than its fruits’ (Article 3:213 paragraph 2 Dutch Civil Code) and therefore go to the shareholder but fall under the usufruct. The distinction between a fruit and a dis-tribution at the expense of capital rights is not always clear. What determines this is whether the withdrawal against the capital of the company is a partial realisation of capital. If this is the case then it is not a fruit. It matters, therefore, whether or not a share is issued at the expense of the reserve for not-distributed profits, in which case it is a fruit, or at the expense of the reserve for reserved profits, in which case it is not a fruit.

A share can be seen as a collection of interrelated controlling and capital rights, including the (claim)right to a dividend. The holder of a pledge is entitled to demand payment of a dividend. owever with the authorisation of the subdistrict court this right can also remain with the pledgor (Article 3:246 paragraph 1 of the Dutch Civil Code). After the dividends have been collected the pledge will also be vested on the collected performance (Article 3:246 paragraph 5 of the Dutch Civil Code). Collection does not mean that which is collected – the dividend – goes to the pledgee. It goes to the shareholder. The prohibition of appropriation (Article 3:235 Dutch Civil Code) prevents a holder of a pledge becoming the direct holder of shares which are issued as a stock dividend. The pledgee can demand satisfaction out of the collected divi-dends as soon as his/her claim becomes due and demandable. The shares which are issued as a stock dividend belong to the shareholder/pledgor. Collection of the stock dividend by the pledgee is then only possible if the pledgee makes a demand on the company at the issue of the stock dividend to the pledgor. As a rule deeds of pledge, where shares are pledged, state that the pledgor is entitled to collect dividends but that this entitlement transfers to the pledgee if the pledgor is in breach of the connected financing documentation. The current view appears to be that stock dividends, bonus shares, claims and other such items also fall under the pledge. To avoid any doubt shares which the pledgor receives after the granting of the pledge, irrespective of whether they are transferred to the pledgor, or issued as new shares, are in the deed of pledge stipulated to be subject to the pledge from the moment they are received. If that is the case, all shares that the pledgor acquires after the pledge, irrespective whether or not it concerns shares transferred or issued to the pledger, will fall under the pledge.