Hungary: Why is equity protection ineffective in Hungary?

30 January 2012 | newsletters

The Hungarian Companies Act ("CA") and others have long contained provisions to protect creditors. One provision prohibits a limited liability company from paying dividends to its shareholders if it does not have sufficient funds.

The prohibition against the payment of excessive dividends is obvious, and also non-lawyers will easily recognise when such a prohibited payment occurs (or is about to occur). The payment of a dividend can, however, also be made in a hidden manner, for example under a rental or a consultancy agreement, or by granting other advantage to a shareholder, for example in the form of a security provided by the company to secure an obligation of the shareholder. In these cases it is much more difficult to judge whether or not the hidden benefit or advantage granted to the shareholder constitutes a prohibited payment. Therefore, the relevant statutory provisions set forth the conditions under which a company is allowed to make payments to its shareholders and require that any contract that a company and its shareholders enter into must comply with the "responsible corporate trading" principle. This means that a company may enter into a contract with its own shareholder if it also did so with an independent third party under the same terms and conditions. There is a similar concept in the Anglo-Saxon business world called the "arm's length transaction" principle.

A transaction can be classified as non-compliant with the principle of "responsible corporate trading" if the company concludes it with one of its shareholders under terms and conditions that are less favourable than those which the company could achieve on the market. This could occur if the company leases property from its shareholder for a much higher rent, or obtains consultancy services for a higher fee than it could from an independent third-party lessor or consultant, or if the company would not even buy these services from an independent third party.

The CA clearly states that non-monetary benefits, in addition to payments in the form of money, may also fall under this prohibition. It is questionable therefore whether the granting of a security for an obligation of the shareholder, such as the repayment of a bank loan, could also qualify as a prohibited benefit. The granting of a security does not immediately materialise as a benefit to the shareholder, since it is uncertain whether it will be used or not. When assessing whether a transaction complies with the principle of "responsible corporate trading", it must be examined whether the company receives any consideration for the payment or the benefit. If the bank loan taken out by the shareholder is meant to finance the continuous operation of the entire group of companies, the assessment will probably find that the company does receive sufficient compensation for providing security. The transaction will therefore comply with the principle of "responsible corporate trading."

If a transaction does not comply with this principle, the shareholder must repay the sum or return the benefit. The managing director of the company who concluded the transaction with the shareholder may also be liable. The obligation to repay only applies if the company can prove that the shareholder acted in bad faith, which will depend on the amount of information that the shareholder had about the company’s financial situation and the consequences of the transaction for the company. This information will, however, be in the hands of the managing director, whose liability also arises. Under the CA, the managing director is liable only towards the shareholders' meeting. Therefore, when looking at the repayment obligation of the shareholder and the liability of the managing director, these two players are mutually dependent. The Bankruptcy Act contains an exception from this mutual responsibility and allows creditors to sue the managing director directly. But this depends on other conditions due to which creditors' claims and equity protection provisions are ineffective and rarely enforced.

This article has also been published in the Book of Lists 2011-2012 of Budapest Business Journal in December 2011.

Kinga Hetényi

Office Managing Partner

T: +36 1 8700 683
k.hetenyi@schoenherr.eu

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