How share repurchases can lead to misleading financial statements

A recent ruling by the Enterprise Chamber of the Amsterdam Court of Appeal shows that the interpretation of an agreement between shareholders in a company can have far-reaching consequences for the financial statements. The risk of misleading financial statements is lurking. What was going on?

Cooperation bailiffs

A nationally known bailiff organization is the result of a nationwide merger of a large number of bailiff and collection offices in 2009. As a result of this merger, a significant number of bailiffs' and debt collectors' offices contributed their offices to a structure in which the offices involved joined a so-called participant agreement. If a participant subsequently wished to exit voluntarily or involuntarily, the participant must offer its shares. A special feature was that not the other participants, but the company in which the participation was made was then obliged to buy back the shares. If subsequently the bank involved objected to repurchase because the continuity and liquidity of the company would suffer, problems arose.

Accountability in the financial statements

The case presented to the Enterprise Chamber concerned the accounting for this course of events in the financial statements. One of the issues was how to deal with the repurchase of shares that had already been agreed but not yet formalized because the purchase price cannot be paid from the company's assets. Should the capital that was attached to the share in question then still be counted as equity? Another interesting issue was to what extent a group parent has to rely on the financial statements of a group subsidiary.

Opinion Enterprise Chamber

First, the Enterprise Chamber says that the group parent has its own responsibility for the accuracy of the financial statements. The layout of a participation's financial statements cannot therefore be decisive without question. Next, the Enterprise Chamber discusses the manner in which the repurchase of the participant's shares (which repurchase, for the record, had therefore not yet been formalized in a legal sense in the sense that the shares had been transferred to the company in a notarial deed). Next, the Enterprise Chamber ruled that at the moment the agreement to repurchase the shares was concluded, the participant in question (read: shareholder) became a provider of loan capital. This is because the mere fact that shares have not yet been delivered does not detract from the company's obligation to purchase the shares in question. As a result, the shares are out of the participant's sphere of risk, and that makes the shares discolored from equity to debt. As a result, an earlier decision to adopt the financial statements is overturned and the Enterprise Chamber issues instructions on how the company's financial statements should be arranged.

Misleading financial statements

If the financial statements give a misleading presentation of the company's condition, the directors are jointly and severally liable to third parties for the damage suffered as a result, thus (succinctly stated) the legal liability of directors in the case of misleading financial statements. Only the director who proves that he is not to blame is not liable. It is not difficult to imagine that creditors in this context, especially if bankruptcy should unexpectedly arise, may take the position that they have relied on financial statements that gave a (too) rosy picture of the company's condition. After all, it makes quite a difference whether the share that was offered (apparently with a purchase price of approximately €5,400,000.00, according to the decision) was counted as equity or debt. Interesting follow-up question: should one of the directors be successfully sued by creditors, can the director in question in turn hold the accountant liable for this? The decision of the Enterprise Chamber does not provide the answer, but it is certainly not excluded.