Dealing with Financial Distress: Underbalance, Capital Loss, and Over-Indebtedness

Financial distress can create significant challenges for Swiss businesses. It requires swift action to meet legal obligations and protect the company’s financial wellbeing. Article 725 of the Swiss Code of Obligations (CO) sets out the responsibilities of directors in managing situations such as underbalance, capital loss, and over-indebtedness. In this article, we define these terms, outline their legal and practical implications, and provide insights to help companies understand and address these situations effectively.

Overview of the legal framework: Article 725 of the Swiss Code of Obligations (CO)

Article 725 of the Swiss Code of Obligations (CO) serves as the foundation for managing financial distress and insolvency in Swiss companies. It outlines the responsibilities of the board of directors (for AGs) or the managing directors (for GmbHs) when a company faces financial difficulties. Specifically, it defines actions to be taken in cases of:

1. Underbalance: Equity falling below the nominal share capital and legal reserves.
2. Capital loss: Equity dropping below 50% of share capital and legal reserves.
3. Over-indebtedness: Liabilities exceeding total assets.

Failure to comply with these provisions can lead to severe legal and financial consequences, including personal liability for directors.

We will now define and explore each of these terms in more detail, outline the practical and legal implications of each in accordance with Article 725 of the CO, and provide practical examples for easier understanding.

Underbalance

Definition: What is underbalance?

Underbalance, also referred to as undercapitalization, occurs when a company’s equity falls below its nominal share capital  (including legal reserves) but remains above the critical thresholds that trigger legal obligations. Specifically, this happens when a company’s assets no longer fully cover its share capital and legal reserves but still cover its liabilities and at least 50% of the share capital plus reserves.

Underbalance can be identified by a “loss carried forward” entry in the balance sheet, which reflects the deficit. This indicates that the company’s financial resources are no longer sufficient to support its shareholder contributions.

Implications: What should be done in the case of underbalance?

While underbalance does not yet require formal legal action, it serves as an early warning sign of potential financial distress. The board of directors should recognize the situation and take proactive steps to remedy the company’s financial health, such as:

• Assess the root causes of the financial shortfall.
• Develop a strategy to restore equity levels, such as cost-cutting measures, revenue generation, or capital injections.
• Closely monitor financial performance to prevent further decline.

Failing to act at this stage may allow the situation to worsen, potentially leading to capital loss or over-indebtedness.

Underbalance example

ABC AG has CHF 500,000 in nominal share capital and CHF 100,000 in legal reserves. After a challenging year, the company’s financial statements reveal:

• Assets: CHF 600,000
• Liabilities: CHF 250,000
• Equity: CHF 350,000 (calculated as Assets – Liabilities)

The company’s equity (CHF 350,000) has therefore fallen below its combined nominal share capital and legal reserves (CHF 600,000). However, since it still exceeds 50% of this total, the company is in a state of underbalance rather than capital loss.

Response:
The board of directors of ABC AG should:

1. Monitor financial performance closely to prevent equity from dropping below 50% of the total nominal share capital and legal reserves, which would escalate the situation to capital loss.
2. Assess the reasons behind the financial decline, such as rising costs or declining revenue.
3. Develop a plan to restore equity levels, such as cost optimization, shareholder contributions, or operational improvements.

Capital loss

Definition: What is capital loss?

Capital loss occurs when a company’s equity drops below 50% of its nominal share capital and legal reserves. This is a more severe form of financial distress and triggers specific legal obligations under Article 725a of the CO.

Implications: What are the legal obligations in the case of capital loss?

According to Article 725a CO, when capital loss occurs, the board of directors (for an AG) or managing directors (for a GmbH) must:

1. Convene a general meeting: Inform shareholders of the situation and propose measures to address the financial shortfall if such measures fall within the competence of the general meeting.
2. Conduct a limited audit: If the company doesn’t already have an external auditor, the most recent annual accounts must undergo a limited audit to ensure the financial statements accurately reflect the company’s financial position. This requirement does not apply if the board of directors applies for a debt restructuring moratorium.
3. Implement corrective measures: These may include restructuring, cost reductions, or seeking additional capital from shareholders or external investors.

Non-compliance with these obligations can result in personal liability for the board or management.

Capital loss example

XYZ GmbH has CHF 1,000,000 in nominal share capital and CHF 200,000 in legal reserves. Over two years, the company incurs significant operating losses, resulting in:

• Assets: CHF 700,000
• Liabilities: CHF 400,000
• Equity: CHF 300,000 (Assets – Liabilities)

The company’s equity (CHF 300,000) is now less than 50% of the combined share capital and legal reserves (CHF 1,200,000). This indicates a capital loss, triggering legal obligations under Article 725a CO.

Response:
The managing directors of XYZ GmbH must:

1. Convene a general meeting of shareholders to disclose the situation and propose corrective actions.
2. Ensure the financial statements undergo a limited audit, especially if the company has opted out of regular audits. This is not needed if XYZ GmbH applies for a debt restructuring moratorium.
3. Present solutions such as operational restructuring, cost reductions, or securing additional capital contributions from shareholders.

Failure to act in response to capital loss could lead to further financial deterioration and eventually over-indebtedness.

Over-indebtedness

Definition: What is over-indebtedness?

Over-indebtedness occurs when a company’s liabilities exceed its total assets, resulting in negative equity. It signals a critical financial state that typically renders the company insolvent unless immediate steps are taken to restore solvency.

Implications: What are the legal consequences of over-indebtedness?

According to Article 725b CO, if over-indebtedness is reasonably suspected, the board or managing directors must immediately:

1. Prepare interim balance sheets: These must be prepared at both going-concern and liquidation (sales) values and submitted to an auditor for review.
2. Notify the court: If the auditor confirms over-indebtedness, the board must notify the court to initiate insolvency proceedings, unless:
   • Creditors agree to subordinate their claims to the extent of the over-indebtedness.
   • The company can implement immediate restructuring measures to restore solvency within 90 days from the submission of the audited interim accounts provided they don’t further jeopardize the claims of creditors.
3. Comply with bankruptcy proceedings: If no corrective measures are possible, the court shall open bankruptcy proceedings for the company, with which the board must comply.

The law clearly states that in following these steps, the board of directors and external/licensed auditor must act with the required urgency (Art. 725b para. 6 CO). Failure to do so can lead to legal consequences, including personal liability for company leadership.

Over-indebtedness example

Anon AG operates in a highly competitive industry. After losing several clients, the company struggles to meet its financial obligations. Its financial statements reveal:

• Assets: CHF 1,500,000
• Liabilities: CHF 2,200,000
• Equity: CHF -700,000 (negative equity, calculated as Assets – Liabilities)

The company also has CHF 300,000 in legal reserves that cannot offset the negative equity.

The company’s liabilities exceed its assets, resulting in over-indebtedness. This critical financial state requires immediate legal action under Article 725b CO.

Response:
The board of directors must:

1. Prepare interim financial statements at both going-concern and liquidation values.
2. Submit these statements to a licensed auditor for review.
3. Notify the competent court if over-indebtedness is confirmed, unless:
   • Creditors agree to subordination agreements, effectively waiving their claims to a degree that restores solvency, or
   • The company implements immediate and successful restructuring measures to return to solvency.

Ignoring these over-indebtedness obligations is serious, and can result in personal liability for directors and potential legal penalties.

What causes financial distress and insolvency?

Financial distress, such as capital loss or over-indebtedness, can arise due to various factors, including:

• Poor financial management or oversight.
• Prolonged periods of operating losses (due to unfavourable market conditions, poor performance, bad planning, etc.).
• Over-leveraging through excessive debt, leading to an inability to cover obligations.
• External factors such as economic downturns, political instability, natural disasters or market disruptions.

In most cases, situations of financial distress are caused by a complex combination of the above factors and cannot be attributed to one alone.

The responsibility of the board of directors

What is the correct response to financial distress?

If financial distress arises at any level, be it underbalance, capital loss, or full over-indebtedness, the board of directors have a responsibility to act decisively in the prescribed manner.

This includes:

• Monitoring the company’s solvency and overall financial health on an ongoing basis through regular checks and financial reporting.
• Ensuring compliance with the directives mentioned in Article 725 CO for dealing with situations of financial distress and insolvency.
• Implementing appropriate corrective measures promptly to restore financial stability.
• In the case of over-indebtedness where corrective measures are not reasonably possible, the board of directors should notify the court to initiate bankruptcy proceedings.

What are the consequences of avoiding responsibility?

It’s essential that the board of directors takes proper responsibility for dealing with the various forms of financial distress such as underbalance, capital loss, and over-indebtedness. Failure to adequately address these situations can result in:

• Personal liability: Directors may be held personally responsible for damages resulting from negligence or inaction.
• Loss of business: Unaddressed financial issues can lead to insolvency and the liquidation of the company.
• Damage to reputation: A company’s reputation and that of the directors can suffer significantly, affecting relationships with creditors, investors, and clients.

What’s more, the directors should never attempt to shirk responsibility through dubious or legally questionable means. Each member can be held accountable for failing to comply with the obligations outlined in Article 725 of the Swiss Code of Obligations, or for not “acting with the required urgency” (Art. 725b para. 6 CO).

Two common examples highlight the risks of attempting to avoid responsibility:

1. Resignation of the board of directors: Resigning from the board of directors does not absolve a member from liability for events occurring before their resignation, and it removes their ability to influence necessary corrective measures.
2. Revocation of a shareholder loan: Attempting to repay shareholder loans when a company is nearing bankruptcy is ill-advised, as such payments can be contested in bankruptcy proceedings and may lead to criminal liability for favoring certain creditors.

These examples illustrate why it’s crucial for directors to act responsibly and in compliance with their legal duties when addressing situations of underbalance, capital loss, and over-indebtedness. Not doing so can only exacerbate the company’s challenges, as well as expose directors to significant personal and legal risks.

What was the impact of the 2023 revisions to the stock corporation law?

The 2023 revisions to the Swiss Stock Corporation Law introduced significant changes to corporate governance, particularly focusing on clarifying and strengthening the obligations of board members to act promptly in cases of imminent insolvency and financial distress. These revisions emphasize personal liability for non-compliance, making it imperative for directors to act with diligence and urgency.

Key changes include:

• Ongoing solvency monitoring: The board of directors is now explicitly required to monitor the company’s solvency on an ongoing basis, enabling them to identify risks of insolvency early and take appropriate action (Art. 725 CO).
• Enhanced auditing requirements: In the event of capital loss, the law outlines new auditing obligations to ensure financial transparency and accurate assessment (Art. 725a para. 2 CO).
• Stricter subordination agreement standards: The reforms introduce stricter requirements for qualifying subordination agreements, which can facilitate out-of-court restructuring. These agreements allow companies to avoid notifying the court of insolvency and undergoing bankruptcy proceedings, provided certain conditions are met.
• These are just a few examples which highlight the effects of the 2023 reforms, which ultimately reinforce the board’s responsibility to act decisively and appropriately in the face of potential insolvency.