The Contingent Share Capital Increase System: Protecting Investors Through The Use of Convertible Bonds and Similar Debt Instruments
The contingent capital increase system is one of the many innovations that were introduced in the Turkish Commercial Code (the “TCC”) of 2011. This system enables both public and private corporations to increase their share capital by issuing convertible bonds, or similar debt instruments. The capital increase is contingent upon a third party’s action rather than the shareholders’ approval as in the firm share capital increase, or a board of directors’ resolution as in the registered share capital increase. This makes the contingent share capital increase an extremely flexible device.
The legal provision enabling this system is a game-changer for attracting investors to finance deals because it entitles the holders of convertible bonds or similar debt instruments to convert their instrument to company shares or in some cases to buy new company shares, as a legally protected right, without the need for any action on the borrower’s part at the time of the conversion or purchase. In this way, should a dispute arise in connection with the transaction, the system provides the holder with a remedy of specific performance, which would not otherwise exist if the transactions were merely governed by a contractual right to call for company shares.
This Article focuses on the newly introduced contingent share capital system, elaborating on the rights of potential beneficiaries, existing beneficiaries, and shareholders, while describing the legal procedure outlined in the TCC, and highlighting the pros and cons of using this device.
Potential beneficiaries and the scope of “similar debt instruments”
In a contingent share capital increase, the potential beneficiary of the shares starts off as a creditor, who lends money to the company in return for newly issued “convertible bonds or similar debt instruments.” These instruments give the beneficiary the right to either request repayment with interest on the due date, or to obtain company shares instead, which can be done either through direct conversion of the debt instrument to shares, or by exercising a purchase option, wherein the beneficiary is entitled to acquire company shares in addition to repayment for the money it has lent to the company.
Debt instruments with conversion rights and purchase options are at the center of the contingent share capital increase. The main issue then is whether the scope of a “similar debt instrument” includes only negotiable instruments, or whether it could be interpreted more broadly to cover any debt instrument, including non-securities such as loans and bank guarantees. The TCC is silent on this issue, and no consensus has yet been reached among Turkish scholars, although at least one foreign jurisdiction has taken the broader approach. Those adopting a conservative approach suggest that convertibles must be in the nature of negotiable instruments issued in series. Those adopting a liberal approach however, argue that contingent capital increases can be carried out on a much smaller scale, for instance in a private loan transaction. The liberal approach is certainly more compelling.
Liberal scholars contend that the beneficiaries do not necessarily have to hold negotiable instruments issued by the company, and the system can be implemented in any type of arrangement so long as (i) the debt is easily determinable, (ii) the debt is eligible to be converted into share capital of the relevant company (by virtue of a provision in the articles of association approved by the shareholders, as further explained below), and (iii) the debt is eligible for set off. This liberal approach would allow parties to a regular loan arrangement to agree, through the contingent share capital system, that the creditor will have the option to acquire shares on the due date, and this would very likely give the borrower leverage in negotiating the interest rate with the creditor, especially in promising start-ups.
It is also worth mentioning that the contingent capital increase provisions of the TCC were adopted from the Swiss Civil Code (Schweizerischen Zivilgesetzbuches), which allows contingent share capital increases through the exercise of conversion rights or purchase options in relation to convertible debt instruments, loans, and similar forms of financing. The fact that the foreign law that inspired the provisions of the TCC allows the use of contingent capital increases in loan transactions also offers strong support for the liberal argument that loans qualify as “similar debt instruments” under a proper application of the TCC, and can thus be converted into share capital as long as the structure for the contingent share capital increase is established pursuant to the legal procedures set forth in the TCC as described below.
The initial step for the contingent share capital increase is to convene a shareholders’ meeting in order to amend the company’s articles of association (“AoA”). Under the TCC, the AoA amendment must specify (i) the nominal value of the contingent capital increase amount in total; (ii) the number, nominal value, and type of each share to be contingently issued; (iii) those who will enjoy the conversion right or purchase option; (iv) that the statutory preemption right of the existing shareholders (attached to the share capital increase amount) has been restricted; (v) the privileges, if any, to be granted to certain shareholders; and (vi) the share transfer restrictions, if any, in relation to the registered shares to be issued. In situations where the conversion right or purchase option is not being offered to the existing shareholders, the AoA amendment must further explain the conditions for the exercise of the conversion right or purchase option, and the principles that apply to the calculation of the issuance price. The relevant convertible bonds or debt instruments can only be issued after the shareholders have amended the AoA accordingly.
Once the shareholders have approved the AoA amendments, the company will issue convertible bonds or “similar debt instruments” to be granted to the creditor, or it will simply enter into a contractual arrangement with the creditor. The respective convertible bond or debt instrument or contractual financing arrangement will define the creditor’s right; more specifically, the document will say whether the creditor has a conversion right or purchase option. When the due date arrives for the company to repay the money lent to it by the creditor, the latter will be entitled to exercise its conversion right or purchase option by way of a written notice to the company.
Upon making the underlying payment in a purchase option, or making the settlement in the exercise of a conversion right via a bank, the share capital will be automatically increased in accordance with the relevant AoA provision (previously amended by the shareholders), and the creditors become shareholders in the company. No further action is required by the shareholders or the board of directors of the borrower for the share capital increase to become effective. The board of directors will only need to apply to the relevant trade registry to adjust of the AoA provision on the share capital amount to reflect the increase, but if they fail to do that, it will not affect the contingent capital increase or the status of the shares acquired by the creditor.
There is a capital markets aspect that must also be taken into account while structuring a contingent share capital increase. The Capital Markets Law and its secondary legislation apply to any debt instrument issuance, even if the issuing entity is not publicly held and the instruments will not be offered to the public. The Turkish Capital Markets Board (“CMB”) has issued a Communiqué on Debt Securities (“the Communiqué”), which forms the secondary and main legislation setting forth the principles that apply during the issuance of debt securities. The Communiqué provides issue limits, and it requires the preparation of issuance documents, and the execution of certain formalities that must be followed for the issuance of debt instruments without a public offering, by a closely held entity.
Assuming that a liberal reading of “similar debt instruments” applies under the TCC, the key question remains as to whether the rules in the CMB Communiqué would be applicable in a contingent share capital increase structure where no debt instrument was issued. Although the answer should be a no and in such a case only the TCC rules would apply, the most prudent course of action for interested investors would be to seek a written opinion from the CMB on the matter.
Protection of existing shareholders
A contingent share capital increase will result in a dilution of the equity interest of the existing shareholders. To mitigate the impact of this, the TCC has introduced certain rules to protect the existing shareholders, including a right of first refusal as well as certain maximum and minimum capital value restrictions.
The TCC requires that the conversion rights or purchase options must first be offered to the existing shareholders on a pro rata basis according to their shareholding in the company. This right of first refusal may only be restricted or revoked if there is a “just cause.” It is not clear from the TCC what constitutes “just cause” and as a result, courts evaluate it on a case by case basis. In any event, it is unlikely that existing shareholders would be interested in an offer to acquire a conversion right or purchase option in most cases since contingent capital increases would normally only be carried out when a company is in need of financial assistance, and the shareholders are not in a position to inject the needed money into the company, or they would prefer to not do so, and would rather borrow money from banks or other third parties instead.
Additionally, the TCC sets forth two main restrictions on contingent share capital increases: First, the maximum nominal value of the share capital to be contingently increased cannot exceed half of the company’s paid-in share capital. Second, the price to be paid in return for the shares to be acquired by the beneficiaries upon the exercise of their conversion right or purchase option cannot be less than the nominal value of the shares.
Regarding the maximum nominal value restriction, the TCC aims to protect the existing shareholders from the conversion right or purchase option holder by imposing a limit on the total nominal value of the share capital to be contingently increased. For example, in a company with 1m TRY share capital, represented by 1m shares, an additional 500k shares can be issued contingently, and the share capital can be increased to 1.5m TRY at most. Obviously, as a result of the exercise of the conversion right or purchase option by the creditors, they become shareholders in the company, and as such, the shareholding structure of the company will change and the equity interest of the existing shareholders will be diluted, but to a limited degree. However, such a limitation could also hinder contingent capital increase implementation in small companies and start-ups, as these would likely have more limited share capital.
The maximum nominal value restriction only relates to the amount of the share capital to be increased, and the shares to be issued, but it is not linked to the price of the bonds or other instruments to be granted to the creditors. So in the foregoing example, the shareholders could approve a contingent share capital increase for 500k shares, but the price of the relevant bonds or instruments to be provided to the holder of a conversion right or purchase option could be much higher. As such, there is no restriction with respect to the upper limit of the value of the convertible bonds or similar debt instruments; the restriction only applies to the value of the corresponding shares.
As for how the minimum nominal value restriction applies, let’s recall our example in the foregoing paragraphs. In a company with 1m TRY share capital represented by 1m shares, the shareholders decided on a contingent share capital increase for an additional 500k shares and the creditor was provided with a conversion right in exchange for some share convertible bonds. The creditor will have to pay in exchange for those bonds at least the nominal value of the shares to be issued at the time of exercise of its purchase option, which would be 500k TRY in our example.
Protection of beneficiaries
Another relationship to consider in a contingent share capital increase system is the one between the creditors as beneficiaries and the company, including the existing shareholders. Beneficiaries need a certain level of protection from decisions of existing shareholders in the general assembly meetings, as well as from board resolutions, because the company’s board of directors was nominated by the existing shareholders. For example, if the shareholders approve a firm share capital increase or a second conversion right or purchase option to a third-party beneficiary, before the first beneficiary has an opportunity to exercise its conversion right or purchase option, then in either case it would lead to the dilution of the expected equity interest of the beneficiary in the company. As a result, the TCC includes multiple protection mechanisms to avoid the dilution of a beneficiary’s interest.
First, conversion rights or purchase options may not be impaired through a share capital increase, an issuance of new options, or in any other way, unless the exchange price for conversion or purchase is reduced, or the beneficiary is compensated, or the rights of the existing shareholders are also damaged.
As noted, additional share capital increases or issuances of new options are explicit instances whereby the beneficiary’s interest would be diluted. The TCC only provides these as examples, and acknowledges that there could be other instances where the beneficiary’s interest could be diluted. For example, the decision to merge with another company, enter liquidation, or convert to another type of company, might result in dilution of a beneficiary’s interest as well. However, the TCC rule is not an absolute prohibition. A company may still proceed with a share capital increase, issuance of new options, merger, or similar transaction, but it will have to prevent harm to the beneficiary by reducing the exchange price for conversion or purchase, or paying compensation to the beneficiary, or in the event that the existing shareholders’ rights are also impaired.
Second, beneficiaries are protected against share transfer restrictions. A beneficiary, especially banks and investment companies would likely sell any shares they acquired by way of the contingent share capital increase, or at least they would prefer to have such an option. If transfer of the shares is restricted however, beneficiaries will be locked into the company against their will for the duration of the restriction. Therefore in principle, the TCC does not allow companies to introduce restrictions on the transfer of shares acquired by beneficiaries upon the exercise of their conversion right or purchase option. Such restrictions can only be enforceable if they are reserved in the amended version of the articles of association approved at the very initial stage of the process (before granting of the conversion right or purchase option). In this way, beneficiaries would be well aware of any share transfer restrictions from the beginning, prior to acquiring the debt instrument, and there may be no further restrictions imposed at a later stage.
The contingent capital increase system has the potential to provide a fresh and compelling answer to corporate financing needs, especially for startups looking for a solid place in the market, and companies seeking financial support without having to restrict the mobility of the assets of the company with encumbrances. They also offer a low-risk investment method, as convertibles mitigate risks associated with such investments by offering a fixed rate of return on bonds. If the acquisition of shares is no longer profitable, investors may simply choose not to exercise their conversion right or purchase option, and cash in the debt instrument instead, thus insulating themselves from losses due to declines in share prices.
Another upside of contingent capital increase is that it eliminates the risk of non-performance by the borrower, which might pose problems in regular transactions involving a conversion right or purchase option, where there is the possibility for the borrower to refuse the share transfer to the beneficiary. In such cases, the beneficiary would not be able to force the company to transfer the shares in court, by way of a specific performance remedy, and could only claim damages. That risk is eliminated in a contingent capital increase since as soon as the conversion right or purchase option is exercised, the beneficiary ipso facto becomes a shareholder, without the need for any action on the part of the borrower.
 The Turkish Commercial Code, Law No. 6102, Official Gazette of February 14, 2011 No. 27846.
 Turkish courts (and thus arbitral tribunals) would normally only award actual monetary damages in contract disputes of this nature, which can make some investors uneasy.
 Contingent share capital increase also fulfills the lack of a legal structure for employee stock option plans by enabling employees to enjoy the right to participate in the equity value of its employer. This Article will not particularly address implementation of the contingent share capital increase in employee stock option plans, but we should note that the same procedure and TCC rules on the process as well as the protection of the existing shareholders and beneficiaries described in this Article will also be applicable in case of issuing stock options by way of contingent share capital increase.
 Law No. 6102 Art. 463.
 Karahan, Sami, ed., Şirketler Hukuku (Corporations Law), 2012, p.585
 Biçer, Levent, Anonim Şirketlerde Şartlı Sermaye (Contingent Share Capital in Joint Stock Corporations), Marmara University Doctoral Thesis, 2009, p.203; Demir, Koray, Şarta Bağlı Sermaye Artırımında Tahvil Benzeri Borçlanma Araçları Kavramı (Bond Like Debt Instrument Concept In Contingent Share Capital Increase), Banka ve Ticaret Hukuk Dergisi (Banking and Commercial Law Magazine), Volume 31, Issue 3, 2015 pp.59-74, p.63; İçtem, Serkan, Contingent Capital Increase System as a New Corporate Financing Structure, Banka ve Finans Hukuk Dergisi (Banking and Finance Law Magazine), Volume 1, Issue 2, 2012, pp.99-117, p.103.
 Demir, p.67 ff.
 See Zindel, Gaudenz G./Pulver, R. Isler, in Basler Kommentar, Art. 653 OR II
 Law No. 6102 Art. 465.
 This implies that restrictions can be introduced for the shares to be issued to the creditors holding a conversion right or purchase option even though such restrictions are not imposed on the shares held by the existing shareholders.
 The Capital Markets Law, Law No. 6362, Official Gazette of December 30, 2012 No. 28513.
 The Communiqué on Debt Securities No.II-31.1
 Law No. 6102 Art. 466 paragraph 1.
 Law No. 6102 Art. 466 paragraph 2.
 Law No. 6102 Art. 464 paragraph 1.
 Law No. 6102 Art. 464 paragraph 2.
 Law No. 6102 Art. 467 paragraph 2.
 Law No. 6102 Art. 467 paragraph 2 states that “Conversion rights or purchase options may not be impaired through share capital increase, granting new conversion rights or purchase options or otherwise in another way…”
 Law No. 6102 Art. 467 paragraph 1.