One of the issues that we often face when conducting corporate due diligences is the violation of the requirements for transactions with affiliates. Transactions concluded without complying with the relevant requirements carry the risk of being challenged or invalidated by the legal entity, its participants or other stakeholders.

1. What are the requirements for transactions with affiliates?

According to the Civil Code of the Republic of Azerbaijan (the “Civil Code”), any transaction, agreement or set of related transactions concluded between a person who is related to the legal entity and the legal entity itself shall be deemed to be a transaction with an affiliate.

To consider this issue, we need to understand who the affiliates are. These persons include the director of the legal entity, its shareholders and board directors, as well as their spouses and close relatives (parents, children, adoptive parents, adoptive persons), grandparents, grandchildren, siblings of spouses, parents, as well as spouses of close relatives and other persons specified in Article 49-1 of the Civil Code. Thus, it becomes clear that the affiliates are those who may directly and (or) indirectly make decisions or affect their adoption.

• In which cases are the affiliates interested in legal entity to conclude a transaction?

•  If the affiliates are a party to the transaction or act in the interests of a third party in relation to a legal entity;
• if there is a share of 20 percent or more in the authorized capital of a legal entity that is a party to the transaction or acts in the interests of a third party in relation to a legal entity (each individually or collectively);
• if the owner of the property of the legal entity is a party to the transaction or acts in the interests of a third party in relation to the legal entity;
• if the legal entity that is a party to the transaction or acts in the interests of a third party in relation to the legal entity is a member of and holds a position in its corporate bodies;
• in other cases specified by the charter.

Here are some examples of the cases we often encounter in our practice:

1. A purchase and sale agreement is made between two legal entities. In the agreement both directors are close relatives.

2. The loan agreement for a legal entity is concluded by the director of the legal entity. The Director is included into the list of persons who, according to the Civil Code, is related to a legal entity.

In many cases, in violation of the requirements of the Civil Code, these contracts are concluded without complying with the relevant requirements, for example, without holding a general meeting of shareholders of legal entities and without reaching the consent of shareholders.

Note: We would like to inform you that even in the case of a General Meeting to conclude transactions with affiliates, if the rules of the General Meeting are violated (for example, shareholders are not notified thereof), the requirements of the Civil Code are deemed to be violated.

In addition to the above-mentioned requirements, when the value of a transaction which should be concluded with an affiliate amounts to 5 percent or more of the assets of a legal entity, this transaction is made with the report of an independent auditor engaged by the legal entity.

• Below are the steps to be taken to avoid such violations:

A list of affiliates of a legal entity should be made and updated from time to time. The lack of such list makes it difficult for the affiliates to track transactions which pursuant to the Charter of the legal entity require the approval of the board of directors at the general meeting attended by the same (in case the value of the transaction to be concluded with such persons makes up to 5 percent of the assets of the legal entity).

When concluding a transaction with an affiliate, the approval of the shareholders (the Board of directors) of the general meeting of should be obtained. For this purpose, it is necessary to hold a general meeting of the shareholders or a meeting of the board of directors. The general meeting of the shareholders of the legal entity shall be authorized if attended by the shareholders holding more than fifty percent of the shares of the legal entity.

Note:

In the absence of the specified quorum, the reconvened general meeting shall be authorized if attended by the shareholders holding 25 percent of the shares of the legal entity. It should be borne in mind that more number of votes may be specified for quorum by the Charter of the legal entity.

If the transaction with the affiliates is not approved before the conclusion thereof (for example, if the affiliate became known to be a party to the transaction after the conclusion thereof), such a transaction may be approved after the conclusion.

• What are the consequences of conclusion of a transaction in violation of the requirements of the law?

1. According to the Civil Code, if transactions are concluded without complying with the requirements of the laws, the actions of the relevant person may be considered by the court as exceeding of powers and the transaction rendered invalid.
2. According to the Criminal Code, a fine exceeding from two up to three times the amount of the damage (earned income) caused by violation of the rules for conclusion of transactions with affiliates of legal entities or failure to provide information on such transactions in accordance with the procedure established by law or imprisonment for a term up to one year shall be imposed.
3. According to the Code of Administrative Offenses, the followings are provided for the violation of the rules for conclusion of transactions with affiliates of legal entities, or failure to provide information on such transactions in accordance with the procedure established by law:

• In relation to joint-stock companies: officials shall be fined to the amount of AZN 1,000 – 1,500, legal entities AZN 10,000 – 15,000;
• in relation to other legal entities: officials shall be fined to the amount of AZN 500 – 1,000, legal entities AZN 5,000-10,000.

It should be further noted that if any damage caused to a legal entity as a result of a transaction deliberately proposed to and/or caused to be concluded by an affiliate in contradiction of the interests of a legal entity, the affiliate shall be held responsible before the legal entity to the amount of such damage.

 In case of a damage caused to a legal entity by several affiliates, they bear joint responsibility before the legal entity.

Analysing the above, we arrive at a conclusion that transactions concluded with affiliates are of particular importance since they carry the risk of being held invalid by court, which lead to the payment of fines and guarantees to the claimant (a third party interested) by the persons who concluded such transactions.

It is possible to avoid such situations by observing the rules for conclusion of such transactions.

For any additional information please contact our Associate Sabina Karimova.