INTRODUCTION
As a general rule, a capital increase constitutes an ordinary corporate transaction serving the company’s financing needs. Nonetheless, the same mechanism may also be employed by a majority shareholder with the purpose of reducing the percentage of shareholding and voting rights of minority shareholders. This phenomenon, commonly referred to as “dilution”, most frequently occurs through the restriction of pre-emptive rights. The Turkish Commercial Code No. 6102 (“TCC”) provides a two-tier safeguard against this risk: the requirement of justified grounds and the affirmative vote of at least sixty percent of the share capital.
What Does Dilution of Shareholding Mean?
Dilution is the reduction in a shareholder’s proportionate interest in the share capital and voting power as a result of a capital increase. Dilution can occur in two forms:
- Legal (direct) dilution: the restriction or exclusion of pre-emptive rights by a resolution of the general assembly.
- De facto (indirect) dilution: although the pre-emptive right is preserved, the amount of the capital increase is set at a level that exceeds the shareholder’s financial capacity.
In both cases, the shareholder’s pecuniary and administrative (governance) rights are weakened. In particular, where a shareholder’s stake falls below one-tenth of the share capital, the threshold required to exercise minority rights under Article 411 of the TCC, the minority may be entirely deprived of the statutory protection attached to minority status.
How Is the Pre-emptive Right Regulated?
Pursuant to Article 461(1) of the TCC, every shareholder has the right to subscribe for newly issued shares in proportion to their existing shareholding in the capital. Unlike the position under the repealed Turkish Commercial Code No. 6762, this right cannot be excluded or restricted by the articles of association. The protective framework of the provision rests on the following principles:
- Restriction is only possible by a general assembly resolution relating to a specific capital increase, and only where justified grounds exist.
- No one may be unjustifiably advantaged or disadvantaged; in this respect, the provision represents the manifestation of the equal treatment principle specific to capital increases.
- The resolution must be adopted with the affirmative vote of at least sixty percent of the share capital; this threshold cannot be lowered by the articles of association.
The Court of Cassation has also accepted that restriction of the pre-emptive right must be reviewed within the framework of the equal treatment principle; in a case where the entire capital increase was allocated to a single shareholder in exchange for that shareholder’s receivable from the company, it found the exclusion of the other shareholders from participating to be contrary to the principle of equal treatment.
Is the 60% Voting Threshold Sufficient on Its Own?
The 60% voting threshold required under Article 461(2) of the TCC refers to sixty percent of the entire share capital, not of those attending the meeting. The resolution’s subject matter must be explicitly stated on the agenda; the board of directors must prepare a report showing the grounds for the restriction and, if shares are to be issued at a premium, the basis for calculating the premium, and must have this report registered and announced.
The function of the threshold is to grant a de facto veto power to any shareholder group holding more than forty percent. However, in companies where a controlling bloc exceeding sixty percent of the share capital exists, the threshold will be met automatically, meaning that for minority shareholders the decisive test becomes the review of justified grounds and of compliance with the principle of good faith.
How Is the Justified Grounds Criterion Applied?
The TCC lists public offerings, the acquisition of businesses, parts of businesses, and equity interests, and employee participation in the company as examples of justified grounds; this enumeration is not exhaustive. The criteria adopted in the review are as follows:
- Company interest: the restriction must serve the interest of the company, not that of individual shareholders; strengthening the position of a controlling shareholder cannot be regarded as a justified ground.
- Necessity: if the purpose can be achieved by another means that does not restrict the pre-emptive right, the restriction is not justified; it must be examined whether internal resources and borrowing options have been exhausted.
- Proportionality: the scope of the restriction must be proportionate to its purpose.
- Consistency of purpose: the true motive behind the resolution must correspond to the stated grounds. Resolutions ostensibly based on a financing need but in reality aimed at reducing a shareholder’s proportional interest constitute an abuse of right.
According to the prevailing view in legal doctrine, the burden of proving justified grounds rests on the company, since the financial data relating to the necessity of the increase lies exclusively within the company’s sphere of control.
How Does the Court of Cassation Approach Capital Increases Aimed at Dilution?
The Court of Cassation is not satisfied with abstract justifications; it requires a concrete examination, through expert review, of whether the increase is based on the company’s genuine and current financing need. In a case involving a company with a sound financial position that did not base the increase on a concrete justification, annulment of the general assembly resolution was found to be appropriate.
The intensity of the dilution is also an independent criterion: it has been accepted that an increase of a magnitude that reduces shareholding ratios to a very small level would harm shareholders’ interests and would be contrary to the principle of good faith. Conversely, where the increase is based on a genuine need, the reduction in ratio alone is not regarded as a ground for annulment. Capital remaining low relative to the volume of operations, a decline in the equity ratio, an increase in liabilities, an inability to meet cash needs from equity resources, and a shortage of working capital as evidenced by liquidity ratios have been accepted as justified grounds.
As regards the type of invalidity, a high-percentage increase is not a ground for nullity by itself; a violation of the principle of good faith is a ground for annulment within the meaning of Article 445 of the TCC. For this reason, a dilution claim must be raised through a timely annulment action with full compliance with procedural requirements; otherwise, the fact of dilution alone will not produce any legal consequence.
What Remedies Are Available Against Dilution?
- A shareholder who attends the meeting, votes against the resolution and has their dissent recorded in the minutes may file an annulment action within three months from the date of the resolution. A request for suspension of the resolution’s execution may be made together with the annulment action.
- Exercising the right to information and subsequently requesting a special audit are of critical importance in determining whether the increase is based on a genuine need.
- Heightened voting thresholds and voting privileges in the articles of association, and anti-dilution, right of first refusal, and tag-along provisions in a shareholders’ agreement, may be envisaged as mechanisms to prevent dilution.
Conclusion
Dilution is positioned under Turkish law not as a prohibited transaction but as a transaction subject to judicial review. A review of case law shows that the focus of scrutiny has shifted from the amount of the increase to the genuineness of its justification. Where a concrete and current financing need is demonstrated, a reduction in ratio is not regarded as a ground for annulment, whereas resolutions adopted on abstract grounds that reduce ratios to a very small level are annulled. For shareholders, the practical conclusion is clear: the risk should be managed in advance at the level of the articles of association and the shareholders’ agreement, rather than through litigation after it has already materialized.
Q&A
Is a reduction in shareholding ratio through a capital increase unlawful in every case?
No. Where the increase is based on the company’s genuine financing need, the reduction in ratio does not constitute unlawfulness. A violation arises where the increase has been carried out, without any company interest, for the purpose of reducing the minority’s ratio.
Under what conditions can the pre-emptive right be restricted?
The existence of justified grounds and the affirmative vote of at least sixty percent of the share capital are required. The matter must appear on the agenda, and the board of directors must have its reasoned report registered and announced. The voting threshold cannot be lowered by the articles of association.
Is the resolution void, or is it voidable/subject to annulment?
In judicial practice, capital increase resolutions are, as a rule, subject to the sanction of voidability. A high-percentage increase alone is not regarded as a ground for nullity; violation of the principle of good faith is assessed within the scope of Article 445 of the TCC.
What is required to bring an annulment action?
It is necessary to be present at the meeting, to cast a negative vote on the resolution, and to have the objection recorded in the minutes. If the recording of the objection in the minutes cannot be proven by written evidence, the action is dismissed on procedural grounds.
