Bankruptcy in Parent Companies

Bankruptcy in Parent Companies

Under Iranian law, the concept of bankruptcy is largely addressed in the context of the establishment and operation of economic entities, and comparatively little attention has been given to the broader economic importance of removing inefficient enterprises from the commercial environment. The current legal framework primarily focuses on the procedural aspects of bankruptcy and, as reflected in practice, still contains ambiguities and inconsistencies. Unlike in many developed jurisdictions, the subject has not been comprehensively addressed.

The legal structure of investment companies is not exempt from these challenges. In the absence of a clear and established written legal practice, bankruptcy in a holding structure, particularly in relation to the parent company and its subsidiaries, remains uncertain in several respects. As a result, holding companies have limited options beyond applying the general approach applicable to investment companies under the Commercial Code.

Conditions for Bankruptcy of a Parent Company and Its Effect on Subsidiaries

Pursuant to Article 583 of the Iranian Commercial Code, a bankruptcy order may be requested and issued for a commercial company from the date its legal personality is established, provided that it has been incorporated in accordance with the Commercial Code.

Before that date, a bankruptcy order may be issued only where, after incorporation, the company’s managers ratify transactions conducted by the founders. In that case, the incorporated company may be declared bankrupt due to transactions carried out in its name by the founders, where the company is unable to pay debts arising from those transactions.

The legislator, in the new draft of the Commercial Code, provided that a bankruptcy order is issued when a trader ceases to pay amounts due. However, the term cessation of payment was not defined. One noted feature of the new draft was the treatment of international bankruptcy, the specialization of liquidation processes, and the training of liquidation administrators. Under current law, cessation of payments and bankruptcy are treated as equivalent, meaning that inability to pay debts is treated as bankruptcy. Under the draft framework, cessation of payment is treated as a stage preceding bankruptcy.

It should also be noted that in groups with multiple subsidiaries, a reduction in the real value of shares below their nominal value does not, by itself, result in the company’s bankruptcy. This is because:

• Bankruptcy occurs when the company’s assets are less than its debts.
• Changes in the real value of shares do not change the company’s capital, which is derived from the aggregate nominal value of shares. In practice, fluctuations in real value affect shareholders’ assets, while the company’s assets are not directly affected by such changes.

With respect to operational companies, if one branch is unable to perform its obligations while other branches are not bankrupt, and the parent company fails to provide the means for payment of that branch’s obligations, it is treated as though the company itself has failed to perform. In such a case, the company’s bankruptcy may be declared and may extend to other branches.

Bankruptcy Pattern of Subsidiaries and Its Impact on the Parent Company

When a subsidiary becomes bankrupt and creditors remain unpaid, creditors may instinctively turn to the parent company as a target for recovery. However, the bankruptcy of a subsidiary does not necessarily harm other subsidiaries or the parent company, particularly where payment capacity exists within the group.

When a holding company obtains a loan, it may secure repayment by using the assets of its subsidiaries. For this reason, subsidiaries and their capital may leave the holding company in a position where, even in financial distress, it can still meet its obligations. The subsidiary is a separate legal entity with its own share structure and legal rules, and it operates independently in business matters, although it is managed by the parent company. The parent company records its ownership of subsidiary shares as an asset on its balance sheet, including bank accounts, operating capital, and other assets, except for the shares issued by the parent company itself.

Purpose of the Parent and Subsidiary Business Structure

The purpose of creating a parent and subsidiary structure is to limit the legal liability of a company when facing bankruptcy-related exposure. The effect of inability to pay debts on a subsidiary managed by a parent company depends on the level and nature of bankruptcy and the company’s ability to meet its financial obligations.

Two situations are commonly referenced:

• A balance sheet insolvency occurs when liabilities exceed assets.
• A cash flow situation, where a company may be capable of meeting payment obligations through conversion or restructuring measures.

Frequently Asked Questions About Bankruptcy in Parent Companies