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The Risks of Using Pseudo-Foreign Corporations in Germany

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Editor's Note: This month, the intriguing question of the liability risk run by directors of pseudo-foreign corporations is examined from a German perspective. This topic is perhaps narrow, but it will nevertheless be of intense interest to those U.S. readers who are aware of the 1954 Treaty of Friendship, Commerce and Navigation between the United States and Germany. This elegantly-named measure provides for recognition, in Germany, of pseudo-foreign corporations incorporated under U.S. law. The downside of recognition is the potential very severe and rigorously enforced liability for failing to apply in accordance with German law for bankruptcy protection at the right time. Many U.S. residents are directors of foreign companies and run such risks either wittingly or unwittingly. To the "possible risk" category must be added directors of pseudo-foreign corporations. The irony is that one of the main reasons for establishing this kind of corporate vehicle is to avoid the very kind of liability which, on the basis of at least one recent German case, cannot be avoided in this way. The change in approach to corporate governance standards spawned in the United States by Enron and in Europe by Parmalat continues unabated!

A growing number of pseudo-foreign corporations (i.e., corporations incorporated outside Germany, but that have their administrative seat where the corporation's affairs are actually managed in Germany), especially English limited liability companies, have been operating in Germany since 2003.1 The main reasons for this trend are the desire to avoid the minimum registered share capital of EUR25,000 required to set up a German limited liability company (Gesellschaft mit beschränkter Haftung, GmbH),2 and the complicated and strict German rules on the protection of the creditors of a GmbH. Yet as this article will explain, attempts to avoid German rules on creditor protection can backfire.

The High Court (Landgericht) of Kiel3 recently held that the managing director of an English incorporated pseudo-foreign corporation (a limited liability company) is liable for damages suffered by creditors if he does not apply for the commencement of insolvency proceedings in due time. German law provides that a managing director of a GmbH is under a duty to apply to the competent court for the commencement of insolvency proceedings without undue delay, but at the latest three weeks after the company has become insolvent either under a cash-flow test or a balance-sheet test. An omission to do so triggers both civil and criminal liability of each director, provided he is at fault.4 However, even after the judgment of the High Court of Kiel, it remains unclear as to whether this liability applies and whether other German rules on creditor protection apply with regard to pseudo-foreign corporations.

Recognition of Pseudo-Foreign Corporations in Germany5

Until recently, any corporation with its administrative seat in Germany had to meet the requirements for the establishment of a corporation under German law. As pseudo-foreign corporations do not meet these requirements (e.g., notarization of articles of association, minimum share capital, registration with the German commercial register), pseudo-foreign corporations were not recognised as corporations and were treated as nonexistent, so that their "shareholders" and "directors" were directly liable. Therefore, the question of the applicability of the rules on creditor protection did not arise. However, in recent years, exceptions from the principle of nonrecognition of pseudo-foreign corporations have been acknowledged:

(a) Since 1999, the European Court of Justice (ECJ) has handed down three landmark judgments concerning the principle of freedom of establishment for corporations within the EU.6 In summary, the ECJ has ruled that:

• each Member State must acknowledge the legal existence of a corporation established under the laws of another Member State, even if the corporation moves its administrative seat to another Member State and/or shall engage in business activities only in a Member State other than the state of incorporation;
• no Member State may require a pseudo-foreign corporation incorporated in another Member State to fulfill certain requirements of domestic law with regard to minimum share capital and directors' liabilities as a prerequisite to establishment.

(b) The German Supreme Court (Bundesgerichtshof, BGH) has recently acknowledged that the principle of freedom of establishment also demands the recognition of pseudo-foreign corporations incorporated under the laws of Member States within the European Economic Area (EEA), which comprises the EU Member States plus Iceland, Liechtenstein and Norway.7 (c) According to Article XXV paragraph 5, clause 2 of the Treaty of Friendship, Commerce and Navigation between Germany and the USA dated Oct. 20, 1954, pseudo-foreign corporations incorporated under the laws of the United States are recognized in Germany.8 It is still unclear whether the recognition of a U.S.-incorporated corporation requires a genuine link of such corporation to the United States. However, the BGH decided that such a genuine link does exist if the corporation engages in marginal business activities in America.9

In the above three cases, as a consequence of the recognition of pseudo-foreign corporations, there is no co-liability of shareholders and directors for the companies' liabilities.10 However, it must be noted that pseudo-foreign corporations not incorporated under the laws of an EU/EEA Member State or the United States are still not recognised in Germany, but since 2002, they have been treated as German partnerships in which "shareholders" and "directors" have unlimited liability.11

Possible Application of the German Rules for Creditor Protection on Pseudo-Foreign Corporations

With regard to those pseudo-foreign corporations that are recognised in Germany, there is much debate as to whether and to what extent German rules on creditor protection are to be applied. So far, there are very few court decisions that address this issue.

General Distinction between (Applicable) Insolvency Law and (Nonapplicable) Corporate Law

(a) It is decisive whether the creditor protection rules are part of company law or insolvency law. In each case, different conflict-of-law rules apply:

• If creditor protection rules are part of insolvency law, they should generally apply whenever a pseudo-foreign corporation has its centre of main interest (which is usually the same as its administrative seat) in Germany, as (i) German courts are competent to open insolvency proceedings with regard to debtors having their centre of main interests in Germany and (ii) German insolvency courts apply German insolvency law (the lex forum concursus).
• If the rules are part of company law, it does not necessarily follow that they are inapplicable to pseudo-foreign corporations, since none of the ECJ judgments have ruled that company law in its entirety is to be governed by the law of the state of incorporation. Thus, in this case, the question remains as to whether creditor protection shall be governed by the law of the state of incorporation or the law of the state of the administrative seat.

(b) In our view, once certain provisions have been identified as company law, they should generally not apply to pseudo-foreign corporations. In other words, with regard to pseudo-foreign corporations recognised in Germany, all company law issues should be governed by the law of the state of incorporation. This is not a necessary consequence of the ECJ judgments on freedom of establishment, but if only the provisions of foreign company law concerning incorporation were applied, and the remaining company law issues were governed by German law, companies would in effect be governed by the company laws of two different states. Exceptions may be necessary where severe disadvantage to creditors cannot be avoided by other means.
(c) If German creditor protection rules do apply to pseudo-foreign corporations, the question remains as to whether their application violates the principle of freedom of establishment under the EC Treaty. However, this can only be the case with regard to corporations incorporated under the laws of EU Member States.

Specific Creditor Protection Rules

We will now briefly describe the main creditor protection rules and then address the issue of their applicability to pseudo-foreign corporations:

1. Preservation of registered share capital. Any funds necessary for the maintenance of registered share capital (which must amount to at least 25,000 euros) of a GMbH shall not be repaid to the shareholders (e.g., by distribution, upstream loans, repayment of shareholder loans substituting equity (also cf. below)12). If and to the extent that a payment of the GmbH to a shareholder results in a negative balance (i.e., the assets do not cover the liabilities and the registered share capital) or aggravates a negative-balance situation, such shareholder must return the payment to the GmbH. If he fails to repay the amount, the liability extends to co-shareholders and directors. Since these rules apply to any GmbH regardless of financial condition, they are part of company law and should therefore not apply to pseudo-foreign corporations.

2. Shareholder loans as equity substitution. If a shareholder (i) grants a loan to a GmbH at a time of a financial crisis,13 or (ii) does not terminate a loan when the GmbH gets into a financial crisis, such loan shall be considered as equity-substituting (eigenkapitalersetzende Gesellschafterdarlehen).14 In insolvency proceedings, shareholder loans substituting equity are subordinated by law. If they have been repaid within the last year prior to the application for the commencement of insolvency proceedings (or after the commencement), such repayment can be contested by the insolvency administrator.

It is disputed whether the rules on the treatment of shareholder loans as equity substitution are part of company law or part of insolvency law. Some scholars argue that since these rules concern the financial constitution of the company, they should be regarded as part of company law. Others argue that since their application presupposes the opening of insolvency proceedings and deals with avoidance rights and the ranking of claims for repayment, they are part of insolvency law. Although the latter view seems to be more convincing, one cannot predict which view a court will favour. If the rules on the treatment of shareholder loans as equity substitution are considered as part of insolvency law, one must pose the question of whether their application would violate the principle of freedom of establishment, which would presumably not be the case.

3. Liability for Destructive Interference (Existenzvernichtungshaftung). Although as a fundamental principle of German company law only the GmbH itself shall be liable for its debts, there are few exceptions where the piercing of the corporate veil is deemed necessary, in particular in the event of interference by a shareholder, which predictably results in the insolvency of the GmbH.15

According to the majority view of scholars, the liability for destructive interference is part of German corporate law. This should result in such liability not applying to shareholders of a pseudo-foreign corporation. However, certain scholars argue that if the law of the state of incorporation does not provide for a similar tool of creditor protection, the liability should nevertheless apply for the sake of creditor protection. This might (although it does not appear to be very likely) constitute a violation of the principle of freedom of establishment under the EC Treaty.

4. Liability for delayed application for the commencement of insolvency proceedings (Insolvenzverschleppungshaftung). As outlined above, each managing director of a GmbH is liable for damage suffered by a creditor caused by a delayed application for the commencement of insolvency proceedings, provided the director was at fault when omitting or delaying the application.

The High Court of Kiel and the prevailing view among the scholars qualify the rules on liability for a delayed application for the commencement of insolvency proceedings as part of insolvency law (or tort law, which would also trigger the application of German substantive law) and, therefore, correctly apply this rule to the shareholders of pseudo-foreign corporations.

Conclusion16

Since pseudo-foreign corporations incorporated in an EU or EEA Member State or—basically—the United States are recognised as legal entities in Germany, the question of the applicability of the German rules on creditor protection to such companies has arisen. Until the BGH or the ECJ provide reliable answers to the various questions involved, all sensible solutions are arguable and may be adopted by courts. Notwithstanding this, there seems to be a developing tendency to apply the German rules on creditor protection to pseudo-foreign companies in order to achieve equal treatment of creditors of both insolvent German limited liability companies and pseudo-foreign corporations alike.

 

Footnotes

1 According to estimates, there were more than 30,000 pseudo-foreign English limited liability companies in Germany in December 2005.

2 According to a draft bill of the Federal Ministry of Justice dated May 29 2006, the statutory minimum share capital shall be reduced to EUR10,000.

3 Judgment of April 20, 2006, 10 S 44/05, GmbHR 2006, 710.

4 Also cf. European Update, December 2005.

5 In this article, "recognition of a corporation" means recognition as a legal entity being distinct from its shareholders, the shareholders and directors basically not being liable for the corporation's debts.

6 Judgments of March 9, 1999 - C-212/97 (Centros Ltd/Erhvervsog Selskabsstyrelsen), of Nov. 5, 2002 - C-208/00 (Überseering BV/Nordic Construction Co. Baumanagement GmbH) and of Sept. 30, 2003 - C-167/01 (Kamer van Koophandel en Fabrieken voor Amsterdam/Inspire Art Ltd).

7 BGH GmbHR 2005, 1483.

8 BGH ZIP 2003, 699; BGH ZIP 2004, 1549.

9 BGH ZIP 2004, 2230.

10 BGH NJW 2005, 1648.

11 BGH NJW 2002, 3539.

12 Simplification of the legal situation with regard to shareholder loans is currently in discussion: According to a draft bill of the Federal Ministry of Justice dated May 29, 2006, the repayment of shareholder loans shall become exempt from the rules on the preservation of the registered share capital. Also, the concept of shareholder loans replacing equity shall be abolished. Instead, all shareholder loans shall be subordinated by law in insolvency proceedings. If they have been repaid within the last year prior to the application for the commencement of insolvency proceedings (or after the commencement), such repayment shall be contestable. These draft provisions shall be included into the German Insolvency Act and shall apply to shareholder loans granted to any corporation, which is subject to German insolvency proceedings, disregarding the state of such corporation's incorporation.

13 A financial crisis shall be assumed if the GmbH is not able to obtain a loan from a bank at normal market terms and conditions due to its financial situation.

14 German law explicitly stipulates that the rules on equity substitution shall apply to any transaction having the economic effect of the granting of a shareholder loan. Whereas the general scope of application of the rules on equity substitution is rather broad, the law provides that they shall not apply to loans or other benefits granted by a shareholder (1) who is not a managing director of the GmbH and whose share(s) do(es) not exceed 10 percent in the share capital or (2) who acquired his share(s) in the company during financial crisis and for the purpose of overcoming the crisis.

15 Such interference may consist of (1) the withdrawal of assets or funds of the GmbH required to carry on its business, (2) the interference with business activities of the GmbH, e.g., the withdrawal of customer relations, or (3) causing the GmbH to take inappropriate risks. If a liability for destructive interference arises, the interfering shareholder(s) shall be liable for the payment of the creditors' claims that remain (partly) unsatisfied in insolvency proceedings.

16 Although case law is scarce, there is a wealth of legal literature on this subject written in German, e.g., Lutter, Europäische Auslandsgesellschaften in Deutschland, Cologne 2005, and, along with many others, the following articles: "Altmeppen" NJW 2004, 97; "Eidenmüller" NJW 2005, 1618; "U. Huber in Festschrift for Walter Gerhardt" (2004); "Sandrock" EWS 2005, 529; "Spindler/Berner" RIW 2004, 7; "Ulmer" NJW 2004, 1201.

Journal Date: 
Friday, September 1, 2006

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