by Rainer Kulms
1. Basic elements of capital regimes
The core characteristics of an incorporated company include legal personality, limited liability and shareholder entitlement to declared dividends. In spite of varying attitudes towards regulation, the company law regimes of the Member States of the European Union have attained a remarkable degree of standardization with respect to shareholder rights and the role of a centralized management under a board structure. The price paid for the acquisition of a share (or a participation in a Gesellschaft mit beschränkter Haftung (GmbH)) quantifies the maximum risk an investor is prepared to assume in view of the business activities of the corporate entity. The shares are fully transferable and freely tradable, subject to corporate charter or statutory restrictions. Free transferability allows for shareholder utility maximization, enabling investors to pursue diversified portfolio strategies.
Limited liability creates specific incentive and risk monitoring problems, hence the potential to affect investor, shareholder and corporate creditor interests asymmetrically. Shareholders are likely to demonstrate less risk aversion as they pay a risk-adjusted price for the purchase of equity, indicating the maximum loss in the event of ‘ruinous’ business decisions. If shareholders succeed in shifting the risk of a problematic business decision to the creditors, trade-offs will have to be found between high-variance investments into innovative ventures, the retention of unprofitable production lines and creditor protection. To address this regulatory challenge, the company law systems of the Member States provide for a dual safety mechanism. Rules on capital formation (ie the statutory duty to pay in a certain amount of the subscribed capital) are supplemented by norms on capital maintenance. At the outset, it is a matter of practicability whether to bind corporations on a statutory minimum capital or instead, impose liability if the corporate funds fall below the threshold established by the corporate charter. In any event, information costs will have to be reduced. Creditors will only assume the risk of doing business with an entity with limited liability if their corporate business partner is equipped with sufficient (legal) capital.
As a matter of regulatory technique, norms on minimum capital are intended to address potential conflicts between shareholders and creditors with the help of a property rule. Statutory rules imposing financial sanctions for the depletion of corporate funds operate as liability rules. Corporations in the vicinity of insolvency pose a different type of regulatory challenge. As far as the duty to file for insolvency is triggered by a depletion of the statutory minimum capital, creditor protection is motivated by an ex ante perspective. Liability norms that require a corporate officer to act responsibly are informed by ex post considerations.
The European Union discussion on optimizing regulatory policies on capital formation and capital maintenance is marked by a double-edged approach. The Second Council Directive on coordination of safeguards in company law matters (public limited liability companies) of 13 December 1976 (Second Company Law Directive (Dir 77/91)) enshrines the concept of statutory minimum capital for corporations (stock corporation). But there is, as of yet, no EU legislation on non-listed small corporate entities (such as the Dutch Besloten Vennootschap (BV), the French Société à responsabilité limitée, the Austrian or German Gesellschaft mit beschränkter Haftung (GmbH)) or private companies (European Private Company (Societas Privata Europaea)). The effects of regulatory competition, as unleashed by the European Court of Justice (ECJ), set the framework for academics and practitioners, discussing capital formation and maintenance rules for those smaller, non-listed corporate entities and private companies.
2. European law (corporations)
The minimum capital provisions of the Second Company Law Directive reflect the traditional corporate attitude of civil law systems. As Art 6(3) explains, the regulatory thrust of the Directive is to include mid-size and large undertakings. According to the recitals, issues of forming a public limited liability company (ie a corporation), capital maintenance and shareholder and creditor protection are strongly interrelated. Harmonization by EU rules is to ensure a minimum level of equivalent protection for both shareholders and creditors. The statutes or instruments of incorporations should not foil attempts of interested persons to acquaint themselves with the basic particulars of a corporation, including the exact composition of its capital.
It is the understanding of the Directive that the capital of a corporation serves both legal capital and risk capital purposes. The corporate capital constitutes the creditors’ security. The Directive insinuates a need for regulatory action on minimum capital. When the 2006 amendments to the Second Company Law Directive were enacted, there was little inclination to dispense with the system of statutory minimum capital for listed and non-listed corporations. The statutory minimum capital is at €25,000 but Member States may at their discretion raise the threshold for minimum capital. The corporate statutes or the instrument of incorporation shall give, inter alia, information on the amount of the subscribed capital paid up at the time the company is incorporated or is authorized to commence business.
At this time, not less than 25 per cent of the nominal value of shares, or in the absence of a nominal value, their accountable par must be paid in. Shares may be issued for a consideration other than cash. Distributions, ie payment of dividends or interest relating to shares, are conditioned upon the following: payments are permissible as long as they do not exceed the total profits made since the last financial year the accounts have been drawn. Such profits will be increased by any profits brought forward plus sums drawn from the reserves available for this purpose. Conversely, profits will have to be decreased by any losses brought forward and by sums to be placed in reserve pursuant to statutory or corporate charter requirements. Shareholders who receive distributions not in accordance with the foregoing are required to return such monies if it can be established that they either had been aware of the irregularity of a distribution or, in view of the circumstances, must be deemed to have been aware of such irregularity. Prior to a focus on international accounting practices, these distribution rules had to be exclusively evaluated in the light of national accounting policies. For practical purposes, the degree of sophistication of Member States law on creditor protection and transparency afforded to potential investors would tilt the scales against or in favour of de-recognition of contingent liabilities or future economic benefits.
The introduction of International Accounting Standards (IAS, International Financial Reporting Standards) has witnessed a re-calibration of accounting principles. There is much debate on whether the more liberal stance of IAS on recognition of future economic benefits should be suppressed by tightening the rules on distributions and reserves in the wake of potential losses or by introducing a more stringent solvency test. In the case of a serious loss of the subscribed capital, a general meeting of shareholders has to decide whether to wind up the corporation or to take other measures (ie the issue of new stock). The corporation may acquire its own shares, but far-reaching restrictions apply. Shares issued for a consideration, in the course of an increase in subscribed capital, have to be paid up to at least 25 per cent of their nominal value.
The Second Company Law Directive does not purport to lay down comprehensive rules on capital formation and maintenance in corporations, barring legislative interventions by Member States. National rules fleshing out the regime on unlawful distributions are permissible. Nonetheless, gaps in the rules on shareholder and creditor protection—whether alleged or real—do not necessarily serve as an invitation to refine the existing statutory schemes which are held in high esteem by individual Member States. The sheer absence of written EU law rules on certain aspects of company law may well trigger regulatory competition between national legal orders. Although regulatory competition with respect to corporations is said to suffer from path dependence, Member State governments have to face increasing criticism as soon as unilateral action is on the verge of jeopardizing the competitive edge of a national company law system. It is no coincidence that the recitals of the Directive Amending the Second Company Law Directive expressly refer to the legislative policy of promoting business efficiency and competitiveness without reducing the protection offered to shareholders and creditors.
3. Gesellschaften mit beschränkter Haftung (GmbH) and other types of private companies
As the Second Company Law Directive does not apply to the Dutch Besloten Vennotschaap, the French Société à responsabilité limitée, the Austrian or German GmbH or other types of private companies, Member States enjoy a considerable amount of discretion in fostering autonomous company law developments. For a long time, the law on private, non-listed corporate entities has been dominated by a status quo between various types of capital formation and maintenance, due to path dependence and national company law traditions. The continental European scheme of capital formation and maintenance on the basis of a statutory minimum capital is in direct opposition to the English system of capital protection in private limited companies, which basically rejects the notion of statutory minimum capital in favour of solvency tests and enforcement mechanisms for wrongful trading in the vicinity of insolvency. Not until the Centros line of ECJ cases on the freedom of establishment (ECJ Case C-212/97 – Centros  ECR I-1459; ECJ Case C-208/00 – Überseering  ECR I-9919; and ECJ Case C-167/01 – Inspire Art  ECR I-10159) was there any noticeable change of position in the European debate on capital protection.
In a recent law reform, the Dutch legislature abolished the statutory minimum capital for the Besloten Vennootschap (B.V.). Now, a combined balance sheet and insolvency test is to protect both the capital and creditors. Norms on personal liability that sanction unlawful behaviour of corporate officers from an ex-post perspective are intended to afford capital protection. The EU Commission’s draft proposal for the European Private Company (Societas Privata Europaea) is informed by a similar policy approach. The 2008 amendment to the German law on the GmbH does not dispense with the statutory minimum capital for ‘regular’ companies. However, the traditional concept of capital protection is substantially diluted by introducing new property rules for Unternehmergesellschaften (‘entrepreneurs’ companies’): the minimum capital is reduced to €1, and meaningful corporate funds will only be assembled as the Unternehmergesellschaft pursues its business activities. In view of the developments in the Netherlands and under English law, it should be noted that German law is somewhat tentatively moving in the direction of a solvency test in order to specify management duties for a GmbH in the vicinity of solvency.
The Statute for a European Company (SE European Company (Societas Europaea)) does not part with the concept of statutory minimum capital. According to the recitals of the Council Regulation, the statutory minimum capital has been set at €120,000 in order to create reasonably-sized companies with business activities on a European scale without making it difficult for small and medium-sized undertakings to form SEs. Conversely, the proposal for a statute for a European Private Company renounces the traditional approach of a high minimum of legal capital, setting the minimum requirement at €1. This is not simply a matter of whether a case for separate norms for listed and non-listed companies has been established. Instead, the regulatory policy debate should concentrate on the interface between company law and insolvency protection.
The High Level Group of Company Law Experts, appointed by the European Commission, complains that the statutory minimum capital gives an inaccurate indication of the company’s ability to pay its debts. Subsequent to modifications of accounting standards, corporate accounts have become ill-equipped to allow predictions on a company’s ability to pay its debts. The Company Law Experts’ assessment culminates in a plea for an alternative system of creditor and shareholder protection. The current minimum capital regime should be replaced by a solvency test, conditioning distributions to shareholders on the company’s ability to honour its financial obligations. Any payment of dividends or other distribution (including share buy-backs and capital reductions against repayment to shareholders) should be subject to a solvency analysis. Such a solvency test should be based on two elements: a balance sheet or net assets test and a liquidity or current assets/current liabilities test. The report of an interdisciplinary group on capital maintenance headed by Jonathan Rickford is much more outspoken in its call for reforming the rules on legal capital for corporations: creditors are described as discounting information on capital maintenance observance, since current accounting rules do not establish safe ground for an informed decision on distributions. Instead (and similar to the findings of the High Level Group of Company Law Experts), a two-tiered solvency test is proposed that evaluates the company’s ability in the ordinary course of business to meet its liabilities and, with respect to the year immediately following, to meet all its debts as they fall due throughout that year.
From a long-term policy perspective, EU rules on corporations will also have to cross the divide between company law and insolvency law by introducing liability rules binding corporate officers on meaningful capital protection. Scholarly debate has never refused to apply the insights from this liability analysis to those Member States that have a strong tradition of adhering to the concept of a fixed minimum capital. Nonetheless, any design to part with statutory minimum capital encounters resistance, inspired by cost-benefit arguments. The concept of fixed capital is said to be enshrined in Romanic and Germanic legal orders, making an important contribution to sound corporate governance. In the face of rules on (unlawful) distributions and managerial duties to take action in the vicinity of insolvency, a pre-emptive function of legal capital is diagnosed and thought to deserve protection.
Jaap Winter and others (High Level Group of Company Law Experts), ‘Report on A Modern Regulatory Framework for Company Law in Europe’ (2002); Jonathan Rickford (ed), ‘Reforming Capital—Report of the Interdisciplinary Group on Capital Maintenance’ (2004) EBLR 920; Marcus Lutter, ‘Das Kapital der Aktiengesellschaft in Europa’  ZGR Sonderheft 17; Ulrich Seibert, ‘Close Corporations—Reforming Private Company Law: European and International Perspectives’ (2007) 8 EBOR 83; Ulrich Noack and Michael Beurskens, ‘Modernising the German GmbH—Mere Window Dressing or Fundamental Redesign?’ (2008) 9 EBOR 97; Horst Eidenmüller and Wolfgang Schön (eds), The Law and Economics of Creditor Protection—A Transatlantic Perspective (2008); Eilís Ferran, Principles of Corporate Finance Law (2008); KPMG, ‘Feasibility study on an alternative to the capital maintenance regime established by the Second Company Law Directive 77/91/EEC of 13 December 1976 and an examination of the impact on profit distribution of the new EU-accounting regime—Main Report’ (2008); Mads Andenas and Frank Wooldridge, European Comparative Company Law (2009); Reinier Kraakman and others, The Anatomy of Corporate Law—A Comparative and Functional Approach (2nd edn, 2009).