by Rainer Kulms
1. Regulatory core
Company law allocates risk. National company law systems in the EU are based on (conflicting) policy choices on how to best balance creditor protection against managerial discretion (which may be eventually exercised to restructure a firm in distress). If a listed corporation is chosen from the available corporate law menu this implies acceptance of statutory concepts on legal capital, capital maintenance and limited liability. The quality of the shield against third-party claims is crucial for investors evaluating the risks of share ownership. As a side-effect, however, the individual shareholder has only a remote chance of influencing the business decisions of a corporation. Conversely, investors will experience much more autonomy if they organize business activities in a partnership. Partners have a direct influence on business decisions, but in turn, cannot escape personal liability. Under certain circumstances, the creditors of the partnership may directly seize upon partner property because asset partitioning is incomplete. The theory of the firm predicts that business people will organize their activities within one single entity if transaction costs are likely to be reduced and—in comparison with a series of market transactions—efficiency gains may be had. As entrepreneurs decide in favour of one corporate form, they also subscribe to a set of legal norms (company law), supplying default rules or mandatory organizational structures and duties for each type of corporate activity.
An appraisal of partnership law within the EU has to account for legislation on private companies taken in reaction to the jurisprudence of the European Court of Justice (ECJ) on the freedom of establishment. The legal norms on management duties in the vicinity of an insolvency of a private company are shifting from an ex ante perspective to an ex post scrutiny, thereby converging on the patterns for decision-making in commercial partnerships. This is not to suggest that differences between corporations (public limited liability companies) and commercial partnerships ought to be neglected. But deregulation policies implemented for the English private limited company, the Dutch Besloten Vennootschap (BV) and the German Gesellschaft mit beschränkter Haftung (GmbH) and the draft statute for a European private company (Societas Privata Europaea) clearly demonstrate that the advantages of asset partitioning have become more readily accessible. Investors are entitled to choose from a greater menu of corporate forms for business activities. Preferences for a direct say in entrepreneurial decision-making, the risk of personal liability and the need for capital will tilt the scales either in favour of a corporation (public limited liability company) or a commercial partnership. Ultimately, tax planning and disclosure considerations will control a business strategy. In Germany, family and middle-class businesses rely heavily on commercial partnerships as a flexible type of corporate organization. In the context of building conglomerates, commercial partnerships are deployed to integrate market-like incentive structures into a business organization generally known for its penchant for hierarchies. The recent developments on the financial markets have provoked a debate whether greater transparency for private equity funds (hedge funds) should be achieved by regulatory interference with the law on commercial partnerships and the reputation mechanisms observed by the investment community.
2. Regulatory perspectives
(Commercial) partnerships are established by virtue of a contract, stipulating the achievement of a common business objective. Under German law, the civil partnership (Gesellschaft bürgerlichen Rechts) gives rise to an entity with perfunctory organizational structures. Commercial partnerships play an important role in European corporate practice, albeit with varying degrees in the EU Member States. Beyond tax considerations, the company law systems of the Member States make a distinction between partnerships imposing personal liability on all partners (eg offene Handelsgesellschaft, offene Gesellschaft, general partnership) as opposed to other entities comprising one partner who assumes unlimited liability alongside limited partners who contribute capital at a stated amount and shall not be liable for the debts or obligations of the firm beyond the amount so contributed (Kommanditgesellschaften, Société en commandite, limited partnership).
General partnerships carry organizational features, enabling them to act as entities on the marketplace. They may have a common business name, can sue or be sued, enter into contracts and acquire rights and duties, but they do not attain the status of legal personality typical of corporations. Each partner has capacity to manage the partnership business. However, the partnership agreement may require that several partners act jointly for the purposes of issuing a binding statement to third parties on behalf of the partnership. Alternatively, the exclusive right to manage the partnership may be conferred on one partner alone. Family and middle-class entrepreneurs prefer partnerships to listed corporations because they attach great importance on monitoring membership, avoiding brain-drain and the disclosure of know-how likely to occur in the event of the acquisition of a partnership interest by a competitor. Conversely, partners desiring to retire prematurely are prevented from realizing the market value of their interest as the buying-off clauses of partnership agreements frequently stipulate for a lump sum settlement based on a book value calculation. Commercial partnerships with a long-term perspective are likely to experience economic constraints as soon as partners require fresh capital for new business activities, generally encountering banks reluctant to extend credit lines.
Most company law statutes on commercial partnerships and similar entities have opted for a less than comprehensive regulatory approach. Some codifications impose a duty not to compete, eventually to be fleshed out by the partnership agreement. With the exception of the statutory duty not to compete, most duties owed by one partner to another have been shaped by judge-made law, expanding traditional concepts of fiduciary relationships and duties. It is noteworthy that the English law on general partnerships and limited partnerships has evolved with very little judicial intervention, relying instead on private contracting and practitioners’ expertise. As a matter of statutory design, commercial partnerships are not devised for perpetuity. Nonetheless, the company law statutes of some Member States or partnership agreements themselves provide for a stipulated continuation of the partnership among the remaining partners after a partner’s death or his retirement from business. The partnership agreement may also call upon a partner’s heirs to assume the rights and duties associated with the partnership interest of the deceased. A partnership is dissolved in accordance with the stipulations of the partnership agreement, but may also be dissolved upon court order. Partners will usually wind up a partnership ‘in-house’ (ie without appointing a receiver), paying the creditors with priority over the partners who are entitled to receive their individual share of the surplus assets thereafter.
The Kommanditgesellschaften, Sociétés en commandite and the limited partnerships under English or Scots Laws (Scottish private law) build on the regulatory concepts of the law on the offene Handelsgesellschaft, offene Gesellschaft and on general partnerships. They add, however, elements of limited liability and partial entity shielding. Creditors of the limited partnership may not seize the private funds of a limited partner beyond the amount contributed by the limited partner under the limited partnership agreement. Statutory law on (managing) general partners prescribes an exact correlation between liability and the power to direct the business of the partnership. The general partner has exclusive decision-making power. He is the sole representative of the general partnership and is personally and unlimitedly liable for its debts. Private practice stretches the limits of traditional partnership law when limited partnerships or Kommanditgesellschaften adopt organizational features of corporations or solicit contributions from investors, reminiscent of investment strategies of listed corporations.
b) Company law cross-overs
Some of the EU Member State jurisdictions endorse cross-overs between partnerships and corporations or private companies. In this context, general partnerships with a GmbH play a crucial role in German law (GmbH & Co KG). Under English and Scots laws, investment funds for venture capital or private equity finance rely on comparable organizational patterns which have evolved into sophisticated multi-tier schemes under the influence of private practice. In this regard, German GmbH & Co KG’s are latecomers in collecting private investments for national venture capital funds. As this industry is still in its infancy, German company law scholarship is not yet prepared to transcend traditional models of creditor protection. Rather, capital maintenance rules are extended to those partnerships tailored to copy the decision-making structures of corporations. A corporation as a (managing) general partner introduces an element of stability into a commercial partnership. However, the existence of a corporate general partner is likely to reduce risk-averse business decisions as the general partner benefits from limited liability. In Germany, the courts bind the managing director of the managing (general) partner on the rules of capital maintenance for both the partnership and the corporate general partner. A limited partner may even be required to reimburse distributions if such payment averts the illiquidity of the managing general partner. Moreover, a limited partner who de facto manages the partnership business shall be liable, inter alia, if his interference amounts to wrongful trading or has delayed a petition for insolvency proceedings.
3. English and Scottish limited partnerships and private equity
In the United Kingdom (UK), limited partnerships form the organizational core of venture capital and buy-out funds. A limited partnership established under English law pools the contributions of private investors who assume the statutory role of limited partners. Contrary to German law practice, limited partners do not directly contribute a relatively large amount of capital. Instead, they commit substantial amounts of their ‘investment’ by way of interest-free loans in order to escape the statutory ban on premature distributions and to gain priority over other creditors in the event of an insolvency of the fund. The general partner of a fund (ie a limited partnership) is an English private limited company. Very often, the managers of the private limited company will organize themselves in yet another limited partnership, either under English or Scottish law. Such a limited partnership (carry vehicle) is, in turn, one of the limited partners of the investment fund. The former will bill fees for management services to the fund, applying an internal distribution scheme to assure a performance-based incentivized remuneration. A sophisticated cascading system of English or Scottish multi-tier commercial partnerships exempts private equity funds from observing accounting rules applicable to corporations. The partnership structure of these funds is neither public nor subject to disclosure rules; tax law considerations determine the design. Tax law dictates whether to include a Scottish or an English limited partnership. Unlike English law, Scots law confers legal personality on limited partnerships. Ultimately, revenue authorities will decide for non-domestic investors whether income from a limited partnership with legal personality will be privileged under the respective income tax statute.
Tax law imperatives account for great homogeneity among limited partnership agreements. However, this does not allay capital market concerns whether the law on commercial partnerships affords adequate investor protection and market transparency. Partnership agreements are long-term contracts placing each party into a locked-in position which is fraught with asymmetric information. Private contracting has developed detailed incentive mechanisms to deter fund managers from implementing investment strategies detrimental to the limited partner-investors. The UK Financial Services Authority has so far rejected calls for regulatory action, referring to the industry’s voluntary codes of professional behaviour. The regulatory policy advocated by the Financial Services Authority is predicated on the assumption that private contracting and reputation mechanisms on the capital market will eventually generate transparency and efficient price mechanisms. It remains an open question whether the law on commercial partnerships and private contracting will accommodate concerns on risk management, valuation and reporting standards.
4. Uniform law for partnerships?
With the exception of EU rules on the European Economic Interest Grouping (EEIG), projects for harmonizing partnership law on a European level are virtually non-existent. Apparently, concerns about national tax law implications and undue interference with freedom of contract dominate regulatory policy choices to a much greater extent than an interest in comparatively assessing partnership law assessment.
Joint Report by the Law Commission and the Scottish Law Commission on Partnership Law (Law Com No 283/Scot Law Com No 192) (2003); Joseph A McCahery, Theo Raaijmakers and Erik PM Vermeulen, The Governance of Close Corporations and Partnerships (2004); Herbert Wiedemann, Gesellschaftsrecht Band II (Recht der Personengesellschaften) (2004); Geoffrey Morse, Partnership Law (6th edn, 2006); Financial Services Authority (United Kingdom), ‘Private Equity: a discussion of risk and regulatory engagement’ FSA Discussion Paper 06/6 (2006); Brigitte Haar, Die Personengesellschaft im Konzern (2006); Henry Hansmann, Reinier Kraakman and Richard Squire, ‘Law and the Rise of the Firm’ (2006) 119 Harvard LR 1333; Susanne Kalss, ‘The Austrian GmbH & Co KG’ (2007) 8 EBOR 93; Darryl J Cooke, Private Equity—Law and Practice (3rd edn, 2008); Mads Andenas and Frank Wooldridge, European Comparative Company Law (2009).