4.2.2 Rules governing legal capital and corporate groups

Mandatory disclosure helps creditors protect themselves, while rule strategies provide standard-form protections for creditors. Some rules are narrowly targeted, as in the case of the specialized rules that govern corporate groups in some jurisdictions. Other rules have a much broader reach, as in the case of the rules that govern 'legal capital.'67 Depending on the jurisdiction, these rules regulate corporate distributions, minimum capital requirements, and the ongoing maintenance of corporate capital. Each of these rules is clear-cut and even mechanical in its application. In particular, such formal rules have always been integral to the regulation of legal capital. One reason, we suspect, is that the information costs of applying and enforcing them are low. Ease of enforcement may also explain why rules governing legal capital were undoubtedly more important for creditor protection a century ago than they are today.

4.2.2.1 Distribution restrictions, minimum capital, and capital maintenance

In most jurisdictions, legal capital regulates three aspects of corporate finance: (1) the maximum permissible outflow of capital, (2) the minimum initial investment of capital, and (3) the level of capital that must be maintained during corporate life. Company laws restrict the outflow of distributions—i.e., dividends and share repurchases—in order to prevent shareholders from diluting the pool of assets that implicitly bonds a company's debts. Although these

reinforces SA shareholders' right lo obtain information about intra-group transactions.- see Art. L. 225-115 Code dr. commerce (extension to 'ordinary' transactions, arguably a prime value diversion mechanism).

63 German law distinguishes two forms of control: one based on an agreement between two companies (contractual group) and the other based on the exercise of unitary management power {de facto group): sec SI 8 Aktiengesetz and infra 4.2.2.2.

66 S312 I Aktiengesetz; Uwe Huffer, AKTIENGESETZ N°38 $313 (5th ed. 2002). It is unclear

whether this obligation also applies to GmbHs: see Hans-Joachim Priester and Dieter Mayer,

Gesellschaft mit beschmnktcr Haftung, MUNCHENER HANDBUCH DES CESELLSCHAFTSRECHT III

N°48 $71 (1996).

67 In most jurisdictions, legal capital is the aggregate nominal (or par) value of issued shares, which

is typically much lower than the actual issue price of these shares. In U.S. jurisdictions that permit'no

par'shares, legal capita! is initially set by a company's organizers, and may be any amount less than (or

equal to) the issue price of a company's shares. Generally speaking, legal capital does not include

reserves, although some jurisdictions require companies to set aside non-distributable reserves from

current earnings as an additional hedge against shareholder opportunism. Note, too, that a few U.S.

jurisdictions permit companies to use economic value rather than book value to set dividend policy.

See 56.40(d) RMBCA and Comment 4.b; §500 California Corporation Code.

distribution restrictions vary across jurisdictions,68 the most common rule is one that prohibits payment of dividends that would impair the company's legal capital, i.e., distributions that exceed the difference between the company's book value and legal capital as fixed by the company's charter. As one might expect, dividend restrictions are more protective—and more confining—when they are combined with conservative accounting practices, such as those of Germany and Japan. Conversely, dividend restrictions do less to protect creditors where, as in U.S. jurisdictions, accounting principles are less conservative and the shareholders meeting, or even the board of directors in some cases, can reduce a company's legal capital with comparative ease.

The rules governing the minimum investment levels for incorporation are termed minimum capital requirements. All of our major jurisdictions apart from the U.S. use the concept of legal capita] to regulate how much shareholders must invest to qualify for incorporation. EU firms that adopt the open corporate form must have initial legal capital of at least Euro 25,000, although Member states may set higher thresholds if they wish.63 Similarly, Japanese minimum capital requirements range from roughly US $30,000 to US $100,000, depending on the type of corporate form.70 Although these numbers are large by U.S. standards (which generally require nothing at all),71 they are actually quite small in comparison to the actual capital requirements of almost all European and Japanese businesses. Presumably they are small precisely in order to permit almost all legitimate businesses to incorporate as 'open' corporations.72 Nonetheless, it remains unclear how much real protection these rules provide to creditors, particularly since any firm's initial capital is likely to be long gone before it files for bankruptcy. Thus, the function of minimum capital, and its continuing popularity in much of the world, poses something of a puzzle.73

6% For an overview of a variety of dividend restriction rules used by U.S. jurisdictions, sec, e.g., Robert W. Hamilton, THE LAWS OF CORPORATIONS 585-90 (5th ed. 2000). For share repurchases, see infra 6.4.2 and 6,4,3.

69 See An. 6 Second Company Law Directive [1977] OJ L 26/1 and [1992] OJ L 347/64, applicable

to Aktiengesellschaften (AG), SA, public companies, etc.

70 5ee Art. 168-4 Japanese Commercial Code (about USD 100,000 for open corporations—

kabushikigaisha) and Art. 9 Japanese Limited Liability Company Act (about USD 30,000 for close

corporations—yugengaisha, a Japanese counterpart of the German GmbH).

71 See Hamilton, supra note 68, 88-9; Bay less Manning and James J. Hanks, LEGAL CAPITAL (3rd

ed, 1990).

72 In theory, company law could toughen minimum capital requirements by, for example, forcing

companies to meet a specific debt-equity ratio. As the on-going debate about debt-equity ratios for

financial intermediaries suggests, however, any such tequirement would be perceived as intolerably

rigid. Different businesses carry different risks; why assume that any non-trivial capital requirement

could possibly be efficient? On the use of debt-equity rations for regulating banks, see, e.g., the so-

called Basle Accord on Bank Capital Adequacy (although the figures used there are not simple balance

sheet numbets but rather adjusted, 'risk-based' figures).

73 It has been argued that even modest minimum capital requirements have a valuable warning

function, especially for foolish entrepreneurs, see J. Hudson, The Limited Liability Company: Success,

Failure and Future, 161 ROYAL BANK OF SCOTLAND REVIEW 26 (1989). Compare the approach

adopted in Centros Ltd and Erhvers- og Selskabsstyrelscn [1999] EUROPEAN COURT REPORTS I

1459 and the Simpler Legislation for the Internal Market (SLIM) Report on the Second Company

Law Directive (2000, available at europa.eu.int).

Finally, the rules governing the reduction of legal capital in established companies are termed, somewhat mislcadingly, capital maintenance (in Europe) or capital uncbangeability (in Japan) rules. At least in theory, these rules should make legal capital a credible financial cushion for creditors. In Japan, for example, companies that reduce legal capital to benefit shareholders may have to secure the existing claims of their unsecured creditors.74 The EU requires open companies to call a shareholders meeting to consider dissolution after a serious loss of legal capital,75 while individual European states have adopted stronger rules. Thus, Germany and Switzerland extend the shareholders meeting requirement to small companies when legal capital is eroded, and further require the immediate filing of an insolvency petition when legal capital is exhausted.76 Creditors clearly benefit from the latter requirement, since earlier bankruptcy proceedings generally leave more on the table for distribution to creditors. In theory, moreover, creditors might benefit from mandatory shareholders meetings for the same reason: a shareholders decision to dissolve before exhausting the firm's legal capital leaves more assets available for distribution to creditors and shareholders.77 In addition, a meeting requirement might also provide creditors with an early warning of impending financial crises.

One difficult issue is whether the possible benefits of the European capital maintenance rules are realized in practice. Like U.S. firms, most European companies maintain only a thin layer of legal capital between the layers of unrestricted shareholder equity and debt on their balance sheets. Thus, by the time the difficulties of most failing companies come to fight, they have long since exhausted their legal capital and become deeply insolvent. There is simply no time for early warnings or shareholder meetings. Even so, however, the capital maintenance rules may still have some value for creditors. They benchmark the points at which boards and controlling shareholders must liquidate or restructure failing companies, and so make it easier for creditors and bankruptcy receivers to sue these parties if they fail to discharge their duties.78

4.2.Z.2 Special rules for corporate groups

A supplementary set of creditor protection rules covers groups of companies in jurisdictions with a specialized law of corporate groups. As we indicated above,

74 Art. 376 Commercial Code. Regarding creditors' rights to get collateral in case of mergers,

divisions and share exchanges, sec infra 6.2.3.

75 Art. 17 Second Company Law Directive. EU law also protects creditors against capital reduction

through charter amendments or share repurchases (set mfra 6.2.3), but not against capital reduction to

restore financial soundness—the reasoning being that shareholder opportunism is then less an issue:

Heinz-Dietcr Assmann, Barbara Lange and Rolf Scthe, Vie Law of Business Associations, in Werner

E Ebke and Matthew W. Finkin (eds.). INTRODUCTION TO GERMAN LAW 137,159 (1996).

" Sec note 10 supra. This is a balance-sheet, not a cash-flow test.

77 This explains why, foe example, French law permits creditors to force liquidation on an open

company (SA) that fails to call the mandatory dissolution meeting after losing half of its legal capital.

See Art. L. 225-248 Code de commerce.

78 On creditors' standing to sue managers for violation of fiduciary duties, see mfra 4.2.3.1. Well-

known cases include the German Herstatt case (BUNDESGP.RICHTSHOF ZIVILSACHEN—BGHZ-— 75,

96) and the U.S. Credit Lyonnais case (17 DELAWARE JOURNAL OF CORPORATE LAW 1099-1992).

German group law—or Konzernrecht—provides the most elaborate example of a developed group law that attempts to balance the interests of groups as a whole with those of the creditors and minority shareholders of their individual members.73

German law distinguishes between 'formal' contractual groups and de facto groups, or associations of companies that are groups in fact but do not acknowledge a collective identity.80 Contractual groups are based on a 'contract of domination,' which empowers corporate parents to instruct their subsidiaries to follow group interests rather than their own individual interests. As a quid pro quo, however, parent companies must indemnify their subsidiaries for any losses that stem from acting in the group's interests.81 Should this fail to happen, creditors may attach the subsidiary's indemnification claim ot sue the parent's directors for damages.82

This same standard extends to groups of closely held German companies (GmbH's) that are controlled by a single parent (qualiftzierten faktischen GmbH-Konzerne)*3 More generally, even if a parent company has not entered into a contract of domination (de facto groups), it must compensate any subsidiaries that it causes to act contrary to the subsidiary's own interests.8'1 Should the parent fail to do so, creditors may again sue the parent for damages.85

The rule-based strategy of Konzernrecht contrasts with the more standard-oriented French approach to the same issues. Under French law, a group's controller need not pay compensation for instructing a member to act in the group's interest rather than in its own interest as long as the group is (1) stable, (2) pursuing a coherent business policy, and (3) distributing the group's costs and revenues equitably among its members.86 European experience thus far suggests that this French approach of focusing on the 'enterprise' better reflects the actual practice of European group structures than the indemnification requirements of

79 For a discussion of German Konzernrecht, see supra note 20 and accompanying text. For a

comparative perspective, see Peter Horomelhoff, Klaus J. Hopt and Marcus Lutter (eds.), KONZERN-

RECHT IIND KA P ITALM ARKTRECHT (2001).

80 See supra note 65. Statutory provisions exist only for subsidiaries that haveadopted the AG form

(5S291-337 Aktiengesetz). However, starting with the 1975 LTT judgment (BGHZ 65,15), case law

has extended many Konzernrecht requirements to groups involving GmbH or non-AG entities.

81 5S302 and 308 Aktiengesetz.

82 SS302, 309 and 322 Aktiengesetz; Huffer, supra note 66, N°18 J302 Aktiengesetz; Emmerich er

at., supra note 20, 281 (applicability to corporations other than AGs).

83 BGHZ 95, 330 [Autokran]; BGHZ 122,123 [TBB]; BGHZ 149, 10 [Bremer Vulkan).

w 5311 Aktiengesetz (subsidiary is an AG). The parent has similar obligations when the subsidiary is a GmbH, based upon general fiduciary duties: Emmerich et al., supra note 20, 401-5. In practice, it is often difficult to establish whether the subsidiary has been harmed or not. The main tests are whether parent-subsidiary transactions are at arm's length and whether the subsidiary's directors have otherwise exceeded their business discretion (Huffer, supra note 66, N*29—36 S311 Aktiengesetz).

8J Huifer, supra note 66, N°2 S317 Aktiengesetz.

as This is holding of the well-known Rozenblum case (Cour de Cassation, 1985 REVUE DES SOCIETES 648).

Konzernrecht.87 Apparently no one, including creditors, takes the German indemnification rules seriously until a subsidiary is insolvent or close to it—at which point it is probably too late because the parent company is likely to be insolvent as well.88 As a result, skepticism about the German compensation rules is widespread,89 which makes the French approach the leading model for European harmonization by default.90

4.2.2.3 Reflecting on the rules strategy

The rules strategy is popular in continental Europe but not among U.S. states, which generally lack most of what we have addressed in this subsection: minimum capital requirements, capital maintenance rules, and an articulated law of corporate groups. What explains this divergence? The answer does not turn on whether a jurisdiction is debtor-or-creditor friendly. The creditor-friendly UK would probably follow the debtor-friendly U.S. in preferring standards over rules, if it were not for the constraints imposed by EU directives.91 Instead, we believe, there are two related explanations for Europe's preference for rules. The first and more traditional explanation is the familiar divide between common law and civil law. Judges in civil law jurisdictions such as France and Germany arc traditionally uncomfortable with open-ended standards, and much prefer to enforce relatively bright-line rules.92

By contrast, the second explanation looks to differences in the capital markets. Rule strategies such as capital maintenance requirements are more effective when financing is conservative and bank-centered, and law or market institutions restrict wholesale leveraging or share repurchases.93 In the past, these conditions generally prevailed in continental Europe, with the result that capital

87 See Wolfgang Schon, The Concept of the Shareholder in European Company Law, 1 EUROPEAN

BUSINESS ORGANIZATION LAW REVIEW 3, 24-7 (2000); Forum Europacum Corporate Group Law,

Corporate Croup Law for Europe, 1 EUROPEAN BUSINESS ORGANIZATION LAW REVIEW 165 (2000).

88 On the lack of effectiveness of indemnification requirements, see Forum Europacum Corporate

Group Law, supra note 87.

89 Peter Hommclhoff, Protection of Minority Shareholders, Investors and Creditors: The Strengths

and Weaknesses of German Corporate Group Law, 2 EUROPEAN BUSINESS ORGANIZATION LAW

REVIEW 61, 65 (2001) (defeating legislative expectation, contractual groups are only formed when

there are significant tax advantages). See also Eddy Wymeersch, Groups of Companies, in Richard

M. Buxbaum et at. (eds.), EUROPEAN BUSINESS LAW 227 (1991) and ihe related discussion.

90 Forum Europacum Corporate Group Law, supra note 87.

91 The Second Company Law Directive obliged the UK to introduce minimum capital requirements

for public companies and, more importantly, to strengthen distribution rules. The UK, however,

successfully resisted (he extension of EU legal capital rules to closely held companies: sec Vanessa

Edwards, EC COMPANY LAW 53 (1999). Compare Judith Frecdman, Limited Liability; Large Com-

pany Theory and Small Firms, 63 MODERN LAW REVIEW 317 (2000) (there is support for legal capital

rules).

92 Compare Marcus Lutter, Limited Liability Companies and Private Companies, in XU INTER-

NATIONAL ENCYCLOPEDIA OF COMPARATIVE LAW 2-58 (1997) (the divergence is due to civil law

jurisdictions simultaneously pursuing multiple aims: have owners contribute something, facilitate firm

financing and protect creditors).

93 See Art. 17, 19 and 23 Second Company Law Directive; see also infra 6.4.2,

maintenance requirements posed little or no burden on financial transactions. Today, however, they impose a considerably larger burden in a riskier, market-oriented environment. For example, EU restriction.'! on using company assets as security significantly impede leveraged buy-outs of smaller EU firms.94 Similarly, capital maintenance requirements are thought to handicap larger EU firms that wish to switch from bank financing to raising equity capital on the share markets.95 Why not then abandon capital maintenance rules because they are too costly? Some commentators suggest a public choice explanation: these rules remain in place because they benefit powerful European interest groups—the banks {who are the primary lenders) and incumbent managers (who face less pressure to perform with a larger equity cushion).96