Beruflich Dokumente
Kultur Dokumente
by
Christoph Kuhner*
Table of Contents
I.Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
II.The embodiment of capital maintenance in European Company Law . 343
III.Capital maintenance regulation and the contractual freedom model . . 345
IV. Capital maintenance as a remedy against precontractual and post-
contractual information asymmetries . . . . . . . . . . . . . . . . . . . 347
1. Adverse selection effects . . . . . . . . . . . . . . . . . . . . . . . . . 347
2. Capital maintenance rules as an instrument for creditor protection
in an environment of post-contractual asymmetric information . . . 348
3. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
V. The case against profit distribution via capital maintenance rules . . . . 352
1. Critical points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
2. Implications for future reforms . . . . . . . . . . . . . . . . . . . . . 354
I. Introduction
Creditor protection through capital maintenance rules has been a key issue in
the harmonisation of European company law. The second directive contains
crucial restrictions in order to safeguard capital maintenance: In a going concern
business, profit distributions to owners have to be funded exclusively from
earnings of the last fiscal year or from retained earnings of prior periods. Hence,
in line with the continental European accounting tradition, the profit distribution
function of accounting rules was enforced by European legislation. Whereas in
some continental European countries this arrangement, with some modifications,
is common for all kinds of limited liability companies, the second EU directive
only applies to public companies.
In recent times, the concept of capital maintenance has been challenged in
several respects.
(i) With its recent rulings, the European Court of Justice has introduced corpo-
rate charter competition: Thus, domestic capital maintenance rules can no
longer be enforced for all domestic limited liability companies.1
(ii) The move of EU accounting harmonisation towards IAS/IFRS challenges
the effectiveness of accounting-based creditor protection because the regula-
tion of profit distribution is not an objective of IAS/IFRS.2
(iii) Ongoing discussion focuses on abolishing capital maintenance rules in order
to render EU company law more flexible.3
Within this context, this paper provides an economic analysis that compares
the costs and benefits of accounting based profit distribution to alternative rules,
notably the solvency test.
The EU has been striving to harmonise company law for decades in order to
coordinate member states company rules aimed at the protection of shareholders
and other stakeholders. The EUs objective in that process was to ensure the
homogeneity of regulation throughout the Union compliant to Article 44 (2)
lit. g) of the Treaty Establishing the European Community.7 The intention was
2002, esp. 29. On the status quo of the discussion: Merkt, European Company Law
Reform: Struggling for a more Liberal Approach, European Company and Financial
Law Review 1 (2004) 335. Influential proposals for reform are presented by the
British Department of Trade and Industry (DTI), Modern Company Law for a Com-
petitive Economy, Final Report, 2001, (www.dti.gov.uk/cld/final_report/). See also the
Rickford Report written by an interdisciplinary group of experts: Rickford (editor):
Report of the Interdisciplinary Group on Capital Maintenance, EBLR 2004, 921.
4 () eine Kulturleistung ersten Ranges () Wiedemann, Gesellschaftsrecht, Band 1,
(1980) 566.
5 See e.g. Carney, The Political Economy of Competition for Corporate Charters, 26 J.
Legal Studies 303 (1997). According to Carney, every statutory protection of non-
shareholders is the result of rent-seeking activities.
6 Enriques/Macey, Creditors versus Capital Formation: The Case against the Euro-
pean Capital Rules, 86 Cornell Law Review 1202 (2001).
7 The Council and the Commission shall carry out the duties devolving upon them
under the preceding provisions, in particular: () by coordinating to the necessary
extent the safeguards which, for the protection of the interests of members and other,
are required by Member States of companies or firms within the meaning of the
second paragraph of Article 48 with a view to making such safeguards equivalent
ed to issue shares against payments lower than their nominal value 10. Further
rules exist in order to avoid the evasion of the aforementioned rules.
(ii) Restrictions on distribution of cash to shareholders: Distributions are limited
to the amount of surplus nominal capital. This is calculated as the differ-
ence between total equity and the sum of subscribed capital, legal reserves
and statutory reserves (Art. 15 (1) lit. (a)). Repurchase of treasury shares
is generally restricted based on the same principles as dividend payments.
Furthermore, the accumulated par value of treasury stock repurchased by
the company and its subsidiaries must not exceed 10 % of the subscribed
capital (Art. 19 (1)). Share repurchases require the assent of a shareholders
meeting. The reduction of the corporations capital by means of repayment
of subscribed capital is subject to special restrictions (Art. 30). In particular,
creditors are eligible to reclaim receivables before any payments will be made
to shareholders (Art. 22).
(iii) Nominal capital thresholds as trigger for legal consequences: 11 If the level of
nominal capital has been diminished by a severe loss, a compulsory share-
holders meeting is obliged to consider the need for the company to be
wound up or for other measures to be taken. The threshold for a severe loss
and the notice period for convening the meeting are subject to individual
member states legislation. However, the maximum threshold for a severe
loss according to Art 14 is half of the subscribed capital.
Although the Second Directive relates to incorporated public companies only,
German legislation on capital maintenance is also binding for private limited
companies in principle, in contrast to legislation of other EU member states.
The law and economics viewpoint denies that capital maintenance is an issue
of regulation. Creditors that are contractual parties will enforce their own stand-
ards for safeguarding their interests. Evidence from countries where there is no
capital maintenance regulation suggests that, in debt contracts, an equilibrium
will be found between the interests of both parties by contractual agreements,
including restrictions on profit distribution to owners. Common means are
so-called bond covenants, i.e. contractual terms restricting the distributions to
owners or providing for the compliance with certain financial ratios.12
10 In case of no-par shares: below the relative share of the subscribed capital, see Art. 8.
11 Art. 17, 2nd EU Directive.
12 For an economic analysis of bond covenants see the pioneering contribution of
Smith/Warner, On financial Contracting. An Analysis of Bond Covenants, 7 Jour-
nal of Financial Economics 117 (1979).
However, the question is whether the contractual freedom model leads to ef-
ficient results, if the relationship between the debtor and the creditor party can-
not be sufficiently represented by frictionless transactions and arms-length bar-
gaining. This might be the case: 13
(i) if there is no contractual relation between debtors and creditors 14;
(ii) if the debtor exercises monopoly power with respect to his creditors;
(iii) if there are problems of collective action.
Whether particular corporate law rules aiming at creditor protection can be
justified on the grounds of these three hypotheses is most controversial.
Corporate debt resulting from non-contractual relationships includes claims
from compensation for damages and claims of fiscal and regulatory authorities. It
is not straightforward why these claims should be safeguarded by the most
sophisticated system of capital maintenance in corporate law which applies only
for limited liability companies. Furthermore, corporate law capital maintenance
rules do not make any distinction between contractual and non-contractual obli-
gations, which indicates that they do not focus on the recoverability of non-con-
tractual claims. Viewed in isolation, the protection of non-contractual creditors
does not provide a basis for legitimating special corporate law provisions.
The second point, monopoly power of the corporate debtor with respect to
creditors, raises the question whether this monopoly power could be regulated
more efficiently by anti-trust law. However, up to this date, creditor protection
has not been an issue of antitrust law, although there is evidence that monopoly
power of debtors is a real phenomenon, consider, for instance, the relationship
between a large company and its small contractors. Monopoly power of the large
debtor which leads to a dominant bargaining position will in many cases discour-
age small contractors from requiring debt covenants 15, and thus, there might be a
legitimate basis for legal safeguards even in corporate law balancing the bargain-
ing power between the two parties.
Finally, it cannot be denied that there are significant collective action prob-
lems inherent in the corporate creditors position. In the presence of a large
number of creditors with individually relatively small claims, a collective action
problem will arise with respect to monitoring the corporate debtor. Although
there might be large and influential stakeholders, for which monitoring activities
13 See also: Armour, Share Capital and Creditor Protection: Efficient Rules for a Mo-
dern Company Law, 63 Modern Law Review 255 (2000).
14 See e.g. Eidenmller, Wettbewerb der Gesellschaftsrechte in Europa, 23 ZIP 237
(2002).
15 Even in cases of transactions where the power of both parties can be considered
counterbalanced, the potential influence of the creditor might be remarkably weak
compared to the ideal conception. Lutter, Gesetzliches Garantiekapital als Problem
europischer und deutscher Rechtspolitik , Die Aktiengesellschaft (1998), 375376
hints at the difficulty for handcraft contractors to ask for the accounts of the client.
are worthwhile from an economic viewpoint, it is not obvious why a single small
creditor should rely on them. Especially in the wake of corporate crises, single in-
fluential creditors will not act as agents of the creditor collective but will pursue
their own interests, possibly at the expense of other creditors.
Most significant collective action problems, further, arise in the case of corpo-
rate insolvency and restructuring. As capital maintenance rules are not relevant in
this event, problems of corporate insolvency and restructuring are not focussed
here. However, the prominence of the corporate insolvency collective action
problem emphasises the demand for special corporate law rules designed to
prevent insolvency.16
The well known financial economics phenomenon of delegated monitoring,
therefore, cannot be straightforwardly applied to the relationship between large
creditors and small creditors of a company.
To conclude: Even from a law and economics perspective of reasoning, there
is a case for creditor protection rules in corporate law. This brings up the question
whether capital maintenance rules of the European fashion can be viewed as effi-
cient arrangements in order to remedy these market failure phenomena.
16 For a comprehensive analysis of the collective action problem see e.g. Jackson, The
logic and limits of bankruptcy law (1986, reprint 2001).
17 See Armour, 63 Modern Law Review (n 13) (2000), 355378; From the perspective
of the banking profession: Walter, Gesetzliches Garantiekapital und Kreditver-
gabeentscheidung der Banken, Die Aktiengesellschaft (1998), 370372, esp. 372.
18 See the text and examples in Mlbert/Birke, Legal Capital: Is There a Case Against
the European Legal Capital Rules?, 3 European Business Organizational Law Re-
view, 675 (2002), 716 f. The signalling effects of nominal capital addressed not to cre-
ditors but to shareholders, are not mentioned here; consider inter alia Peterson/
Hawker, Does Corporate Law Matter?, 31 Akron Law Review, 175 (1997).
19 Brealey/Myers, Principles of Corporate Finance, 7th ed. 2003, 513519.
In sum, the capital maintenance system of the 2nd EU Company Law Direc-
tive, together with the system of accounting principles of the 4th directive, can be
viewed as a heuristic but sustainable attempt to attenuate typical underinvestment
problems in post contractual debtor-creditor relationships.
In the capital maintenance system of the 2nd EU directive, the rule that a gen-
eral meeting of shareholders should be called in case of a serious loss of the sub-
scribed capital in order to consider whether the company should be wound up or
any other measures taken (2nd directive, Art. 17) is designed to prevent undue
delay.25 However, as this rule does not include compulsory requirements with
respect to liquidation or restructuring of the company, its efficiency in preventing
undue delay should not be overestimated.
This moral hazard behaviour pattern occurs if a limited liability debtor deli-
berately undertakes negative present value projects in order to increase corporate
risk. In the literature, this phenomenon is also known as the overinvestment
problem. Gambling for resurrection usually occurs in connection with corpo-
rate crises, i.e. in a situation where equity capital has lost its value almost comple-
tely. Under these circumstances, the residual claimants will have an incentive to
perform high-risk projects as long as these projects reveal a very asymmetric dis-
tribution of expected cash flows: If, with a rather small probability, the project is
successful, huge positive cash flows will be generated which will benefit primarily
the owners of the company who are in the position of residual claimants. If, on
the contrary, with a rather high probability, the project fails, creditors will lose
their claims in the wake of corporate bankruptcy; however, the losses of the cor-
porate owners will be on a small scale because equity capital had lost most of its
value already before the high risk negative present value-project was realized.26
25 Related to the role of nominal capital as an alarm signal see Lutter, Die Aktien-
gesellschaft (1998), n 15, 376; similar: Hertig/Kanda, Creditor Protection, Kraak-
man/Davies/Hansmann et al, The Anatomy of Corporate Law A Comparative
and Functional Approach, 2004, 71, 85; Khnberger, Der Betrieb (2000), 2077 has
a critical opinion regarding the obligation to disclose losses of capital from a concep-
tional and practical viewpoint.
26 The seminal analysis of this phenomenon is Jensen/Meckling, Theory of the Firm:
Managerial Behavior, Agency Costs and Ownership Structure, 3 Journal of Financial
Economics 305 (1976), 333343. A short outline of those misleading incentives pro-
Critics of capital maintenance rules argue that, not only, these regulations are
unable to counteract debtors overinvestment but, even worse, aggravate this
problem: As profit distribution rules prohibit the withdrawal of cash by corporate
owners, locked-in liquid funds which otherwise would have been distributed to
the owners will be, in a gambling for resurrection situation, invested in negative
present value-projects. Thus, creditor protection by capital maintenance rules in a
setting of underinvestment problems is contrasted by the potentially damaging
effect of these rules in a gambling for resurrection scenario.27 It is argued that
nothing can be said about the aggregate effect of these two trade-offs and, there-
fore, legislation should renounce from fine tuning creditor protection by capital
maintenance rules.28
These negative implications of capital maintenance restrictions on profit dis-
tribution can be proved even in simple economic model settings. However, we ar-
gue that the relevance of this particular implication should not be overestimated.
Gambling for resurrection becomes an attractive option for corporate owners not
until the point when the mere existence of the corporation as a going concern is
severely threatened.29 It seems to be unrealistic to expect that, in such a scenario,
a large volume of liquid funds locked in within the corporate entity by capital
maintenance rules will be available for high risk negative present value-projects.
Conventional wisdom suggests that such gambling for resurrection projects are
not funded by huge amounts of liquid reserves but by alternative forms of non
cash commitment, including in many cases activities in derivative financial mar-
kets.30
Summing up, capital maintenance rules will not prohibit overinvestment prob-
lems. On the other hand, it cannot be expected that overinvestment problems are
aggravated by the presence of these rules. We conclude that incentives to gamble
for resurrection should be discouraged by alternative measures of corporate law
including veil piercing and management liability.31
3. Conclusion
1. Critical points
Viability does not imply efficiency. Criticism referring to the capital mainte-
nance rules in the fashion of the 2nd EU-Directive on efficiency grounds includes
the following points:
(i) Irrelevance of the level of nominal capital for creditor protection;
(ii) Lack of flexibility with respect to the need of capital structure changes in
response to typical situations in the corporate life cycle;.
(iii) Lack of suitability for capital structure signalling;
(iv) High transaction costs due to the complexity of the capital maintenance
rules.
In a going concern business, the balance-sheet equity figures do not represent
any sort of economic value of the corresponding net assets with respect to the
balance sheet date.32 It only quantifies the historical values of assets which were
designated as investments by the corporate owners (legal capital, capital reserves)
plus accumulated profits of former periods not distributed to the shareholders
(profit reserves). It is not straightforward that safeguarding these historical
book values through capital maintenance rules serves creditor protection pur-
poses efficiently. Furthermore, the rules of the 2nd Directive do not make any
attempt to fine-tune the amount of necessary legal capital with respect individual
corporate risk: Art. 6 (1) of the 2nd Directive provides for a mandatory minimum
capital of 25.000 for all stock corporations, regardless of their size and of the
riskiness of their activities. To assume that by this rather coarse regulations credi-
tors of all kinds of corporations, global ones as well as small ones, enjoy a
comparable level of protection seems rather heroic.
Another major point of criticism is the inflexibility of the incumbent sys-
tem: 33 All kinds of corporate restructuring activities, including leveraged buy
outs, pay-offs of founding or dissenting shareholders or capital restructuring
activities in the course of a crisis, are significantly inhibited by Art. 15 (1a) of
the second directive that prohibits distributions to owners out of subscribed capi-
tal, e.g. in the form of share repurchase,34 except for cases of reductions of sub-
scribed capital, and by Art. 8 which forbids share issues at a price below their
nominal value, or, where there is no nominal value, their accountable par 35.
Capital reduction via Art 30 ff., however, is an extremely cumbersome and costly
procedure.
Lack of flexibility also potentially prohibits signalling activities by variation
of dividend payments and share repurchases.36 Institutional economics outlines
this type of signalling as an efficient instrument to overcome information asym-
metries between management and the capital market, concerning the corpora-
be proved ex post, i.e. taking into account the firms solvability after the cash
withdrawal through the distribution to owners. This mechanism of creditor pro-
tection is implemented in the US and in many other jurisdictions of anglo-saxon
origin:
Thus, in the U.S., any dividend and any sum a company pays to repurchase its sha-
res is a fraudulent transfer if the company, after paying the dividends or repurchasing
its shares, is left insolvent or with unreasonable small capital. 47
The rule referred to in the quotation is a U.S. common law rule; 48 it is there-
fore not subject to the corporate charter competition of U.S. state corporate law.
A similar regulation is implemented in the U.K. private company law: Any profit
distribution threatening the solvency of the company is prohibited by a so-called
solvency declaration: Directors of the company have to provide a solvency
declaration if a distribution to the owners diminishes capital reserves. In the sol-
vency declaration, management has to confirm that the distribution in question
does not affect the going concern status of the business in the fiscal year follow-
ing. Solvency declarations which prove to be inadequate after a company has
gone insolvent have for consequence drastic legal sanctions on management.49
Unlike capital maintenance rules, the solvency test and resp. the solvency
declaration directly address the future financial prospects of a company and
therefore rely on prognostic information.50 In case of litigation, courts have to use
judgment in order to decide whether a certain distribution which took place at
some date in the past was adequate from a solvency point of view.51 In the litera-
ture, it is emphasized that such a judgment is based on imprecise standards, it is
based merely on reasonable expectations and on business judgment referring to
the date of the litigious distribution.52
Basically, there are two accounting alternatives on which a solvency declara-
tion could be based: 53 The first alternative involves a balance sheet test based on
liquidation values of assets and of liabilities. If it can be shown that, after a certain
cash withdrawal for distribution purposes, this difference is positive, the solvency
47 Kahan, Legal Capital Rules and the Structure of Corporate Law, Hopt/Wymeersch,
(ed.): Capital Markets and Company Law, (2003), 147.
48 See Kahan, ibid, 148.
49 (British) Companies Act, sec. 173, in this regard: Davies, Legal Capital in Private
Companies in Great Britain, Die Aktiengesellschaft 1998, 348.
50 On the forward looking focus of solvency tests: Leuz/Deller/Stubenrath, An
International Comparison of Accounting Based Payout Restrictions in the United
States, United Kingdom and Germany, 28 Accounting and Business Research 1998,
111, 114.
51 On that matter see also: Hertig/Kanda (2004), (n 25), 87.
52 In this sense: Rickford, EBLR 2004 (n 3), 974.
53 For an overview over different solvency test regimes see Rickford (2004) (n 3),
971987.
test has a favourable outcome in respect to the planned distribution to owners be-
cause the debtors claims can be satisfied by the liquidation of the company.
The second alternative involves a prospective cash flow statement in order to
prove whether the free cash flows of future periods are sufficient to ensure a
going concern business after the planned distribution has taken place. Solvency
declarations based on the second alternative, i.e. prospective cash flow state-
ments, seem to be more widespread compared to liquidation value-balance sheet
tests. Taking into account the large number of jurisdictions in which solvency
testing based on prospective cash flow estimation is common, it is however puz-
zling that, up to this moment, a state-of-the-art technique of drafting prospective
cash flow statements has, apparently, not evolved. In the literature on this subject,
only ambiguous information on an adequate methodology of forming cash flow
forecasts is identified.54 There does not seem to exist any generally recognised set
of forecasting principles, which may form the fundament of legal judgments on
the viability of distributions to owners.
In particular, there does not even exist consensus about the adequate time
horizon of such a cash flow forecast. In the US Model Business Corporation Act
as well as in many US state corporate laws, there is the requirement that solvency
testing must guarantee the safety of payment of liabilities as they mature:
No distribution may be made if, after giving it effect, the corporation would not
be able to pay its debts as they become due in the normal course of the business.
( 6.40 (c ) (1) MBCA.)
With respect to the time horizon of the corresponding cash flow forecast, this
means nothing more and nothing less than that the forecasting period stretches
out until the date of maturity of the longest term debt. In the presence of extremely
durable liabilities e.g. pension liabilities this would require a cash flow forecast
over several decades. On the other hand, there are proposals in the literature
which aim at a forecasting period of only 12 months (!).55
Taking into account the broad range of possibilities inherent in drafting pro-
spective cash flow statements, the completely different nature of a solvency test
compared to balance sheet oriented capital maintenance needs to be emphasised.
Completely different by nature is its business judgment quality. Business judg-
ment implies that legal conformity of a certain distribution to owners is not
ensured by compliance with well-shaped legal accounting rules but is reached by
compatibility with imprecise standards.56
57 Rickford, EBLR 2004, (n 3) 971, argues in favour of the solvency rule in British
Law with regard to efficiency and effectivity on the grounds of absence of scandals
of excessive distribution to shareholders.
58 The situation outlined here is very similar to concepts from other areas, where in-
creased compliance is effectuated by imprecise standards and the imposition of sanc-
tions. See for instance Ewert, Liability and Precision of Auditing Standards, 155
Journal of Theoretical and Institutional Economics 1999, 181226.
59 The proposition that increased certainty in the determination of cash distributions
does not necessarily imply a higher level of creditor protection is discussed in Kuh-
ner, Das Spannungsverhltnis zwischen Einzelfallgerechtigkeit und Willkrfreiheit
im Recht und in der Rechnungslegung, Betriebswirtschaftliche Forschung und
Praxis (2001), 523, 537.
60 See Kahan: Legal Capital Rules and the Structure of Corporate Law, in: Hopt/
Wymeersch, (ed.): Capital Markets and Company Law, Oxford 2003, 145148.
61 Altmeppen/Wilhelm, Gegen die Hysterie um die Niederlassungsfreiheit der
71 Cal. Corp. Code, Sec. 500 (a), (b). The balance sheet test is augmented by the obliga-
tion to comply with a horizontal ratio margin (working capital / short-term liabili-
ties > 1, sec. 500 (a) (2)).
72 Ben-Droar, 16 University of California Davies Law Review 375 (1983), referred to
in: Armour, Capital Maintenance, Department of Trade and Industry (DTI), (with-
out date), http://www.dti.gov.uk/cld/esrc6.pdf, 12.
73 Consider the criticism by Schneider, Betriebswirtschaftslehre Bd. 2 Rechnungs-
wesen, vol. 2, 1997, 318324.
74 Berry/Faulkner/Hughes/Jarvis, 25 British Accounting Review 1993, 131150;
Deakins/Hussain, 26 British Accounting Review vol. 1994, 323335, referred to in:
Armour, Capital Maintenance, (n 72), 13. Results of the studies are in line with
Walters pronouncement: Walter (1998) (n 17), 372.
82 This idea is supported by another result of the study: Additional borrowing restric-
tions relying on cash flow based ratios (e.g. interest payments / EBITDA) tend to re-
place those relying on accounting based rations (e.g. equity ratios) during the later
periods when compared to the earlier periods. Consider Begley/Freedman 2004
(n 79), 8890.
83 Hence, Enriques and Maceys opinion on nominal capital maintenance frame-
woks, namely that companies would often refrain from distributing cash due to fears
that this would be erroneously declared as null and void by courts ex post, is hardly
convincing at least as far as related to Germany, consider Enriques/Macey (2001),
(n 6), 1196f.
84 For instance, liability for intrusions destroying the economical basis, see Lom-
bardo/Wunderlich, 2004, (n 31), 2226.
85 Consider also Fleischer, Grundfragen der konomischen Theorie im Gesell-
schafts- und Kapitalmarktrecht, ZGR 2001, 1, 13f.