Liability Issues Involved in the Economic Realignment of Private Limited Companies

10.05.2011

[] The private limited company is a form of incorporation that represents an extremely common way of structuring corporate activities and doing business. What makes this business form so attractive is that it can be used to exclude the possibility of personal liability on the part of shareholders and limit liability to the amount of share capital or corporate assets.

In the case of violation of the provisions of law governing the legal formation of a private limited company (which are referred to as incorporation provisions), shareholders may, however, expose themselves to the risk of personal liability. It is the intent and purpose of the incorporation provisions to ensure the existence of the capital required by law and the articles of association to protect creditors when a company is created since this is ultimately what justifies the limitation of liability to corporate assets. The treatment of the economic realignment of a private limited company is the same as that of the initial legal incorporation of a private limited company with the result that the provisions of law that the legislature has enacted to cover the creation of a previously non-existent legal person are applied accordingly in the case of the entrepreneurial realignment of a private limited company that already exists. According to the case law of the Federal Court of Justice, the incorporation provisions and the accompanying liability model apply not only to the initial legal incorporation but also in cases involving what is referred to as the economic realignment of private limited companies as well. Depending upon the individual case, this may entail a significant risk that the purchasers of a private limited company or, in the case of the realignment of a private limited company, previous shareholders will find themselves personally liable for the debts of a company despite the fact a decision to do business through a private limited company generally limits the liability of those involved.

II. Economic Realignment

The term economic realignment includes the acquisition of shelf or shell companies as well as resumption of business operations by a previously inactive private limited company under the same shareholders.

1. Acquisition of a Shelf Company

For present purposes, shelf companies are private limited companies that are established by providers of legal services. They have the legally required share capital and, as the name indicates, are offered for sale "off the shelf." Although the share capital has been fully paid in, no liabilities exist and the company has not been previous engaged in business activities, the acquisition of a shelf company is considered to involve the economic realignment of a private limited company (see Federal Court of Justice, order of 9 December 2002 - II ZB 12/02, NJW 2003, p. 892 and 893). In that respect, it is assumed in the case law that the private limited company is an inactive legal entity that becomes active upon acquisition (Federal Court of Justice, order of 7 July 2003 – II ZB 4/02, NJW 2003, pp. 3198 and 3199).

2. Acquisition of a Shell Company

The acquisition of what is referred to as a shell company also qualifies as economic realignment. This involves the acquisition of a private limited company that has suspended operations, i.e., a company that legally exists and has already been actively involved in the conduct of business in the past but had completely ceased operations by the time of sale to the purchaser. In this case, the private limited company would then resume business operations under the purchaser after acquisition (see the Federal Court of Justice, order of 7 July 2003 – II ZB 4/02, NJW 2003, p. 3198 and 3199). In practice, this type of economic realignment is of only marginal importance. The risk of also acquiring residual liabilities along with the shell is too great and unfathomable.

3. Resumption of Business Operations by a Private Limited Company

As far as the case law and scholarly commentary are concerned, the term economic realignment also covers constellations in which an existing private limited company that has ceased operations in the past resumes its business operations again. In such cases, it is immaterial whether the resumption of business operations occurs in conjunction with a sale or change in shareholders in the meantime (see Munich Higher Regional Court, judgment of 11 March 2010 – 23 U 2814/09). In that respect, it is necessary to make a distinction here as compared with the restructuring or reorganization of a private limited company, which do not qualify as economic realignment, although it may be difficult to make this distinction in practice. The main reason why the restructuring or reorganization of a private limited company does not qualify as economic realignment is that the company has not suspended business operations although it may well have significantly realigned, expanded or restricted its activities (see the Federal Court of Justice, order of 7 July 2003 – II ZB 4/02, NJW 2003, pp. 3198 and 3200).

III. Liability

1. Exposure to Liability

Classification of the acquisition of a shelf or shell company or resumption of business operations by a private limited company as an economic realignment means that the provisions of law governing the incorporation of a private limited company that are intended to ensure the existence of the subscribed capital of the company are applicable accordingly and that the acquisition of the company or the resumption of business operations with a view to actually providing the share capital of the private limited company becomes at the same time subject to scrutiny by the court of registry. As a result, the court of registry must be notified accordingly in the case of an economic realignment and the managing director of the private limited company must confirm that the contributions to share capital described in section 7(2) and (3) of the Private Limited Companies Act have been made and that he continues to freely dispose of such contributions as required by section 8(2) of the Private Limited Companies Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung – GmbHG) (see the Federal Court of Justice, order of 9 December 2002 – II ZB 12/02, NJW 2003, p. 892). In the case of an economic realignment, as in the case of the initial legal incorporation of a private limited company, the confirmation of the managing director also serves to demonstrate that any losses already incurred by the company have not, entirely or even in part, consumed the contributions to share capital due or made by shareholders.

In the event the court of registry is not notified of the economic realignment of the private limited company – due to failure to appreciate the legal situation, omission on the part of the shareholders or other reasons, the shareholders then become personally liable with no limit in respect of either time or amount. In such case the conditions pertaining to liability that apply in the case of excessive debt when a private limited company is initially incorporated apply. The shareholders are then liable for the difference between the legally required or constitutive share capital and the actual value of the corporate assets as of the time of notification of the court of registry of the economic realignment. The liability of the shareholders covers the period from the time of acquisition of the shelf or shell company or resumption of business operations to the time of the notification of the economic realignment (according to the Munich Higher Regional Court , judgment of 11 March 2010 – 23 U 2814/09, with further references).

Finally, it is important to keep in mind that liability for excessive debt arising from failure to notify the court of registry of the economic realignment of a company is not limited exclusively to those shareholders who were directly involved in the process of realignment following either the acquisition of a shelf or shell company or resumption of business operations. The Munich Higher Regional Court recently ruled that even shareholders who acquire interests in a private limited company after economic realignment, i.e., from a private limited company that has already resumed business again, are liable for excessive debt. Whether or not a new shareholder had any positive knowledge of the economic realignment is irrelevant for the purposes of application of the principles of liability for excessive debt (see Munich Higher Regional Court, judgment of 11 March 2010 – 23 U 2814/09).

By analogy, section 11(2) of the Private Limited Companies Act also means that individuals acting on behalf of a company may be personally liable if they do so before the court of registry is notified of the economic realignment of that company. However, such liability is based on the assumption that not all shareholders have consented to commencement of business operations.

2. Limitation of Liability

Application of the incorporation provisions in the case of an economic realignment, and in particular the rules governing liability for excessive debt, entails a risk of significant exposure to personal liability for the shareholders of a private limited company although they will regularly have opted for incorporation in the form of a private limited company precisely to protect themselves against unlimited personal liability for the debts of the company. The principles governing liability in the case of an economic realignment that have been elaborated by the Federal Court of Justice in its case law to protect creditors do not in all cases do justice to the situations encountered in actual practice and may entail personal liability on the part of shareholders that is not always equitable. In that respect, it comes as no surprise that reservations have been expressed in the case law and scholarly commentary in respect of practical considerations and arguments advanced in favor of a limitation of liability in the case of the economic realignment of private limited companies.

A)

In a judgment from the year 2009 that has not yet become final, the Chamber Court expressed its agreement with the opinion advanced here to the effect that the risk exposure of shareholders of private limited companies to liability due to the application of the incorporation provisions and the model for liability for excessive debt is in need of correction (see Chamber Court, judgment of 7 December 2009 – 23 U 24/09, NZG 2010, p. 387). The case brought before the Chamber Court for decision involved the question as to whether the shareholders of a private limited company should be held liable under the rules governing excessive debt due to failure to notify the court of registry of the economic realignment and failure on the part of the managing director to submit the appropriate statement of confirmation required under section 8(2) of the Private Limited Companies Act although the share capital of the private limited company had been completely paid in by the shareholders when business operations commenced. The Chamber Court ruled that the shareholders were not liable for losses incurred after the commencement of operating activities under the rules governing liability for debt in the case of this constellation. The Chamber Court convincingly grounded its judgment, which runs counter to the rulings of other courts, arguing that the personal liability of shareholders in the case of the actual existence of the full amount of share capital when business was commenced could not be justified by the intent and purpose of application of the incorporation provisions in the case of an economic realignment, which is namely to ensure that capital is actually provided to protect creditors of the company (also according to Beck'scher Online-Kommentar GmbHG/Jaeger, section 3(43).

B)

Like the Chamber Court, the Munich Higher Regional Court has also already recognized the necessity of limiting the risk of personal liability by shareholders in the case of the economic realignment of a private limited company and gives shareholders the possibility of escaping liability if they can prove that the constitutive share capital was covered by the corporate assets of the private limited company at the time of the economic realignment (see Munich Higher Regional Court, judgment of 11 March 2010 – 23 U 2814/09). In addition, the Munich Higher Regional Court has at least considered a suggestion from the scholarly literature that would limit the personal liability of the shareholders to the difference between the share capital pursuant to the articles of association and the actual amount of the corporate assets at the time of the registration of the amendments to the articles of association following the acquisition or reorganization (referred to as differential liability) (see Munich, judgment of 11 March 2010 – 23 U 2814/09; Ulmer GmbHG, section 3(166).

C)

Finally, the Federal Court of Justice reaffirmed, in an order from the year 2010, its rulings on personal liability in the case of the economic realignment of a private limited company. At the same time it made it clear that there can be no question of personal liability if a private limited company commences business operations only after the usual start-up and lead times following its establishment and registration, but had already engaged in concrete activities to plan and prepare for the commencement of business operations as long as the business operations commenced thereafter remain within the scope of the purpose for which the company was formed pursuant to its articles of association (Federal Court of Justice, order of 18 January 2010 – II ZR 61/09, NZI 2010, p. 316).

IV. Outlook

Experience has shown that entrepreneurs do not, in view of the mandatory application of the incorporation provisions along with the personal liability for excessive debt imposed by the Federal Court of Justice, automatically preclude the possibility of personal liability for the debts of the company by choosing to operate as a private limited company. As of now, it is still completely unclear whether the case law of the Federal Court of Justice, which has established extra-statutory legal obligations and grounds for liability in a manner that is tantamount to the creation of legislation, is even constitutionally without reproach and acceptable. This is all the more the case since provision has already been made elsewhere for the protection of the creditors of the registered company, which is the actual intent and purpose of such application of the incorporation provisions in the case of an economic realignment, namely through prohibition of covert dividends, rules governing liability for the destruction of a company and the liability of members of managerial and supervisory bodies. Legal practitioners will in the future continue to have a special obligation to advise their clients of the potential exposure to liability in connection with an economic realignment and avoid any occurrence of such liability through appropriate measures.

GÖRG Newsletter

We inform you about current legal developments in the areas that are relevant to you.

Please subscribe to receive our newsletter.

We're using cookies to statistically monitor the usage of our website.

OK Deny tracking Privacy policy