Freedom of Establishment for Companies

I recently posted my forthcoming book chapter, Centros, the Freedom of Establishment for Companies, and the Court’s Accidental Vision for Corporate Law (forthcoming in EU Law Stories, Fernanda Nicola & Bill Davies eds., Cambridge University Press 2015) on SSRN.

This chapter attempts to tell a short intellectual history of the debate about free choice in corporate law in the EU. In contrast to the United States, in many EU Member States it was traditionally not permissible to set up a corporation in one Member State in order to run the company with its head office (meaning the center of its actual commercial and financial operations) in another. This changed with three cases of the European Court of Justice (ECJ), namely Centros (1999), Überseering (2002), and Inspire Art (2003). Consequently, EU member states can no longer effectively deny the legal capacity to pseudo-foreign corporations, or apply key provisions of their own corporate law to them. At least in principle, founders can now exercise the freedom of establishment for companies to “pick and choose” the best national legal form.

While the freedom of establishment had been granted to companies already in the Treaty of Rome, it remained ineffective for decades. After the creation of the European Economic Community (EEC), it had been assumed that company law would be largely harmonized on the community level, thus eliminating the most important differences between the Member States laws, creating a level playing field for third parties interacting with firms in the common market, and preventing the establishment of a European Delaware. However, since the harmonization project remained a patchwork, large differences remained. Member States felt justified in maintaining protectionist measures impeding free choice of corporate law. Many analysts on the Continent saw dicta in the Daily Mail case of 1988 as providing a justification for the real seat theory, which the private international law tool to prevent free choice of the law of incorporation. Far fewer observers seemed to have paid attention to the Segers case of 1986, which apparently said the opposite.

The triad of Centros, Überseering and Inspire Art thus was a particularly disruptive surprise. This result is one that policymakers, lawyers, and legal scholars had sought to avoid for many decades, given its potential to undermine national corporate law policies, which is why the real seat theory and other protectionist tools were used to stop pseudo-foreign corporations at the border. The ECJ, which took a more cautious approach only in the Cartesio case of 2008, was seen as opening the door to regulatory competition in European corporate law. For a few years in the mid-2000s, the ECJ’s case law thus opened the door to regulatory competition in European corporate law, and in particular to English Private Limited Companies, which became the legal form of choice for many founders, particularly in Germany. In the end, there was little “offensive” regulatory competition, since no Member State had the incentive to capture a large part of the market for incorporations. Member States did, however, engage in “defensive” regulatory competition by eliminating requirements in their laws that seemed to drive founders to the UK. The popularity of the English Private Limited Company on the Continent ended after a few years, apparently because the UK itself was not particularly interested in attracting (and retaining) pseudo-foreign incorporations.

In consequence, the ECJ thus unwittingly nudged Member States toward a certain vision of corporate law that had never been intended by policymakers. With respect to the actual subject matter, the entire line of cases exposes the inherently political character of the ECJ’s mandate in corporate law. The core issue was clearly capital regulation. Continental European countries have traditionally relied on an intricate doctrinal system based on minimum capital and capital maintenance provisions that was enforced with a varying degree of seriousness. In both cases, the national legislation was intended to prevent a circumvention of minimum capital by using an English form of business organization that was not subject to the Second Directive. In both cases, the intention was to shield an ex ante creditor protection system from circumvention. While there are many, probably the overwhelming arguments against legal capital, the court avoided a deep policy discussion and, in a rather simplistic manner, applied the test it developed for the freedom of establishment to corporate law. In applying its criteria, the court inevitably engaged in a superficial policy analysis, and, in doing so, made a number of assumptions that are at least debatable, mainly regarding the abilities of creditors to protect themselves.

So far, no case has clarified what kind of credit protection mechanisms would pass muster under the court’s test. However, it appears that the vision toward which the court has thus nudged the Member States is characterized by two elements. First, creditors (and possibly other parties) interacting with a firm cannot, as a first approximation, expect uniform protection that applies to an entire set of companies. They are thus expected to rely on information they receive and to process it accordingly. Second, the court has pushed Member States from an ex ante to an ex post approach that to a large extent corresponds to the distinction between rules and standards. It is thought that the court would not object to measures imposed ex post in an individualized fashion, such as criminal penalties or veil piercing, or possibly bankruptcy doctrines holding directors liable by continuing to operate a company putting creditors further at risk.

Nevertheless, in the end the impact of Centros has been relatively small. Full-scale regulatory competition has not arrived in Europe, in part—as several scholars predicted in the early 2000s—because no Member State developed strong incentives to provide a “popular” legal form for the entire union. The main accomplishment of regulatory competition at this point is the erosion of legal capital, or more precisely minimum capital, as other elements of the legal capital system have remained largely in place. While this is an important issue for small, typically newly founded firms, it is largely irrelevant for the large firms that are the primary subject of the convergence debate. However, it is indeed an element of a larger trend in corporate law as well as in other fields that reflects Anglo-Saxon modes of business regulation more than Continental European ones.

The full paper is available for download here.