Centros, a landmark 1999 decision by the European Court of Justice (now Court of Justice of the European Union or CJEU), has profoundly transformed European company law. Previously, many EU member states used the “real seat theory” to hinder regulatory arbitrage. Under this theory, a company had to incorporate pursuant to the procedures of the jurisdiction where its administrative center was located. For example, for a firm with its headquarters in Germany to acquire full legal status in the eyes of German courts, it had to be formed under German law. The theory was not aimed at protecting creditors or shareholders but rather a country’s authority to determine the law of businesses operating within its borders. The real seat theory compelled founders to select the law of the real seat jurisdiction, thus protecting that jurisdiction from competition.
All of this changed after Centros. The case involved Danish founders who had formed a private limited company (“Limited”) in the UK – intending to use it only to do business in Denmark – and requested that the Danish authorities register a branch office. After the registration was denied and a preliminary reference submitted to the ECJ, the court found that the Danish authorities had violated the freedom of establishment enshrined in primary EU law. The court followed Centros in Überseering (2001), where it ruled that Germany was required to recognize the legal status of a corporation that had been set up in the Netherlands but acquired by German owners, who shifted all of its activities to Germany. The court again followed Centros in Inspire Art (2003), ruling that the Dutch act on “formally foreign companies,” which imposed certain restrictions and liabilities on pseudo-foreign corporations and resembled pseudo-foreign incorporation statutes in New York and California, also violated the freedom of establishment.
While so far failing to prompt regulatory competition among jurisdictions for publicly traded companies, Centros and its progeny have had at least two consequences. First, the discourse about EU company law and national corporate law systems has become more international. While the CJEU case law was not the only factor in this development, it likely contributed. Second, some member states have adjusted their laws to mitigate the effects of Centros. In a recent article in the European Business Organization Law Review, I explore “defensive regulatory competition,” the attempt by certain member states to stop the flow of incorporations to other member states by modifying the law.
While the debate on regulatory competition in the United States focuses mainly on publicly traded firms, in light of the practical impact of the case law, the European debate has turned to regulatory arbitrage opportunities for newly founded privately held firms. In the U.S., there is some debate on whether states have an incentive to attract closely held corporations and LLCs. But initiatives of this type may not always be easy to distinguish from the objective of creating a business-friendly environment. On the demand side, the empirical literature seems to be divided as to whether differences in legal doctrine drive corporations’ choices of where to incorporate or whether the general business environment, the role of the Delaware courts, or the prestige of the Delaware brand is the most important factor.
In Europe, it seems quite clear that no jurisdiction is actively attempting to become the European Delaware, either for publicly traded businesses or privately held firms. The UK became the destination of many continental European founders in the mid-2000s, but it never actively sought to attract such incorporations and did not have the incentives to do so. However, founders began to cross borders to take advantage of simpler incorporation procedures and, in particular, the absence of a requirement in a number of jurisdictions, including the UK, that private limited liability companies have a minimum amount of capital. An additional factor may have been the absence of regulatory arbitrage opportunities in the past: Differences in minimum capital requirements are easier to detect than differences in doctrines or statutes relating to directors’ and members’ liability risks. Moreover, the key issue is costs at the firm formation stage, not later liability risks. While the former affect every firm, the latter are hard to predict and will likely affect only some firms.
In the past 15 years, Europe has seen a trend among member states to facilitate firm formation and to reduce minimum capital requirements. Some reforms have been characterized as “defensive regulatory competition.” If member states do not seek to attract firms, they may still try to prevent firms from leaving. There are various possible motivations. First, policy makers may truly think it is important for their member state to retain control over the large bulk of corporations operating in its territory. Second, lawyers may be concerned about losing business to their peers in other member states. Third, changes in the law have occurred for unrelated reasons. For example, minimum capital requirements negatively affect a country’s ranking in the World Bank’s Doing Business Index.
All of this raises a number of empirical research questions, and my article looks at some of them. One question, for example, is whether cross-country incorporation is important from a quantitative perspective. Arguably, in most countries it remains a fringe issue. Only in a few countries and in a few years did the number of firm formations in the UK of this type exceed 5 percent of the total. Second, has “defensive regulatory competition” affected the number of Centros-type firm formations? My paper reports difference-in-differences regressions to compare and test the impact of two reforms. The first is Germany’s MoMiG of 2008, which included a package of reforms and created the UG (haftungsbeschränkt) variation of the German GmbH. The second is a change in Belgian law introducing the SPRL-starter in 2010 (which has recently been made redundant by Belgian’s abandonment of the legal capital system for the SPRL/BV). The German reform, whose effectiveness has been subject to some debate, appears to have had a modest impact. It likely strengthened a trend among German founders away from the English private limited company.
This post comes to us from Professor Martin Gelter at Fordham University School of Law. It is based on his recent article, “Centros and Defensive Regulatory Competition: Some Thoughts and a Glimpse at the Data,” available here.