Can the choice of place of incorporation constitute an abuse of the corporate form? The case law of the Court of Justice of the European Union (CJEU) is telling for it spells out the Court’s understanding that, despite the freedom to establish in the other EU Member States that companies enjoy, the CJEU can take some measures against ‘abuse’ in choice of incorporation. However, applying measures against abuse-based choice of incorporation is rather challenging. To explain those challenges, one can jump-start with the analysis of the term abuse. One possible way of defining it is to describe abuse as ‘a situation where someone employs a legal entitlement to gain advantage. In doing so, this person follows the letter of the law, but not its spirit. In other words, the legal entitlement is used not for the purpose for which it was intended’. The other challenging issue is to understand why the choice of incorporation may be considered abusive if such choice stems from a legal entitlement that EU corporate law generally gives to corporations.
The Member States of the EU are bound together through a certain level of comity and some degree of mutual ‘faith and credit’ in each other's legal systems, which has informed EU law and the case law of the CJEU. Member States have often imposed restrictions on the choice of incorporation, which were meant to shield them against regulatory arbitrage. However, in this context, it is difficult to define the free choice to incorporate in another Member State as abusive. In a recent chapter titled ‘Abuse of Company through Choice of Incorporation?’ in Abuse of Companies 13-33 (H Birkmose et al. eds., Wolters Kluwer 2019), we explore this difficulty in the context of two scenarios. First, we highlight cross-border incorporations of private limited companies and look at the systemic consequences of a line of judicial decisions that started with Centros and compare them to regulatory competition and the role of ‘pseudo-foreign incorporation statutes’ or long-arm statutes in the United States (US). Second, we look at cross-border mergers, comparing them with ‘reverse mergers' in the US, a phenomenon that some scholars and practitioners have considered problematic and that allows an ex post choice of jurisdiction for established corporations.
While the number of firms incorporating beyond borders has remained relatively small, the changes propelled by the case law of the CJEU had a systemic effect. In cases like Centros, Inspire Art and Überseering, the CJEU was widely understood to invalidate Member States’ attempts to apply the ‘real seat theory’ to corporations from other EU and European Economic Area (EEA) countries, thus ushering in an era of regulatory competition. While rejecting the harsh consequences of the real seat theory, the CJEU did not create a mechanism clarifying when the incorporation of companies in other member states constitutes abuse. To the contrary, the CJEU’s case law contributed to the development of regulatory arbitrage in Europe.
The response of the Member States to the CJEU case law boiled down to measures meant to protect them against the effects of regulatory competition and help them retain control over corporate law within their territory. The literature has identified two types of measures: ‘defensive regulatory competition’ and ‘insolvensification’. Defensive regulatory competition refers to the elimination or reduction of features making domestic firms unattractive to founders. The second strategy—insolvensification—refers to the attempt to transfer creditor protection doctrines out of the ambit of the firm’s place of incorporation, and into the European Insolvency Regulation’s ‘Center of Main Interest’ criterion that is at least not explicitly subject to free choice. Insolvencification translates into rather sophisticated creditors triggering ex post protective mechanisms such as veil piercing, criminal penalties, and bankruptcy doctrines holding managers and shareholders liable for trading in insolvency.
Centros opened Europe to the phenomenon of regulatory arbitrage. However, in the US, regulatory arbitrage has been a reality for publicly traded firms and privately held firms for more than a century. In the US, the internal affairs rule triggered a classic debate about the merits and demerits of regulatory competition. Under the internal affairs rule, the law of the state of incorporation governs the relationships between the corporation and its directors, managers, and shareholders. The regulation of the internal affairs of the corporation by the law of the state of incorporation allows firms and their shareholders to choose the state that best suits their needs. The debate that has grown around regulatory competition yields two doctrinal factions that contradictorily claim that regulatory competition leads to a ‘race to the top’ or a ‘race to the bottom’. In the context of this debate, abuse has not been advanced in the US as a possible remedy. Abuse has not been considered even when the discussion about the reasons leading founders to choose Delaware as a jurisdiction for incorporation overwhelmingly has been heated. Other mechanisms can be used to circumvent the fact that abuse is not part of the general vocabulary of the American debate. Veil piercing, long-arm statutes that apply certain aspects of the state’s corporate law to corporations from outside the state, but with a qualifying connection to it, and bankruptcy law (that is federal law and thus applicable to all states) have been giving courts some leeway to create remedies ex post.
There are other instances where a general remedy for the abuse of the corporate form by choice of incorporation could be justifiable. The operational developments inherent to cross-border mergers, including reverse mergers, can be telling. The EU Directive on Cross-Border Mergers (CBM Directive) regulates this type of operations. Theoretically, the cross-border merger can be used to evade employee participation, to harm creditors by subjecting them to a less favorable corporate law, or to move the company to a different ‘Center of Main Interest’ to apply a different insolvency law, or to change the relationship between the corporation and its shareholders or to implement intra-group restructurings. However, the CBM Directive provides a negotiation mechanism designed to preserve employee participation, analogous to the one implemented for the process of forming a European Company. The former (Third) Company Law Directive—now part of the Consolidated Company Law Directive—establishes safeguards that either allow a creditor to veto the merger, be paid off or request security.
Furthermore, even though the Member States cannot discriminate between domestic and cross-border mergers, they may introduce additional protections for minority shareholders that opposed the cross-border transaction. Some Member States have therefore introduced special withdrawal rights. In the face of these measures, the doctrine of abuse of corporation by choice of incorporation seems to be far-reaching and redundant.
We explore these issues more extensively in our chapter.
Lécia Vicente is Assistant Professor of Law at Louisiana State University Paul M. Hebert Law Center.
Martin Gelter is an Associate Professor of Law at Fordham University.