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The Future of Creditor Protection through Capital Maintenance

Rules in European Company Law An Economic Perspective


Christoph Kuhner*

Accounting-based profit distribution restrictions have been a key issue of the

EUs company law harmonisation efforts. At present, the concept of creditor pro-
tection via maintenance of a minimum level of nominal capital is challenged in
several respects: (i) With its recent rulings, the European Court of Justice has intro-
duced corporate charter competition: Thus, domestic capital maintenance rules can
no longer be enforced for all domestic limited liability companies. (ii) The move of
EU accounting Harmonisation towards IAS/IFRS challenges the effectiveness of
accounting-based creditor protection because the regulation of profit distribution
is not an objective of the IAS/IFRS. (iii) Ongoing discussion focuses on abolishing
capital maintenance rules in order to render EU company law more flexible. In
this context, the paper provides an economic analysis, comparing the costs and
benefits of accounting-based profit distribution to those of alternative rules, nota-
bly the solvency test. Efficiency of creditor protection rules is addressed as a prob-
lem of optimal precision of legal standards.

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

* Professor of Financial Accounting and Auditing, Faculty of Economics, Business

Administration and Social Sciences, University of Cologne.

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342 Christoph Kuhner

VI. The alternative: ex post regulation of profit distribution . . . . . . . 355

VII. Different corporate law institutions of creditor protection as a pheno-
menon of path dependency . . . . . . . . . . . . . . . . . . . . . . . 359
VIII. The empirical evidence . . . . . . . . . . . . . . . . . . . . . . . . . . 361
IX. Synthesis and summary . . . . . . . . . . . . . . . . . . . . . . . . . 363

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

1 European Court of Justice, judgment of 30 September 2003, case C-167/01 Inspire

Art, also refer to: Eidenmller & Rehm: Niederlassungsfreiheit vs. Schutz des
inlndischen Rechtsverkehrs: Konturen des Europischen Internationalen Gesell-
schaftsrechts, ZGR 2004, 159188, veering toward the same result: European Court of
Justice, judgment of 5th November 2002, case C-208/00 berseering.
2 Regulation (EC) No 1606/2002 of the European Parliament and of the Council of
19 July 2002 on the application of international accounting standards, Art. 5 requires
listed companies to compile their consolidated statements in accordance with IFRS.
Increasing significance of IFRS at the level of individual accounts is likely to be ex-
pected. In this context see: Ferran, The Place for Creditor Protection on the Agenda
of Modernisation of Company Law in the European Union, ECGI-Working Paper,
51/2005, Oct. 2005, 1624.
3 See esp.: Corporate governance Report of the High Level Group of Company Law
Experts on a Modern Regulatory Framework for Company Law in Europe, Brussels

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The Future of Creditor Protection 343

Capital maintenance through profit distribution restrictions is thus a most con-

troversial issue in the academic discussion: Whereas some decades ago a German
scholar praised capital maintenance as an outstanding cultural achievement of
modern society,4 authors in the intellectual tradition of the law and economics
school condemn capital maintenance rules of the continental European fashion as
inefficient regulation maintained by rent seeking interest groups 5:
We believe, that certain interest groups with more influence in Europe than in the
United States benefit significantly from the legal capital rules, despite their ineffi-
ciency. () Two other interest groups that clearly benefit () are accountants ()
and lawyers (who must guide through the labyrinth of needlessly complicated legal
capital rules). () Furthermore, most European corporate lawyers have invested
significant human capital in becoming familiar with the legal capital rules. Repealing
these rules would destroy the value of that human capital. 6

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.

II. The embodiment of capital maintenance in European Company Law

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, ( 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

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344 Christoph Kuhner

to prevent competition between members for attracting businesses the sense of

a race to the bottom which would result in a general attenuation of the charter-
ed protection level.8 Traditionally, within that process of harmonisation, the
predominant concept was the principle of nominal capital maintenance for
public companies. This concept has been formative for shaping a number of EU
Directives that have come into force during the last three decades.9 However, the
concept of capital maintenance in corporate law has not initially been designed by
EU rulemakers, but reflects the sophisticated doctrines of capital maintenance in
individual member states, especially in Germany.
The second EU Directive envisions a minimum level of nominal capital, initi-
ally paid in by the shareholders, which acts as a floor for determining the legiti-
macy of subsequent cash distributions: Distributions are legitimate only if they
do not result in a level of nominal capital lower than the floor. That means, only
the profit of the current year and retained earnings from previous years may be
paid out to shareholders in a going-concern business (Art. 15 (1) lit. (c), 2nd EU
Directive). Capital maintenance particularly consists of three areas of regulation:
(i) Raising of subscribed capital: The establishment of an incorporated public
company requires a minimum nominal capital of 25.000 EUR according
to Art. 6 (1). Article 4 requires subscribers of capital to bring in assets of
measureable value; services or manpower are not eligible for crediting against
the minimum capital requirement. Business activity may not commence be-
fore 25 % of subscribed capital have actually been paid in (Art. 9 (1)); 100 %
of the subscribed capital must be paid in within 5 years of commencement of
business as far as it consists of non-cash assets. Tangible assets are only ac-
cepted if their value has been certified by an independent expert or by a pub-
lic authority in a separate report (Art. 10 (1)). This report is required to meet
the requisites listed in article 10. If the corporation acquires assets from sha-
reholders which amount to 10 % or more of its subscribed capital, a formal
report of similar type is required. According to Art. 8, it is generally prohibit-

throughout the Community () Art. 44 Abs. 2 g) Treaty Establishing the European

8 See Corporate governance Report of the High Level Group of Company Law Experts
on a Modern Regulatory Framework for Company Law in Europe, Brussels 2002, 29;
related to the history of harmonisation efforts of the EU: Wouters: European Com-
pany Law: Quo Vadis?, 37 Common Market Law Review 257 (2000), 268. A differen-
tiating view on the separate phases of EU harmonisation consider the short elabora-
tion of Deakin, Regulatory Competition vs. Harmonisation in European Company
Law, ERSC Centre of Business Research, University of Cambridge, Working Paper
No. 163 (2000), p. 49.
9 See esp.: Second Council Directive of 13 December 1976 (77/91/EEC) and subsequent
directives, esp. Fourth Council Directive of 25 July 1978 based on Article 54 (3) (g) of
the Treaty on the annual accounts of certain types of companies (78/660/EEC).

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The Future of Creditor Protection 345

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.

III. Capital maintenance regulation and the contractual freedom model

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).

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346 Christoph Kuhner

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
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.

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The Future of Creditor Protection 347

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.

IV. Capital maintenance as a remedy against precontractual and postcontractual

information asymmetries

1. Adverse selection effects

The relationship between creditors and borrowers involves a natural asym-

metry of precontractual information concerning the debtors ability to pay which
cannot completely be overcome by spontaneous signalling or screening activity.
Mandatory disclosure of creditor-relevant information is the main instrument to
eliminate pre-contractual information asymmetries. A combination of compul-
sory restrictions to cash distributions and the (upwardly) non-restricted choice of
a minimum level of nominal capital may be a further, promising option to van-
quish pre-contractual information asymmetries. Companies that pay due atten-
tion to solid financial conduct will have the option to choose a high level of mini-
mum nominal capital which will in turn serve as a signal of solidity towards the
market. Companies that pay little attention to financial stability or that invest in
high-risk projects are likely to refrain from taking this costly measure. Whether
this signalling mechanism is an efficient tool to attenuate the outlined adverse
selection phenomena is an empirical question.

16 For a comprehensive analysis of the collective action problem see e.g. Jackson, The
logic and limits of bankruptcy law (1986, reprint 2001).

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348 Christoph Kuhner

Up to now, the empirical evidence is at least to say mixed. Some authors

emphasise the marginal, sometimes even negligible relevance of nominal capital
measures for borrowing decisions.17 Other studies point at the fact that many
companies operating in a capital maintenance jurisdiction indeed choose a level of
nominal capital much higher than the minimum amount defined by law. This be-
haviour might indicate that the signalling mechanism described above is in fact
adopted by companies.18 However, the overall empirical evidence related to the
signalling hypothesis is ambiguous and does not allow to draw positive implica-
tions related to the effectiveness of a legal capital maintenance framework.

2. Capital maintenance rules as an instrument for creditor protection in an

environment of post-contractual asymmetric information

From a viewpoint of institutional economics, the principal objective of ac-

counting-based capital maintenance rules is to regulate the corporate debtors be-
haviour in an environment of post-contractual information asymmetries. Their
options for actions can only imperfectly be restricted by specific terms and claus-
es in contractual arrangements, because they are, to a large extent, not observable
by the counterparty. And even if they are observable, noncompliances might not
be verifiable by a court, which means that it is not possible to enforce contractual
sanctions if they are observed. In the literature on moral hazard in post-contrac-
tual debtor/creditor relationships, certain typical patterns of debtors moral
hazard behaviour have been identified 19:
(i) Cash in and run
(ii) Undue delay in bankruptcy proceedings
(iii) Gambling for resurrection
(iv) Enhancement of incumbent creditors risk by increased debt raising

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.

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The Future of Creditor Protection 349

a) Cash in and run

This type of debtors moral hazard behaviour in a post-contractual context

means that he simply takes the cash raised by the credit contract and runs away.
However, this is only a metaphor for a well-known behaviour pattern of owners
of a limited liability company who will have incentives to withdraw cash from the
limited liability debtor entity, even when these cash withdrawals cannot be justi-
fied on the grounds of the companys business model and the explicit and implicit
expectations of creditors. In a going concern business the cash in and run-phe-
nomenon implies the well known underinvestment problem: 20 In such a situa-
tion, owners will have no incentive to reinvest surplus cash flows from debt
financed projects in positive present value-projects. In contrast, they will be in-
clined to appropriate these cash flows even if the position of creditors will be
deteriorated by the cash withdrawal. Incentives to cash in and run increase with
rising leverage, long-term financing and volatility of operating cash flow.
The most significant objective of profit distribution restrictions via capital
maintenance rules aims at solving this underinvestment problem in a heuristic
fashion: Distributions to owners are limited to the total amount of accounting
profits of the present period and retained earnings accumulated in prior periods.
In contrast to cash flow figures, accounting profits provide for the maintenance
of invested capital stock by including accruals like depreciation and amortisation
expenses and provisions for future losses. Economically, depreciation and amor-
tisation expenses, e.g., reflect necessary deductions from free cash flow in order to
generate a basis for profit distribution purposes. As these deductions represent
capital expenditures necessary for replacement investments in assets that have a
limited economic life, i.e to safeguard capital maintenance, underinvestment is
prohibited. This elementary result can be illustrated even in fairly simple model
settings. Most of the traditional accounting principles can be reconstructed on the
grounds of the capital maintenance restriction.21 In this context, the profit realisa-
tion principle 22 and the principle of loss anticipation 23 should be mentioned.24
20 See Wagenhofer/Ewert, Externe Unternehmensrechnung, 2003, 155f. (reference is
made to Myers, 5 J. Fin. Economics vol. 1977, 147175).
21 On this argument see in detail Kuhner, Maintaining economic stability as a motive
for statutory accounting requirements, 6 European Accounting Review 733 (1997).
22 The realisation principle is codified in EU company law, see Art. 31 (1) c) aa) Fourth
Council Directive 78/660/EEC of 25 July 1978: () only profits made at the
balance sheet date may be included ().
23 See especially: Art. 31 (1) c) bb) Fourth Council Directive 78/660/EEC of 25 July
24 For an analysis of this background see Leuz, Rechnungslegung und Kreditfinan-
zierung Zum Zusammenhang von Ausschttungsbegrenzung, bilanzieller Ge-
winnermittlung und vorsichtiger Rechnungslegung, 1996, also: Leuz, The role of
accrual accounting in restricting dividends to shareholders, 7 European Accounting
Review 579 (1998).

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350 Christoph Kuhner

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.

b) Undue delay in bankruptcy proceedings

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.

c) Gambling for resurrection

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-

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The Future of Creditor Protection 351

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-
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

vides Fleischer, Erweiterte Auenhaftung der Organmitglieder im Europischen

Gesellschafts- und Kapitalmarktrecht Insolvenzverschleppung, fehlerhafte Kapi-
talmarktinformation, Ttigkeitsverbote , ZGR 2004, 437, 446f.
27 For a pioneering analysis see Kalay, Shareholder-Bondholder Conflict and Divident
Constraints, 10 Journal of Financial Economics, 211 (1982).
28 See Wagenhofer/Ewert, Externe Unternehmensrechnung, (2003), 181.
29 Wagenhofer/Ewert, Externe Unternehmensrechnung, (2003), 181, assume a
default probability of 50 %.
30 Ewert/Wagenhofer, Externe Unternehmensrechnung, 2003, 608, stress the effec-
tivity of financial investments, i.e., eventually, derivative transactions on complete
capital markets. The notion of investment is, in that respect, misleading in so far
derivative transactions are characterised by a very small amount of initially invested
money. See also Rammert, Lohnt die Erhaltung der Kapitalerhaltung? Betriebswirt-
schaftliche Forschung und Praxis 2004, 578, 581 f.
31 Such concepts in British and US company law are discussed in Fleischer, ZGR
2004, n 26, 447450. With respect to German law, it can be assumed that the new

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352 Christoph Kuhner

d) Increasing incumbent creditors risk by post-contractual debt raising

Similar to their role in the presence of overinvestment incentives, capital

maintenance rules are not designed to prevent corporate owners from post-con-
tractual financial risk enhancement by debt raising. However, the non-existence
of profit distribution restrictions might encourage managers to raise more debt in
order to provide liquidity for the payout. The ultimate prevention or restriction
of post contractual debt raising should be the task of private contractual arrange-
ments between debtors and creditors, including financial covenants.

3. Conclusion

The conclusion of our conceptual analysis of the effectiveness of capital main-

tenance rules for creditor protection is weakly positive: Far from being a univer-
sal remedy, these rules, from a conceptual viewpoint, provide a viable means to
prevent underinvestment by corporate owners in a post-contractual moral-
hazard setting. With respect to the other typical behaviour patterns of debtors
moral hazard, their contribution to conflict solution is poor or even non-existent;
on the other hand, it cannot be expected that they aggravate debtor-creditor con-
flicts of the above mentioned types see 2b)d).

V. The case against profit distribution via capital maintenance rules

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;

concept of Haftung fr existenzvernichtende Eingriffe (liability for intrusions

destroying the economical basis) also covers cases of gambling for resurrection. See
esp. BGHZ 149, 10, 16f. = WM 2001, 2062 (Bremer Vulkan); see e.g. Lombardo/
Wunderlich, ber den konomischen Sinn und Unsinn eines Haftungsdurchgriffs
im Recht der Kapitalgesellschaften, contribution to IX. Symposium zur konomi-
schen Analyse des Rechts: Sozialschutz oder Marktrationalitt Von einem Paradig-
menwechsel im Zivilrecht?, Travemuende, 2427 March 2004, 12, esp. 2026.

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The Future of Creditor Protection 353

(iv) High transaction costs due to the complexity of the capital maintenance
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
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-

32 For alternative concepts of capital maintenance and a concept of interpreting nomi-

nal capital as a figure with economic substance see Krmmel, Pagatorisches Prinzip
und nominelle Kapitalerhaltung, in: Moxter/Mller/Windmller/Wysocki (eds.),
Rechnungslegung. Festschrift fr Karl-Heinz Forster (1992), 307320.
33 Related to the following aspects see also: Mlbert/Birke, European Business
Organization L. Rev., (n 18), 721 f., and for a short list of points of criticism: Schn,
Editorial, ZHR 2000, 1, 2.
34 See Enriques/Macey, Cornell Law Review, vol. 86 (2001) (n 6), 1197 regarding
Art. 23, of the second 2. Directive of the EU.
35 See Enriques/Macey, Cornell Law Review, vol. 86 (2001) (n 6), 1199.
36 See Enriques/Macey, Cornell Law Review, vol. 86 (2001) (n 6), 1196f.

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354 Christoph Kuhner

tions financial perspectives.37 Particularly, in environments of systemic crises,

this mechanism might be used as a white flag.38
Finally, critics of the continental type capital maintenance system emphasise
the high complexity of some of the rules being part of the system. High com-
plexity results in high transaction cost to be incurred by the corporations subject
to the capital maintenance regime, but also by society through the maintenance of
an appropriate legal infrastructure.39

2. Implications for future reforms

The main objective of capital maintenance regulation in the second EU Direc-

tive is to ensure that cash and assets once brought into the corporation can only
be redistributed to shareholders upon compliance with the restrictive require-
ments of a capital reduction. Dividend payments are limited to the nominal
amount of retained earnings and profits of the reporting period. It has been
shown that this framework is generally capable of curtailing the problem of
underinvestment. On the other hand, the framework of capital maintenance in
corporate law does not distinguish between the different risk profiles of com-
panies and thus can be described as a rather ponderous device. In addition, capital
maintenance rules are stringent and rigorous, resulting in restraints on the flexi-
bility of companies to reorganise their capital structure with regard to their
specific needs.
In order to remedy this drawback of the traditional capital maintenance
framework, some suggestions have been made with a view to render it more
flexible: 40 The shareholders might be given unlimited discretion over the level of
nominal capital that would subsequently be safeguarded against disbursement.
This option would result in abolishing the general rule that investments by share-
holders cannot be subject to dividend distribution during the going-concern pe-

37 See for a summary of the discussion: Brealey/Myers (n 19) 438447.

38 Apparently, it was successfully practised by certain enterprises to signal financial
health during the stock market crash in October 1987. See Kbler, Rules of Capital
Under Pressure of the Securities Markets, Hopt/Wymeersch (ed.), Capital Markets
and Company Law (2003), 95143, 102.
39 See esp. Enriques/Macey, Cornell Law Review, vol. 86 (2001) (n 6), 1184f. The
complexity of capital maintenance rules in corporate law has been also criticised by
German scholars. Merkt, for instance, mentions the exaggeration of elaborateness
where the excess cannot be legitimated by the purpose of creditor protection.
Merkt, Der Kapitalschutz in Europa ein rocher de bronze?, ZGR 2004, 305, 311.
In particular, the large body of jurisdiction established in order to prohibit evasion of
the capital maintenance regime by structured transactions is frequently criticized on
the grounds of its extremely high complexity.
40 Consider Schn, Die Zukunft der Kapitalaufbringung/-erhaltung, Der Konzern
165 (2004); also: Schn, The Future of Legal Capital, 5 EBOR 429 (2004).

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The Future of Creditor Protection 355

riod of a business: In particular, reserves in excess of par could be distributed to

the shareholders without that a reduction of capital would be necessary. From a
contractual viewpoint, such a commitment represents a bid 41 made towards the
collectivity of all potential creditors (collective guarantee) 42 and therefore
might be apt to solve the collective action problems inherent in single creditors
monitoring. At the same time, shareholders perfect discretion to opt for the level
of nominal capital could, presumably, revitalise the signalling mechanism out-
lined above.43
In such a regime, creditor protection would consequently be treated as a func-
tion separate from other functions of the capital maintenance regime: 44 New cash
or other assets could be brought in without a formal increase of the nominal capi-
tal, and redistribution of funds or assets would also be possible without a formal
reduction of capital, as long as the remaining level of reserves would exceed the
statutory minimum level of nominal capital, which would act as a reassurance of
financial stability for the creditors. A prerequisite for such an amendment is the
introduction of genuine no-par shares.45
A further option for more flexibility would be the legal permission to
repurchase more treasury stock, which is currently limited to 10 % of the sub-
scribed capital. From the viewpoint of creditor protection, such an amendment
would be in line with the traditional capital maintenance system as long as share
repurchases are funded by profit reserves.46

VI. The alternative: ex post regulation of profit distribution

Regulating distributions to owners through accounting rules of profit deter-

mination can be classified as a sort of ex ante regulation: Legitimacy of a certain
distribution is determined ex ante, i.e. without primary regard to the corporate
solvability after the distribution has taken place. Alternatively, the legitimacy can

41 Schn, Der Konzern 2004 (n 40), 166.

42 Ferran (2005), (n 2), 11.
43 See chapter IV.1. (above).
44 The important function of the capital maintenance regime with respect to the clarifi-
cation of legal inter-shareholder relationships, determined by their share of the sub-
scribed capital, is not subject of this paper.
45 Schn, Der Konzern 2004 (n 40), 170, in conjunction with Corporate governance
Report of the High Level Group of Company Law Experts on a Modern Regulatory
Framework for Company Law in Europe, Brussels 2002, 8990.
46 Vgl. Schn, Der Konzern 2004 (n 40), 170, in conjunction with Corporate govern-
ance Report of the High Level Group of Company Law Experts on a Modern
Regulatory Framework for Company Law in Europe, Brussels 2002, 89 f. This con-
cept is subject-matter of an intended amendment to the Second Company Law
Directive. See

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356 Christoph Kuhner

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
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),

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The Future of Creditor Protection 357

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

54 See Kuhner/Sabiwalsky, Instrumente zur Verhinderung glubigerbeschdigen-

der Ausschttungen im US-amerikanischen Unternehmensrecht Vorbild fr
Europa? , Der Konzern 2006, forthcoming.
55 Rickford, EBLR 2004, (n 3), p. 980.
56 See Rickford, EBLR 2004, (n 3), 974, who points at the role of business judgment
related to solvency tests.

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358 Christoph Kuhner

Imprecision of standards has for consequence comparatively more degrees of

freedom for management in drafting the prospective cash flow statement. On the
other hand, imprecise standards give rise to a broader range of potential outcomes
of litigation, respectively: Ex ante, it will be more difficult for management to
anticipate whether a certain distribution decision will be accepted by courts on
the grounds of the underlying assumptions of the forecast. In contradiction to
widespread prejudices, distribution rules based on solvency tests therefore do not
necessarily lead to a lower level of creditor protection.57 Assuming a game-theo-
retic scenario which involves as players managements and courts, and assuming
risk averse behaviour by managers, it can be easily proved that managers will be
more reluctant towards distributions potentially threatening the solvency of the
company in a framework of imprecise standards than in a framework of precise
standards governing the respective judgments of courts.58 From a conceptual
viewpoint, therefore, solvency tests may be at least as well suited for creditors
protection as capital maintenance rules are.59
However, the real evidence on enforcement of solvency-based creditors pro-
tection in common law jurisdictions is very sparse and very vague.60 Apparently,
courts only very rarely draft decisions concerning the viability of a solvency test.
Considering the prevailing observations on law suits and decisions, it is not at all
straightforward that the solvency test requirement really is a powerful tool for
the enforcement of debtors well behaviour.
In the evolving landscape of corporate law competition in the EU, the ques-
tion where the jurisdictional competence of approving the viability of the sol-
vency test is actually located will be of crucial importance: Assuming the com-
mon law character of the solvency rule, the competence to evaluate solvency tests
will be with the jurisdictions in which corporate activities actually take place, i.e.
the jurisdiction in which the administrative seat of the corporation is actually
located, without regard to the corporate charter affiliation of the company.61 Sol-

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

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The Future of Creditor Protection 359

vency testing will therefore be subject of national insolvency jurisdiction and

legislation. As a consequence, it is hard to anticipate which way a solvency juris-
diction based on imprecise standards will take in an environment of statutory law
of the continental European fashion.

VII. Different corporate law institutions of creditor protection as a phenomenon

of path dependency

Criticism by anglo-american authors concerning corporate law capital main-

tenance rules is, on the one hand, based on the above mentioned (and modified)
hypothesis emphasizing the lack of necessity to protect creditors by law and
regulation. On the other hand, the persisting system of capital maintenance rules
is suspected to work inefficiently. As a consequence, the abolishment of balance
sheet oriented capital maintenance rules in corporate law is postulated.62 In this
context, it is argued frequently that, in the U.S., a similar evolution away from
legal capital rules which were wide-spread in the states corporate law has taken
place in the past decades.63 Nowadays, they are virtually of no importance.
However, the counterargument goes that the evolution of corporate law in
the U.S. cannot be regarded generally as a paradigmatic move towards a more
efficient state of the world but, more specifically, has been subject to path-depen-
dency: Specific to the evolution of corporate law in the U.S. is the observation
that courts did not perform serious attempts to enforce capital maintenance rules
effectively 64 and that, in consequence, a significant body of case law on capital
maintenance did not develop.65 The decline of balance sheet oriented capital
maintenance can be seen as a logical response to these specific circumstances. The
shape of corporate law institutions in contemporary U.S. law is, therefore, not
presumed to reflect a higher evolutionary level compared to continental Europe
but, instead, a different evolutionary path.66

Scheinauslandsgesellschaften, Der Betrieb 2004, 10831089 argue for a purely

domestic responsibility of courts with respect to creditor protection.
62 See esp. Enriques/Macey, Cornell Law Review, vol. 86 (2001) (n 6), 1203.
63 See Mlbert/Birke, European Business Organization L. Rev., (n 18) 697698.
64 See Andrieux, Capital Social et Protection des Cranciers. Approche Comparative
France/Etats-Unis, 2 Global Jurist Topics vol. 2002, esp. 2327; Eidenmller/
Engert, Die angemessene Hhe des Grundkapitals der Aktiengesellschaft, Die Ak-
tiengesellschaft 2005, 97, 105.
65 See. Wstemann, Institutionenkonomik und internationale Rechnungslegungs-
ordnungen, 2002, 5154; emphasizing this argument based on the fact that US courts
traditionally did refrain from drafting interpretations on financial accounting rules.
66 For a comprehensive analysis of the phenomenon of path-dependency in corporate
law: Heine, Regulierungswettbewerb in Gesellschaftsrecht, 2003, 194231. See also
(from a corporate governance perspective): Bebchuk/Roe, A Theory of Path De-
pendence in Corporate Ownership and Governance, 52 Stanford Law Review, 127

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360 Christoph Kuhner

It is striking to observe how strongly path dependent evolution of legal insti-

tutions influences the normative perspective of accounting academia in Germany
and in the U.S., respectively. In Germany, a most influential strand of accounting
scholarship traditionally argues that by far the most important if not exclusive
function of balance sheet and profit & loss account which can be supported on
economic grounds is profit distribution,67 whereas provision of decision useful
information on future cash flows is regarded as a task which by nature cannot be
fulfilled adequately by these accounting instruments, but only by instruments of
prospective cash flow statements.68 The main-stream normative perspective of the
anglo-american profession and academia directly maintains the opposite view-
point: Balance sheet-based profit distribution rules are rejected on the grounds of
their inflexibility and ineffectivity in favour of solvency testing based on prospec-
tive cash flow statements; the role of the balance sheet and the profit and loss
account as providers of decision useful information to investors and creditors,
however, is emphasised.69
From this puzzling evidence we conclude that there may not exist one univer-
sal role of accounting instruments for all epochs and for all environments. Poten-
tially the specific characteristics of an economic system in their entirety deter-
mine whether highly verifiable accounting standards are the superior instrument
for restricting profit distributions. This hypothesis might apply for the rather sta-
ble financial environment in post-war Germany, however it might not apply else-
where, for instance in the disruptive development of the capital market in the US
during the last two decades.70 Finally, the evolution of legal frameworks is subject
to path-dependency and, therefore, does not necessarily converge towards a
global optimum.

(1999); Schmidt/G. Spindler, Path Dependence, Corporate Governance and Com-

plementarity A Comment on Bebchuk and Roe, 5 International Finance 311
67 See for instance Moxter, Grundstze ordnungsgemer Rechnungslegung, Dssel-
dorf 2003, 21f.; Sttzel, Bemerkungen zur Bilanztheorie, ZfB 1967, 314340;
Streim/Bieker/Leippe, Anmerkung zur theoretischen Fundierung der Rechnungs-
legung nach International Accounting Standards, Schmidt/Ketzel/Prigge (eds.):
Sttzel, Moderne Konzepte fr Finanzmrkte, Beschftigung und Wirtschaftsver-
fassung, 2001, 177207.
68 Representative for the literature: Moxter, 2003, (n 67), 251265; Streim, Die Ver-
mittlung von entscheidungsntzlichen Informationen durch Bilanz und GuV ein
nicht einlsbares Versprechen der internationalen Standardsetter, Betriebswirtschaft-
liche Forschung und Praxis 2000, 111131, see also Rammert (2004), (n 30), 590.
69 Consider only the corresponding paragraphs in the frameworks of International
resp. US accounting standards: Financial Accounting Standards Board (FASB):
Statement of Financial Accounting Concepts No. 1. 37; International Accounting
Standards Board (IASB): IASB-Framework par. 10.
70 See, in outlines: Hertig/Kanda, (2004), (n 25), 87f.

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The Future of Creditor Protection 361

VIII. The empirical evidence

Empirical studies on the efficiency of profit distribution restrictions in corpo-

rate law have concentrated on the following issues:
(i) Are accounting-based profit distribution restrictions capable of prevent-
ing disbursements to shareholders in the wake of bankruptcy?
(ii) Is the amount of nominal capital a relevant factor in corporate lending
(iii) Are accounting-based profit distribution restrictions in individual agree-
ments common to legal frameworks without capital maintenance regula-
ad (i): The suitability of profit distribution restrictions based on retained
earnings reserves in the Californian Corporations Code 71 for preventing distribu-
tions within a year before insolvency has been surveyed in 1983 72. Based on 100
cases of insolvency between 1970 and 1076, the distribution restrictions prevent-
ed payout successfully in 66 % of all cases. The same test methodology was ap-
plied to sound corporations and distributions were prevented in 28 % of the
companies only. Nevertheless the results might support the idea that such rules
do have the desired effect, no statement can be made with respect to their effi-
ad (ii): Evidence for the influence of the amount of nominal capital on corpo-
rate lending decisions would support the idea of a perceived risk-absorbing func-
tion of the nominal capital.73 However, two UK surveys on decision-making be-
haviour of bank managers show that the level of nominal capital is not a relevant
Ad (iii): The relevant question is whether profit distribution restrictions,
similar to the statutory rules mentioned before, are common in individual agree-
ments within legal frameworks where no such regulation exists. If they are, this
would indicate that the statutory rules are substantively appropriate, yet it would
not demonstrate the necessity of statutory intervention.

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),, 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.

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362 Christoph Kuhner

Profit distribution restrictions as elements of individual loan agreements,

shaped similarly to those restrictions in legal frameworks with capital mainte-
nance regulation, have been observed frequently among private placements. Ten
studies, published between 1979 and 1996, show that in 23 % up to 80 % of sur-
veyed cases, the parties agreed on such dividend constraints in the US, the average
result was above 50 %.75 The restriction is generally determined on the basis of
US-GAAP accounts, however, in many cases adjustments are made to these ac-
counts in order to eliminate effects of non-reliable recognition and measure-
ment.76 For example, recognition of certain intangible assets and market value
measurement for certain balance sheet items was eliminated in many of the sur-
veyed cases. Evidently, lenders insist on accounting rules that converge towards
the principle of prudence as known in Germany.
On the contrary, there is significant evidence against accounting-based profit
distribution restrictions within lending agreements in Britain. The legal frame-
work in Britain is shaped according to the EU Company Law Directives. This is
demonstrated by four studies undertaken between 1992 and 1996.77 Furthermore,
in their surveys, Leuz/Deller/Stubenrath have not found significant evidence of
accounting-based contractual distribution restrictions in Germany.78
The empirical evidence indicates that distribution restrictions as laid out in
the 2nd EU Company Law Directive may be qualified as effective instruments for
creditor protection because, in a framework without suitable regulation (USA),
there is demand for contractual clauses resembling to the British and German
statutory rules.
However, this neat result is challenged by the results of a recent study from
the US.79 It compares the relevance of dividend covenants in public placements in
the US during three periods: 19751979, 19891993 and 19992000.80 The pre-
sence of accounting-based restrictions seems to have diminished from 44 % in the
first period to 9 % in the most recent period. There may be several alternative ex-
planations 81 for this result, with contradicting implications. One potential expla-
nation refers to an alleged tendency of creditors to refrain from US-GAAP as a
basis of covenants in debt contracts, as, in recent decades, principles of conser-
vative and prudent accounting have lost largely lost relevance in the context of

75 Consider the overview in Leuz/Deller/Stubenrath, 28 Accounting and Business

Research 1998, 115 f.
76 See Leuz/Deller/Stubenrath, Accounting and Business Research 1998, (n 50)
77 See the overview in Leuz/Deller/Stubenrath (1998), (n 50), 118120.
78 See Leuz/Deller/Stubenrath (1998), (n 50), 122124.
79 Begley/Freedman, The Changing Rule of Accounting Numbers in Public Lending
Agreements, 18 Accounting Horizons 2004, 8196.
80 See Begley/Freedman, 2004 (n 79), 86.
81 J Begley/Freedman (2004) (n 79), refrain from a more detailed analysis.

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The Future of Creditor Protection 363

US-GAAP. In effect, the accounts would not be helpful in protecting creditors

any more. On the other hand, during the last three decades creditors might have
become increasingly aware of the fact that accounting profit, in general, is more
vulnerable to earnings management compared to, e.g., cash flow figures, which
may result in a diminished relevance for contractual distribution restrictions.82
Last but not least, the increased standing of rating agencies in the process of mo-
nitoring debtors might have crowded out the significance of bond covenants for
public placements.
As a result, empirical studies indicate that accounting-based profit distribu-
tion restrictions may be an appropriate means for protecting creditors. Yet the
empirical evidence does neither provide evidence for the supremacy, nor for the
necessity of a statutory regime of nominal capital maintenance.

IX. Synthesis and summary

Two major alternative models for the protection of creditors interests in

limited liability companies are available for future European corporate law: The
traditional concept of nominal capital maintenance via accounting-based profit
distribution restrictions and the solvency-test based model of ex post-regulation
provided by US common law. It can be expected that the European Court of
Justice will maintain its strategy to enforce corporate charter competition. There-
fore, in the future, both alternative models will be available for European corpo-
The methodology for determining the maximum amount for profit distribu-
tion within the traditional model relies on a sophisticated framework of company
law statutes and accounting rules which provides a high level of legal certainty for
both creditors and shareholders.83 It has been shown above that accounting-based
profit distribution restrictions are generally suitable for the prevention of certain
distributions which can be harmful to creditors and undermine the notion of effi-
ciency in certain situations. Still, this concept is not an all-in-one device for any
type of agency problems. It needs to be accompanied by management liability for

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.

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364 Christoph Kuhner

certain (rare) events.84 The downside of accounting-based profit distribution

restrictions is a lack of flexibility with respect to capital restructuring measures
appropriate to certain situations in the life of a corporation.
In contrast, the alternative concept of solvency tests allows greater flexibility.
Nevertheless, this is associated with disadvantages related to legal uncertainty, as
the legitimacy of distributions will be assessed ex-post by the courts.
On the grounds of the empirical evidence and taking in account of the uncer-
tainty related to the future jurisdiction on solvency tests, no statement can be
made regarding the superiority of the two alternatives.85 Competition between
both models will provide the ultimate answer. Complementary to the market for
corporate law, careful reform of existing standards might overcome the above-
mentioned disadvantages of traditional capital maintenance rules. To the author,
it does not seem unlikely that the core of the present system, i.e. dividend distri-
bution based on (accumulated) accounting profits which are determined by a set
of conservative accounting rules, will, as a benchmark treatment, enjoy a longer
life than predicted by its numerous critics.

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.

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