Policy Update 026 Pre-event Interview

Utilizing LLCs and New Business Forms for the Promotion of Innovation in Europe

Professor of Corporate Governance and Innovation, University of Amsterdam, Amsterdam Center for Law and Economics

Joint ventures among existing firms and startups are well known for promoting innovation, and are becoming increasingly critical for Japan. For startups, application of their strategies according to the stage of corporate development and constructing a viable exit strategy are also crucial. Yet a firm's ability to attract risk capital depends on the form of the business entity, financing methods of its activities, the financing environment, and the institutional and legal framework of the country. The RIETI-CARF policy symposium, "What Financing Mechanisms and Organizations of Business Entities Best Facilitate Innovation?" on February 27 and 28 will discuss ideal forms of financing according to the stage of corporate growth, look into legal framework concerning corporatization by examining overseas cases, and will seek to provide insight as to the direction of policymaking in this area and the market environment. Overseas scholars such as University of Amsterdam Professor Joseph McCAHERY will present cases of corporate legislation in Europe to examine the commonalities and shared problems with Japan. RIETI interviewed Dr. McCahery about business partnership forms and their impact on startups and innovation in the EU.

Dr. McCahery has been Professor of Corporate Governance and Innovation at the University of Amsterdam since 2005. He is also Professor of International Business Law at Tilburg University (Netherlands). Dr. McCahery was a Visiting Faculty Member, Faculty of Law at Leiden University (Netherlands) in 1998, and Lecturer in the University of Warwick (UK) School of Law in 1992-'97. Prior to his academic career, he served as Judicial Clerk for The Honorable Nathaniel R. Jones of the U.S. Court of Appeals for the Sixth Circuit, Cincinnati, Ohio from 1988-'89. His research covers Corporate Law, Corporate Finance, International Securities and Banking Regulation, and European Business Law. He has authored and edited numerous publications including Venture Capital Contracting and the Valuation of High Technology Firms (Oxford University Press 2004, co-edited with Luc Renneboog), The Governance of Close Corporations and Partnerships: US and European Perspectives (Oxford University Press 2004, co-edited with Theo Raaijmakers and Erik P.M. Vermeulen) and "Does the European Company Prevent the 'Delaware-effect'?", European Law Journal, 11(2005) (coauthored with Erik P.M. Vermeulen). He is currently completing a book (with Professor Vermeulen) on The Corporate Governance of Non-Listed Companies, which is scheduled to be published by Oxford University Press at the beginning of 2007 and a collection on The Law, Economics and Management of Joint Ventures (also with Professor Vermeulen), which will be published by Cambridge University Press in 2007. Dr. McCahery received his Ph.D. from the University of Warwick and his J.D. from City University of New York at Queens College.

RIETI: Within the existing legal frameworks in the Netherlands, what types of business form are proving best at facilitating innovation and why?

McCahery: In general, business participants prefer to use a legal business form that defines and sets forth the ownership structure, provides important contractual provisions in advance, supports the enforcement of implicit contracts and internalized norms, and gives the business relationship legal entity status. That said, the regulation of legal business forms defines the organizational and governance framework for non-listed firms. The question then is: which legal business form proves best at facilitating innovation in the Netherlands? Even though Dutch law offers a variety of legal business forms, business parties tend to select the close corporation form (besloten vennootschap). The figure below shows the predominant use of the close corporation as the top legal organizational form in the Netherlands.

Figure: The popularity of the Dutch close corporation form, the Besloten Vennootschap met beperkte aansprakelijkheid.
Source: Centraal Bureau voor de Statistiek (CBS)

Figure: The popularity of the Dutch close corporation form,Click to enlarge

Currently, the Dutch close corporation is undergoing reform to modernize its core provisions and to simplify the structure for greater accessibility. For many years, the debate on the regulation of close corporations could be described in terms of a trade-off between the need for creditor and minority shareholder protection, in case of firm failure. In order to meet the needs of the specialized and idiosyncratic relationships in close corporations, legislative and (more importantly) judicial adaptations and additions to the analogy of partnership law have been made in a piecemeal fashion through the years. For instance, the Dutch Supreme Court articulated severe restrictions on the transfer of interest for shareholders of close corporations, based on enhanced good faith and fiduciary duties, where the articles of incorporation did not explicitly address these matters.

While many commentators view the "quasi-partnership" variation as being the archetypical close corporation, other scholars point to a wider range of closely held firms that employ the corporate form, such as high-tech operations backed by sophisticated outside investors. The latter argue that although the traditional close corporation does not meet the needs of the typical small firm, its structure is especially well-suited to innovative companies, which are characterized by a high proportion of "match-specific assets." There may be something to this view.

Because it is not yet clear when and to what extent the partnership principles should be applied to close corporations, the "partnership law" analogy is full of perils and pitfalls. For instance, it is not always possible to effectively draft around the statutory provisions of corporate statutes, in that the contractual variations may not always be fully enforced. This is especially true when a contract between shareholders conflicts with the close corporation's articles of association. The fact that many closely held firms are unlikely to adjust statutory corporate rules, leaving dispute resolution to rest solely on judicial discretion in applying vague legal standards of good faith and fiduciary duties, reinforces critics' view of the partnership metaphor. The judicial discretion to meddle in the internal affairs of close corporations might entail deficiencies and inconsistencies, in that the firm's participants (e.g., the investors and creditors) might no longer be able to rely on the business form they deal with. Judicial interpretation, especially when it stands apart from the statute itself, could limit the statute's certainty and its value for both public and closely held firms. Furthermore, it appears that, once partnership-type doctrines are accepted in the close corporation context, these doctrines are difficult to opt out of. Finally, because these doctrines are vague and open-ended, they may create confusion, thereby preventing the formation of firms, international joint ventures in particular. There is therefore a prima facie case for corporate law reform and the development of new business forms, such as the Limited Liability Partnership (LLP).

RIETI: You have discussed in your research papers the differing attitudes toward new ventures in the U.S. and the EU. For instance, that the U.S. "has an inborn tolerance of risk" as opposed to the more conservative EU. How can legal framework deal with and surmount limiting attitudes toward investment and innovation?

McCahery: While the lack of an entrepreneurial mindset partly explains the different attitudes toward risk between U.S. and Europe, there are of course other economic factors that may contribute to the difference in the relative performance of the two markets. In particular, the European venture capital market is constrained by regulatory hurdles that limit early-stage investment, and capital market structures that hinder the ability of venture capital funds to liquidate their positions in innovative startups. However, a central problem for Europe remains how to stimulate the development of an efficient institutional and legal structure that encourages venture capitalists to actually invest in startup firms and stimulates a steady supply of entrepreneurs. Economists observe that the internal governance structure of startups often proves decisive in the eventual success of the firm, and plays a crucial role at several stages of the financing and development of startup firms. It is submitted that if governance structures are effective in limiting opportunism and controlling the level of risk, venture capitalists are more likely to contribute capital to startup firms. Thus, problems stemming from incomplete contracting, for example, can be reduced by selecting an efficient legal form that sets the contracting framework and assists in aligning the parties' conflicting interests. In my conference paper with Tilburg University Professor Erik P.M. Vermeulen, we show moreover the importance of non-binding guidelines in assisting business parties to organize and manage their venture in the most effective manner. To be sure, the attention to the contractual and organizational structure of business firms may increase now that it is widely accepted that the venture capital market is prone to violent cyclical movements. Indeed, the jitters in the financial markets over the last several years altered the players' attitude and reinforced the importance of the role of governance and organizational structures for economic performance. Economic evidence indicates the importance of corporate governance for private equity investors in selecting where to make their investment.

RIETI: In your papers coauthored with Professor Vermeulen you have considered the possibility of introducing a U.S.-style LLC business partnership form in the European Union. Have any EU countries yet initiated such a form? What sorts of results are they experiencing, or what is preventing the introduction of this form?

McCahery: In our work, we argue that the needs of closely held firms are not easily met through the adaptation of a new legal business form, emphasizing the theoretical importance of making available a coherent set of standard forms. However, European countries are not eager to adopt new statutory amendments to modernize their business organization law. Despite the increased pressures from SME organizations and professionals, law reforms tend to be piecemeal and reactionary, leading to the creation of inefficient legal codes and a paucity of limited liability vehicles. As in the U.S., business forms should be viewed as products that jurisdictions supply in response to the demands of firms, the consumers of these laws. Unsurprisingly, new legal business forms may be necessary to modify the current framework, which seems to be inefficient and burdensome for closely held firms.

There are a number of explanations for the persistence of inefficient rules for closely held firms in Europe. First, even if a given business form would make closely held firms more efficient, it may not be in the interest of most lobby groups (i.e., professional advisors and creditors) to modify the law to allow more efficient business forms to emerge. Predictably, legislatures respond by failing to adopt value-increasing legislation from which they could derive valuable tax revenues and other economic benefits. Lawmakers present a good case for adapting the existing, suboptimal regime to meet the needs of closely held firms. Second, there are few incentives to introduce legal innovations. The standardization of provisions in corporate codes may account for the lock-in to the existing mandatory framework. When increasing return benefits are present, the value of the existing provisions increases. In most European countries, the majority of closely held firms are organized under the provisions of close corporation codes. These codes not only create considerable learning benefits, but firms also expect to obtain further benefits as new firms incorporate under the same code. Such benefits explain why firms have an incentive to continue to use this legal regime. Newly formed firms are more likely to migrate to existing business corporation statutes that confer larger benefits to the user. Moreover, because the "standardized" corporate form offers certainty, business lawyers, when advising clients about choice of business form decisions, tend to recommend the close corporation -- even if this is suboptimal.

The conclusion is that continuous use of the close corporation, even if not ideally suited to a wide range of closely held firms, will serve to reduce the incentives for lawmakers to innovate. Given the way in which lawmakers have responded to date, the emergence of new legal innovations responsive to the needs of closely held firms appears to be unlikely, especially in the absence of fully-fledged competitive lawmaking. In most European jurisdictions, the SME business community is not likely to play a featured role in the evolution of business forms. The national lawmaking process is led by politicians and civil servants who give high priority to the preferences of large firms. Thus, unless national lawmakers find a compelling reason to actively develop statutory changes, closely held firms are likely to be locked into an inefficient framework.

Nevertheless, the advent of competitive pressures from offshore jurisdictions has created some incentives for national policymakers to generate new statutory measures. The enactment of the LLP statute in the United Kingdom, which is, like the U.S. LLC, a hybrid between a partnership and a corporation, exemplifies defensive regulatory competition that seek to stem the outflow of professional firms to Jersey. A further manifestation of this new pattern in responsive lawmaking is the adoption of new flexible business organization statutes, such as the French Société par Actions Simplifiée (SAS), designed to stimulate the formation of joint venture enterprises. In practice, these initiatives appear to be successful with: 1) 2,500 LLPs registered in the UK some two years after the implementation of the statute and; 2) the introduction of the SAS led to many firms selecting the form capturing approximately 10% of the total firm registrations in France during its first decade in existence.

The above interview originally appeared in RIETI Report on February 21, 2006.Interview conducted by Takako Kimura, online editor, on February 20, 2006.

February 20, 2006