Update from Germany - April 2006
April 2006
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In This Issue:
- New German Securities Prospectus Act May Jeopardize Stock Option Programs of Non-EU Subsidiaries in Germany
- Obstacles to Granting Upstream Security in German LBOs
- Subsequent Bonuses May Be within the Law
but Mannesmann Was Not - German-listed Companies Now Required to Disclose Board Member Remuneration
- The Entry Standard—Tailor-made Capital Market Access
for Small- and Mid-caps
New German Securities Prospectus Act May Jeopardize Stock Option Programs of Non-EU Subsidiaries in Germany
by Dr. Patrick Nordhues
U.S. and other non-EU companies with German operations may encounter problems with stock options plans for German employees. On July 1, 2005, the Securities Prospectus Act (Wertpapierprospektgesetz, WpPG) came into force in Germany, implementing the EU Prospectus Directive. Together with the Commission Regulation (EC) No. 809/2004 of April 29, 2004 (Prospectus Regulation), the WpPG creates uniform provisions for the preparation, approval and publication of prospectuses for securities offered to the public or admitted to trading on an organized market (stock exchange listing). Non-EU companies may now have to produce a prospectus for their German subsidiaries if these entities wish to implement a stock option program for their employees.
The WpPG sets forth that companies implementing stock option programs (Mitarbeiterbeteiligungsprogramme) may have to publish a prospectus if the relevant program provides for a “public offer of securities.” In contrast to the old Securities Sales Prospectus Act (Verkaufsprospektgesetz), the WpPG only provides for limited exceptions to the prospectus requirement that typically do not apply to non-EU companies’ German subsidiaries. For example, in regard to stock options programs there is no obligation to publish a prospectus for an offer of securities made by an employer if its shares are already admitted to trading on an organized market or by an affiliated undertaking within the meaning of the German Stock Corporation Act (AktG). However, only markets within the European Economic Area (EEA) are recognized as organized markets. In Germany the Official (Amtlicher Markt) and the Regulated Market (Geregelter Markt) belong to the organized market, while the Open Market (Freiverkehr) does not. Stock options programs offering shares in companies that do not trade shares on an organized market within the EEA require a prospectus. This applies in particular to U.S. and Asian groups that offer shares of stock in listed holding companies to the employees of their German subsidiaries. Often, the shares of the holding company are traded in the Open Market in Germany, which is not an organized market within the meaning of the WpPG. Trading on the home market (e.g., the New York Stock Exchange, Nasdaq) is also not sufficient to circumvent the prospectus requirement as only markets within the EEA qualify as organized markets. Therefore, the public offer of non-EU shares within a stock option program triggers the prospectus requirement under the WpPG.
Non-compliance is not an option as the WpPG imposes strict penalties. Any infringement of the WpPG is an administrative offence and can be punished with a fine of up to €500,000. In addition, if a company fails to publish the required prospectus, any acquirer of publicly offered securities has, according to the Securities Sales Prospectus Act (Verkaufsprospektgesetz), the right to request the offering party or the issuer to buy back the securities against reimbursement of the purchase price. However, many employers might not be willing to bear the high costs for the preparation of a relevant prospectus and, therefore, renounce their stock option programs for their German employees.
U.S. and other non-EU companies with German subsidiaries should carefully consider the implications of the WpPG and re-evaluate their stock option programs with regard to prospectus publication requirements in Germany.
Obstacles to Granting Upstream Security in German LBOs
by Dr. Martin Kock
In leveraged buyout transactions (LBOs), private equity investors seek to pledge, inter alia, the assets of a target company (the target) as security in order to obtain acquisition (senior debt) financing. The acquisition financing is generally provided to the acquiring special purpose vehicle (Newco). However, the debt is typically expected to be serviced and repaid from cash-flow of the target. The security to be granted by the target protects the lenders if the target’s cash flow proves to be insufficient. The better the cash flow and the ability of the target to provide security, the more favorable will be the amount and the terms of the acquisition financing granted to Newco. This being a universal concept, the German laws on stock corporations and limited liability companies as well as recent court decisions in Germany provide several hurdles that must be overcome in order to structure acquisition financing agreements that will not become subject to successful legal challenges in the event of insolvency or restructuring.
Limited Liability Companies (GmbH)
Section 30 of the German Act on Limited Liability Companies (GmbHG) provides that a limited liability company may not distribute assets to its shareholders if and to the extent such assets are needed by the target to maintain net assets of at least the value of its registered capital. Providing securities to a financing entity in connection with a loan that was granted solely to Newco would be deemed to be a distribution of assets to Newco unless the target itself is also a beneficiary of the loan (which is mostly not the case in an LBO).
Even though a non-compliant security agreement with a bona fide financing entity would presumably be valid, entering into such agreements would be illegal for the target and its management. It was disputed in Germany whether already the granting of security could exhaust the registered capital or whether the registered capital is only affected upon exploitation of the security by the financing entity. A 2003 court decision of the German Federal Supreme Court (BGH) tends to favor the first view: entering into security agreements affects the equity position of the target because, for purposes of section 30 GmbHG, the actual liquidation of the collateral will be deemed to have taken place.
Related BGH decisions regarding measures taken by a shareholder that destroy the economical basis of the GmbH (existenzvernichtender Eingriff) increase the risk for all participants. The BGH argued that a shareholder is not allowed to use assets of the controlled GmbH for its own purposes if such financial assistance of the subsidiary renders the latter unable to service its debts. If such destroying measures are implemented, the managements of both the shareholder company as well as the subsidiary could be personally liable for damages that creditors of the subsidiary incur because the latter is no longer able to serve its trade debts.
Because of these risks private equity investors as well as the management should insist that the security agreement contain
a so-called “section 30 clause” pursuant to which the collateral may not be liquidated if such liquidation would cause the equity of the target to fall below the registered capital. Financial entities will attempt to agree on security agreements without such clauses—as stated above—as the inadmissibility from a corporate law point of view (rendering the managers subject to damages) does not affect the validity of the security transfers.
Stock Corporations
The situation with stock corporations is more clear, albeit even more unsatisfying. A stock corporation is not allowed to make distributions to its shareholders other than by way of ordinary dividend distributions (see section 57 of the German Stock Corporation Code, or AktG). This hurdle could be overcome by entering into a profit-and-loss transfer agreement (Ergebnisabführungsvertrag). However, the second statutory hurdle is insurmountable. Under section 71(a) AktG, target companies may not provide securities to financing companies for the benefit of Newco acquiring the target’s shares. The statute also clearly provides that not only is such transaction inadmissible, but the security transfer is invalid. Therefore, a stock corporation cannot grant upstream security. If the assets of the target secure the acquisition, then the participants will have to consider either the change of the corporate form into a GmbH (a “cold” delisting if shares in the AG are publicly listed) or an asset deal or spin-off where the target would transfer its assets either directly to Newco or a newly established subsidiary (which will subsequently be sold). Either measure requires the consent of the shareholders with a qualified majority.
Subsequent Bonuses May Be within the Law but Mannesmann Was Not
by Dr. Paul Melot de Beauregard
Perhaps the most spectacular lawsuit in decades to touch Germany’s economy is the so-called Mannesmann case. After Vodafone Group took over its former business rival Mannesmann in early 2000, the management of Mannesmann received high bonuses mainly for the enormous increase of the shareholder value before the takeover. CEO Klaus Esser’s bonus alone totaled around €15.9 million, and other managers received comparable amounts. These payments inevitably raised the suspicion of the authorities, and the public prosecutor of Düsseldorf brought an action before Düsseldorf District Court. The prosecutor accused the former members of the management and advisory board, including the current CEO of Deutsche Bank, Josef Ackermann, of infidelity and claimed the defendants had misused their power to dispose of the shareholders’ property.
After a rather long trial tightly watched by the media, Düsseldorf District Court found the accused not guilty. The authorities, which had been temporarily criticized for their behavior vis-à-vis the other parties as well as the press, appealed to the Federal Court of Justice, the highest German criminal court. This court had to decide a central legal question: could subsequent payments of bonuses without any contractual basis constitute an action of infidelity?
The court’s decision was both inconclusive and surprising. The court found that subsequent bonuses lacking any basis within the manager’s service contracts or other contractual, performance-related documents could be in line with the law if the company, i.e., the shareholders, benefited from the arrangement. It would be sufficient to assume it was beneficial if the payments created an “effect of stimulation” and signaled to both the current and future management that outstanding performance is valued. However, the judges set limits: in such cases the amount of the bonus should be reasonable relative to its benefit to the company, which obviously is a question of each case. On the other hand the court held payments that just reward the management but do not lead to any future advantage of the company are not allowed, regardless of their amount. In this case the property of the company would be reduced without any compensation. This would create a criminal act under German law (so-called “unfaithful prodigality”).
According to the court, the bonuses in the Mannesmann case did not create an adequate “effect of stimulation.” The defendant’s assumption that management raised the stock-market value of the company significantly was invalidated by the court’s argument that contractual remuneration adequately compensated management’s performance. As a result, the verdict of the Düsseldorf District Court was overruled, and the case was remanded to another chamber of the same court. Today, we wait for the second round to start. In the meantime, companies may choose to proceed cautiously in management compensation until it is more clear when bonuses fall fully within the law.
German-listed Companies Now Required to Disclose Board Member Remuneration
by Sybille Flindt
On August 11, 2005, the Act on the Disclosure of Remunerations of the Members of the Board of Directors (Gesetz über die Offenlegung der Vorstandsvergütung, VorstOG) went into effect in Germany. The law provides that—starting with business years beginning after December 31, 2005—the total amount of remuneration for every individual member of the board of directors of a listed German stock corporation has to be disclosed. Individual names must be in the explanatory notes on the accounts (Anhang zum Jahresabschluss) or in the management report (Lagebericht). Until now, displaying the total amount of remuneration for all members of the board of directors was sufficient, but now salaries, profit sharing, stock options, allowances and any supplementary compensation have to be disclosed for every member of the board of directors.
German legislators intended these detailed disclosure requirements to make it easier for shareholders to determine whether salaries of the members of the board of directors were reasonable relative to their tasks and to the situation of the company. Moreover, legislators hope disclosure of individual names will prevent board members from demanding unreasonably high salaries. The new law is designed to moderate members’ salaries, which the public often considers too high.
The forced publication of remunerations continues to be a topic of public debate in Germany. In principle, the members of all German political parties agreed that ensuring reasonable salaries of the board members will improve investor protections. However, they dispute whether the VorstOG is an appropriate tool to control salary policy. They note that despite the fact U.S. companies publish the salaries of the board members, disclosure by itself does not limit compensation.
Legal Battles Anticipated
The VorstOG raises several legal questions, some of which will presumably be brought to the courts in the near future. First, the scope of application of the VorstOG is subject to discussion. The VorstOG only applies to listed stock corporations. As regards the definition of a listed stock corporation, the VorstOG refers to section 3 paragraph 2 of the German Stock Corporation Code (AktG). According to this, only companies whose shares are traded in the Regulated Market (Geregelter Markt) or Official Market (Amtlicher Markt) are considered as listed companies, whereas the admission to the so-called Unofficial Regulated Market (Freiverkehr) are not. Further, the VorstOG does not apply to foreign companies listed at the German stock exchange, and legal publications have criticized the fact that the classification as a company under the VorstOG depends on such formal criteria and is made irrespective of the size of the company and the number of directors.
Second, while a shareholder resolution may waive disclosure requirements, in some cases this may not prevent public disclosure of individual board members’ salaries. Under the VorstOG it is possible for shareholders to rule out individual disclosure of the remunerations by a resolution passed by a three-fourths majority. In cases where disclosure is not desired or not appropriate, it is upon the shareholders to renounce individual disclosure. However, contrary to non-listed corporations, which are not subject to any disclosure requirements regarding manager remuneration, listed companies must still disclose the total salaries of all board members even if individual disclosure is renounced at the shareholders’ meeting. Problems may arise in the case of listed stock corporations with only one or two directors; in this case one can easily determine individual director salaries from the total remuneration.
The obvious unequal treatment of listed stock corporations depending on the size of their management board has already led to discussions about a restrictive interpretation of the new VorstOG. In particular there is debate about whether or not the obligation to disclose the remuneration of individual members of the board of directors is compatible with the constitutional right to self-determination with respect to personal information (Recht auf informationelle Selbstbes-timmung). In this context, the previous statutory provisions, which provided for an exemption from the obligation to disclose the total amount of remuneration if one could conclude from this data the amount of individual compensation, is brought forward as an argument. Nevertheless, it remains to be seen how German courts will interpret the new law.
Company Reaction
Some managers and companies already have announced that they will refuse a publication of their individual salaries—irrespective of a shareholders’ resolution. In such case, they may face fines up to $65,000. It is likely some managers would rather accept this fine than publish their individual salaries. The shareholders of a listed corporation that does not publish the remuneration of its directors could consider asserting an action to disclose. However, in the past the courts were rather reluctant to force individual salary disclosure on shareholders’ demand. Again,
it remains open as to how company and shareholder behavior will affect the VorstOG and how the courts will interpret the new law.
The Entry Standard—Tailor-made Capital Market Access for Small- and Mid-caps
by Dr. Patrick Nordhues
In Europe, there are two defined ways to access the capital market: markets regulated by the EU and markets regulated by the stock exchanges themselves (regulated unofficial markets). In Germany, the Open Market (Freiverkehr) at the Frankfurt Stock Exchange (Frankfurter Wertpapierbörse) is the statutory market segment in the regulated unofficial market. On October 25, 2005 the Open Market started the segment “Entry Standard” with additional transparency requirements. An attractive listing option for young and established small to medium-sized companies, the Entry Standard is open to all companies seeking to trade their shares under reduced formal requirements and at a low cost. Private equity and venture capital investors may use the Entry Standard as an exit route for their portfolio companies.
Admission to Trading
A company may admit shares to trade on the Entry Standard if they are already admitted to trading in the Open Market. In such case an application has to be submitted by a trading participant registered at the Frankfurt Stock Exchange (e.g., banks and stock brokers). This participant monitors the company’s compliance with transparency requirements and acts as a coordinator between the company and Deutsche Börse. The registered trading participant must give The Frankfurt Stock Exchange a maximum of five trading days to admit the shares to trading. The issuer begins the admissions process with the preparation of an exposé. The trading participant must assure the issuer will comply with the rules of the Entry Standard and agree to monitor the transparency requirements to be fulfilled by the company. In addition, if new shares of the company will be offered to the public, the issuer must submit a prospectus under the German Securities Prospectus Act (Wertpapierprospektgesetz) to be approved by the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht).
Due to the reduced level of regulation, admission costs for the Entry Standard are much lower than those for an initial public offering (IPO) on an EU-regulated market. The annual listing fee is €5,000, and the fee for inclusion in exchange trading is €1,500 with an exposé and €750 with a prospectus.
The shares of companies listed on the Entry Standard are traded on the floor of the Frankfurt Stock Exchange and on the fully electronic pan-European trading system XETRA.
Duties in the Entry Standard
Because the Entry Standard is a market segment organized under private law, the legal framework is defined by the Rules for the Regulated Unofficial Market (Freiverkehrsrichtlinien). These rules state that the Open Market rules plus certain disclosure requirements apply for the Entry Standard. For companies, this means reduced regulation and limited transparency requirements.
One of the benefits of trading at the Entry Standard is that it is not equivalent to a stock exchange listing as defined in the German Stock Corporation Act (Aktiengesetz). Since the Open Market and the Entry Standard are not organized markets as defined by the German Securities Trading Act (Wertpapierhandelsgesetz), certain regulations do not apply, including the obligation to publish ad hoc announcements, notifications when threshold levels are reached and compulsory publication of directors’ dealings.
However, the Rules for the Regulated Unofficial Market require a company to immediately publish business operations updates on its website. Nonetheless, such obligations are less restrictive than the legal obligation of ad hoc announcements under the German Securities Trading Act, which requires the publication of facts that affect the company (such as takeover offers or block trades).
In addition, the company has to publish on its website:
- Audited consolidated financial statements within six months following the end of the fiscal year;
- An interim report within three months following the first half of each fiscal year; and
- A brief, up-to-date company profile and a calendar of company events.
Compliance with these publication duties is monitored by the respective trading participant. With regard to insider trading and market abuse, shares traded on the Entry Standard fall within the scope of the German Securities Trading Act and are monitored by the German Federal Financial Supervisory Authority.
Why List?
Companies wishing to differentiate themselves within the Open Market and increase investor visibility opt for a listing in the Entry Standard—an entry segment that does not exclude the possibility of a subsequent listing in the regulated official markets, the General Standard or Prime Standard. With fewer transparency requirements, investor protection regulations and, therefore, reduced liability, companies may find a listing in the Entry Standard a more attractive option than a traditional listing in organized markets.
McDermott Will & Emery News from Germany
Which Lawyer by PLC, the successor publication of Global Counsel 3000, recently recognized two of our practices and lawyers. In Germany, we are recommended in the tax and media practice areas. In these areas Arndt Raupach is recommended in tax, and Ralf Weisser is considered leading in media.
The World Customs Organization has also recognized the experience and skill of our German lawyers. From April 6 to 8 Dr. Wolfgang von Frentz and Dr. Oliver Steffens will be in Bangalore, India to speak at the 2006 WCO IT Conference & Exhibition. The conference focuses on IT companies operating or planning to operate in the IT outsourcing business. Wolfgang and Oliver will present “Globalization and its Benefits—Legal Questions and Outsourcing.” They expect the topic will interest conference attendees as they are the only speakers presenting on legal issues.
