Shell Shock: In Defence of the ‘Real Seat Theory’ in International Company Law

Shell companies are a huge problem, and not only since their use by Russian oligarchs has become the focus of media attention in the context of the war in the Ukraine.  Such companies are used regularly for tax evasion, money laundering, or to hide and shield assets from creditors or government agencies.  Companies registered in well-known tax heavens are key tools for the ‘rogue offshore finance industry’, to quote the ‘International Consortium of Investigative Journalists’ which published the ‘Panama Papers’ in 2016.  But the industry is active onshore as well.  In the UK, the ‘Scottish limited partnership’ came to prominence as the ‘Scottish Laundromat’.  It has also been portrayed by scholars as an example of legislative capture by the private equity industry.

‘In light of Russia’s invasion of Ukraine’, the UK government has introduced legislation which seeks to ‘crack down on dirty money’ by requiring ‘anonymous foreign owners of UK property to reveal their real identities to ensure criminals cannot hide behind secretive chains of shell companies, setting a new global standard for transparency.’  Similar efforts to increase transparency are being undertaken in the US with the ‘Corporate Transparency Act’.

These legislative efforts do not go to the root of the problem.  They take it for granted that a company which is registered or incorporated in one state should necessarily be judged according to the laws of that state.  But this is not true.  If the case has an international dimension such as, for example, foreign shareholders or assets in another jurisdiction, one has to undertake a conflict of laws analysis to determine the applicable company law.

In this post I am going to argue that courts and agencies should apply the ‘real seat theory’ and not the ‘incorporation doctrine’ when performing this analysis.  This would effectively tackle the problem of shell companies at the root, and it would not interfere with legitimate business activities.

The ‘incorporation doctrine’ was developed in the 18th century in England.  According to this doctrine, a company is governed by the laws of the jurisdiction in which it has been incorporated or registered (for companies other than corporations).  This allowed British companies to do business in the colonies based on English company law even if the ‘real seat’ of the company was abroad.  The ‘incorporation doctrine’ is a convenient tool to export a jurisdiction’s company law.  And it is a doctrine which caters to the interests of a company’s shareholders.  They decide which jurisdiction’s company law to use when doing business.

The ‘incorporation doctrine’ dominates the conflict of laws approach in Common Law jurisdictions around the world.  The situation in Civil Law jurisdictions is very different.  Germany, for example, has always applied and continues to apply the ‘real seat theory’.  According to this theory, it is a company’s ‘real seat’ or ‘actual head office’ which determines the applicable company law.  Based on this theory, in a 2008 landmark decision, the German Federal Supreme Court held that a Swiss stock corporation which had its real seat in Germany was to be treated as a German partnership.  It could not be treated as a German stock corporation because it was not incorporated in Germany.  The consequences for the company’s shareholders were, of course, dramatic: unlimited liability for the company’s debts.  This was good news for the company’s creditors.  The general message to entrepreneurs and shareholders is clear: if you plan to have your real seat in Germany and want limited liability, you should use a domestic corporate form to do business.

Both doctrines or theories are reflected in international legal texts, sometimes even in the same article or paragraph.  In European insolvency law, for example, Article 3(1) of the European Insolvency Regulation (EIR) states that ‘[t]he courts of the Member State within the territory of which the centre of the debtor’s main interests is situated shall have jurisdiction to open insolvency proceedings (‘main insolvency proceedings’). (…) In the case of a company or legal person, the place of the registered office shall be presumed to be the centre of its main interests in the absence of proof to the contrary’ (emphasis added).

For sure, Article 3(1) deals with jurisdiction in international insolvency cases and not with the applicable company law.  But the underlying concepts are the same: the presumption is for the ‘place of the registered office’ but the ultimate test is the ‘centre of the debtor’s main interests’ (COMI), i.e. the company’s real seat.  Article 3(1) reflects a compromise position between the Common Law and the Civil Law approach to the issue.  At the core of the famous COMI concept (see also 11 US § 1502(4)) for determining jurisdiction for main insolvency proceedings in international insolvency law lies the ‘real seat theory’.

While the conceptual contrast between the two rival approaches to conflict of laws issues in international company law is stark, the differences are much less important in commercial and legal practice.  An operating company will usually have its ‘registered office’ in the jurisdiction in which it also has its ‘real seat’.  This is the factual background for the presumption in Article 3(1) EIR.  The presumption is justified precisely because of this regularity.

But in some cases, the approaches will yield different results, especially in cases involving shell companies.  If the ‘real seat’ of a company is not in the incorporation or registration state, shareholders will usually be personally liable for a company’s debts—as in the 2008 decision of the German Federal Supreme Court.  In addition, those who act on behalf of the company will also usually be personally liable because they act for an entity which does not exist in the purported legal form.  This is an effective remedy to target fraudulent ‘shell structures’, including in cases involving multiple shell companies which can make it very difficult to identify the ultimate owner(s).

I am not claiming that this policy shift would eliminate fraudulent shell companies.  But it certainly would make life for the ‘rogue (offshore) finance industry’ and its beneficiaries much more difficult, and rightly so: a company should serve the interests of all its stakeholders, including society at large, and the connecting factor in a conflict of laws analysis which bests reflects this approach is the ‘real seat theory’.  This is the place where a company’s creditors, employees and society at large look to in their dealings with the business.

What, if anything, would be lost if ‘incorporation doctrine’ countries were to adopt the ‘real seat theory’ instead?  Companies may legitimately want to cross borders, moving their ‘real seat’ from one jurisdiction to another.  They can do this under the ‘incorporation doctrine’ without changing their legal status.  By contrast, if they move into a ‘real seat jurisdiction’, they have to adapt, for example by merging with a company—including a shell company—in the target jurisdiction.  The legitimate commercial move can be accomplished, albeit in a different form.

The incorporation doctrine allows groups of companies to use the same corporate form for all group members regardless of their ‘real seat’.  This is a commercial benefit.  But how large is it?  Statistical information on the organisation of European groups of companies, for example, is based on identifying ‘legal units’ in different jurisdictions, i.e. it reflects the (apparently dominant) practice of using local corporate forms for organising a group’s economic affairs.  It appears that adopting a uniform corporate form for the members of a corporate group is the (rare) exception and not the rule.

That leaves us with the old debate about the ‘Delaware effect’, whether there is a ‘race to the bottom’ or a ‘race to the top’, and the alleged ‘Genius of American Corporate Law’.  Do we need the ‘incorporation theory’ to facilitate regulatory arbitrage and regulatory competition between jurisdictions for the best ‘corporate law product’?  If that old debate has produced any tangible result, then it is this: we do not know for sure whether regulatory competition is good or bad for shareholders, and we have no idea whether it is good or bad for society overall.

In summary, moving from the ‘incorporation theory’ to the ‘real seat theory’ is a policy choice which has a clear benefit in terms of utilizing a potent tool to fight international commercial crime.  At the same time, this move would come at little, if any, discernible costs for the legitimate affairs of businesses.

But are all (Common Law) jurisdictions free to make this move?  That depends of course on the international obligations of states.  After Brexit, the UK is no longer bound by the four fundamental freedoms enshrined in the ‘Treaty on the Functioning of the European Union’, including its provisions on the freedom of establishment for companies (Articles 49 and 54).  But even before Brexit, Member States were always free to deal with the ‘creatures’ of their own laws more or less as they wished, according to the Daily Mail decision of the CJEU.  Member States were certainly free to define the relevant ‘connecting factor’ (see Polbud).  The situation is different from the perspective of a Member State into which a foreign company wishes to move its ‘real seat’ without planning to reincorporate or move its registered office as well.  Member States must, according to the Centros jurisprudence of the Court, recognize the foreign company ‘as such’.  This appears to force them to apply the ‘incorporation doctrine’.  But the issue is far from settled, at least as shell corporations are concerned, which never had their ‘real seat’ in the incorporation or registration state in the first place.  There is no movement or new establishment of the company involved in this case.  Hence, the better view is that the Treaty’s free movement provisions are not engaged.

The incorporation doctrine is a relic from the United Kingdom’s colonial past.  It has no place in an ‘enlightened stakeholder capitalism’ which seeks to balance the interests of different corporate stakeholders in an international context.  This goal is best achieved by applying the real seat theory.

Horst Eidenmüller is Statutory Professor for Commercial Law at the University of Oxford