Incorporation in the United States

The European Company's Guideto Incorporation in the United States

Part I: Comparison of Corporation Lawsbetween the United States and Europe

For Part II: Please contact International Subsidiary Development Inc.

There is no better way for the European Union (EU) business to build a significant presence in the United States (“US”), than to set up a US subsidiary. However, the corporation laws in the United States differ significantly—from overall style of governance to laws that govern the smallest details of running the business—from those of Europe and Britain. This article will survey some principle differences between US and EU corporation laws of which the newcomer should be mindful.

I. Introduction & Incorporation Styles

We will begin with a general overview of US corporation law compared to the EU. The majority of EU nations adopt a much different philosophy than the US when it comes to governing corporations within their borders.

a. Corporation Laws in the US

Any US state, regardless of entity type, will recognize a lawfully incorporated company from another US state. Thus, the internal governance of a corporation generally falls subject to the sovereignty of the state where it is incorporated, while its external activities—in terms of managing employees and selling products—are governed by federal laws and the laws of the state where it actually does business. So, for example, Montana residents operating a company incorporated in Delaware or Nevada will find that Delaware or Nevada corporation laws determine the internal corporate governance of their company, while Montana state law and to a certain extent US federal law determine how the company actually operates.

Two theories of corporation law have therefore emerged. Firstly, because management may choose to incorporate in a “foreign” (meaning from another US jurisdiction) state, the “race to the bottom” and, conversely, “race to the top” theories each explain some effects of this “competition” for state incorporation.

"Race to the bottom" posits that, because management may choose where to incorporate, they will choose states where governance laws is more favorable to management. This in turn will lead to more management-friendly laws that will attract more corporations. Governance standards therefore will protect the interests of shareholders and creditors afford less and less. Management will be able to do more and more at the expense of shareholders and other stakeholders.

Conversely, "race to the top" argues that, to attract and retain investors and obtain credit, management will choose states with corporate laws that protect the company as a whole, including shareholders and creditors. The rationale for this is that if corporate laws are unfair to stakeholders, they will “walk with their feet” and invest in (or lend to) companies that are incorporated under laws that are more favorable to them. Laws that scare away investors and drive off creditors will prompt legislatures to promulgate more favorable shareholder and creditor laws, and the courts of the state will interpret those laws in ways that protect stakeholders.

Given that most industrial states in the US now offer corporation codes with procedures that are fairly easy for management to use, and that these same statutes, and the case law interpreting them, also tend to protect the economic interests of shareholders and creditors, a blend of the two theories is probably correct.[1]

With respect to the external activities of an entity, state law—especially those governing contracts, employment, intellectual property and real estate—apply no matter where the corporation is domiciled. For example, a Massachusetts- or New York-domiciled corporation doing business in California may not be able to enforce a covenant not to compete against a former employee there. Though courts in most Eastern states will enforce such covenants, California and other Western states maintain a strong public policy against them, and their courts refuse to enforce such covenants.

Adding further complexity, foreign domiciled entities must comply with most of the same corporate registration requirements and pay similar franchise taxes as “domestic” (locally incorporated) entities. Thus, the Delaware corporation doing business exclusively in Massachusetts faces twice the corporate filing requirements and franchise taxes as its domestically domiciled cousin down the street.

b. The Style of Incorporation in the European Union

There are two incorporation styles within the EU: (1) the minority “incorporation” method, which resembles US corporation law, and (2) the “Real Seat” method. “Incorporation" member nations include: the Netherlands, the UK, Ireland, and the Scandinavian nations. These nations generally recognize any lawfully incorporated EU company, regardless of domicile, or where the company’s principle place of business is located.

The prevailing “Real Seat” method, however, requires the internal affairs of a company to be governed by the laws of the member nation where the company has its headquarters, or "real seat." Real Seat member nations do not recognize a company that does not actually do business or locate its management within the member nation of its incorporation. So a company incorporated in France that transfers its real seat to Germany must re-incorporate in Germany.

c. Other US and EU Corporation Law Differences

There are thus clear difficulties with the recognition of cross-border entities within the EU that do not exist within the US, where it is easy to change the laws that control its governance by simply switching the state it is incorporated in.

In the EU, though a Real Seat company must first liquidate or wind up its affairs before changing its corporate jurisdiction, and management will therefore think twice before deciding to move its operations. And because of this difficulty, the concept of “forum shopping” for a favorable state of corporate domicile will probably be new to a foreign company looking to set up a US subsidiary—especially if it is from a “Real Seat” EU member nation.

II. Mechanics of Maintaining a Corporation

a. Basic Structure

In comparing the mechanics of a US corporation with one in the EU, this article will consider German corporation law because it is the nation typically cited when discussing the state of EU corporate law. In Germany, a publicly held entity is called an Aktiengesellschaft (“AG”), and its governance rules are set forth in the Aktiengesetz (“Stock Corporation Act”). Whilst most US states’ corporation laws tend towards the flexible and management friendly, German corporate law might be considered controlling—perhaps even rigid—by comparison.

b. Registration / Formation

While a German AG is registered with its local chamber of commerce, a US corporation is registered with the Secretary of State of its domicile and also any state where it is considered to be doing business. An AG must have its articles of incorporation authorized by a notary and, among other things, entered in the Register (Registrar) of Companies before announcing the company in writing at the local court. After the local court checks the documents submitted for accuracy and completeness, the corporation is added to the German Register of Companies.

The US process of filing articles of incorporation or a corporate charter is not as lock step. Most the paperwork for completing and maintaining the charter can now be found on most states’ Web sites.[2] However, due to the complesities of the forms and necessity of having competent local legal representation, it is strongly advised that a US law firm be engaged for such activities. After the incorporation and organizational meeting, the minutes and adopted By-Laws should be filed in a minute book.

c. Board Structure

A German corporation has three distinct components: a will of the shareholders as expressed at a general meeting thereof (“Vorstand”), an executive committee, and a supervisory board (“Aufsichsrat”).

i. Shareholders’ Meeting

At the general meeting, the shareholders can elect an auditor, discharge the executive committee and supervisory board, amend articles of incorporation, and elect representatives to the supervisory board. Like a German AG, a US corporation must obtain shareholder approval to increase authorized capital. Unlike in Germany, US shareholders may increase authorized capital prospectively, thereby permitting the board of directors to issue new shares from time to time as they may see fit. By contrast, a German management board must obtain shareholder approval for each new share issuance. Shareholders may give advance approval of such new issuance, but it must be very specific in nature.

The mechanics of shareholder voting are very different in the US compared with Germany. Unlike the highly formal requirements of the Aktiengesetz, most US states’ corporation laws provide that almost any action requiring approval through a vote at a general or special meeting of the shareholders may be approved with written consent instead.

ii. Executive Committee

The executive committee is responsible for managing the German AG and its dealings with third parties. These functions typically resemble those of senior executives of a US corporation. But the members of a German executive committee, including chairman or speaker, are regarded as peers and thus share a collective responsibility for all management decisions. The roles of US officers are, by contrast, more divided, even hierarchical.

Another difference is that, while directors of German and US corporations must take into account the interests of shareholders, the Germany corporation’s executive committee and supervisory board must also consider interests of outsiders such as company employees and the public.

iii. Supervisory Board

The supervisory board of a German AG oversees the company’s executive committee and appoints its members, consisting of shareholder and employee representatives. Members of the supervisory board generally may not be involved in the day-to-day management of the company. Depending on the company, up to one half of supervisory board members might be elected by the AG's employees.

By contrast, the US corporation operates under a single board of directors consisting of significant investors, industry personages and, in the largest corporations, people with political connections. A US company’s chief executive officer reports to this board.

d. Board Control

Another aspect of US management-friendliness is that the directors of a US corporation declare dividends whereas the shareholders of a German corporation do so. US Directors also usually are the ones to approve a company’s by-laws, whereas in Germany most of the governing elements are included within the articles of incorporation, a harder document to modify.

A US board of directors may now, in the wake of the corporate takeover wars of the 1980s, stagger its elections such that in any given year the entire board cannot be voted in or out. For example, in one year, of a nine-member board, only three might come up for election by the shareholders, thus thwarting any insurgency for up to two years or more.

While US state laws place few restrictions on the composition and activities of the board of directors, certain US federal considerations must be taken into account by larger companies. Companies whose shares are publicly traded, must, for example, observe the proxy rules of the Federal Exchange Act of 1934 in communicating with shareholders, especially regarding contested elections of directors. In addition, corporations listed on stock exchanges such as the NYSE or NASDAQ must, under the combination of federal accounting and exchange listing rules referred to generally as Sarbanes-Oxley, enforce certain corporate governance control measures. These exceed US state requirements, including matters such as:

· audit committees;

· independent directors; and

· mandatory shareholder approvals of certain transactions.

e. Liability Issues

The liability of a director for his actions or negligence differs in the US compared to Germany. A German AG’s management board bears a duty to exercise the care of a diligent and prudent business executive. Since 1977, Germany has had a business judgment rule and the Corporate Governance Code committee had before it a proposed amendment that would codify it.

The supervisory board can act on behalf of the company in asserting any claims against the management board. If the shareholders’ meeting decides, or if 10% of the AG’s shares so demand, the company must assert a potential claim against management board members, the equivalent of a US derivative suit. The German Stock Corporation Act does not allow for direct actions by shareholders against members of management.

Directors in the US must be reasonable, prudent, and honest, but they need not be correct. In the US, the board of directors is mostly protected by the business judgment rule. Directors and officers will not be liable for damages the corporation sustains as a result of business decisions that, absent a breach of duty or lack of care, cause harm to the company. Moreover, Delaware law gives corporations broad authority to indemnify directors and officers, reimbursing them for any damages or attorneys’ fees incurred in a lawsuit brought against them for actions taken on behalf of the company. Indeed some state’s corporate statutes automatically indemnify directors.

By comparison with Germany, a US shareholder may directly sue the corporation to enforce his or her individual rights, e.g. to receive a declared dividend. But an individual must bring a suit on behalf of the corporation against a director for breach of care and loyalty. Typically, a US shareholder must first request the corporation to bring the suit, and if the corporation fails to do so only then may he bring the derivative suit on its behalf. Damages recovered thereby go not to the shareholder, but to the corporation

The next article in this series compares and contrasts US and EU as it affects the choice of and maintenance of a corporate entity. Please contact International Subsidiary Development Inc. to request a copy.

This article was written by:

Mr. Swiggart an attorney in Boston, Massachusetts & Mr. von Taube a 2006 Juris Doctor candidate at the Widener University School of Law, in Wilmington, Delaware.

Mr. Swiggart is affiliated with International Subsidiary Development Inc.

[1] For an overview of some recent changes to the corporation law of a prominent US industrial state see Massachusetts' New Business Corporation Act - New Chapter 156D Compared with Old Chapter 156B, by one of the authors of this article.

[2] See, for example, the site of the Corporations Division of the Massachusetts Secretary of State