In the United States, the freedom to incorporate in any state, and the relative ease with which this freedom can be exercised, establishes the ideal conditions for regulatory competition: states compete for incorporations by designing business-friendly corporate laws, and by establishing an expert judiciary to apply the rules in a commercially sensible and predictable way. As things stand, Delaware is the clear winner of that competition, accounting for the majority of US incorporations, and its success is then magnified by the network externalities which flow from it: more lawyers become familiar with its laws, more standardised documents and textbooks assume that its laws will be selected, and more cases are heard and reported in its courts which, in turn, enhances predictability.
Some worry that this competition is a negative force, encouraging a “race to the bottom” by prioritising the interests of management, who usually select the state of incorporation, over those of the shareholders. But many academics have argued that, in fact, what follows is a "race to the top", facilitating innovation and efficiency in rule-making while balancing the interests of all stakeholders, who can "price" the rules and encourage managers to choose a state which accommodates their needs through market mechanisms. (For an interesting recent contribution to this debate by the SJ Berwin Professor of Corporate Law at Cambridge University, click here.)
For many reasons, the legal and tax environment in Europe is much less conducive to such regulatory competition than it is in the United States, although it would be a mistake to assume that it does not exist. Some years ago, a number of German companies started to incorporate in the UK, and in response Germany made some adjustments to its corporate law, while the Channel Islands have introduced several company law reforms over the years to make Jersey and Guernsey companies more attractive to foreigners who have no business there - and with some success. Of course, the UK’s now widely used Limited Liability Partnership was hurriedly concocted as a response to competition for professional partnership incorporations, and British limited partnership laws are now being modernised, spurred in part by changes in Luxembourg and France. These developments have all been positive, and there are reasons to think that competition will intensify, especially as the impending UK exit from the EU will cause many businesses to re-evaluate their corporate and fund structures.
The latest set of corporate and fund law changes have emanated from Luxembourg, already a popular EU destination for holding companies and fund vehicles. Among the many innovations adopted this month was the introduction of a new corporate entity, the société par actions simplifieés or SAS, which enables promoters to design their own set of governance rules and could serve as a holding company for private equity investors. Of course, the SAS is not a new idea: it was originally introduced in France in 1994 as part of France’s response to international corporate competition at the time, and similar models have subsequently been adopted elsewhere. As in France, Luxembourg’s SAS must be run and represented by a president, who can appoint a director in charge of day to day management. The fiduciary duties of these officers will be the same as those currently existing for directors of the other two main corporate vehicles: the SA or Sàrl. The reforms to these other corporate vehicles in Luxembourg conform the law to established market practices, a move aimed at providing greater legal certainty, as well as facilitating greater flexibility in designing appropriate financial instruments and management incentive plans and reducing the costs of liquidation on exit.
Luxembourg’s fund reforms are also significant: the new vehicle, the fonds d’investissement alternatifs réservés, or RAIF, which comes into force and is available to use from early next week, will be a useful alternative to the regulated vehicle combining advantageous tax and regulatory treatment with contractual flexibility. As a wrapper for the relatively new (and already popular) Luxembourg limited partnership, the RAIF significantly increases the attractiveness of Luxembourg as a fund domicile for private equity promoters.
Luxembourg, like the Channel Islands, has a long history of innovating its corporate laws to attract business – and the huge success of France’s SAS vehicle and its recent fund innovations have no doubt prompted Luxembourg’s latest competitive move. It seems likely that this competition will now intensify in the coming years, and this is likely to bring benefits to private equity managers and their investors – although it is doubtful that any one country will emerge as Europe’s answer to Delaware.