The European Court of Justice ("ECJ") has ruled that cross-border migration by way of converting into a company format subject to the laws of a different EU member state is protected and permitted by overriding EU law even in cases where the national laws of the two countries in question do not provide for such a possibility.

  1. The Decision of the ECJ in the VALE-Case

In its judgment of July 12, 2012 (Case C-378/10, VALE Építési kft), the ECJ has answered one of the last open, fundamental questions of cross-border movement of European companies among EU member states. While the decision taken by the ECJ in itself did not surprise experts in EU law, it will almost certainly necessitate legislative changes in the German Code on Company Conversions (Umwandlungsgesetz – UmwG) as well as the statutes of several other EU member states. In the meantime it opens the door for structuring options that so far did not exist under German law.

In the case at hand, an Italian limited liability company dealing in construction decided to move its business operations from Italy into Hungary. Rather than just opening a Hungarian branch office or remaining an Italian corporate entity operating with a primary place of business or operations (administrative seat) in Hungary, VALE decided to shut down its operations in Italy entirely and convert its legal format from an Italian limited liability company into a Hungarian limited liability company.

The Italian authorities accepted the move and deleted the entity from the Italian commercial register, but the Hungarian authorities refused to register VALE as a converted Hungarian entity because Hungarian law only allows for a conversion of company formats among Hungarian entities, not for cross-border conversions from foreign jurisdictions.

The ECJ which was involved by the Hungarian Supreme Court by way of preliminary ruling proceedings held that the existing Hungarian law that limits company conversions purely to domestic Hungarian entities is contrary to Art. 49 TFEU and 54 TFEU which together guarantee the freedom of movement and establishment for EU companies. Hungarian law was thus held to discriminate against foreign entities and restricts them from exercising their freedom to move and establish themselves in Hungary. In line with its earlier jurisprudence in the SEVIC-case (Case C-411/03, ECR. 2005, I-10805) where the court held that cross-border mergers have to be permissible among EU member states, the ECJ acknowledges that such a cross-border conversion is fraught with a number of specific legal difficulties and uncertainties that arise from the successive applicability of two national legal orders. That alone, however, is not sufficient justification to exclude such a measure entirely and thereby restrict free movement unduly.

Rather it would be sufficient to provide for safeguards in the national Hungarian laws that ensure that any foreign entity that converts itself into a Hungarian company does meet the procedural and substantive criteria for local entities in terms of protecting the interests of consumers, creditors, employees and other similar considerations.

The court, however, has not given detailed technical guidance as to how such a multijurisdictional conversion can be effected. It has only stated that the procedural rules for such a conversion are not found at the level of EU law, but rather in the laws of the two affected jurisdictions.

  1. The Impact on German Law

The ECJ judgment will affect German law profoundly. Very much like Hungarian law in the case at hand, German law also only allows for company conversions in a purely domestic context.

As recently as in February 2012, a German Higher District Court (Oberlandesgericht) in Nuremberg adjudicated that the conversion of a limited liability company from Luxembourg (S.à r.l.) into a German limited liability company (GmbH) was legally impossible and could not be registered in the German commercial register due to the lack of applicable German legal provisions allowing for such cross-border conversion.

Based on the above ECJ judgment, this German judgment would now be contrary to EU law and a restriction of the freedom of establishment. Rather than reject the registration of the Luxembourg entity as a German GmbH without further in-depth analysis, the German courts would now be forced to apply (a) the applicable Luxembourg law that allows for the migration and conversion across the border and then (b) apply the existing German law originally designed for conversions of German entities mutatis mutandis to the foreign company. EU law would therefore demand the creative modification of the existing rules in such a way as to facilitate a cross-border conversion, whilst at the same time ensuring that the foreign entity migrating into Germany conforms to the largest extent possible to the requirements of German law in corresponding, purely national cases.

The legal challenges involved in such an exercise are obvious.

In the medium term, it can be expected that the German legislator will react to the judgment by amending the German Code on Company Conversions (Umwandlungsgesetz – UmwG). This would be in line with the approach taken after the SEVIC-judgment when a separate subsection was introduced into the UmwG that specifically deals with cross-border mergers. A similar section dealing with cross-border conversions is likely to be inserted into the existing statute.

  1. Consequences for the Legal Practice

This new court judgment -- but most certainly any subsequent transformation into predictable and reliable statutory law -- will open up interesting structuring options for internationally active groups of undertakings with several subsidiaries in Europe. Rather than simply move the administrative seat or operations abroad while maintaining a company's original corporate identity as a local entity, this judgment opens the door to actually chose a more attractive legal order and migrate to a different EU member state whilst maintaining the economic and legal identity of the converted company.

This could be attractive, for instance, in order to change the system of corporate liability, taxation, to modify employee co-determination or to deal with other similar issues. However, when structuring any such move, the ECJ's important caveat in the VALE case that the exercise of the freedom of movement and establishment implies the actual pursuit of an economic activity through a fixed establishment in the host member state for an indefinite period of time should be kept in mind as it would seem to bar purely notional letter-box companies shopping for the most favorable corporate regime.

When compared to a cross-border merger, the main benefit of a conversion would be that the cross-border conversion does not result in a transfer of assets to a different entity by legal succession ‑ with the resulting disadvantages of legal succession such as potential problems with real-estate transfer tax being triggered or certain public permits having to be re-applied for. 

Another conceivable practical application might be to move dormant German entities abroad to a jurisdiction where the liquidation of the converted entity is quick and cost-efficient. This would circumvent the mandatory one-year waiting period typical for German company liquidations.

It should be noted, however, that for the time being such a conversion based purely on the ECJ judgment and current German law would involve significant uncertainties. As the measure will need to be approved by the registration authorities in both chosen jurisdictions and there are no technical guidelines on the formalities in the ECJ judgment itself, nor practical precedents for the German register courts to lean on, any conversion would likely be costly in preparation and fraught with all the risks caused by a lack of legal certainty. Coupled with the high, non-negotiable German notarial fees that are based on the value of the entity in question, such a conversion will not be cheap, quick or routine. 

Therefore, while the ruling opens up interesting structuring considerations, clients are currently best advised to monitor the further development of the law, both in Germany and other similar jurisdictions facing the same changes and challenges. For now, the risks involved with such a conversion in most cases still outweigh the benefits.

With regard to U.S. or other non-EU member states, it is worth remembering that the German legislator did not introduce crossborder mergers with such third countries when allowing for cross-border mergers based on EU law. It is likely to again restrict crossborder conversions only to those countries covered by the ECJ judgment, i.e. other EU member states and members of the European Economic Area.

Having said this, to the extent that certain other European jurisdictions actually allow the conversion into or from third jurisdictions like the U.S. or Switzerland, such jurisdictions could (at least in theory) be used as an interim stepping stone for in- or outbound company conversions into or from the European Union territory.