Limited partners of a (fund) parent company may be liable for repayment if dividends are distributed by an insolvent subsidiary
By judgment of 3 August 2021 (case II ZR 123/20), Germany’s Federal Court of Justice ruled that the limited partner of a parent company (fund of funds) is directly and personally liable to the creditors of the subsidiary for repayment of dividends not covered by profits. The reason for the liability is that such dividends serve to return the limited partnership capital contribution to the limited partner in economic terms, reinstating the partner’s obligation to make a capital contribution. If the subsidiary becomes insolvent, its insolvency administrator will assert the claim for repayment.
I. Context of the decision
1. General exclusion of limited partner’s liability in the case of full payment of its capital contribution registered in the commercial register (maximum liability)
The partners of a limited partnership are made up of one or more personally liable partners (general partners) and one or more limited partners with limited liability. The liability of a limited partner is limited to the value of their capital contribution (maximum liability) registered in the commercial register if and to the extent that the limited partner has made this capital contribution in accordance with sections 171(1) and 172(1) German Commercial Code. to the extent this capital contribution has not been made, the limited partner is liable to the partnership’s creditors jointly and severally (and to the partnership directly) up to the maximum liability amount registered in the commercial register.
2. Reinstatement of liability if the maximum liability amount is repaid
Direct liability, initially remedied by payment of the maximum liability amount, may be reinstated in accordance with the first sentence of section 172(4) German Commercial Code if the capital contribution is repaid to the limited partner. From an economic point of view, such a repayment takes place if profit disbursements or withdrawals are made in accordance with the second sentence of section 172(4) German Commercial Code although the limited partner’s capital share no longer covers its maximum liability amount due to losses. Unlike in the law pertaining to limited liability companies (GmbHs), repaying a capital contribution is not prohibited by law for a limited partnership with regard to the partners’ relationship internally, but merely reinstates the limited partner’s direct liability in external relations under sections 172(1) and 172(4) German Commercial Code.
3. Asserting the claim against the limited partner in the partnership’s insolvency
If the limited partnership is insolvent, section 171(2) German Commercial Code provides that for the duration of the insolvency proceedings, any direct claim against the liable limited partner owed to the partnership’s creditors under sections 171(1) and 172(4) of the German Commercial Code can only be asserted by the insolvency administrator (or custodian in the event of debtor-in-possession proceedings). This is to prevent a race among the creditors. A pooled assertion of the direct claim by the insolvency administrator is intended to ensure that all creditors can be satisfied evenly in accordance with the first sentence of section 1 German Insolvency Code.
II. Substance of the decision of the Federal Court of Justice of 3 August 2021
The Federal Court of Justice had the opportunity to consider two issues it had not yet ruled upon concerning the liability of a limited partner of a two-tier fund in the event of the insolvency of the subsidiary. The Federal Court of Justice first made it clear in the judgment that, in the case of a two-tier fund, the creditors of the subsidiary could pierce the corporate veil for the limited partner of the parent company. Furthermore, the Federal Court of Justice decided that the insolvency administrator of the insolvent subsidiary may pursue the claim for liability against the limited partner of the parent company under section 172(2) German Commercial Code unless the parent company is also insolvent.
In the case decided by the Federal Court of Justice, insolvency proceedings had been initiated in respect of the assets of three shipping funds (subsidiaries) organised in the legal form of a limited partnership. The limited partner of each shipping fund was a fund of funds (parent company), also in the legal form of a limited partnership. The fund of funds held one limited share in each of the subsidiaries. No insolvency proceedings had been initiated in respect of the assets of the fund of funds. The defendant was one of the limited partners of the fund of funds.
The three shipping funds as subsidiaries distributed dividends to the fund of funds as a parent company which were not covered by profits. The fund of funds then distributed dividends not covered by profits to the subsequent defendant.
The insolvency administrator of all three insolvent shipping funds claimed payment from the defendant as a partial return of the liability contribution paid pursuant to sections 171(1), (2) and 128 in conjunction with section 172(4) German Commercial Code.
2. Legal assessment by the Federal Court of Justice
The Federal Court of Justice upheld the appeal on a point of law by the insolvency administrator as claimant.
In doing so, the Federal Court of Justice initially found that, in a two-tier limited partnership, where a capital contribution is refunded, the parent company (fund of funds) as a limited partner is directly liable for the subsidiary’s liabilities to its creditors to an amount equal to the value of the liability amount thereby economically returned under sections 171 and 172 German Commercial Code in conjunction with section 128 German Commercial Code. Regarding the fund of funds’ liability, its limited partner is in turn liable to the creditors of the subsidiary if the conditions laid down in sections 171 and 172 German Commercial Code are met. The Federal Court of Justice hereby rejects the view held in some cases (Munich Regional Court I, judgment of 13 September 2019 – 10 HK O 6362/18, LSK 2019, 28676; Munich Higher Regional Court, recorded notice of 24 July 2019 – 20 U 4429/18, not published) that a two-tier fund cannot be held liable. That view was based on the fact that a limited partner is liable only to the creditors of the company in which it holds a stake itself. The Federal Court of Justice, on the other hand, held in the judgment that the creditors of the subsidiary can have direct recourse to the limited partners of the fund of funds provided that the liability requirements of sections 171 and 172(4) German Commercial Code are consistently in place in the ownership chain.
Furthermore, the Federal Court of Justice ruled in the previously disputed issue of whether this liability could only be invoked by the insolvency administrator of the subsidiary company if it became insolvent that this can be affirmed as long as no insolvency proceedings have been initiated in respect of the parent company’s assets.
The court held that section 171(2) German Commercial Code only specified that the insolvency administrator should take over the enforcement of claims in place of the partnership’s creditors. It stated that the scope of liability is then governed by substantive law. In that respect, the Federal Court of Justice assumes that liability across the ownership chain is also possible in the case of two-tier funds organised in the legal form of a limited partnership and can be filed in the subsidiary’s insolvency proceedings by its insolvency administrator or custodian.
Next, the Federal Court of Justice held (although this was not relevant to the judgment) that where insolvency proceedings are initiated over the assets of the parent company, too, the subsidiary’s insolvency administrator may not file claims under sections 171 and 172(4) German Commercial Code against the limited partner of the parent company, since the parent company’s insolvency administrator would then have to file claims against the limited partner of the parent company as a bundle pursuant to section 171(2) German Commercial Code. In that case, the creditors of the subsidiary are then insolvency creditors in the insolvency proceedings concerning the assets of the parent company with their direct claims, so the subsidiary’s insolvency administrator can only register in the insolvency table the (reinstated) liability of the parent company as a limited partner pursuant to sections 171(1), (2) and 172(4) German Commercial Code in insolvency proceedings concerning the assets of the parent company in a bundle as a claim.
III. Conclusion and practical advice
The decision of the Federal Court of Justice may appear unfair from the perspective of the limited partner of the parent company against which the action is brought, since as a rule a limited partner will primarily look at its direct interest (in the parent company or a fund of funds) if profits are paid out. If it now turns out that the amounts belonging to the funds of funds should not have been distributed because the alleged profits from the subsidiaries are in reality dividends which are not matched by any profits, this breaks the chain of legitimacy for retaining the amounts also received at the level of the ultimate limited partner. Whether the limited partner was able to recognise this is legally irrelevant in principle.
However, the decision of the Federal Court of Justice is consistent from a legal point of view. With its decision, the Federal Court of Justice aims to counteract investment structures which are primarily chosen to avoid liability risks (piercing the corporate veil). If a limited partner were always liable only to the creditors of the company in which it holds a direct stake, then the formation of parent companies would prevent liability risks under sections 171(1), 172(4) and 128 German Commercial Code at the expense of the creditors of the (operational) subsidiaries. Assuming that the parent company had no task other than to pass on dividends from the subsidiaries to its limited partners, this would undermine the liability system of the limited partnership. As a result of the judgment, the limited partner, as the “beneficiary” of the dividends distributed, must, to a certain extent, “take the blame” for economic difficulties within the subsidiaries.
From the perspective of an insolvency administrator of such a subsidiary, there is now legal certainty that a bundled enforcement of claims may take place against the limited partners of the fund of funds for the benefit of the insolvency estate, unless the parent company is also in insolvency proceedings.
Limited partners of a two-tier or multi-tier fund are required, based on the judgment, to look more closely in future at whether distributions are possible without there being a return of capital contributions, in order to be able to assess their liability risk under sections 171(1), 172(4) and 128 German Commercial Code. Low maximum liability amounts registered in the commercial register help to minimise the scale of liability risks in such a case.