Severance payment in the german GmbH

After the exclusion of the shareholder, the question concerning severance payment and the amount of severance payment arises.

The claim to severance payment is an important property right of german limited liability companies’ (GmbH) shareholders. The determination of the amount of severance payment and the effectiveness of contractually agreed severance payment arrangements is often the subject of bitter shareholder disputes.

In corporate practice, shareholders often see the need to not only exclude shareholders from the company in the event of important reasons, but also to get rid of them - contrary to the regular case provided for by law - without a severance payment. Such constructions can be found in different colors in various statutes of german medium-sized GmbHs, especially concerning the matter of private equity and venture capital investments.

Further information can be found here:

• Severance pay for german shareholders
• Severance pay in german partnerships
• Company valuation for german severance payments
• Information rights in the german GmbH
• Shareholder exclusion by means of leaver clauses in german GmbHs

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Legal expertise around the severance payment of a german GmbH shareholder

ROSE & PARTNER has a team of attorneys, specialists in german corporate law and german tax law as well as tax advisors with many years of experience in corporate law and shareholder disputes. In this context, questions of company valuation and compensation claims regularly play a major role. Our specialized team is active at our offices in Hamburg, Berlin, Munich, Cologne and Frankfurt as well as throughout Germany. Our main areas of advice can be summarized as follows:

1. Drafting of german shareholder agreements and severance pay concepts
2. Legal advice in the event of loss of shareholder status: german shareholder disputes
3. Examination of the effectiveness of german severance pay clauses as well as negotiation of german severance disputes: Severance pay shareholder value
4. Company valuation according to german standard market valuation methods and valuation of severance claims
5. Valuation for tax purposes in the case of german severance payments and advice on the structuring of shareholder squeeze-outs for tax purposes

When are german shareholder squeeze-outs or recoveries without severance payment possible?

The highest court rulings only permit recoveries without severance payment in very exceptional cases (see German Federal Court of Justice (BGH), judgement of April 29, 2014 - II ZR 216/13, para. 13). An overview of the case groups of shareholder squeeze-outs without severance payment is provided below:

• German GmbH does not pursue a commercial but a non-material purpose (see BGH, judgment of 02.06.1997 - II ZR 81/96);
• Exclusion of severance payment in the event that a german GmbH shareholder dies and his share can be collected (see BGH, judgment of 20.12.1976 - II ZR 115/75);
• In the case of an agreed manager and employee profit participation for temporary use, which were granted without capital investment (see BGH, judgment of September 19, 2005 - II ZR 222/55).

The possibilities of a collection without severance payment in Germany are therefore limited. It should be borne in mind that german shareholder squeeze-outs without severance payment also have implications under german tax law and may give rise to charges under gift and tax law among the shareholders.

When drafting their articles of association in connection with shareholder squeeze-outs, collections and severance pay clauses, german shareholders should respect the guidelines outlined below:

Guidelines on severance pay of german GmbH shareholders, share and company valuation.

According to the settled case law of the highest courts, the severance payment for a german GmbH shareholder who loses his shareholder position represents an essential membership and property right. In german corporate practice, the amount of the severance payment is often disputed. Severance payments become relevant not only in the case of shareholder squeeze-outs and compulsory collection in Germany, but also if the shareholder terminates his participation.

The shareholder of a GmbH in Germany can always terminate his participation for good cause. Ordinary termination is possible if the articles of association allow it. It should be noted that a shareholder of a GmbH who is subject to a non-competition clause in the articles of association may become "trapped" in the GmbH if termination is not possible. The exclusion of a termination can lead to a threatening situation for this german shareholder affected by the non-competition clause.

Following the execution of a termination and collection, the question of the amount of the severance payment arises. In german practice, many articles of association have so-called severance pay clauses, which contain specifications on the severance pay amount, due date and more detailed payment modalities (e.g. payment in installments). However, in the absence of a contractual provision, the law and the case law rules on severance payments apply in Germany.

Legal requirements for severance payments in the GmbH in Germany

The legal severance payment of a GmbH is derived from the regulation of the § 738 par. 1 sentence 2 of the German Civil Code (Bürgerliches Gesetzbuch – BGB). It follows from this provision and the case law of the highest courts that the eliminated shareholder is compensated for the true share value. However, the german law does not provide for a specific valuation method for the valuation of the limited liability company share in order to determine a severance pay. In practice, the so-called capitalized earnings method is usually used for questions of company valuation. However, articles of association often contain severance payment clauses that limit the amount of the severance payment. However, a complete exclusion or even a disproportionate limitation of the severance payment can lead to the nullity of the severance clause in Germany. Due to the far-reaching economic consequences of shareholder squeeze-outs and the existing narrow scope for severance payment restrictions, bitter shareholder disputes often arise.

Severance payment amount, valuation procedure and valuation methods in Germany

The severance payment is derived from the value of the german company. When valuing a company in Germany, the following principle applies: There is no overall true and correct company value. The company value rather depends on many aspects, which are often influenced by special effects outside the company. If there exist no specifications within the articles of association, disputes regularly arise concerning the correct valuation method and amount of of severance payment. If there are no tangible reference prices, such as timely sales of shareholdings, the parties involved must agree on a valuation method. The german highest court case law recognizes that effective fair market values can generally be developed from earnings-related valuation methods (BGH, judgement of January 12, 2016 - II ZB 25/14). Accordingly, the german enterprise value is determined from future discounted surpluses. The following is an overview of the valuation methods commonly used in german practice:

• The standard of the IDW Institute of Public Auditors in Germany represents the so-called capitalized earnings method according to IDW S1. The basic principle for the determination of the company value is the sum of the future increase in purchasing power of the shareholders. This cash flow consideration takes into account the fact that company profits solely are not very meaningful if they are required for reinvestment in the company.
• The so-called discounted cash flow (DCF) method, which is based on the discounting of future cash surpluses, takes a similar view.
• The simplified discounted earnings methodology is used by the tax authorities for tax purposes (§§ 199 ff. BewG). The starting point for this method is an adjusted profit from the tax balance sheet.
• In german practice, there are also flat-rate procedures that multiply sales and earnings figures by industry and size-dependent factors, so-called sales and earnings multiples.

A dispute about the determination of the correct valuation method does not arise if there are clear specifications on the valuation method and valuation procedure in the articles of association. However, compensation rules in the articles of association may also be invalid if they contain high compensation restrictions which do not take account of the requirements of case law. In german GmbH articles of association, for example, so-called book value clauses can be found which may be void, at least in the case of profitable companies.

Reasons for severance payment restrictions in Germany

Paying the full fair market value of an investment affected by a redemption, can result in a very high cash outflow for a german company. High severance payments can even create existential risks for a german company. Therefore, in the interest of the Company, severance payments are limited at the expense of the shareholders concerned. In case of such restrictions on severance payments, the conflicting interests of the departing shareholder, who is seeking a high severance payment, and the company or the remaining shareholders, who are interested in a low severance payment, become apparent.

Requirements of case law on the limitation of the amount of the severance payment in Germany

The case law of the german highest courts takes into account the described conflict of interests between the squeezed-out shareholder and the german GmbH by sanctioning excessive restrictions of the severance payments in favor of the squeezed-out shareholder:

Traditional german case law prohibits limiting a severance payment to such an extent that a shareholder willing to give notice would be impaired in his free decision to leave the company. Provisions in the articles of association that unduly restrict the shareholders ability to terminate the partnership are inadmissible under § 723 para. 3 BGB. Restrictions on the severance payment that lead to a gross disproportion between the severance payment amount stipulated in the articles of association and the actual market value of the shareholding are considered invalid according to case law. The question of whether or not there is a gross disproportion depends not only on the difference in value, but also on the individual circumstances, such as the length of membership and the shareholder's contribution to the operating business and success of the german company (see BGH, judgement of December 17, 2001 - II ZR 348/99). If a severance payment restriction is deemed void from the outset due to its gross disproportion, the german Company must pay the shareholder concerned severance compensation in the amount of the full market value. The invalidity of the provision follows from § 138 of the BGB. If a gross disproportion arises only during the life of the german company, according to the case law of the BGH there should be no nullity of the severance payment clauses, but a corrective should be found by means of a supplementary interpretation of the contract (see BGH, judgment of 20.09.1993 - II ZR 104/92). In the event of such a subsequent invalidity of the severance payment clauses, the judges of fact shall determine an appropriate severance payment amount by way of contract interpretation. Often, the court will make a reduction in accordance with the law in Germany.

The german case law concerning collection and severance pay restriction makes it clear that a german company and its shareholders are dependent on experienced attorneys and lawyers specializing in german corporate law already during the formation of the company and later in the event of a dispute over a severance pay amount.

In its judgement of April 29, 2014 (II ZR 216/13), the BGH took a clear position on an issue often discussed in the german literature regarding the right of severance payment. The BGH ruled that a severance payment clause which not only limits but completely excludes the severance payment in the event of the exclusion of a german shareholder due to a gross breach of duty (typical bad leaver clauses) is void.                               

The arguments of the german case law

The BGH had to rule on a compensation clause standardized in the articles of association of a german GmbH, under which a "gross breach of duty by the GmbH shareholder lead to the possibility to collect the share without severance pay. After the claimant had been excluded from the GmbH by a shareholders' resolution and her share had been collected, a further resolution was made in the case under review which clarified that the company was not obliged to make a severance payment to the shareholder who had breached his duties. The excluded claimant did not want to accept this and went through the courts up to the BGH in Germany.

The BGH ruled in favor of the shareholder concerned in the dispute in specialist journals as to whether it was possible to collect the shares without severance pay in the event of a gross breach of duty. The BGH clarified that a collection without severance payment agreed in the articles of association is immoral and void. According to the BGH, such a clause cannot be interpreted as an effective contractual penalty in Germany. The 2nd Senate justifies its view with the fact that the contractual penalty is a certain means of pressure and pursues a proper provision of services or a generalization of damages. According to the BGH judgement, however, both regulatory purposes do not fit for the collection without compensation. Since in the case decided there was no reference at all to any damage suffered by the Company, there could be no question of generalization damages. The BGH also expressed its concern that such a clause would force proper performance and referred to the fact that the collection itself was already to be regarded as a "total loss", since the shareholder concerned would lose his future profit claims. The BGH did not want to accept that a share collection without severance pay as a sanction going beyond total loss would encourage a shareholder to perform better.

The BGH remains true to its traditional line of case law on severance pay in Germany. In principle, the BGH restricts the freedom of contract by counteracting a shareholder's free right to terminate the contract and unreasonably low severance payments. The right of a shareholder to receive severance pay for the loss of his shareholding is one of his basic membership rights worthy of protection (see BGH, judgement of September 27, 2011 - II ZR 279/09). The case law of the BGH has repeatedly rejected excessive reductions in severance pay to the detriment of the departing shareholders. Reference is made again and again to the principle that the company owes the departing shareholder the "true" share value, which can only be reduced with a sense of proportion.

In german practice, it should be noted that provisions in the articles of association regarding the exclusion of shareholders or the collection of shares as well as the limitation of the amount of severance pay must be measured against the requirements of the BGH. Otherwise, there is even a risk that the provisions of articles of association will become null and void in Germany. This could result in destructive shareholders only being able to be excluded from the german company with increased efforts and increased severance payments. However, in the case of initiatives to exclude shareholders, the statutory restrictions on severance payments, such as the principle of capital maintenance (§ 34 para. 3 in conjunction with §. 30 GmbHG), must always be observed and planned for.

Liability risks for german shareholders following collection resolutions

The BGH protects a german shareholder who has been squeezed-out or who has himself terminated the company not only with regard to the question of determining the amount the severance pay, but also with regard to the subsequent realization of the severance payment. Since in german practice the severance payment is often stretched over years, the shareholder concerned bears the credit and insolvency risk of the GmbH owing the severance payment:

According to recent case law of the BGH, the remaining shareholders may be liable if the shareholders' meeting collects the share of a shareholder and the company can no longer pay the severance payment, e.g., due to financial difficulties. The BGH gives the excluded shareholder the right to hold the remaining co-shareholders liable if he defaults on his claim for severance payment from the german GmbH. Such direct shareholder liability is said to arise if the remaining shareholders act in breach of trust towards the squeezed-out shareholder and do not ensure that the severance payment can be made from the GmbH's unrestricted assets or the shareholders do not dissolve the company (see BGH, judgement of May 10, 2016 - II ZR 342/14).