Defective Company – Definition, Legal Consequences, and Winding-up
The defective company is a practically relevant legal term in corporate law, which regulates the legal consequences of an invalid or flawed company formation. The core issue is how a company is to be treated when, after its formation, defects in the formation process or the articles of association become apparent. In German law, the so-called doctrine of the defective company has been developed over time, whose basic principles have also been adopted in the jurisprudence and literature of other legal systems.
Concept and Emergence of the Defective Company
A defective company typically arises when the articles of association would actually be void due to a defect in intent, content, or form, but the company is nevertheless executed by the parties and treated as an existing company for a certain period. Despite the legal defect, there is a de facto bond between the partners and corporate relations are maintained.
Classic Applications
- Defect in form: The mandatory notarization required for founding a GmbH was omitted.
- Violation of law: Statutory prohibitions concerning the formation of a corporate structure are breached (e.g., violation of the circumvention prohibition under Section 134 BGB).
- Defects of intent: For example, the articles of association are concluded under deception or duress.
Distinction from Other Types of Companies
The defective company is distinguished both from a so-called de facto company, where there is no valid articles of association at all, and from a sham company, which is entered into for appearance only. The distinction depends on the type of defects and the practical execution of the partnership.
Legal Consequences of the Defectiveness
The central issue regarding the defective company is how the effects of defectiveness on the corporate relationship and its winding-up should be dealt with.
Nullity and Unwinding
According to general contract law—especially § 142 BGB (retroactive effect of avoidance) and § 812 BGB (unjust enrichment)—the finding of a defect generally leads to the nullity of a contract and unwinding on the basis of the law of unjust enrichment.
Doctrine of the Defective Company
Departing from these principles, German jurisprudence—in particular the Federal Court of Justice—has developed the doctrine of the defective company. According to this doctrine, a company that has already been executed cannot be dissolved or unwound retroactively unless particularly worthy interests dictate otherwise.
- Ex nunc effect: Despite the defect, the company is regarded as valid until the time the defect is asserted. The legal consequences apply only prospectively (ex nunc effect), instead of the contract being void ex tunc.
- Protective principle: Primarily, the practical concerns associated with the company and the protection of the partners, as well as creditors, should be taken into account.
Limits to the Doctrine
Unwinding in relation to third parties is particularly excluded when the defective company has already participated in legal transactions and creditor interests are affected. The doctrine does not apply in cases of serious violations of the law, such as nullity due to immorality or a criminal act.
Special Corporate Law Provisions
In the special statutory provisions of the German Limited Liability Companies Act (GmbHG), the Stock Corporation Act (AktG), and for partnerships (GbR, OHG, KG), there are special considerations regarding defects in articles of association, especially regarding defects of form, intent, and in company formation.
Winding-Up of Defective Companies
Liquidation and Settlement
If a defective company is dissolved, settlement generally takes place according to corporate law standards. Dissolution is carried out in the same way as for a valid company – typically by means of liquidation, realization of company assets, and distribution of the liquidation proceeds to the partners in accordance with their share.
Compensation Claims
Partners whose entry into the company was defective regularly have a corporate compensation claim during the winding-up. Unwinding under the law of unjust enrichment is reserved for exceptional cases.
Protection of Third Parties in the Context of Defective Companies
Creditor interests are especially at the center of legal protection: Creditors must be able to rely on the continuity of the company relationships, even if there is a defect in the articles of association. The doctrine of the defective company therefore prevents a retroactive nullification that could disadvantage creditors.
Contractual Partners and Third-Party Relationships
Third parties in commercial transactions can assert claims against the company as if it were a properly formed company, unless there are special circumstances to the contrary.
Defective Company in an International Context
Comparable constructs for addressing de facto existing but legally defective companies also exist in other European legal systems, although the doctrinal derivations and concrete legal consequences may vary in individual cases.
Summary and Significance
The defective company constitutes an important instrument for the protection of legal transactions in corporate law. It prevents corporate relationships from being immediately voided in the presence of formation or content defects, which would otherwise create economic and legal uncertainty for partners and creditors. Application of the principles of the defective company requires that the defects do not violate fundamental principles of the legal system, that the company has actually participated in legal transactions, and that there are no overriding legal provisions to the contrary.
Further Reading
- Münchener Commentary on the BGB, Volume 2, Corporate Law, current edition
- Ulmer/Habersack/Löbbe, GmbHG, current edition
- Palandt, German Civil Code (BGB), Corporate Law, current edition
Note: The specific legal consequences of the defectiveness of a company depend on the respective type of company, the established defect, and the interests of third parties and must always be assessed on a case-by-case basis.
Frequently Asked Questions
What are the legal consequences of a defective company under German law?
Under German law, the existence of a defective company results in a de facto corporate relationship between the parties being regarded as valid, despite the defect affecting the company formation (for example, defect in form, incapacity of a partner, or a statutory prohibition), insofar as legitimate interests require this. Retroactive nullity as with other void legal transactions does not usually occur. Rather, the company relationship is maintained until dissolution and settlement, so that partners’ claims are generally treated as if the company had been validly formed. This serves both protection of legitimate expectations and security of legal transactions. However, the application of these principles is limited to partnerships and is generally excluded for corporations because mandatory formation requirements exist for them.
When does the legal concept of a defective company apply?
The legal concept of the defective company is applied when a corporate contract has indeed been agreed but suffers from a legal defect which, under general regulations, would actually lead to nullity. The typical scenario is the formation of a civil law partnership (GbR), a general partnership (OHG), or a limited partnership (KG), where, although dealing externally seems proper, the articles of association—for example—have a defect in form or violate a legal prohibition. As soon as the company acts externally and the legitimate interests of partners or third parties are affected, the concept of the defective company is applied. This is to prevent adverse effects on legal transactions or the financial interests of the parties involved.
What conditions must be met for a defective company to be assumed?
To assume a defective company, the parties must have first concluded articles of association that would be void or voidable due to a legal defect, such as a breach of form, incapacity of a participant, or a statutory prohibition. Despite this defect, the company must have actually operated in legal transactions, i.e., it must have manifested as a corporate entity externally. Moreover, a worthy interest—on the part of a partner or a third party—must exist that outweighs the retroactive nullity. In such cases, the company is to continue until its dissolution and settlement as if it were validly established. Thus, a defective company presupposes the existence of a long-term corporate obligation and actual execution in legal transactions.
What is the difference between a defective company and a sham company?
The defective company must not be confused with the sham company. While a defective company involves a genuine contractual intention to form a company, merely suffering from a legal defect, the sham company lacks true intention to form at least by one party. A sham company exists if the outward impression of a company is given, but actually no valid articles of association exist or one of the participants is not acting to form a company. In such situations, the contract is generally treated as void, so—unlike the defective company—protection under the doctrine of the defective company is not granted.
How does the principle of the defective company affect legal transactions already concluded?
The principle of the defective company means that all transactions undertaken in performance of the articles of association are regarded as valid, even though the articles of association have a legal defect. This applies especially to contracts with third parties and between the partners. Otherwise, retroactive nullity of the articles of association would require the reversal of all corporate actions, which could lead to significant legal and economic uncertainty. By continuing the company, its transactions are therefore also recognized until proper liquidation and settlement.
Can minors or persons lacking legal capacity validly enter into a defective company?
As a rule, minors or other legally incapable persons cannot validly conclude a corporate agreement because they lack legal capacity. If, however, a company in fact comes into existence with their participation and has already been executed, the doctrine of the defective company does not apply if the protection of the minors or incapable participants prevails. This protection principle generally takes precedence over the interest in maintaining the company. Only in exceptional cases, e.g., upon express approval by a legal guardian or family court, can a minor be validly treated as a partner of a defective company.
Is the doctrine of the defective company applicable to corporations (such as GmbH or AG)?
The doctrine of the defective company is predominantly applied in German law only to partnerships, e.g., to the civil law partnership (GbR), the general partnership (OHG), and the limited partnership (KG). For corporations such as the limited liability company (GmbH) or the stock corporation (AG), the doctrine does not apply. This is because corporations have strict formation requirements designed to protect legal transactions and especially creditors. In particular, if notarization or minimum capital contribution is lacking, the company is deemed void; thus, the need for protection as with partnerships does not prevail.
