Relief for private equity investors: greater flexibility regarding manager shareholdings

The Federal Court of Justice has relaxed the requirements for the validity of so-called early termination clauses, thereby providing greater scope for the incentive scheme based on equity participation that is popular with private equity investors.

Background

In practice – particularly in private equity structures – it is common to grant executives an indirect stake in the company as part of management share ownership schemes, in order to retain them and motivate them to increase the company’s value. Such programmes generally provide for so-called call options or redemption rights, which grant the majority shareholder the right to repurchase the manager’s stake upon their departure from the management board or termination of their employment. 

According to the case law of the Federal Court of Justice (BGH), such repurchase rights constitute so-called ‘free termination clauses’ if the majority shareholder has the power to trigger the repurchase right by dismissing the managing director or terminating the employment contract. According to established case law, free termination clauses are, in principle, contrary to public policy and therefore void, because the constant threat of exclusion, acting as a ‘sword of Damocles’, may impair the free exercise of shareholders’ rights (see Section 138 of the German Civil Code (BGB)). 

However, in its landmark decision of 19 September 2005 (II ZR 173/04 – ‘Manager Model’), the Federal Court of Justice (BGH) recognised for the first time that an unrestricted termination clause may, in exceptional circumstances, be objectively justified and thus valid. Namely, where the position of shareholder was granted to the manager merely as an annex to his position as managing director and has no independent significance beyond that. Consequently, the BGH’s criteria – in particular a minimal economic risk for the manager and a share in current profits – were interpreted by some as cumulative requirements that must all be met for the clause to be valid. This strict interpretation led to considerable legal uncertainty in drafting practice, as typical private equity investment structures did not readily comply with the BGH’s supposed requirements.

Facts

In the case now decided by the BGH, the claimant, a managing director of a group company, had joined, as part of a management participation scheme, as a limited partner in an investment company (GmbH & Co. KG), which held a total stake of 1.28% in the group holding company. The claimant made a contribution to the investment company in the amount of the market value of approximately EUR 150,000 for his share, thereby indirectly holding a stake of approximately 0.38% in the group. No share in current profits was provided for; the manager was only to participate in the proceeds of a subsequent sale of the group (exit). 

The partnership agreement provided for a call option granting the majority shareholders (two private equity funds) the right to repurchase the manager’s stake if he was no longer acting as managing director or had been relieved of his duties. The purchase price depended on whether a so-called ‘good leaver’ or ‘bad leaver’ scenario applied (i.e. whether or not the manager himself had given cause for his dismissal). A ‘good leaver’ was to receive the market value, whilst a ‘bad leaver’ was to receive the lower of the market value and his own investment. Following his dismissal without cause and his release from duties, the defendants exercised the call option and paid the claimant approximately EUR 35,000 as the market value of his shareholding – a fraction of his original investment. 

The Augsburg Regional Court and the Munich Higher Regional Court (on appeal) had upheld the claim and deemed the call option to be contrary to public policy and void. The Munich Higher Regional Court had essentially justified this on the grounds that, in view of the lack of ongoing profit sharing, the economic risk assumed by the manager and the acquisition at market value, the shareholding had an independent significance extending beyond the position of managing director. 

Decision

The Second Civil Division of the Federal Court of Justice (BGH) has set aside the appeal judgment and referred the case back to the Munich Higher Regional Court. In particular, it has established the following principles:

In terms of legal doctrine, the Federal Court of Justice adheres to its previous case law, subjecting termination clauses to a so-called ‘substantive review’ (Section 138 of the German Civil Code). Unlike the purely exercise-based review (Section 242 of the German Civil Code (BGB)) sometimes called for in the legal literature, it is not the actual exercise of the clause that is measured against the standards of good faith, but rather its abstract content. Accordingly, free termination clauses are to remain fundamentally void if the conditions set out in Section 138 of the German Civil Code (BGB) are met. Only this preventive review can effectively protect the shareholder’s freedom of decision – a mere retrospective review of the exercise of the clause is not sufficient for this purpose. 

Of considerable practical significance, however, is the comprehensive assessment of all circumstances and the interests of both parties in each individual case, as now postulated by the Federal Court of Justice. Whilst the criteria cited in the ‘manager model’ case law must be taken into account, they do not constitute mandatory, cumulative requirements. Rather, the decisive factor is whether (i) the shareholder status was granted to the manager by virtue of his position as managing director and for a purpose associated with that position, (ii) this purpose ceases to apply upon termination of the executive or service position, and (iii) in view of its structure, his shareholding is not otherwise to be attributed any relevant independent significance vis-à-vis his position as managing director. 

In this regard, the Federal Court of Justice (BGH) has also clarified that the lack of a share in current profits does not negate the incentive and retention function of the management shareholding. The share in exit proceeds is comparable to a bonus payment in the event of a successful business transaction and, particularly in private equity models, is explained by the objective known to the manager of working towards an increase in the value of the company for the purpose of its sale. 

Even the acquisition and retransfer of the shareholding at market value and the associated risk of negative business performance do not necessarily preclude the objective justification of the clause. In this regard, the Federal Court of Justice emphasised that the assumption of economic risk serves the legitimate purpose of deterring management from engaging in irresponsibly risky transactions. Furthermore, a manager who bears economic risk himself is more inclined to exercise his shareholder rights independently, despite the risk of termination. The ‘sword of Damocles’ of impending exclusion therefore has a less intense effect.

According to the BGH, whether the severance payment to be paid to the manager in the event of his dismissal is appropriate is relevant solely to the validity of the severance payment clause, but not to the validity of the dismissal clause itself. The only decisive factor in this regard is the objective justification for the risk to the free exercise of shareholder rights associated with the dismissal clause.

In the BGH’s view, any risks of abuse – such as a targeted dismissal shortly before an exit – can be countered by means of what is known as ‘exercise control’. According to this, the exercise of a right may, in individual cases, be contrary to good faith and therefore inadmissible, under Section 242 of the German Civil Code (BGB) or Section 162(2) BGB. However, the Higher Regional Court had not carried out this assessment and must now do so. 

Practical note

The BGH’s decision creates significantly more scope for structuring management participation schemes, as are particularly common in the private equity sector. In practice, the ‘manager model’ case law was often interpreted to mean that a valid termination clause required the manager to bear no or only a minimal economic risk and to share in current profits. The Federal Court of Justice has now clarified that these are not mandatory requirements. Consequently, numerous participation structures common in practice, the validity of which was previously subject to uncertainty, are likely to rest on a more solid legal footing.

Nevertheless, it should be noted that the Federal Court of Justice has not granted a blanket approval for all arrangements. Validity remains a matter of assessing the individual case as a whole. Arrangements in which the manager’s participation goes beyond mere incentives in addition to the position of managing director – for example, because they are granted substantial rights of co-determination or the participation has independent significance in concept – may still fail to meet the requirements of Section 138(1) of the German Civil Code (BGB).

In contractual practice, it is therefore advisable to ensure, when structuring management shareholding programmes, that the shareholding is conceptually clearly linked to the manager’s role. The manager should (where legally possible) not be granted any shareholder rights beyond those serving a retention and incentive function. In addition, the severance pay provision should be examined separately, as the Federal Court of Justice (BGH) expressly distinguishes between the validity of the early termination clause and the severance pay clause. Finally, the supplementary exercise control emphasised by the Federal Court of Justice deserves particular attention: even a valid call option must not be exercised in an abusive manner, for example to deliberately deprive the manager of their share in an impending exit. 

(BGH, judgment of 10 February 2026 – II ZR 71/24)