Federal Court of Justice on Call Options in Management Equity Programs

Private equity funds invested in a group of companies specializing in LED lighting (“P Group”). To facilitate indirect management participation, a GmbH & Co. KG (“P KG”) was established specifically for this purpose, which held a 1.28% stake in P Group GmbH, a holding company under which the actual P Group operates.

The plaintiff was an external managing director of an operating subsidiary of the P Group and joined P KG as a limited partner in exchange for a contribution at fair market value. His interest did not confer a right to ongoing profit sharing, but merely a share in the exit proceeds.

The articles of association of P KG contain a call option under which a manager’s interest could be acquired by the remaining shareholders upon the termination of his executive or service position –regardless of the legal basis. The amount of the severance payment was determined by a good/bad leaver provision. 

Following the plaintiff’s removal as managing director and the termination of his managing director’s employment contract, the defendants exercised the call option. The plaintiff sought a declaration that he remained a shareholder and argued that the call option provided for in the articles of association constituted a free exclusion clause that was contrary to public policy pursuant to Section 138 para. 1 BGB and was therefore void. While the courts of first and second instance ruled in favor of the plaintiff, the Federal Court of Justice overturned the judgment and remanded the case to the Higher Regional Court of Munich.

3. Exit-Only Investment and Economic Risk

The fact that the management participation is designed exclusively to provide a share in the exit proceeds and does not provide for ongoing profit sharing does not preclude objective justification. The Federal Court of Justice views such a structure - particularly in private equity arrangements - as comparable to a bonus payment in the event of a successful business transaction.

Nor is the fact that the plaintiff invested at fair market value and bears an economic risk relevant to the validity of the exclusion clause. Objective justification within the framework of a management model does not necessarily require that a manager assumes no or only a minimal economic risk.

4. Separation of the exclusion clause, severance pay provision, and control of exercise

Whether the severance pay provision is appropriate in a specific case concerns solely its validity. This is irrelevant for the assessment of the exclusion clause. 

Risks of abuse - such as through tactical timing shortly before an exit - must also be examined not at the level of assessing the validity of the exclusion clause, but within the framework of the exercise control (Sections 242, 162 para. 2 BGB). The Higher Regional Court of Munich - consistent with its legal opinion - did not examine the exercise control. Therefore, the Federal Court of Justice set aside the Higher Regional Court’s judgment and remanded the case to it for a new hearing and decision.

The Federal Court of Justice confirms that call options are not per se invalid in cases of management equity programs upon the termination of the management function and may well be valid. In doing so, the Federal Court of Justice expressly clarifies that not all criteria established by the Federal Court of Justice in its 2005 decision on management cases need to be met. Rather, provisions in scenarios involving the acquisition of the equity interest at fair market value and models with pure exit participation can also be validly agreed upon if the shareholder status is functionally structured as an adjunct to the management function.

At the same time, the ruling emphasizes the need for careful structuring on a case-by-case basis. Validity depends largely on whether the specific structure demonstrates that the equity interest has no independent significance apart from the management function and that the purpose of the equity interest ceases upon the termination of its affiliation with the corporate group or its employment contract or activity.

Despite its permissibility, risks remain in its exercise, particularly in light of the abuse-of-rights review regarding the exercise of the termination clause, which is still pending before the Higher Regional Court of Munich. 

The Federal Court of Justice strengthens the legal predictability of call options in management equity programs, particularly in the private equity environment, without abandoning the fundamental protection against unrestricted termination clauses.

The key factor remains the need to consider all circumstances of the individual case as a whole. The Federal Court of Justice’s decision underscores the importance of carefully and fairly structuring leaver provisions.

For reasons of legal certainty, it is advisable to briefly document the objectives pursued by the leaver concept - in particular, incentivizing and retaining managers in the long term, as well as ensuring the continuity of management after the closing - in the contract itself. Regardless of the contractual structure, it should be noted that the subsequent exercise of a leaver call option is subject to the exercise control provisions under Sections 242 and 162 para 2 BGB. In such cases, it is advisable not to leave the exercise of an option at an “inopportune time”—such as shortly before an exit—merely to abstract exercise controls, but rather to exclude it contractually and, ideally, to describe it in a way that is easy to understand using specific examples of timing. In the case of economically significant buybacks, the validity of corresponding exclusion clauses must be examined with particular scrutiny.