Can Bolkestein finally break the takeover directive deadlock?

Date: 20/03/03

The EU's internal market chief is eager to reach a compromise over the controversial takeoverdirective, but major challenges still lie ahead, writes policy analyst Arman Khachaturyan

ADVANCE without retreating. This was the mood in which Internal Market Commissioner Frits Bolkestein presented his arguments for one of the most highly contested pieces of EU legislation, the proposed takeover directive, during a recent conference organised by the Centre for European Policy Studies.

The proposed directive is aimed at providing a common regulatory framework for corporate conduct, a level playing field, transparency and protection for minority shareholders. Overall, it is designed to promote an active market for corporate control and shift power to the shareholders.

Despite cautious optimism, after nearly 14 years of debate, the proposed directive faces major challenges.

It has raised concerns across member states and the business community over its potential economic, social and political consequences. The proposed directive has largely followed the recommendations of the 'High Level Group of Legal Experts', headed by Jaap Winter. The Winter Report is, unfortunately, open to conflicting interpretations and even contradictory in parts.

Its guiding principle is that shareholders are the owners of a company and any decision to sell or not should be theirs. The second is that there should be proportionality between risk-bearing capital - ie cashflow - and who has the ultimate power to decide whether to allow a takeover.

These principles are of utmost importance in the pursuit of the level playing field. The question is, will the Winter Report team actually deliver this?

Paradoxically, Winter redefines the concept of ownership in the takeover context and with regard to the 'breakthrough rule'. This allows the owners of 75 of cashflow rights to remove any obstacle to a takeover by, for instance, nominating new directors, modifying articles of association or annulling defensive mechanisms.

Lawyers generally define ownership as the exclusive right to use, possess, and dispose of property, subject only to the rights of people having a superior interest and to any restrictions on the owner's rights imposed by agreement with, or by act of, third parties or by law.

Economic literature also defines ownership as that of residual control rights or residual decision-making power over the property, beyond agreed contractual clauses among and between the interacting parties.

Ownership is exercised by voting rights. However, the Winter Report shifts ownership and voting rights from the owners to the non-owners.

As previously explained, upon acquisition of 75 of risk-bearing capital, the bidder can break through any mechanisms and structures that deviate from the principles of shareholder decision-making and proportionality between risk and control.

Thus, in the takeover context, the claimants of residual profits become residual decision-makers, based on the argument that they bear the ultimate effects of their decisions.

Paradoxically, this would mean that, in the takeover context, i) ownership rights are shifted from the real owners to the non-owners; and ii) the decision to sell is not in the hands of the owners but the non-owners.

The central issue in the proposed directive is the level playing field concept. Whether the board neutrality and breakthrough rules are sufficient to create this is still the subject of much debate.

Bolkestein believes that the one-share one-vote regime is the long-term objective and that it is conducive to optimal allocation of resources. He sees this as the way to promote shareholder democracy and to achieve a single, integrated and liquid securities market in the European Union.

However, economic theory would suggest that the breakthrough rule i) violates the principle of shareholder democracy and decision-making; ii) violates freedom of contracting, iii) is capable of reducing the value of the target firm; iv) eliminates any 'control premium' (the amount a majority shareholder receives above market price for a controlling block of shares) after the bid has been announced; and v) moves structures of ownership and concentration into economically less efficient structures.

There is also, logically, an inconsistency between the aims of the mandatory bid and the breakthrough rules, in so far as the latter deprive the shareholders of the target company of any private benefits, irrespective of the mandatory bid rule. In general, the breakthrough rule is a costly and inefficient measure.

It remains unclear how the board neutrality principle can be enforced in the EU, given that corporate ownership and control have been traditionally dominated by concentrated ownership, disproportionate classes of shares, voting trusts, voting caps, pyramids and cross shareholding structures. Unlike the US, which is characterised by a dispersed shareholder base and traditional conflict of 'monitoring and incentives' by small shareholders, most EU countries have solved the conflict by applying foregoing mechanisms of ownership and control.

Moreover, unlike the US, European social democracies have traditionally exerted pressure on firms to take into account employment considerations, which generally have been to the detriment of shareholder value maximization.

In this context, on one hand, board neutrality can provide shareholders with better information and safeguards against opportunistic behaviour by the incumbent management. On the other hand, board neutrality can fail to take into consideration wider stakeholder interests in the company.

Dutch MEP Ieke van den Burg believes the board neutrality rule is based on the dogmatic pursuit of shareholder value maximization, rather than taking into account the wider interest of stakeholders.

In general, then, board neutrality and breakthrough rules are neither necessary nor sufficient to ensure a level playing field.

Each rule should be assessed on its own merits and efficiency implications. The focus should be shifted from achieving a level-playing field at any cost to ensuring the most competitive takeover regulation is in place at national levels.

Multiple or dual class voting shares have been another major point of contention. Economic theory would suggest that, in general, these shares out-perform the one-share one-vote regime in terms of their economic efficiency. However, the one-share one-vote system is more politically attractive in so far as it promotes shareholder democracy and weakens the insiders' position; it also acts as a disciplining device for incumbent management.

Despite fierce opposition from Nordic countries, Germany has repeatedly argued that the proposed directive should cover multiple class voting shares. In July 2001, the European Parliament's takeover rapporteur, Klaus-Heiner Lehne, argued: "There is in practice no reason why companies which were family controlled, but not family owned, should enjoy special privileges."

Eager to reach a compromise, Bolkestein believes that the inclusion of multiple-class voting shares in the proposed directive would be a step in the right direction.

Moreover, the Commission is willing to compromise and welcomes acceptable and legally sound ideas which go beyond its proposals.

One way or another there will be a heated debate in the coming weeks over the necessity and rationale of harmonisation of the takeover regulations. There is no doubt that the expectations of those affected should be the primary driver behind any final decision.

The question is whether there is a consensus on the expectations.

• Arman Khachaturyan is a visiting fellow from Italy's University of Siena at the Centre for European Policy Studies, Brussels. www.ceps.be

Major feature. The EU's internal market commissioner is eager to reach a compromise over the controversial takeover directive, but major challenges still lie ahead.

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