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Accountability

The second objective of EU action, according to Commissioner McCreevy, is to empower shareholders. Indeed, a high level of transparency is of little use if shareholders cannot take action to address the incompetence of the directors or straightforward expropriation by unscrupulous managers and/or controlling shareholders.

Here too there are some important emerging regulatory trends. Whereas, in the area of transparency, the European Commission has succeeded in setting the stage for the emergence of a single disclosure system for all European issuers, the jury is still out when it comes to the empowerment of owners to hold companies accountable across EU borders.

Shareholder rights and participation

The key legislative measure in this area is the Commission’s directive on shareholder rights.22 The directive has been hailed by most market participants as a long-needed levelling of the playing field between companies and shareowners. According to the directive’s preamble, ‘Significant proportions of shares in listed companies are held by shareholders who do not reside in the Member State in which the company is registered. Non-resident shareholders should be able to exercise their rights in relation to the general meeting as easily as shareholders who reside in the Member State in which the company is registered.’ The directive facilitates shareholder access and empowerment in the following ways:

A record date will determine the eligibility of investors to participate in the general meeting, as opposed to current requirements in several EU markets for the blocking of shares, sometimes for several days before the annual general meeting. Blocking has been advanced by many institutional investors as a reason for not voting, as it restricts their ability to move fast when unexpected risks arise.

Companies will need to publish the AGM agenda well in advance of the meeting, so that it can be transmitted through the custodian chain to the beneficial owners of shares. Most importantly, relevant background information on the decisions shareholders will be asked to make must also be published at the same time as the agenda.

Member States’ laws must not prohibit or create obstacles to the use of electronic shareholder voting. Furthermore, Member States must not overcomplicate the assignment of proxies and thus create obstacles in shareholder participation.

22 See Provisional text of the Directive on the exercise of certain rights of shareholders in listed companies, June 2007, available at http://ec.europa.eu/internal market/company/ docs/shareholders/dir/draft dir en.pdf.

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Shareholders will be allowed to ask questions before the AGM.

Shareholders will have an opportunity to put items on the agenda of the general meeting.

The adoption of the Shareholder Rights Directive should increase the level of participation and engagement of institutional investors in the affairs of European companies. Hitherto, many large institutions have shied away from voting given high share-blocking risks, the disproportionate cost of voting, and the paucity of AGM-related information. These obstacles will be considered later. Facilitation of shareholder engagement should focus boards on addressing investor concerns and raise their shareholder value consciousness. Companies should also start to feel less concerned over the possibility of certain small minorities, hedge funds or other short-termist investors, hijacking shareholder voice to the detriment of long-term shareholder value.

The market for corporate control

From Vodafone’s acquisition of Mannesmann in 2000 to the saga of E.ON’s bid for Spanish Edensa in 2006, cross-border consolidation has been one of the thorniest areas of EU economic integration. It should come as no surprise that negotiations for the adoption of the EU 2004 Directive on Takeover Bids has been by far the most politically charged of all corporate governance related measures. The Directive was meant to be a legislative lever to limit entrenchment of national elites in inefficiently controlling economic resources by enabling a truly market-driven allocation of these resources through the emergence of an efficient pan-European market for corporate control. The adoption of the Directive came after twenty years of discussions and the last-minute thwarting of a previous draft by a rebellious European Parliament in 2001. The issue over which the earlier draft fell was the protection of large German companies from mostly foreign predators. For over three decades, these large corporates had served masters other than their shareholders. By law employee interests were (and still are) considered equal to those of shareholders, and worker representatives fill half of the seats on supervisory boards of companies. Employee co-determination combined with a vast network of cross-shareholdings had managed effectively to shield managers from serious shareholder scrutiny for the better part of the twentieth century. No surprise then that German companies had become laggards in generating shareholder wealth. This resulted in their undervaluation, which made them attractive to various bidders including private equity and hedge funds. Ironically, one of the reasons that German companies became fair game was an earlier round of domestic company law reform aimed at enhancing shareholder power by outlawing most anti-takeover defences (most importantly board-driven poison pills).

Being the outcome of this twenty-year policy wrangle, the Takeover Bids Directive is unlikely to bring about the changes of momentum sought by the

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Commission. Moreover, some of the regulatory solutions it has espoused may prove to be counterproductive.

There are, certainly, some positive aspects to the Directive. It sets a minimum level of transparency requirements regarding ownership structure and control arrangements (discussed above). It requires timely and orderly provision of information to the market in the form of an offer document, and it establishes squeeze-out and sell-out rights for small stranded minorities after a takeover battle. The Directive also spells out the principle of a mandatory bid to all holders of securities when control is sought – although it does leave a lot of leeway to Member States in shaping mandatory bid thresholds, thus providing the potential for regulatory arbitrage and divergence rather than convergence of regulatory regimes. For example, an Italian shareholder holding 40 per cent of shares may be able to sell for a substantial control premium without extending benefits to free float shareholders, while bidders of UK companies will need to launch expensive bids for 100 per cent of the equity once they acquire more than 29.9 per cent of voting securities.

The most sensitive issue was the regulation of anti-takeover defences. The approach of the Directive is three-pronged: limiting the power of the board to raise obstacles by calling for shareholder approval of any major defence move; a temporary non-applicability of special voting rights or voting limits when such decisions are taken – so that minority shareholders with multiple voting rights cannot impose their will on the majority holding one vote per share; and the so-called breakthrough clause allowing bidders who have acquired more than 75 per cent of outstanding voting stock to adopt amendments to the articles of association during the first post-bid general meeting that remove multiple voting shares or other control arrangements. This solution was advocated by the Winter Report and effectively addresses two difficult policy tradeoffs:

a fair and effective balance between the often conflicting objectives of accountability to outside investors and the existence of strong, responsible owners;

a balance between the need to protect existing, long-standing contractual arrangements (such as multiple voting rights) and the public policy imperative of making the European takeover market more efficient and integrated.

The final compromise made the above approach optional for Member States by giving countries the choice to allow individual companies to opt out of the regime. Moreover, even when companies are subject to the regime, the ‘reciprocity exception’ allows them to opt out when they are the target of a bidder who is not subject to the same regime. This optional approach is counterproductive first, because of its complicated and unpredictable nature. It is difficult, for example, to predict the defensive options available to a target company, as these depend on whether potential bidders are themselves subject to the Directive’s regime. It is also unclear what will happen in a threeor four-way

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contested bid. Investors will find it hard to price the availability of takeover exits into the share price. In addition to the lack of transparency, the Directive may actually be setting the clock back in terms of company law in some countries. A 2007 European Commission report on the implementation of the Directive confirms our view of the Directive being rather counterproductive. According to the Report, two Member States, Cyprus and Spain, which had board neutrality (i.e. the board was not able to adopt anti-takeover measures without shareholder approval) in place by the time of the publication of the report, have decided to implement the Directive by introducing reciprocity. Italy may also decide to do the same. As regards the breakthrough rule, the vast majority of Member States have not imposed (or are unlikely to impose) this rule, but have made it optional for companies. Just 1 per cent of listed companies in the EU will apply this rule on a mandatory basis since only the Baltic States have imposed the requirement in full. In contrast, Hungary had a partial breakthrough rule before transposition, which has been eliminated.23

One-share-one-vote

The unsatisfactory regime of the 2004 Takeover Bids Directive suggests that the EU corporate control market will continue to be marked by regulatory divergence. Nevertheless, consolidation is continuing to occur. The significant increase in the level of transparency, combined with the expected increase in shareholder engagement by Anglo-American institutional shareholders in European cross-border situations, should limit the damage from regulatory back-stepping on poison pills.

But poison pills are only part of the anti-takeover arsenal. In many European large companies there are important asymmetries between pecuniary rights related to shares (cash flow rights) and control, most importantly voting rights attached to shares. A 2007 study on the proportionality principle in the EU (‘Proportionality Principle study’) commissioned by the European Commission found that Control Enhancing Mechanisms (CEMs), enabling asymmetries between cash flow rights and voting rights, are widely available in Europe: 44 per cent of the 464 European companies considered in the study have CEMs; this includes a majority of large caps (52 per cent of the companies analysed) and one quarter of recently listed companies.24

In principle, markets welcome flexibility in shaping rights along the risk– return curve. For example, most company laws uncontroversially allow voting rights to be forfeited in return for privileged status in cash distributions, as

23European Commission, Report on the Implementation of the Directive on Takeover Bids, February 2007, pp. 6 and 7.

24See ISS, Shearman & Sterling & ICGN, ‘Report on the Proportionality Principle in the European Union’, May 2007, p. 9. The study covers sixteen Member States (Belgium, Denmark, Estonia, France, Finland, Germany, Greece, Hungary, Ireland, Italy, Luxemburg, The Netherlands, Poland, Spain, Sweden and the United Kingdom) and three other jurisdictions (Australia, Japan and the United States).

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is the case with most classes of preferred stock. Investors, however, recoil at arrangements that undermine one-share-one-vote where the only purpose is to protect and entrench management, even if such arrangements are described as protecting the long-term stability of the company. Voting rights ceilings are a good example of such an arrangement. The EU study found that voting rights ceilings, along with priority shares, golden shares and multiple voting rights, are among the CEMs that are most negatively perceived by investors. According to the study, voting rights ceilings ‘hinder the emergence of large shareholders, thereby making takeovers virtually impossible. At the same time, they fragment power and impede effective monitoring. That is, they simultaneously undermine the two primary mechanisms for disciplining managers: outside monitoring and control contestability.’25

What should EU public policy have to say about the most prevalent of asymmetries, that of multiple voting rights? In Sweden, where these rights are most popular among large listed issuers, block holders typically hold more than 50 per cent of control rights while being exposed to between 12 and 20 per cent of the equity risk. That is because the risk–return characteristics of the multiple voting class of securities are identical to those of the single vote class. According to their proponents, multiple voting rights allow companies to have their cake and eat it: strong, engaged owners with the power to act as true principals in overseeing and remunerating management, on the one hand; and a wide equity base and capital market access providing companies with growth funding, on the other hand. Conceptually, however, this arrangement is suspect because it makes little economic sense for the controlling owners. Like private equity investors, they put in the effort and underwrite the cost of long-term active engagement in the governance of the company. But unlike them, they agree to share disproportionately the resulting benefit with other shareholders. As the theory goes, rational economic actors would have to compensate for this free rider loss by appropriating private benefits of control. These may range from company perks to much more serious appropriation of corporate opportunities and, in extremis, to the ‘tunnelling’ of assets and cash flows. The latter is often the case in emerging market companies where large cash flow to control rights asymmetries exist in the context of a weak legal and institutional environment. Ultimately, the question is whether, and to what extent, in an environment where the rule of law is highly developed, the risk of private benefits outweighs the public benefits of better managerial monitoring combined with broader capital market access.

In an FT op-ed, two prominent investor representatives support the idea that the EU should adopt rules imposing one-share-one-vote on listed companies, albeit recognising that this might, in the short term, be politically unfeasible. In their words, ‘distortions of the proportionality between voting rights and share

25 See ‘Report on the Proportionality Principle in the European Union’, May 2007, p. 16.

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