Towards a European Modified Business Judgment Rule for Takeover Law
Humboldt University of Berlin - Faculty of Law; Humboldt University of Berlin - Faculty of Economics
Richard W. Painter
University of Minnesota Law School
European Business Organizations Law Review
The text of the proposed European Union takeover directive was last revised in June 1999, and there is still controversy about a crucial feature that it shares with London's City Code and Germany's voluntary Takeover Code: a strict "neutrality rule" that would require the board of a target corporation to desist from deploying most defensive measures without shareholder approval. The proposed directive thus follows the rule laid down in Principle 7 of the City Code which outlaws, on the part of the target's board, "any action, which could effectively result in any bona fide offer being frustrated or in the shareholders of the offeree company being denied the opportunity to decide on its merits."
This strict neutrality rule is mitigated in the proposed European takeover directive and in the German voluntary Takeover Code, both of which exempt a few defensive measures - such as looking for a white knight - from the strict ban on defensive measures deployed by the board of a target corporation without prior shareholder approval. The vast majority of defensive measures - such as raising new capital, making significant acquisitions or selling significant assets - are permitted, however, only if authorized by a general shareholders' meeting which takes place during the period of the takeover bid. This exception is in most cases practically impossible to use because the notice and preparation period for a general shareholders' meeting is too long (in Germany, more than two months).
The argument in favor of the strict neutrality rule begins with the principal-agent theory of corporate law widely held by institutional investors and legal scholars, particularly in the United States: directors are the agents of shareholders and are charged with acting in shareholders' best interests rather than their own in managing the corporation. The strict neutrality rule extrapolates from this agency duty a specific rule for hostile bids which requires directors' to desist from acting in circumstances where their own interests conflict with those of shareholders. Allowing directors to act, but subject to more intense scrutiny by courts, is not sufficient for proponents of strict neutrality. A strict ban on director action that could frustrate the bid without prior shareholder approval is believed to be required.
This argument for board neutrality, however, does not consider the fact that directors sometimes need to respond to shareholders' collective action problems when a tender offer is coercive. Nor does it consider the fact that defensive measures sometimes increase the price paid for a target company. Furthermore, the argument for board neutrality refuses to accommodate any responsibility of directors to non-shareholder stakeholders, an important feature of corporate law in many European countries.
In Europe, arguments for the strict neutrality rule are also empirically based on England's positive experience with the City Code. This empirical observation, however, does not support the theoretical argument for a strict neutrality rule standing alone, as the City Code not only restricts the board of the target company, but also restricts the conduct of the bidding corporation, fostering a balance of power between the two. Other countries that have adopted the strict neutrality rule, but not the City Code's restrictions on the bidder, such as Austria, and Germany in its voluntary Takeover Code, have done so relatively recently and so far have very limited actual experience with hostile tender offers.
Yet another problem is that the strict neutrality rule does not exist in a vacuum. In European countries that are politically hostile to hostile takeovers, board neutrality may be circumvented by government imposed defensive measures, and regulation can be enforced in a way that makes it nearly impossible to operate a target company once it is acquired. These burdens are likely to be far more disastrous for shareholders, and perhaps even for other stakeholders, than defensive measures implemented by a board of directors chosen by the shareholders. The strict neutrality rule, in this context, sends just the wrong message: that incumbent managers and other stakeholders should turn to politicians to fend off hostile bidders rather than to their own board of directors.
Furthermore, regardless of what the European takeover directive says, hostile bids will be difficult in some countries, particularly Germany, unless the legislature does something about a costly but effective bulwark against hostile takeovers: cross ownership of equity among corporate conglomerates. A rule that gives more discretion to target company boards could allay fears that German companies will be powerless to defend themselves and thus encourage the business community to recognize the inefficiencies of crossholdings as a means of defense. Divestment of these holding would in turn provide more capital for core businesses, inject liquidity into Germany's capital markets and bestow more power on individual shareholders.
If, however, the strict neutrality rule is not suitable for Europe, it is incumbent to suggest alternative ways to restrict the discretion of target company directors, who face an obvious conflict of interest in a hostile bid. Taking into account the number of trans-Atlantic takeover bids that are likely in the 2000's, and the fact that United States target corporations are bound by a "modified business judgement rule" that is more flexible than the strict neutrality rule, one solution could be the introduction in Europe of a modified business judgement rule that, although not identical, is comparable, to the American rule.
The modified business judgment rule in the United States is defined by extensive judicial interpretation, usually by courts in Delaware and other states that have a high degree of expertise in corporate law. This review process could be difficult to replicate in civil law countries, although some countries might develop a body of case law on takeover bids and other aspects of corporate law. There is, however, an alternative to relying solely on judicial review: Member States could in some instances allow ex-post shareholder voting (expedited with the help of the Internet) to veto defensive measures initiated by directors that do not maximize shareholder value.
Furthermore, if it is determined that some version of the American modified business judgment rule passes the test for transferability to Europe, Europeans will have to decide on which level - the European level or that of Member States - specific details of the new rule should be introduced. Here, the technique of a European directive is advantageous, because it allows the European Union to state a general principle in the directive and then leave it to the Member States to fine tune that principle in drafting legislation that conforms with the directive yet adopts to local practices of corporate governance. Within the confines of the directive, the individual Member States would thus be free to craft their own rules subject only to the discipline of jurisdictional competition. Now that the European Court of Justice has cast doubt on the "seat doctrine" requiring a corporation with its "center of gravity" in a Member State to comply with that State's corporate law, jurisdictional competition, long a hallmark of American corporate law, could possibly flourish in Europe as well.
Part II of this article discusses the business judgment rule as it is applied by the courts in Delaware, the most popular state of incorporation in the United States, to target corporation directors in hostile takeovers. Part II also briefly discusses the Williams Act, a federal law which provides some measure of protection to target company shareholders by regulating tender offer disclosure and bidding procedures. [Note: this doctrinal discussion of Delaware case law on takeover defenses and federal regulation of tender offers is intended for European readers and may be redundant to some United States readers.]
Part III provides a brief statistical comparison of takeover bids in the United States and in Europe, showing that takeover bids (particularly hostile bids) are still more common in the United States than in Europe and that premiums paid to shareholders are generally higher in the United States than in Europe. Part III also suggests explanations for these differences.
Part IV then discusses some advantages and disadvantages of adopting the American style modified business judgment rule in Europe in place of the strict neutrality rule. Advantages include (i) facilitating a more level trans-Atlantic playing field for hostile takeover activity than that which would evolve under the strict neutrality rule, (ii) protecting shareholders from coercive bids without the extensive, and in Continental Europe unworkable, regulation of tender offers that is currently mandated under London?s City Code; (iii) reducing political pressure on Member States to erect antitrust and other barriers to takeovers, while encouraging managers and other stakeholders to make an economic case to directors rather than a political case to regulators; and (iv) encouraging corporations in Germany and some other countries to rely less on cross-ownership of equity among corporate conglomerates as a defense against hostile takeovers. Disadvantages of the modified business judgment rule in a European setting include (i) difficulties with importing a rule based on common law into civil law countries, and (ii) the risk that the modified business judgment rule could be too pro management in its implementation by a European judiciary even less attune than its American counterpart to the concept of shareholder wealth maximization. These two difficulties, however, are surmountable, particularly if Member States rely less than the United States on ex-post judicial review and more on ex-post veto of defensive measures by shareholders. The Internet and related technological innovations make expedited shareholder voting a realistic alternative to the American tradition of rushing to the Delaware Court of Chancery for approval or repudiation of a takeover defense. Depending upon a range of factors, including the availability and quality of judicial resources in a particular Member State, and the feasibility of shareholder review of defensive measures through electronic voting, the relative importance of the judiciary and shareholders in reviewing directors' business judgments could differ depending on the Member State.
Part V proposes a generally worded business judgment rule for the European takeover directive as well as more specific language that could be adopted by one or more Member States.
Number of Pages in PDF File: 51
JEL Classification: F02, F23, G34, K22
Date posted: December 17, 2000
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