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Spring 2001

Europe on the Takeover Defense

by B. Espen Eckbo
Tuck Centennial Professor of Finance and
Director of the Center for Corporate Governance

The European Union is in the middle of a little-noticed, internal power struggle that could shape the future competitiveness of European firms. The battle threatens basic shareholder rights that most people don't even think about. The situation may be best explained by the following scenario:

Corporate Restructuring
Center Research
Imagine that you purchase a house, which you intend to rent to tenants. You hire a gardener to maintain the grounds. You also ask a couple of acquaintances from the rental business to form a supervisory board to watch over your investment.

After a while, you learn that the gardener isn't doing his work. The garden is so untended and wild that it discourages the highest-paying tenants. As a result, your investment suffers. The supervisory board members may be directors, but they have not paid attention to your property. They spend only an average of 10 days a year looking into the business. One of the directors, who is a friend of the gardener, argues that it is not clear the gardener is causing your investment to suffer and, instead, blames the weather.

When you talk with the gardener about the problem, he tells you that you can always sell your house. He knows that, as an employee, he is protected under European labor market laws from being fired outright. However, that protection is much weaker if the house is sold to a new investor. So you, the owner, decide to solve your problem by getting another investor to take over the property and hire a new group of employees.

The problem is that the gardener is aware of the possibility of such a "hostile" takeover, and he already has plotted his defense strategy. There are two main lines of defense; both require the board to cooperate.

First, the gardener talks his director friend into having the company adopt a certain "shareholder rights plan," more accurately called a "poison pill." According to this plan, if someone makes a controlling bid for the property, the current shareholders will receive a large, extraordinary dividend, draining the company's value at the buyer's expense. While it is in the board's power to suspend the plan if a bid materializes, this will be done only if the bidder agrees not to replace the gardener. Thus, the poison pill is not intended to eliminate all bids, only those considered to be hostile takeovers.

The second line of defense is no less damaging to you as an owner. The gardener has convinced the board that its fiduciary duty should not simply be to you, the owner, but also to other constituencies, including all employees and the people who live in the neighborhood. Specifically, this expanded definition of fiduciary responsibility requires directors to have "a view to safeguarding jobs."

The gardener's position now seems secure. If the first line of defense fails-the firm is taken over by a hostile bidder-the second line of defense makes it difficult for the new owner to get board approval to hire a new gardener.

As the owner, you may believe the courts will protect your ownership rights. You assume the courts will enforce your right to sell your ownership position to whomever you want and without interference from existing management. Moreover, you may believe that since you hired the board of directors to look after your investment, they cannot suddenly turn against you with the excuse that they are responsible for the rights of other constituencies. After all, these other constituencies, particularly the employees, voluntarily entered into agreements with you under which they are fairly compensated for their labor. The right to prevent you from selling the firm to a hostile bidder was never part of their agreements. So, you file a lawsuit.

The likelihood that you will win such a lawsuit depends very much on where your firm is incorporated. In common-law countries, such as the U.S., the U.K., and Canada, there is a precedent for enforcing shareholder rights, and you may very well prevail. The story is different, however, in civil-law countries, including France, Germany, and Japan.

You, as well as other investors, will hesitate to invest in an enterprise if your rights are not going to be protected. This illustrates why the economic growth and development of nations depend on their respective legal systems and law enforcement. It is not a coincidence that capital markets are generally far better developed in common-law countries than in civil-law countries.

This brings us to current events in the European Union. The single-market idea calls for a unified legal system-a system that must apply to the area of corporate takeovers. The problem is that hostile takeovers interfere with the labor market, whenever employees are laid off, for example. In the U.K., with its relatively flexible labor market rules, this is not considered a particular problem. In France and Germany, however, employee protection is much stronger, and the labor unions-and top executives-are fighting the prospect of hostile takeovers that they fear will emerge to restructure much of Europe's inefficient companies.

The latest development in this battle is the attempt to amend the new "single" takeover directive drafted by the Council of Ministers of the European Union. The European parliament is threatening to add two damaging amendments. The first will allow European Union companies to adopt poison pills without prior shareholder approval. The second widens the fiduciary duties of corporate directors to include employees as well as shareholders.

There can be no question that if the prejudiced interests behind these amendments prevail, the result will be an economically weakened Europe. Capital markets on the European continent historically are small and inefficient compared to the U.S., and these amendments will further entrench the inefficiencies. It is a development I would not wish on my own countrymen.

This article was written by B. Espen Eckbo, Tuck Centennial Professor of Finance and director of the Center for Corporate Governance at the Tuck School of Business at Dartmouth. Professor Eckbo conducts research in corporate finance and capital markets, with emphasis on corporate governance, mergers and acquisitions, investment banking, portfolio management, and performance evaluation. His work has been published in the top international academic finance journals, including Journal of Financial Economics, Journal of Finance, and Review of Financial Studies. His email address is b.espen.eckbo@dartmouth.edu.

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