(By Paul Davies) 

III. Securities Markets Law and Shareholder Value

In the previous section we assumed that the re-concentration of shareholdings would have its main impact on corporate governance through intervention on the part of institutional shareholders in the affairs of their portfolio companies, such intervention taking the form of the shareholders using their company law entitlements to replace or reform under-performing management. This assumption can be queried on two grounds. First, intervention could also operate not at the level of individual companies but at the level of companies (or, at least, listed companies) as a whole and could occur indirectly rather than directly.

By this is meant that institutional shareholders, via their trade associations, could seek to influence the bodies which set the rules which govern the ways companies operate. Such activity need not be instead of, but rather in addition to, intervention at individual company level, but the attractions of the more generalised form of intervention are clear. It is cheaper because the costs of intervention are spread over a large number of companies (all the companies governed by the relevant rules) and the free rider problem is reduced or even eliminated because the intervention is effected via the institutional investors trade associations (Association of British Insurers, National Association of Pension Funds, Institutional Shareholders Committee etc). Second, such intervention in rule setting may concentrate, not on company law, but on the rules governing the operation of the securities markets. It is easy to see why institutional shareholders should find it easier to influence securities market than company law rules. Company law rules are set, at least currently, through the normal legislative process where the institutional investors would be only one among a number of powerful influences on the ultimate shape of the legislation. Considerable parts of securities market law, however, have been devolved to regulators which are closer to the market participants, notably the Stock Exchange and, now, the Financial Services Authority, for the listing rules and the City Panel on Take-overs and Mergers for the rules on take-overs. It is likely that institutional shareholers will have greater influence over rule-setting of this type than over the general legislative process. Indeed, it could be said to have been one of the objectives of delegating rule-setting in this area that those close to the market should have more influence over the process. In this section of the paper, therefore, attention shifts from company law to securities markets law 5 1 and the role of institutional shareholders in the reform of the latter set of rules. The first contrast with company law which emerges is that securities market law did undergo profound changes in respects relevant to the issue of shareholder value in the period between Crosland and Hampel. Two areas of change seem to have been particularly pertinent to the rise of shareholder value, and we shall now examine them in turn.

(A) Pre-emption Rights on Issue

Franks and Mayer report a strong linkage between turnover of executive directors and the provision of new equity finance. Why does a company’s need to raise new equity finance give its shareholders, especially the institutions, an effective opportunity to apply pressure to the company’s management? There is, of course, the general need for the company to submit to the scrutiny of the securities market in such a case. A company will be able to sell its share on terms which are more attractive to it if it can demonstrate a track record of promoting shareholder value. Pre-emption rights, it will be argued below, reinforce the value-enhancing impact of the market by binding the company to the promises explicitly and implicitly made at the time of a share issue – or, at least, make it more difficult for the company to adopt a particular financing technique which would undermine such promises. Even before statutory pre-emption rights were introduced into British law by means of the second EC Directive, the Stock Exchange rules, reflecting institutional investor preferences, included pre-emption rights. Moreover, despite the statutory changes of 1980, the Companies Act rules continue to b relatively unimportant since they apply only to equity issues for cash and may be disapplied by vote of the shareholders for periods of up to five years. Disapplication resolutions have become routine items on the agenda for the annual general meetings of listed companies. Much more important in practice are the Pre-Emption Group guidelines, which indicate the circumstances in which institutional shareholders will vote in favour of disapplication resolutions, even when these conform to the requirements of the Companies Act.

The Pre-Emption Group Guidelines, which are essentially the result of bargaining between the institutional shareholders and companies and their advisers, under the aegis of the Exchange, indicate that institutional shareholders will accept waiver of their statutory rights if the company (a) restricts the new shares to be issued for cash to 5% of the issued ordinary shares in any one year and 7.5% over any rolling period of three years, and (b) restricts the discount on any issue to 5%. In addition, the Association of British Insurers has issued guidelines for vendor placings (where the company does not formally issue its shares for cash and so is not caught by the statutory rules, but the shares are in effect so issued because the vendor to the company immediately places in the market the shares received in exchange for its assets). In this case the guidelines are that the discount must be restricted to 5% and the consideration must not exceed 10% of the shares in issue. Neither of these sets of guidelines prevents the company from seeking ad hoc approval for issues which do not conform to the guidelines.

The main objective of these rules is, of course, to protect the existing shareholders from the dilution of their existing positions in the company, either control dilution or, more likely, financial dilution, since in the case of discounted non-pre-emptive issues the cost of the discount is borne by the existing shareholders. However, it seems likely that the pre-emption rules also have governance consequences by increasing the reliance of the management on the current shareholders. This may occur both positively and negatively. Positively, management is put in a position in which it must actively solicit shareholder support for issues which do not conform to the guidelines. Negatively, the guidelines make it difficult for management to pursue a strategy of issuing deeply discounted shares to new investors as part of an implicit bargain whereby the new investors will support the incumbent management against existing shareholders. Although the statutory pre-emption rule and the guidelines have been criticised for raising the cost of capital, the guidelines have survived a competition law challenge, and have been positively commended by the Company Law Review on corporate governance grounds.

(B) Takeover regulation and shareholder value (and some Anglo -American contrasts)

The second area of securities market law which is relevant to the present paper is regulation of the market in corporate control. These rules link back to our discussion above of the shareholders’ removal rights, for the alternative, often available to institutional shareholders contemplating the removal incumbent management under their company law powers, is to accept a bid from an offeror (perhaps found by or on behalf of the institutions themselves) which, after obtaining control, will do that job in place of the current shareholders. In contrast to the static company law (at least in the area of control rights), take-over regulation in the UK underwent a very big change in its regulatory structure during the post-war period. This was the introduction in 1968 of the first City Code on Take-overs and Mergers and its subsequent development by the City Panel on Take-overs and Mergers. Although now a substantial and sophisticated body of rules,61 the Code is founded upon two central ideas, both of which are apt to promote the idea of shareholder value, viewed from the perspective of the shareholders of the target company. The two principles are: equal treatment of target shareholders (designed to deal with acquirer opportunism) and the ‘non-frustration’ rule designed to place the decision on the fate of the bid exclusively in the hands of the shareholders of the target company and to reduce the target management to an information-providing and persuading role. It is the second idea which mainly concerns us here and which provides the contrast with takeover rules in the United States. It is to be found in General Principle 762 of the City Code and is given more concrete expression in Rules 21 and 37. These constitute a tough set of provisions, because they focus on the effects of board action, not target management’s bona fides or purposes. If the effect of a proposed move by target management is to frustrate a bid, then shareholder approval is required. Thus, the City Code deals with the acute conflict of interest which target management faces in a takeover bid by shifting the decision over the success of the offer out of the hands of the target board and into the hands of the target shareholders. Although it is common in some quarters to lump together British and US corporate law and takeover regulation, there is a distinct contrast in this area between what British and US rules require. US takeover rules (predominantly in this respect the province of state corporations laws) do not sideline target management. Rather, the target board is put in a position of considerable influence (though not one of invulnerability) and can control to a substantial degree the issues of whether the bid is put to the shareholders of the target at all and, if so, on what terms. By holding it to be consistent with directors’ fiduciary duties for boards of potential targets, first, to adopt without shareholder approval a poison pill defence and, second, in the face of an actual offer to refuse to redeem the pill (again whether or not the shareholders approve), provided this is done in the bona fide belief that it is necessary to protect the integrity of the business strategy which the board has put in place, the US rules are clearly less responsive to the conflicts of interest to which target boards are subject in hostile bids and more responsive to the argument that setting business strategy is the preserve of centralised management rather than of the shareholders. The board is not invulnerable because the above provisions do not protect the incumbents from a proxy contest at the next annual general meeting in which the shareholders seek to replace them by a set of directors who are more open to bid approaches; and this knowledge will no doubt feed back into the board’s decision whether or not to redeem the pill. Nevertheless, the poison pill (together with anti-takeover statutes) does give a determined management the inestimable advantage to time to prepare its position against the bid.

What are the rationales for the US approach? As already hinted, one might be that the decision on a bid and its potential change of business strategy is one more appropriately taken by the board of the target than its shareholders. This is not, however, persuasive. The decision which the bid presents to the target company is at least as akin to an investment decision which shareholders make when they decide to buy or sell shares in a particular company as it is to management decisions which are allocated to the board. In other words, shareholders may be as expert in taking this class of decisions as directors and, given their infrequency and importance to the sharehold ers, one can expect that shareholders will appropriately inform themselves about the decision which has to be taken.

Alternatively, it might be argued that the board of the target should control the bid process in order to protect target shareholders against bidder opportunism (principally the various forms of pressure to tender). This may seem a more plausible argument where takeover regulation is embedded in the common law of directors’ duties, as it is in the relevant respects in the US, rather than in customised takeover code, as is increasingly the European norm. Where there is a fully developed code, such as the City Code, it is possible to deal separately with the issues of target management conflict of interest and acquirer opportunism, rather than relaxing the rules on the former in order to address the latter set of issues. As noted above, the City Code’s second ‘big idea’ is equality of treatment of the target shareholders, which principle is aimed at controlling bidder opportunism. Thus, the two fundamental principles of the Code aim, separately, at the control of bidder and target management opportunism as against the target shareholders. The third possible rationale is that protection of the position of the incumbent management is seen as a proxy for the protection of non-shareholder interests affected by the takeover. This rationale is supported by the presence of constituency statutes in many US states, which, at least in the context of takeover bids, permit the incumbent board to abandon their exclusive consideration of the interests of the shareholders and to give equal consideration to a wide range of additional interests. Takeover rules which respond to the conflicts of interest of incumbent management by placing the decision on the offer with the target shareholders, as the City Code does, find it difficult to give any substantial recognition to the interests of stakeholders other than target shareholders, because there is no longer a corporate decision-making process into which consideration of such stakeholder interests can be built. The actual takeover transaction is effected by private treaty between bidder and the shareholders individually.

Nevertheless, it can be questioned whether the US rules do more than permit the entrenchment of target management under the guise of protecting target shareholders against bidder opportunism or protecting the interests of non-shareholder groups. Probably, effective stakeholder protection requires general corporate mechanisms for building their interests into the governance of the company, which mechanisms continue to operate into the bid situation, rather than ad hoc amendments to the principle of shareholder control which are triggered only when a takeover is in prospect.

It is an interesting question why British and US takeover regulation has developed in such different ways. In a recent article Bebchuk and Roe have linked anti-takeover rules, such as those to be found in the US, with historically diffuse ownership structures. The argument is essentially one grounded in political theory. If shareholdings are diffuse, shareholders will be no match for the influence of managers in the political process and the result will be rules which discourage takeover bids, especially hostile ones: ‘Professional managers are clearly a much more powerful group in a country with diffuse ownership (such as the United States) than in one with concentrated ownership (such as Germany). The implication would seem to be that the pro-shareholder British rules are result from a higher degree of shareholding concentration in the UK and thus a greater influence wielded by shareholders in the rule-making process in the UK.

There are a number of difficulties with these propositions, two of which relate to the statistics on shareholder concentration in the US and the UK and the third, more fundamentally, to the nature of the alleged link between shareholder concentration and pro-shareholder takeover regulation. First, it is not clear that at the level of the individual company, which is the level to which Bebchuk and Roe seem to refer, British shareholdings remained concentrated in family hands until a later period than in the US. It has indeed been argued by Chandler that this was the case and that family ownership in the UK ceased to be an important feature of British shareholding structures only in the 1980s.6 7 However, there is work by others which supports the thesis that family ownership had ceased to be significant in the UK by the Second World War or shortly thereafter. If the latter argument is correct, then the concentration of ownership at the individual firm level would seem a poor explanation for the pro-shareholder orientation of the City Code.

Second, given that Bebchuk and Roe’s analysis concentrates on the respective influence of professional managers and shareholders on the rule-setting process for the market in corporate control, it is far from clear that it is the level of shareholder concentration at individual company level which is the crucial determining factor, as against shareholder concentration at the aggregate level (level of the whole economy). Governments and other rule-setters might well be influenced by the views of an important set of providers of funds to companies via the securities markets, irrespective of the extent to which they held controlling blocks in particular portfolio companies. Indeed, if there were a large number of families, each with a holding confined to a particular companies (or group of companies), whereas the non-controlling institutional holdings were in the hands of relatively few institutional shareholders, the latter might be more successful that the former in the political process because they could co-ordinate their actions more effectively. Whatever the truth about the l vels of family holdings in the UK before the 1980s, we have already seen from Table 16 9 that when the City Code was introduced institutional shareholders held about 20% of the equity shares of companies listed on the London Stock Exchange and this could be the basis for effective lobbying of the rule-setters, even if these aggregate holdings rarely translated into individual institutions holding controlling blocks in portfolio companies.

However, this second argument might be thought to be supportive of theBebchuk and Roe proposition, albeit in an amended form. The explanatory factor is, indeed, the level of shareholder concentration, and Bebchuk and Roe were mistaken only in looking at concentration at individual firm level rather than at the aggregate level. Even if it is true to say that family ownership had ceased to be a dominant feature of shareholding in the UK by the Second World War, one could argue that there was substituted for family ownership a growing concentration of shareholdings in the hands of institutional shareholders. By the 1960s this had reached the point where those shareholders were able to influence significantly the drafting of the City Code of 1968 and its subsequent amendments. Nevertheless, this point does not fully get Bebchuk and Roe out of the woods, because the levels of aggregate institutional shareholdings do not appear to have been significantly higher in the UK than in the US in the post-war period. 70 So it may be that it is not simply the aggregate level of institutional shareholding which is important but that level coupled with the respective skills of institutional shareholders and professional managers in co-ordinating their views through their trade associations in the lobbying process for new rules and also on the nature of the legislative processes they were aiming to influence. As Bebchuk and Ferrell point out in a contemporaneous article, 7 1 the British procedure for producing a set of takeover rules (via the City Panel) gave institutional shareholders in the UK an advantage over the representatives of management because the rule -making process was delegated by Government to the City institutions, led by the Bank of England. UK regulation ‘is not imposed from the outside by a detached governmental body but rather by a group that has strong connections to the interested parties’ and that that group ‘gave less weight to managerial interests because of the close connection at least some of them had with the interests of shareholders.’ By contrast, the constituency statutes of the US are the product of state legislatures, which are not so much ‘detached governmental bodies’ but vehicles for the expression of particularist local interests of the type likely to suffer in hostile bids. They are thus relatively fertile ground for lobbyists in the managerial cause.

The third difficulty with the Bebchuk and Roe argument is its implication that the higher the degree of concentration of shareholdings, the higher the level of shareholder interest in takeover rules which facilitate hostile bids. See, for example, their contrast between the US and Germany in the quotation above. However, Germany has traditionally been noted as a country where both shareholdings are highly concentrated in family hands and where management are even more deeply entrenched by the relevant takeover law than is the case in the US. The explanation is probably that, where shareholdings are highly concentrated, the controlling shareholder has little interest in promoting takeover regulation which sidelines management if a bid is made. In such a case, the board is likely to consist of the nominees of the majority shareholder and will do what that shareholder wants, and thus rules formally shifting the decision on the bid into the hands of the shareholder are unnecessary. To put the matter another way, if the bidder deals with the directors in such a case, it is in effect dealing with the majority shareholder and hostile bids, whereby the bidder appeals over the heads of the incumbent board to the shareholders of the target, are beside the point. Thus, controlling shareholders have little interest in the first fundamental principle which underlies the City Code.

However, if controlling shareholders view the first principle behind the Code with indifference, they may regard its second principle (shareholder equality) with positive alarm. If block-holders, whether they be families groups or other commercial corporations, see their interests as lying in their ability to continue to extract the private benefits of control from the company in which they are invested and have confidence that, should they wish to dispose of their shares at some indeterminate time in the future, they will be able to obtain a good price in a friendly deal, they may see the equality principle as a threat to their position. If, in order to deal with bidder opportunism as against target company shareholders, the take-over regulation contains a mandatory bid rule, then the impact of that rule may be to deprive block-holders of the ability to realise a premium for control when they eventually sell out. Whether that consequence follows will depend upon how the mandatory bid rule fixes the price to be offered in the required bid. If that price, as in the British Code, is fixed at the price paid by the acquirer for the controlling block, then all premium for the sellers of large blocks will be eliminated. If, as in the draft EC Directive, the price to be offered in the mandatory bid is required to be only ‘equitable’, there may be scope for differential pricing which preserves at least a part of the block-holder’s premium. This may demonstrate that large block-holders may wield sufficient political influence to preserve some of the private advantages of control under take-over regulation, but one still lacks a positive reason for such controlling shareholders to seek takeover regulation.

Overall, the relationship between levels of share concentration, whether at individual firm or aggregate level, and attitudes towards facilitating takeover bids, especially hostile bids, turns out to be complex. At either end of the spectrum, that is, where shareholdings are highly dispersed or highly concentrated, there may be significant opposition to such regulation. In the former case the opposition may be effectively promoted by incumbent management, which fear for their jobs, whilst the highly dispersed shareholders are incapable of mounting effective opposition to the managerial arguments. In the latter the opposition may come from large shareholders who fear for their sale premiums and do not need regulation to foster hostile bids. It is perhaps only at intermediate levels of shareholding concentration that rules promoting hostile bids are obviously in the shareholder interest. At such levels, the shareholders have no control premium to sacrifice to the equality principle whereas their ability to use the traditional control devices of company law as against the incumbent management is so set about with potential difficulties that they see value in adding to their armoury the additional weapon of the hostile bid and side-lining incumbent management in the bid process.

Whatever the explanation for the stance taken by the City Code, it seems clear that its provisions facilitating hostile bids provide a major incentive to the management of British companies to maintain a high price for its shares on the stock market. This is true not only defensively, ie a company whose securities are highly priced does not provide an attractive target for potential bidders. A high share price also provides a currency with which the management can launch bids, either because potential offerees will find paper offers by such a bidder attractive or because a company with a high share price will find it easier to raise the cash with which to make a cash offer or to provide a cash alternative to a paper offer. This statement of the incentives on the management of companies to promote shareholder value (defined in terms of a high stock price) should not lead, however, to the conclusion that the takeover threat operates across the board to produce this result. First, the incentive to the managements of potential bidders to maximise share price may bring about only a partial alignment of the interests of bidder shareholders and management. Whereas the gains in takeovers to target shareholders are well established, the empirical evidence about the gains to bidder shareholders shows these are quite modest or even negative. This may suggest that the mechanisms for aligning management and shareholder interests in the choice of bid targets or in the decision about how much to pay for a target are not fully efficient. Indeed, it is a feature of most takeover codes that they do not address principal/agent problems as between bidder management and bidder shareholders but leave them to the general corporate law, which, as we have seen, is rather ineffective. There may be a case for a bigger shareholder input into the decision by the bidder’s management to launch a bid. Second, turning to takeover targets, although targets tend to be moderately under-performing companies, there is evidence that the worst performing companies are under-represented among takeover targets. It was pointed out some time ago that truly bad performance might be an effective takeover defence,80 because the process of turning around such companies would be too daunting for potential bidders. On this basis, the scope for the takeover threat to promote shareholder value at the bottom of the performance table would seem to depend on how quickly the market picks up the beginnings of under-performance and how quick the descent is the company’s descent from under-performance to an economic condition which provides its own shelter from takeover bids.

IV Conclusion

The argument in this paper has been that the move to shareholder value in the UK has not been driven, on the legal front, not by changes in the law relating to directors duties nor the rules on shareholders’ appointment and removal rights, despite the central role one might expect such rules to play in determining how central management exercises the discretion vested in it. Rather, what has been important are changes in shareholder structure These have operated at two levels. At the first level, they have permitted shareholders to extract some greater value from their traditional company law entitlements, especially in relation to the removal of under-performing management. At a second level, re-concentration of shareholdings in the hands of the institutions has permitted them to bring about changes in the rules and practices of the securities markets which are favourable to the promotion of shareholder value, notably in the areas of pre-emption rights and takeover bids. One conclusion from this analysis is that those who oppose putting shareholder value centre-stage in managerial objectives would do better, as far as listed companies in the UK are concerned, to concentrate on reform of securities market law rather than core company law, despite the apparent direct relevance of the latter to this issue.

(Edited by: China West Lawyer)