Is the Board Neutrality Rule Trivial?

In our paper, Is the Board Neutrality Rule Trivial? Amnesia About Corporate Law in European Takeover Regulation, which was recently made publicly available on SSRN, we suggest that there are two axes upon which we can assess the significance or triviality of the adoption of a board neutrality rule in European Union Member States. The first axis is the extent to which a Member States’ adoption of an unqualified board neutrality rule makes a consequential difference to the ability of boards to fashion and deploy defenses without requesting shareholder approval to do so: without a board neutrality rule does corporate law provide the tools to boards to construct defenses, and does it allow them to be used without restraint? If one emerges with a positive response from the analysis of these questions, the second axis comes into play, namely, the potency of such available defenses. There are two elements that structure defense potency: the first depends upon the nature of the defense itself – an asset sale, for example, is significantly less potent than a poison pill; the second element is the background corporate governance rules such as rules on director removal and the calling of shareholder meetings that enable or restrain the defenses’ deployment for non-corporate/non-shareholder value purposes.

In all three of our selected jurisdictions we have seen that there are multiple and overlapping fields of regulation. And in each of these jurisdictions there is variation in the importance and effectiveness of these different fields of regulation: variation in what does the work of restricting board defensive power. The rules restricting formal availability are, for example, more important in Germany and Italy – where there are serious doubts about the formal availability of a poison pill or similar mechanism even with ex-ante shareholder approval – than in the UK. General rules requiring explicit shareholder authorization to use board power for defensive purposes are more important in the UK (the improper purpose doctrine) and Germany (the Holzmüller doctrine) than in Italy. In the UK and Italy, the background corporate governance rule set is a stronger constraint on the potency of available defenses than it is in Germany where supervisory board and management board removal is more difficult. However, whilst there is variation in the role played by these different fields of regulation in each of the three jurisdictions, the conclusions we have reached for the UK, Germany, and Italy are very similar. Although we acknowledge variation in the strength of the argument, the case for the triviality of the board neutrality rule can be made in each country.

In the UK the non-frustration rule is trivial. Only asset sale defenses are available without shareholder involvement, and even their use requires specific ex-ante or ex-post defensive authorization from the shareholders. Where explicit, authorization is granted ex-ante to construct and deploy defenses the background rule set, and the role of UK institutional investors would prevent their use for any purpose that was not compellingly justified in terms of corporate and shareholder betterment. In Germany, poison pills are unavailable, although their functional substitutes may be with explicit shareholder approval and considerable practical difficulty; share issues of greater than 10 per cent of the outstanding shares require, in effect, explicit shareholder authorization to be used defensively. This leaves less than 10 per cent share issues and share buy-backs with a general ex-ante shareholder authorization (that may always be subject to shareholder imposed conditionality) and only asset sales requiring no authorization (subject to Holzmüller). But asset sales are not potent defenses – they are difficult to put in place in the tight time constraints of a bid and may be unavailable if the sold assets are closely interconnected with the remaining assets.

Of our three jurisdictions, Italy arguable presents the weakest case for the triviality thesis. Whilst we think that a strong case can be made that poison pills are not formally available at all in Italy, there is some doubt about this. But even if available they would require ex-ante authorization in order to issue a large grant of warrants. Furthermore, asset sale defenses are available without shareholder involvement, and there is scope to issue a sizeable block of shares non-preemptively to friendly third parties, but again with ex-ante shareholder authorization. Importantly, shareholders unhappy about managerial abuse of defensive capability could put a stop to this by imposing conditions on rolling grants of the authorization to allot shares. Furthermore, there is under Italian law a soft requirement to obtain the shareholders’ view of defensive actions, but this is more of a market practice supported by academic commentary than a legal rule. As in the UK, the background Italian corporate governance rule set is strongly pro-shareholder and would constrain board use of these defenses for entrenchment purposes.

What does this mean for the Takeover Directive’s approach to its anticipated review of the implementation and effect of the board neutrality rule in the European Union? We cannot, of course, extrapolate from these three Member States to the remaining 24. However, what is clear from this article’s findings is that there is a distinct possibility that the board neutrality rule is not merely trivial for the Member States analyzed in this paper but trivial for the European Union as a whole. Accordingly, looking only at the adoption or rejection of the board neutrality rule by the Member States does not enable us to draw any conclusions about the extent to which boards of European companies can use defenses to entrench themselves or throw sand in the wheels of European economic integration.

What is also clear from this analysis is that corporate law in European Member States provides regulation of takeover defenses just as it provides for the regulation of any exercise of corporate power. Such regulation represents a balance of board and shareholder power that has evolved since the 19th century.
Such a balance of power readily addresses surprises that may arise from how boards deploy corporate power. A mandatory board neutrality rule cuts through this crafted balance of power and, in so doing, as any bright line does, overreaches itself. This is seen most clearly where it prevents informed shareholders from ex-ante electing to allow boards to use and control board power for defensive purposes when a hostile bid is made. Approaching 140 years ago in a different context where board loyalty was questioned, a famous English Lord Chancellor, Lord Hatherley, when asked to overrule the election that shareholders had made in the articles, observed that it was not ‘for the Court to lay down rules for the guidance of men who are adult, and can manage and deal with their own interests’. It would, he observed, have been be ‘a violent assumption if anything of that kind were attempted’. We see in Germany, the UK and also in Italy that it is difficult for boards to maneuver defensively without explicit shareholder approval, and that the balance of power allows shareholders to respond if managers overstep the mark. And we see from the United States that widely-held shareholders, often led by the bidder as shareholder but also pre-emptively prior to a bid, are not in this context cowered by rational apathy. In European Member States where the situation is similar to Germany, the UK, and Italy it would indeed, therefore, be a ‘violent assumption’ to assume that a board neutrality rule would be beneficial for companies and shareholders and that it should be imposed through European legislation.

A practical conclusion follows from our analysis. In order to determine whether or not the board neutrality rule is an important regulatory tool that would justify revision of the Directive to make it a mandatory rule within the European Union, the Commission should carry out the type of analysis set forth in this article for all Member States. If the analysis of the corporate law of these Member States suggests that the corporate legal restrictions on defensive action are as significant as they are in the UK, Germany, or Italy, then in our view it would be time for the European Commission to hang up its neutrality boots. There are more important matters that require its attention.

The full paper is available for download here.