Germany’s Implementation of the Shareholder Rights Directive: On a Path to Failure?
When the final version of the amended Shareholder Rights Directive came out last year, many scholars criticised the significant leeway that was left to national legislators in implementing its rules for related party transactions. The German Ministry of Justice recently published a draft bill for the implementation of the directive. It casts doubts on the government’s willingness to strive for higher corporate governance standards.
In 1965, the German legislator introduced the Konzernrecht, a remarkable set of new rules for groups of companies aiming to improve the level of minority shareholder protection in stock companies. Around the same time, the London Stock Exchange decided to improve shareholder protection as well, by putting in place new listing rules for class 4 transactions, a type of transactions later renamed related party transactions (RPTs).
While both sets of rules seek to police tunnelling transactions between a company and its major shareholder, their regulatory approaches are entirely different: UK Listing Rules primarily require RPTs to be publicly disclosed and approved by a majority of disinterested shareholders before their completion. The German Konzernrecht, on the contrary, imposes harsh liability on a parent company and its directors for any damages resulting from their influence on a subsidiary and requires the subsidiary’s management to prepare an audited, but non-public yearly report of all intragroup transactions entered into.
The German approach, unlike the British, did not become a legislative top export. However, it contributed to preventing major RPT scandals like the collapses of Enron or Parmalat in Germany. But with no significant reforms since 1965, scholars have increasingly doubted that the Konzernrecht is still up to date with modern corporate governance standards.
Last year, the European Union amended its Shareholder Rights Directive (SRD) requiring all member states to enforce ex ante disclosure and approval procedures for RPTs (see here for a brief description) – i.e. exactly the kind of safeguards that German company law currently lacks. This could have been the signal for an adequate modernisation of the shareholder protection regime in Germany. However, in its recently published draft bill for an implementation of the revised SRD (‘ARUG II’), the German Ministry of Justice merely adopted a minimalist approach on the required RPT rules.
The Scope of the Proposed RPT Rules
The draft bill requires listed companies to seek the approval of the supervisory board for RPTs exceeding a defined threshold, and to publicly disclose them. All transactions with the same related party are aggregated for the purpose of the new rules. However, these rules generally do not apply to transactions concluded in the ordinary course of business, and on normal market terms. The new safeguards supplement the existing rules of German Konzernrecht, capital maintenance rules and duties of directors.
For both the disclosure and the prior approval requirements, the draft bill establishes a single high threshold of 2.5 % of the company’s assets. It is evident that a threshold based on one quantitative criterion cannot satisfactorily separate material transactions from immaterial ones. However, the Ministry of Justice has chosen only one criterion to facilitate the application of the new rules, thus rejecting well-tested and refined materiality thresholds like the UK class tests.
As prescribed by the SRD, ‘related party’ has the same meaning as in the International Accounting Standards, including notably directors and major shareholders (see IAS 24.9). The draft bill also chooses a definition for the term transaction that is very close to the one in IAS 24. By making use of all exemptions the SRD allows for, however, it considerably narrows the scope of the new rules.
The Proposed Approval Mechanism: Complicated, yet Ineffective
According to the draft bill, RPTs must be approved by the supervisory board of the company before they are entered into. Related parties and directors who might have an interest in the transaction due to their relationship with a related party are excluded from the vote. This is a sensible safeguard that can enhance shareholder protection significantly. However, according to the draft bill, it does not apply if a company establishes a special RPT committee.
In such a case, the special committee evaluates whether the supervisory board should approve an RPT. The relevant related party is not allowed to be a member of the committee. However, for some reason, other directors with an interest in the transaction may be members of the committee as long as the majority of its members are disinterested. If the committee opines against the RPT, the supervisory board can only approve it if an independent auditor issues a positive fairness opinion. In any case, all members of the supervisory board – including directors that are not independent of the related party – participate in the vote with the exception of the related party itself.
Having seen the much simpler, yet more rigorous approval procedure for companies without a special RPT committee, one wonders why this alternative approval mechanism has been included. Apparently, the Ministry of Justice intends to nudge companies into establishing special RPT committees. However, by letting conflicted directors participate at multiple stages of the mechanism, it uses bad corporate governance as an incentive. Paradoxically, the draft bill also bars companies from conferring final decision rights on the RPT committee, an option many scholars have recommended.
If the supervisory board denies approval, the management board cannot enter into the RPT. However, it is entitled to ask the shareholders’ meeting for authorisation of the transaction in a ‘majority of the minority’ vote without the related party’s participation.
Public Disclosure of RPTs
The draft bill provides that listed companies must disclose RPTs immediately after their conclusion, with the announcement containing all relevant information to decide whether the transaction was made on fair and reasonable terms. Unlike the new approval procedure, this provision will be part of German capital markets law. It will be enforced by BaFin, the federal financial supervisory authority.
Further Legislative Procedure
The SRD requires RPT provisions to be implemented by 10 June 2019, leaving only a short time for the ARUG II bill to be passed. As a result of its minimalist approach, the Ministry of Justice does not expect its proposal to undergo major changes in the legislative process. Considering the present flaws in the draft, it is to be hoped that this expectation will be proven wrong.
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