A Law and Economics Analysis of the European Takeover Directive: What about Enforcement?
A vast literature studies the role of institutions, such as regulation, for economic outcomes. An implicit assumption in many theoretical and empirical studies in the field is that the law is perfectly enforceable. However, in practice, most of the time this is not the case. The law may not be perfectly enforceable for several reasons. One reason is that enforcers may be capacity-constrained and therefore cannot prosecute each case. Another reason is that the costs of enforcement are too high to motivate economic agents to insist on their rights.
There is another ‘European-specific’ reason for imperfect enforcement: European member states, which are obliged to transpose EU-level directives into national laws, often have considerable discretion over the design and scope of their enforcing bodies within their jurisdictions, which they may use to conserve or increase their competitive advantage. That leads to heterogeneous enforcement of European law across member states.
Imperfect enforcement is relatively understudied in economics and management. To address this research gap, we examine in a recent publication in the Journal of Corporate Finance how the heterogeneous enforcement of the European Takeover Directive (ETD) impacts shareholder value in corporate control transactions.
The ETD was passed in 2004 (with an implementation period until 2006). It consists of several mandatory statutes and some optional ones, which aim at creating a level playing field for Mergers & Acquisitions (M&A) in Europe. Key provisions include a Board Neutrality Rule, a Mandatory Bid Rule, Sell-out and Squeeze-out Rights, and a Breakthrough Rule.
Because the ETD is modeled on the UK City Code, it did not entail significant changes in national takeover law in all member states. Therefore, we can use ‘treated’ and ‘control’ countries in our sample to examine the ETD's economic effect in a difference-in-differences research design.
We find that the ETD improved shareholder rights, at least on the paper. Acquisitions by firms in treated countries created significantly more shareholder value. We find that three channels help explain why acquirers in treated countries are more profitable post-ETD. First, these acquirers are more likely to select targets that improve their corporate governance (eg, they import blockholders that can monitor management) after the ETD. Second, these acquirers also prevent losses to shareholder value by curbing overinvestment in declining industries relative to those acquirers in control countries. Third, we report some evidence that the implied cost of equity decreases post-ETD (plausibly due to improved investor protection).
Against the background of these results, we focus our study on the role of enforcement quality. In particular, we ask whether the heterogeneity in enforcement quality across member states affects the ability of firms in treated countries to capture the wealth-increase from improved investor protection.
For this purpose, we create a Takeover Law Enforcement Index (TLEI). Our TLEI is based on the instruments with which national enforcers can and do punish violations of the ETD’s core statutes. This takes into consideration information on the public enforcement instruments related to the ETD’s key provisions and disclosure requirements, comprising the enforcers’ power to suspend legal rights, the availability of court orders, fines, damages, penalty fees, and other material instruments. For example, Finland’s enforcers have the mandate to punish violations of the ETD’s key provisions with many different instruments, including fines, damages, the possibility to charge acquirers who violate the Mandatory Bid Rule an accrual of penalty fees for the delay, and the possibility to obtain a court order to remove a defense that is violating the Board Neutrality Rule. Finland is therefore a country that ranks high on our TLEI (which is summarized in Table 2 in our publication) and contrasts with other countries where enforcers lack many of those instruments.
The TLEI helps to classify whether treated countries have weak or strong enforcement of the new takeover law in place. That allows us to analyze the marginal effect of enforcement quality on the capturing of rents associated with improved takeover law in treated countries, employing a difference-in-differences-in-differences framework.
Our results suggest that enforcement quality is crucial for the ETD’s effect in EU member states. Countries with weak enforcement, such as Ireland and Greece, do not economically profit from the ETD. The economic gains in these countries are statistically indistinguishable from zero. In contrast, the ETD resulted in significant wealth increases in countries which designed powerful enforcing bodies, such as Finland and Sweden.
The economics of law enforcement is non-trivial in our research context. Acquirers in treated countries experience 4-5% higher acquirer returns post-ETD, but only if they have strong enforcing institutions. Given the median acquirer size in treated countries, this translates into increased shareholder value of $90-$115 million per transaction.
Overall, our results suggest that takeover law can mitigate agency conflicts, but its real value depends on its enforcement. In the specific European context, the European Commission may be well-advised to tighten leeway in national enforcement design for future lawmaking.
Paul P Momtaz is a Researcher at the UCLA Anderson School of Management and at the House of Finance of Goethe University, Frankfurt.