A critical assessment of the role of directors in relation to takeovers of public companies

Table of Contents

1. Introduction

2. Takeovers of Public Companies
a) General
b) Takeover Offer

3. Motives for Takeovers
a) General
b) Corporate Control as a Value Generating and Disciplining Tool

4. Allocation of the Acceptance-Decision on a Takeover Bid

5. Anti-Takeover Defences and the ‘No Frustration Rule’
a) Post-Bid Defensive Measures
b) Pre-Bid Defensive Measures
(i) Directors’ Duty to Promote the Success of a Company
(ii) Directors’ Duty to Exercise Powers for Proper Purposes
(iii) Directors’ Power to Allot Shares
(iv) ‘Poison Pill’ 13

6. Target Board’s Advisory Role: Recommendation and Promotion of an Offer
a) Information Standards of Care
b) Independent Advice and Divergence of Views
c) Conflicted Directors and the Role of Non-Executive Directors
d) Disclosure of Directors’ Agreements and Interests
e) Compensation for Loss of Office
f) Competing Bids
(i) Target Directors’ Duty to Auction and to Recommend the Highest Bid?
(ii) Binding the Target Board to Recommend a Specific Bid by Contract

7. The Role of the Bidder Directors
a) Shareholder Approval in Premium Listed Companies
b) Directors’ Duties in Taking a Takeover Decision

8. Conclusion

Bibliography

1. Introduction

The takeover of Cadbury by Kraft Foods in 2010 triggered a debate whether the UK’s open market for corporate control made it too easy for overseas companies to take over domestic companies and also led to a political investigation of the regulating framework of takeover offers.¹ Concerns were raised about the role of the target directors responding to (unsolicited) takeover bids. In particular, it was argued that contrary to their role ‘to act in the interest of the company as a whole’,² target directors act more like ‘auctioneers’ recommending the highest bidder rather than ‘stewards’ promoting the long-term interests of a company while considering the implications of the takeover in their advice to the shareholders.³ This statement was based on the fact that the board of Cadbury had changed its recommendation to its shareholders from rejecting the offer several times to recommending it merely on the ground that Kraft had increased the offer price for the company’s shares.⁴

Target directors have an ambiguous role in corporate takeovers. On the one hand, once a bid is imminent, they are significantly involved spending most of their time in responding to the bid and advising the shareholders whose interests the directors must primarily represent. On the other hand, they face various potential conflicts of interests as takeovers can have significant personal and professional implications on them.

This essay critically assesses the role of directors in relation to takeovers of public companies. Their corporate powers are constrained by a range of rules in the Takeover Code⁵. However, takeover regulation leaves significant room for board discretion which is therefore subject to common law and general company law.⁶ As we will see, the target directors only have an advisory role vis-à-vis the shareholders, with the latter taking the ultimate decision on acceptance of the takeover bid.

The essay is structured as follows. Section 2 starts by introducing the context of takeovers of public companies followed by a brief summary of common motives for takeovers in section 3. Special emphasis is placed on the effects of the theory of the market for control on directors which at various points had an influence on the takeover regulation. Section 4 then deals with the allocation of the acceptance-decision on a takeover bid to the shareholders. In order not to interfere with this right by taking defensive measures which could frustrate a takeover bid, the Takeover Code has imposed a strict ‘no frustration rule’ on target directors. This is covered by section 5. Reference will also be made to the respective directors’ (fiduciary) duties under common law and company law. Subsequently, section 6 critically discusses the advisory role of the target directors when recommending a takeover offer to the shareholders, the various conflicts of interest to which they are exposed and how the takeover regulations attempt to solve them. Although the takeover regime mainly focuses on the role of target directors, section 7 outlines some of the constraints which the directors of the bidder are subject to when launching a takeover bid. Section 8 concludes.

2. Takeovers of Public Companies

a) General

Generally speaking, ‘takeovers’ or ‘mergers and acquisitions’ (M&A) refer to transactions which transfer the control of companies or their assets.⁷ Such control transactions can be effected in three ways: by (i) an acquisition of the target company‘s assets; (ii) an acquisition of the target company’s shares; (iii) a merger of the target and bidder company.⁸

The most popular form of control transactions for publicly traded companies is the share deal by means of a takeover offer.⁹ Therefore, they are usually referred to as ‘takeovers’. In this case, the offeror makes an offer to all shareholders of the target company to acquire their shares in exchange for a consideration in cash, securities or a mixture of both of the offeror.¹⁰ The target shareholders can then accept or reject the offer.

Consequently, the explanations in this essay are limited to takeover offers with respect to publicly traded companies within the scope of the Takeover Code.¹¹

b) Takeover Offer

A takeover offer (bid) is one to acquire (i) all the shares in a company (target) which at the date of the offer are not already held by the offeror (bidder), and (ii) the terms of the offer are the same for all the shares.¹² Thus, a takeover offer not only envisages a transfer of shares to the offeror but a change of control in the target company.¹³

A bidder may well make an offer to the shareholders without the support of the directors of the target company. A takeover is then considered ‘hostile’ if the target board does not recommend the offer to its shareholders, but the bidder nevertheless continues with the offer to the shareholders while bypassing the board.¹⁴ However, most takeovers of public companies are friendly with full support of the target board.¹⁵

3. Motives for Takeovers

a) General

There are many motives for taking over another company. On the one hand, there are strategic motives such as combining the assets of companies to create synergies through economies of scale and cost savings.¹⁶ Moreover, takeovers may be used to obtain a patent, eliminate a competitor or strengthen the own market position. On the other hand, taking over another company may be driven purely by managerial hubris and the desire to run a larger company (empire building).¹⁷

b) Corporate Control as a Value Generating and Disciplining Tool

The market place on which the above-mentioned transactions (see section 2 a)) take place is generally known as the ‘market for corporate control’.¹⁸ The market for corporate control is regarded as a disciplining tool used to reduce the agency costs associated with the separation of ownership and control in public companies with dispersed share ownership.¹⁹ The concept is based on the thesis that in an efficient capital market the (in)efficiency of managers (i.e. agency costs) is reflected directly in the company‘s share price. Competing management teams regard a low share price as a sign of inefficient management and are therefore willing to pay a premium over the market value of the shares in exchange for corporate control. Thus, there is an opportunity of generating value by taking over another company while replacing the incumbent managers with a more capable management team. Simultaneously, the threat of a (hostile) takeover and being replaced following a change of control provides a direct incentive for slack managers to promote the interests of the shareholders and to keep the share price high by performing well. This will decrease the possibility of a takeover bid and increase the chances that shareholders resist an offer because they think they are better off with the incumbent management. The takeover threat also has an indirect disciplining effect through non-executive directors who also fear to be replaced and therefore discipline or remove managers.²⁰

4. Allocation of the Acceptance-Decision on a Takeover Bid

The authority of a board of directors to manage the company’s business is derived from the shareholders through delegation in the articles of association.²¹ However, it cannot be inferred from this that directors also take the decision whether to accept or reject a takeover bid. Rather, a takeover offer is an offer made to the shareholders of the target company.²² The share transfer associated with an accepted offer has no impact on the corporate entity and does not require any exercise of corporate power to complete the sale. Therefore, the directors have no formal say or veto right over the proposed takeover. Also, the articles of publicly traded companies may not provide for any transfer restrictions so as to provide directors a role in the acceptance-decision of a takeover bid.²³ Consequently, the decision either to accept or reject a takeover offer eventually rests with the shareholders because it is an investment decision rather than a management decision.

On the one hand, allocating the acceptance-decision on a takeover bid to the shareholders facilitates the market for corporate control and its disciplining effect on directors who are continuously exposed to a takeover threat (see section 3 b) above). On the other hand, the takeover threat may make directors too responsive to shareholders and pressurise them towards short-termism rather than acting in the long-term interest of the company as a whole.²⁴ In particular, a change of control following a successful takeover may not only have impacts on the incumbent directors which may be replaced, but on other stakeholders of the target company, notably employees whose jobs may fall victim to cost-cutting measures.

For this reason, target directors may be in a conflict of interest and therefore be tempted to use their management powers to maintain the independence of the target company by frustrating a takeover bid employing defensive measures (i.e. anti-takeover defences).²⁵ The target board may, for instance, issue new shares to a friendly investor or dispose material assets (crown jewels) in order to discourage a potential bidder to make or continue with a takeover offer. However, according to the general principles of the Takeover Code, the target board must ‘act in the interests of the company as a whole’ and must not deny the shareholders the opportunity to decide on the merits of a takeover bid.²⁶

5. Anti-Takeover Defences and the ‘No Frustration Rule ’

Target directors are therefore subject to a strict ‘no frustration rule’ which prevents them from taking any action without shareholder approval that frustrates a takeover offer or that denies shareholders the opportunity to decide on its merits.²⁷ A distinction must be made between two points in time: when a bid is imminent and when there is no prospect of a bid.²⁸

a) Post-Bid Defensive Measures

The no frustration rule applies once a bid is made or the target board ‘has reason to believe that a bona fide offer might be imminent’.²⁹ This makes the implementation of anti-takeover defences post-bid considerably difficult, unless the defensive action is completed prior to the imminence of a bid.³⁰ But even then, such pre-bid defences must be designed not to require directors’ action after the bid is imminent.

If applicable, the no frustration rule requires shareholder approval for any specific defensive action proposed by the target directors in the context of a takeover bid and cannot be given in general or in advance.³¹ Defensive actions include, for example, the issue of shares, the sale and transfer of shares, the disposal or acquisition of assets of a material amount, entering into contracts otherwise than in the ordinary course of business, redemption and repurchase of shares, litigation on behalf of the target company³² as well as any other frustrating actions.³³

The purpose or intention of the target directors in taking a defensive action is irrelevant for the no frustration rule; it does not matter whether the frustration of a bid is a secondary consequence of an action taken for another reason.³⁴ Once an action has the effect of frustrating a bid, shareholder approval is required.

The no frustration rule requires target board action. It does not apply to defensive measures that are triggered by other means, such as the bid itself, without an act of the target directors (e.g. a poison pill, see section 5 b) (iv) below).³⁵ However, where the specific defence requires approval or refusal of a bid by the target board, this would be considered as an action.

Target board’s therefore remain only the following defensive strategies: (i) persuading the shareholders that accepting the offer would not be in the best interest of the company or that the offer price for the shares does not reflect the true value of the company and the shareholders would be better off with the incumbent management in future rather than with the bidder; (ii) lobbying the Competition and Markets Authority to the extent that the takeover attempt affects public interests; (iii) seeking an alternative bidder as a ‘white knight’; or (iv) simply not cooperating with the bidder where the latter relies on the recommendation of the offer or the support of the board for some reason.³⁶ In particular, point (iv) puts the target board in a strong negotiating position as neither the Takeover Code nor company law requires the board to grant a potential bidder access to the company’s books.³⁷ Moreover, seeking an alternative bidder does not breach the no frustration rule as the target shareholders were not deprived of their decision on the bid but even received an additional bidder.³⁸

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¹ Business, Innovation and Skills Committee, Mergers, Acquisitions and Takeovers: The Takeover of Cadbury by Kraft (HC 2009-10, 234); UK Government, Government Response to the Business, Innovation and Skills Committee’s Report on ‘Mergers, Acquisitions and Takeovers: The Takeover of Cadbury by Kraft ’ (Cm 7915, 2010); Blanaid Clarke, ‘Reviewing Takeover Regulation in the Wake of the Cadbury Acquisition – Regulation in a Twirl’ (2011) 3 Journal of Business Law 299; Georgina Tsagas, ‘A Long-Term Vision for UK Firms? Revisiting the Target Director’s Role Since the Takeover of Cadbury’s Plc' (2014) 14[1] Journal of Corporate Law Studies 241.

² City Code on Takeovers and Mergers (12th edn 2016 as amended) (Takeover Code), General Principle 3.

³ Tim Webb, ‘Lord Mandelson Calls for Overhaul of Takeover Rules’ The Guardian (London, 1 March 2010) <https://www.theguardian.com/business/2010/mar/01/lord-mandelson-mansion-house-keynote> accessed 10 April 2019; Tsagas (n 1) 243.

⁴ Tsagas (n 1) 247.

⁵ Takeover Code (n 2).

⁶ David Kershaw, Principles of Takeover Regulation (OUP 2016) para 10.01.

⁷ ibid para 2.01.

⁸ ibid para 2.02.

⁹ ibid para 2.19.

¹⁰ Louise Gullifer and Jennifer Payne, Corporate Finance Law: Principles and Policy (2nd edn, Hart Publishing 2015) 677; Paul L Davies and Sarah Worthington, Gower’s Principles of Modern Company Law (10th edn, Sweet and Maxwell 2016) para 28-1; Kershaw (n 6) para 2.26.

¹¹ Takeover Code, Introduction 3(a) and (b); Davies and Worthington (n 10) paras 28-14-28-15; Kershaw (n 6) paras 4.70 ff.

¹² Companies Act 2006 (CA 2006), s 974(1)-(3). Although this definition is located in the special provisions on ‘squeeze-out’ and ‘sell-out’ in part 28 chapter 3 of CA 2006, it can serve as an example to explain the meaning of a takeover offer.

¹³ Gullifer and Payne (n 10) 677; Davies and Worthington (n 10) para 28-1.

¹⁴ Davies and Worthington (n 10) para 28-1; Kershaw (n 6) para 2.21.

¹⁵ Kershaw (n 6) para 2.21.

¹⁶ ibid paras 1.05-1.06.

¹⁷ ibid para 1.11.

¹⁸ ibid para 1.01.

¹⁹ Adolf A Berle and Gardiner C Means, The Modern Corporation and Private Property (Macmillan 1932); Henry G Manne, ‘Mergers and the Market for Corporate Control’ (1965) 73[2] Journal of Political Economy 110, 112-113; Michael C Jensen and William H Meckling, ‘Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure’ (1976) 3[4] Journal of Financial Economics 305; Frank H Easterbrook and Daniel R Fischel, ‘The Proper Role of a Target’s Management in Responding to a Tender Offer’ (1981) 94[6] Harvard Law Review 1161, 1169-1174 and 1182-1184; Frank H Easterbrook and Daniel R Fischel, ‘Takeover Bids, Defensive Tactics, and Shareholders’ Welfare’ (1981) 36 The Business Lawyer 1733, 1735-1736 and 1744; John C Coffee, ‘Regulating the Market for Corporate Control: A Critical Assessment of the Tender Offer’s Role in Corporate Governance’ (1984) 84[5] Columbia Law Review 1145; Michael C Jensen, ‘Takeovers: Their Causes and Consequences’ (1988) 12[1] Journal of Economic Perspectives 21, 27-28; Gullifer and Payne (n 10) 710-711; Davies and Worthington (n 10) paras 28-1 and 28-19; Kershaw (n 6) paras 1.30-1.32; Paul L Davies, Klaus J Hopt and Wolf-Georg Ringe, ‘Control Transactions’ in Reinier H Kraakman and others (eds) The Anatomy of Corporate Law (3rd edn, OUP 2017).

²⁰ Kershaw (n 6) para 1.39.

²¹ Model Articles for Public Companies, art 3; Gullifer and Payne (n 10) 680-681; Davies and Worthington (n 10) paras 14-2-14-3; Kershaw (n 6) paras 10.01 and 11.21.

²² Gullifer and Payne (n 10) 677 and 695-696; Davies and Worthington (n 10) para 28-19; Kershaw (n 6) para 11.16.

²³ Financial Conduct Authority (FCA) Handbook, LR 2.2.4; Gullifer and Payne (n 10) 700.

²⁴ Davies and Worthington (n 10) para 28-19; Kershaw (n 6) paras 1.48 and 11.14; Davies, Hopt and Ringe (n 19).

²⁵ Gullifer and Payne (n 10) 697.

²⁶ Takeover Code, General Principle 3.

²⁷ ibid r 21.1(a).

²⁸ Gullifer and Payne (n 10) 696; Davies and Worthington (n 10) para 28-19.

²⁹ Takeover Code, r 21.1(a).

³⁰ Davies and Worthington (n 10) para 28-20; Kershaw (n 6) para 11.03.

³¹ Davies and Worthington (n 10) para 28-20; Kershaw (n 6) para 11.10.

³² Takeover Panel, Statement 1989/7, Consolidated Gold Fields and Statement 1989/20, BAT Industries; Kershaw (n 6) para 11.08.

³³ Takeover Code, r 21.1(a).

³⁴ Gullifer and Payne (n 10) 704; Davies and Worthington (n 10) para 28-20; Kershaw (n 6) para 11.05.

³⁵ Kershaw (n 6) para 11.06.

³⁶ Gullifer and Payne (n 10) 705; Davies and Worthington (n 10) para 28-20.

³⁷ Davies and Worthington (n 10) para 28-55.

³⁸ Directive 2004/25/EC of the European Parliament and of the Council of 21 April 2004 on takeover bids [2004] OJ L142/12 (Takeover Directive), art 9(2); Gullifer and Payne (n 10) 705.