The European Commission has long been a proponent of a fair takeover market and increased contestability of control. Achieving these goals will ultimately produce a significantly higher turnover in corporate control, increased efficiency gains, and higher economic growth. One of the measures under discussion is the EU-wide adoption of the Mandatory Bid Rule (MBR).1 Under the MBR, also known as the Equal Opportunity Rule, the buyer of a block of shares has to offer the same price to all shareholders.
Currently, there is considerable heterogeneity in takeover regulation across EU countries.2 While most countries have gradually adopted weak versions of the MBR, each country applies the MBR with a fair amount of discretion. For example, the United Kingdom’s City Code mandates a strict application of the MBR, where all bids for blocks of 30% or more of the stock must be followed by a bid for the remaining shares at the same price. In contrast, in the United States, the Market Rule (MR) applies whereupon the buyer of a block of shares negotiates privately, and trades exclusively, with the current owner of the block.
While the harmonisation of takeover regulation appears an important step towards a leveled pan-European takeover market and ultimately towards the full integration of capital markets, it is questionable whether a homogeneous takeover code should include a strict MBR. This article reviews the evidence found in our paper “Determinants of the Block Premium and of Private Benefits of Control” on the costs and benefits of the Mandatory Bid Rule versus the Market Rule.3
The benefits of the Mandatory Bid Rule
When the ownership structure of a public corporation is characterised by a minority shareholder with control and otherwise dispersed shareholders, the controlling minority shareholder can extract private benefits at the expense of the dispersed shareholders. When a controlling block is traded, the buyer and seller not only exchange the cash flow rights in the block, but also the private benefits derived from its control rights.
One argument in favor of the MBR is that it may force the buyer to end up with a larger block of shares, producing a greater incentive alignment between the buyer and the remaining dispersed shareholders. This would result in a smaller extraction of private benefits.4
Another argument in favor of the MBR is that it may prevent value-decreasing control transfers.5 Indeed, some privately negotiated trades may occur because the buyer expects to extract more private benefits than the seller does in spite of the fact that the firm is expected to be worth less under the control of the buyer. Such transactions would not occur under the MBR because the dispersed shareholders would have to be paid the same as the seller, which is more than what their shares were worth before the trade.
The costs of the Mandatory Bid Rule
On the costs side, the MBR may lead to a partitioning of the block when the block owner’s valuation is sufficiently low relative to the block buyer’s valuation. A smaller controlling block reduces the incentive alignment between the new controlling shareholder and dispersed shareholders, increases extraction of private benefits and lowers firm value. In contrast, through a private negotiation, the buyer and seller may share the gains from the trade without changing the concentration of ownership.6
Another cost associated with the MBR is that it may deter value-increasing takeovers because the takeover price fails to compensate the block owner for his private benefits. These trades may still take place under the MR because the buyer of the block can offer a higher price only on each share of the block via the private negotiation.7
Measuring the effects of the MBR: US evidence
Our research studies minority-controlling block trades in the US between 1990 and 2006. Because the US operates under the MR, and because any trade that occurs under the MBR would also occur under the MR, our analysis of its effects is complete.
We study the two main outcomes of block trades: the difference between the price per share in the block and the price of the floating shares after the trade is announced (the block premium) and the change in the share price after the announcement (the price run up). The information contained in both is used to infer the level of private benefits under the ownership of either buyer or seller as well as the public benefits that each may generate. A related strategy has been used by Alexander Dyck and Luigi Zingales.8 Being able to disentangle the private benefits of control from the increase in the share value due to the change in control is critical in order to perform an empirical evaluation of the costs and benefits of the MBR versus the MR.
We first evaluate the welfare change associated with the block trades in our sample under the MR. We estimate that block trades increase overall welfare by 19% on average. These gains are largely explained by the fact that the share price increases substantially, i.e., 14%, after the trade announcement.
We find that the typical determinants of private benefits of control (e.g., the target’s availability of free cash, the tangibility of its assets) explain well the variation in the block premium across deals, but that private benefits alone only account for a small proportion of the level of overall gains. Consequently, we estimate that most of the gains go to the dispersed shareholders, whose welfare increases by 18% on average. This result partly dispels the notion that sale-of-office transactions are prejudicial to dispersed shareholders.
What would happen to welfare and takeover volume if we were to impose the MBR on our sample of block trades? Assume first that all deals go through the MBR as well. We identify deals in which the block is traded at a discount and the share price increases as those where it is likely that a tender offer would partition the block: a controlling shareholder that is willing to relinquish control while enjoying the upside potential of the shares will negotiate at a discount. Blocks traded at a premium reveal that the seller would likely contest the takeover, in which case the tender offer will result in a more concentrated ownership. Half of the deals in our sample exhibit a block discount and a simultaneous increase in share price. Hence, the MBR would decrease the average block size. This effect is estimated to represent a loss of 3% of welfare.
In addition, we find that roughly 50% of the deals would not take place under the MBR. Figure 1 shows the breakdown of loss in turnover between welfare-increasing and welfare-decreasing deals. The MBR reduces the number of welfare-decreasing deals by about 50% but also halves the number of welfare-increasing deals. The combined effect represents an average loss of welfare of about 10%.
Figure 1. Estimated Effects of the Mandatory Bid Rule on Turnover and Welfare
Michael Barclay and Cliff Holderness conjectured in their paper “The law and large-block trades” that the MBR should not lead to welfare increases relative to the MR because dispersed shareholders already seem to be extracting significant gains as observed by the large price run ups. We confirm their conjecture by showing that the trades where the application of the MBR would bring efficiency gains are those where the price run up is low or negative (see Figure 2).
Figure 2. Relationship between the Observed Price Run-up and the Estimated Effects of the MBR on Welfare
One interesting question is whether the implementation of the MBR could be refined if made conditional on some publicly observable variable. Currently, some countries condition the MBR on the block size. We find that the largest gains or losses in efficiency from imposing the MBR are concentrated in the smaller trades. This is because smaller blocks are those that can benefit (lose) the most from a tender offer that increases (decreases) the size of the block. This result implies that a UK-style policy is conservative: it reduces the welfare losses but also the gains. Consider now conditioning the MBR on the price run up. Ideally, all else equal, and as illustrated in Figure 2, a regulatory agency would only impose the MBR on those trades for which the price run up is negative. This mix between MR and MBR would produce the highest increase in welfare. However, a policy implementation of this conditional version of the MBR would confront potential changes in incentives for buyers and sellers facing the new regulation.
A dynamic market for corporate control can bring many benefits to an economy. It allows for organisational restructurings, increased efficiency, and reduced private benefits extraction eventually leading to increased economic growth and overall welfare. Our study demonstrates that turnover in block trades of minority controlling blocks is much reduced with the use of the Mandatory Bid Rule relative to the use of the Market Rule. Moreover, the welfare impact of the MBR may be very large and negative: the MBR deters otherwise welfare-increasing deals by forcing inefficient tender offers and fails to deter welfare-decreasing deals that go through under the Market Rule. More research should be aimed at finding ways to impose the MBR on a conditional basis.
1 Eric Berglöf and Mike Burkart “European Takeover Regulation,” Economic Policy, April 2003.
2 See Berglöf and Burkart (2003).
3 Rui Albuquerque and Enrique Schroth, “Determinants of the Block Premium and of Private Benefits of Control” CEPR Discussion Paper 6742
4 Denis Gromb, Mike Burkart, and Fausto Panunzi “Agency conflicts in public and negotiated transfers of corporate control,” Journal of Finance 55: 647-677, 2000.
5 Lucian Bebchuk “Efficient and Inefficient Sales of Corporate Control” Quarterly Journal of Economics 109: 957-993, 1994.
6 See Gromb, Burkart and Panunzi (2000).
7 See Bebchuk (1994).
8 Alexander Dyck and Luigi Zingales, “Private benefits of control: An international comparison,” Journal of Finance 59: 537.599, 2004.