1.2.2.1 Ownership Disclosure as an Enforcement Mechanism

In the words of Reinier Kraakman, disclosure can facilitate enforcement insofar as it "discourages opportunism in its own right" and "permits other legal controls that deter self-dealing decisions by corporate insiders."1 To see how ownership disclosure can do this, it is useful to distinguish between firms with dispersed ownership and firms with concentrated ownership, as their need for enforcement is different.

Many European firms have concentrated ownership.2 In these firms, there is not a problem of "strong managers, weak owners" but rather of "strong blockholders, weak owners."3 Because of the potential of private benefit extraction by blockholders and the resulting need for monitoring of their behavior, disclosure of major holdings is particularly important for these firms.4 Three examples illustrate this.

First, disclosure may expose the potential for trading on inside information or other forms of market abuse. Large shareholders can be expected to have access to inside information more readily than small shareholders. Under U.S. law, holders of a 10% stake are deemed to possess insider information, and their trading activity is therefore subject to stringent disclosure requirements.5 The European Commission had the same concern in mind when it proposed the mies on disclosure of major holdings; this would prevent "uncontrollable tumors" and stop "misuse of price-sensitive information."6

Today, the primary instrument to prevent this is the European Market Abuse Directive, which contains mies aimed at safeguarding market integrity.7 The Transparency Directive has a complementary function by identifying shareholders who are not on an insider list, but may nonetheless have access to inside information and may be tempted to use it. This facilitates private or public enforcement, albeit to a modest extent, given that subsequent transactions will not have to be disclosed unless they cause the crossing of one of the relevant thresholds that trigger a disclosure obligation. Disclosure may also prevent those whose interests are exposed from engaging in market abuse in the first place, consistent with the notion that sunlight is the best disinfectant.8

Second, disclosure of the identity of the person who ultimately controls the firm makes it easier to detect diversion of corporate assets.9 Such diversion may occur, for example, through related party transactions that are not conducted at arms' length (tunneling). To be sure, in many jurisdictions, issuer disclosure mies already require disclosure of related party transactions. But at least in Europe, these mies only require periodic disclosure.10 What is needed is some degree of ex ante disclosure.11 This alerts outsiders to potential conflicts of interest, which may induce them to monitor more intensely. This, in turn, may discourage the controlling shareholder from engaging in tunneling in the first place. In spite of these benefits, research suggests that continental European countries still have relatively few ex ante disclosure requirements.12 Particularly for those countries, ownership disclosure may constitute a useful form of ex ante disclosure.

Controlling shareholders may divert corporate assets not only through tunneling, but also by forcing the company to simultaneously pay out dividends and assume significant debt, to the detriment of long term stakeholders. This, at least, appears to be the concern of the European Commission, which has therefore proposed that private equity funds acquiring a 30% stake in listed companies not only disclose their identity but also provide other information to stakeholders (i.e., the issuer, minority shareholders and employee representatives), such as a policy for preventing and managing conflicts of interests between the fund and the i s suer. 13

Lastly, ownership disclosure can enable shareholders to make informed corporate governance decisions, such as choosing directors or authorizing fundamental transactions.14 In Europe, both the Transparency Directive and the Shareholders' Rights Directive aim to ensure that shareholders can exercise their rights in an informed manner15 Ownership disclosure contributes to this, again, by exposing potential conflicts of interest.

Of course, even if it is clear that there is a conflict of interest, the controlling shareholder will, as a practical matter, determine the outcome of the vote. This limits the extent to which ownership disclosure can improve the quality of the shareholder decisionmaking process in firms with concentrated ownership.16 To counter this problem, related party transactions are often subject to exclusive approval by the noninterested shareholders. In those cases, ownership disclosure fulfifls a special role. As Bernard Black has argued, "insiders have a further incentive to disguise their ownership, so they can pretend to be noninterested [and vote]. Disclosure mies, and rules that treat affiliates of insiders as interested shareholders, are needed to prevent this."17 This is one of the reasons why he counts ownership disclosure among the "core institutions" that control self-dealing.

Empirical studies underscore the role of disclosure in mitigating agency costs. One study finds that high disclosure standards are strongly associated with lower levels of private benefits.18 This finding is consistent with the law and finance literature. In a recent study, La Porta et al. construe a "disclosure index" that includes ownership disclosure as a variable. They find that as disclosure improves, the size of the block premium decreases.19 True, the law and finance literature has been subject to criticism.20 But even scholars who have gone so far as to construe a new "shareholder protection index" have consistently included ownership disclosure as a variable.21 This means they too are of the view that ownership disclosure can protect minority shareholders, the principal argument made here and implicitly adopted by the European Commission.22

Finally, while the importance of ownership disclosure in this context should not be underestimated, neither should it be overestimated. Shareholders who have amassed such a large stake that they are able to engage in abusive behavior are likely to be known even if they have not publicly disclosed their stake. Moreover, in terras of enforcement, ownership disclosure merely represents a first step. The quality of minority shareholder protection will largely depend on minority shareholders' ability to hold the controlling shareholder accountable. Still, the fact that mandatory ownership disclosure ensures that investors and regulators are informed of potential conflicts of interest on timely basis suggests it has marginal value.

While many European firms are characterized by concentrated ownership, there are also numerous firms with dispersed ownership, particularly in the UK.23 How does ownership disclosure reduce agency costs in these firms?

Before answering this question, it is important to nuance the distinction between firms with dispersed ownership and firms with concentrated ownership. As pointed out by Armour and Gordon, we can distinguish two types of firms with dispersed ownership.24 One is characterized by retail ownership and predominantly found in the U.S.; the other by institutional ownership and predominantly found in the UK. Multiple blockholders can together increase agency costs much like a single controlling shareholder can, by conspiring to extract private benefits.25 This risk of "intra-shareholder agency costs" requires the same type of enforcement as in firms with concentrated ownership, discussed earlier. Armour and Gordon suggest that this explains why the UK has stringent ownership disclosure rules compared to the U.S.26

In terras of reducing managerial agency costs, however, the function of ownership disclosure applies in roughly the same way to both types of firms with dispersed ownershipby facilitating the market for corporate control, the mechanism through which management is disciplined by takeovers and the threat thereof. To be sure, the tone of the political debate at the level of individual European countries suggests that, to put it mildly, vulnerability to takeovers is not always desired. Inevitably, this has ramifications at the European level — the complicated legislative process preceding the Takeover Directive springs to mind.27 Still, it appears that at least the European Commission believes in the virtues of the market for corporate control. The very reason it proposed the Takeover Directive was to create favorable conditions for the emergence of a European market for corporate contro1.28 One such condition is that the initial threshold for ownership disclosure is set at the right level, which can be explained as follows.

On the one hand, ownership disclosure can positively impact the market for corporate control. First, by understanding who is in control and determining the size of the free float, potential bidders can estimate the likelihood that their bid will succeed. The High Level Group correctly observed that lack of transparency of the ownership structure may result in malfunctioning of the market for corporate contro1.29 Hence, the Takeover Directive now requires significant direct and indirect shareholdings to be published in the annual report.30

Second, transparency of major holdings enables the potential bidder to identify parties who could be approached for irrevocable undertakings.

Third, disclosure enables other potential bidders to mount a competing offer by alerting them that a third party is amassing a stake in the target. Disclosure matters here since the larger the toehold, the smaller the likelihood that a competing offer will succeed. This is because the initial bidder will partially bid for its own shares, and is therefore able to pay a higher price on the whole.31 A toehold can also offer a strategie advantage vis-á-vis competing bidders, since the refusal of the initial bidder to tender its shares in a competing bid could hamper competing bidders' ability to squeeze out the minority upon completion of their bid.

The flipside of the coin is that mandatory disclosure of stakebuilding can discourage the initial bidder from making a bid in the first place, at least when the threshold that triggers disclosure is set too low. This is because such threshold limits the size of the toehold a potential bidder can silently purchase, and the gains he can realize as a result thereof.32

The bidder's gains from stakebuilding can be considered from different perspectives. From an efficiency perspective, they can be considered a reward for the effort of searching for potential synergies.33 They can also be considered as a means to finance the relatively high bid premium that target shareholders will expect due to the freerider problem associated with takeover bids.34 This way, the bidder will still be able to retain some of the gains from his monitoring upon acquisition of the firm. Even if a third party ends up realizing the synergy gains, sale of the toehold will ensure that search costs are made up for. From this perspective, by reducing the potential gains from acquiring a toehold, mandating early disclosure reduces the incentives to incur search costs, to the detriment of the market for corporate contro1.35

An alternative perspective is offered by the Takeover Directive, which justifies its mandatory bid rule — i.e., the forced sharing of the control premium with other shareholders — by citing the need for protestion of minority shareholders and emphasizing that shareholders should be treated equally.36 However, as argued by Luca Enriques, the rule has dubious effects on minority shareholders' welfare, precisely because of the chilling effect on takeover activity, and no justification in terras of equal treatment.37 Much of his line of reasoning applies equally to the limitation of a bidder's profits from stakebuilding on grounds of fairness and equal treatment.38

Adding to the complexity is the fact that disclosure functions as an early warring system to target management, enabling it to respond, for example, by mounting defensive measures.39 Mandatory disclosure thus potentially undermines the market for corporate contro1.40 Yet disclosure can also be useful, because control contestability comes not only with benefits but also with costs. These include the costs of inefficient takeovers and of insiders responding to takeover threat by behaving myopically.41 Thus, some protection from takeovers may promote insiders' incentives to increase firm value. Moreover, temporary defenses could benefit existing shareholders by strengthening the board's bargaining position. Once the playing field is leveled, the board can negotiate a higher offer price in the case of a bid that undervalues the target. In addition, the board can erecourage others to lasinch a superior bid.

Outside the takeover context, early disclosure can make life difficult for activist shareholders, particularly in combination with tight rules on acting in concert.42Indeed, one commentator has suggested that Germany's recent decision to lower its initial reporting threshold to 3% was driven by the controversial approach of Deutsche Bfirse by hedge funds in 2005.43 In some countries, issuers are provided with additional tools to trace suitors. UK-listed companies, for example, have a statutory right to demand clarification from any person whom they believe to be interested in the company's shares.44 One expert group has recommended the European Commission consider adopting such a right at the European level.45 Still, this tool may prove to be of linie help if the target is unaware of the stakebuilding.

For policymakers, the challenge is to weigh these competing interests to achieve a balance that inevitably is "delicate and perhaps even unstable."46 A study by the FSA concludes that, by minimizing toeholds and providing information on impending takeovers, ownership disclosure should overall improve the contestability of the market for takeovers.47 This suggests that ownership disclosure can be a valuable mechanism to improve corporate governance.