September 28, 2012 / 7:33 PM / in 5 years

Analysis: Bomb ticks on EADS pact as politics cloud merger

PARIS (Reuters) - Doubts are growing over the resilience of a Franco-German shareholder pact at the heart of EADS EAD.PA, placing a new timebomb under $45-billion European merger talks with British defense contractor BAE Systems (BAES.L).

With firms already racing an October 10 deadline to overcome growing political obstacles, fears over what would happen as core EADS industrial partners seek to disinvest have set the fuse on further discord within months if BAE talks break down.

After acting as a power-sharing mechanism for over a decade, the pact which balances national interests via stakes held by the French state, French conglomerate Lagardere LAGA.PA and German engineer Daimler (DAIGn.DE) will be wound up if EADS and BAE forge the world’s largest defense company.

But so fragile has the partially confidential pact become, as Lagardere and Daimler prepare to sell stakes to concentrate on core businesses, that there are doubts whether the status quo would hold for more than a year even if the British merger talks fail and EADS tries to return to business as usual.

That could promote fresh arguments between French and German politicians over control of one of Europe’s strategic companies, without the rights or guarantees the pact now offers.

“Whether the deal goes ahead or not, the shareholder pact is going to disappear at some point. The rights are fragile and provisional,” said a person with knowledge of the safeguards.

A spokesman for EADS declined comment.

EADS was born from a merger of French, German and Spanish interests in 2000 with a unique structure allowing the Paris government and Daimler to cohabit at arm’s length. Daimler owns a voting share of 22.5 percent of EADS. It shares control with Lagardere, which has 7.5 percent but also represents the French government’s 15 percent through the 12-year-old share pact.

Negotiations to remove the structure and merge with BAE have reached a critical point: France is unwilling to surrender official oversight of EADS, which makes both Airbus airliners and key military hardware; and Berlin has raised the stakes by demanding a state shareholding with equal rights to the French.

The situation mirrors a Bastille Day impasse in 1999 when French Prime Minister Lionel Jospin vetoed the creation of EADS without French state shares. Today Germany wants its own role, beyond any influence it may have tried to exert through Daimler.

Negotiating in complete secrecy, EADS’ founders managed 13 years ago to square the circle with an unusual pact. Its job: to erect a screen between the French state and a skeptical Daimler.

A system of boxes surrounding the French government investment left civil servants some powers while giving Daimler and Lagardere final say on key matters like board nominations.

It is the vulnerability of these core arrangements - both companies seem keen to cash in their stakes - as much as short-term market or regulatory pressure, that could eventually persuade quarrelling governments and industrialists to cling together to find a way out of the current deadlock.

“The governments face a dilemma,” said a person who has participated directly in similar European-wide negotiations.

“They can hold onto rights which are provisional and subject to Daimler and Lagardere remaining, or they can exchange these rights against permanent ones enshrined in a special share.”

Similar to golden shares, the special shares would let Britain, France and Germany block takeovers, replacing another of the current pact’s functions in protecting EADS.

A350 EXIT SEAT

If the BAE deal falls through, shareholders attuned to the next opportunity for structural change will at once set their calendars to the first flight of Europe’s newest passenger jet, the Airbus A350, which is scheduled for the middle of 2013.

From the time Europe’s first carbon jetliner takes off, speculation is likely to swirl around the 7.5-percent stake held by Lagardere, whose chief executive has committed to stay on board EADS only until the risky plane project is finalized.

The timing of a sale has been left deliberately vague, with the plane’s first delivery not expected until the second half of the following year and market prices certain to play a role.

When it does happen, events could cascade quickly inside the pact which is a Russian doll of nested agreements, according to industry specialists and a Reuters analysis of available texts.

The first fuse to pop could be a mini-pact applying solely to the French partners, which places a floor on the proportion of the French core stakes to be held by the state and Lagardere.

Secondly, a frustrated Daimler has for months been seeking ways to sell some of its shares to the German state without blowing up the very Franco-German pact it helped design; it is unlikely to pass up any chance to sell when Lagardere opts out.

After a decade that saw significant birth pangs to the A380 superjumbo, both companies want to focus on core businesses - notably media for Lagardere and vehicle making for Daimler.

Even without the first rule, the larger pact would collapse once Daimler fell below a 10-percent holding in EADS unless the French government also were to sell some of its shares, which it has so far refused to do.

It is hard to predict what would happen next, but experts say it suggests turbulence for governments, EADS and investors.

Without the pact, alternative takeover defences may have to be cobbled together and France would keep a separate veto over matters relating to EADS production of nuclear missiles for the French military. But other special rights for pact members, like helping shape acquisitions or industrial strategy, would vanish, leaving the government with a strake but less clout than before.

After a bruising battle over BAE, France and Germany would find themselves badly misaligned, raising doubts over whether Germany would give up its quest for an equal stake. Worse, past divisions have filtered into the company hampering governance.

Yet skilful compromise would be needed more than ever to prevent a dash for state shares backfiring, for example by accidentally triggering a mandatory offer for the whole of EADS.

With all this at stake, people with knowledge of the pact say a last-minute compromise is likely. But like a hard-fought European bailout to help EADS pay for massive losses on the A400M military plane two years ago, it may not look elegant.

As one veteran of past battles in the sector said: “The problem is that everything has been built on a foundation of mistrust between nations that have a problem accepting purely industrial projects and where everyone is seeking guarantees.”

Additional reporting by Mark John; Editing by Alastair Macdonald

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