France has maintained a degree of state control over its strategic defense industries for decades, but government bungling in managing its shareholdings has led to calls instead for U.S.-style veto power over ownership changes on national security grounds, a regulatory shift that is anathema to European Union anti-protectionism rules.

Over the past 10 years, the French state has often proved unable to act with a single voice, and in some instances displayed rank incompetence in handling its equity interests in key defense groups, according to France's audit agency, the Cour des Comptes, an approach that has left the government in a weakened position as shareholder in the very companies it wants to influence.

As it privatized and reorganized the country's aerospace and defense industry, the French government kept significant shareholdings in key companies in a bid to protect an industrial base it viewed as essential to national security. But occasionally poor stewardship of its holdings has gradually eroded the state's ability to achieve that goal, the report reveals. The government's role has deteriorated to where competing companies have become entangled with each other, and with the nation's strategic interests.

European aerospace giant EADS—co-builder of the Eurofighter Typhoon—now is the biggest minority shareholder in Dassault Aviation, builder of the Rafale, the European fighter's main competitor. Dassault, in turn, controls a blocking minority stake—through its holding in electronics supplier Thales—in shipbuilder DCNS, a mostly state-owned company essential to France's nuclear deterrent. A blocking minority gives the minority shareholder rights to reject certain transactions voted by the majority.

“The maneuvering room for the government as a customer of the defense industry is an important parameter for the future of the industrial fabric,” says Didier Migaud, president of the Cour des Comptes, which this month released a report: “Weaknesses of State Shareholdings in Defense Companies.” To maintain strategic influence, the state needs to adopt a comprehensive strategy for dealing with its industrial partners, he says.

Antoine Gelain, a defense industry analyst with Octagon Partners in London, says that combining a coherent technology and industrial strategy with so-called “golden shares” or other specific control mechanisms could address what has become a conflict of interest between the French state as shareholder and its role as a customer.

“Government ownership in defense companies is an approach that is out of date, all the more so as the French state does not have any kind of industrial strategy, so they cannot use their shareholdings to influence the industry because they do not know what direction they want the industry to go,” Gelain says, adding that government ownership undermines the value of these companies by limiting managerial freedom to maneuver. “It penalizes not only the companies, but also the French government as a shareholder.”

In their report, French auditors concede that the nation's record of government shareholding in key defense industrial groups is not all bad. French companies that were once hidebound, uncompetitive, state-owned monopolies have learned to act on the global market and are now among the industry's top ranks by revenue.

But some of these same companies have resisted following the government's direction and have on occasion outmaneuvered the state's efforts to guide strategic interests. The most pertinent example is Dassault, a family-controlled company in which the government has gradually lost shareholding power over the past three decades, much of it through missteps in handling its equity interest.

Moreover, the state has inadvertently ceded to Dassault control of key strategic interests in Thales, in which the aircraft manufacturer holds a 26% stake; and in DCNS, in which Thales since early 2012 has held a 35% blocking minority.

As a result, the government has at times been unable to impose its will on Thales, and to a lesser degree DCNS, a position for which former Dassault Chief Executive Charles Edelstenne says the state has only itself to blame after privatizing certain strategic defense industries, only to regret some of the inevitable consequences.

“Privatization of these companies was a political act—a sovereign decision by those elected by the French people to make national policy,” Edelstenne says. “But once the state has decided to privatize these companies, it is difficult to criticize private shareholders for exercising rights the law gives them, and which the state has accepted through shareholder agreements.”

The audit agency also worries that Dassault and the French government have differences when it comes to the future direction of DCNS. While the state wants to keep control of the group, Dassault would prefer to see it run as a more industrial entity through Thales.

In its report, the audit agency attributes much of the state's diminished shareholder power to outmaneuvering on the part of defense companies, but in some cases it has been the result of administrative incompetence.

For example, following the 2005 merger of aerospace supplier Snecma and defense group Sagem, France retained a 30% voting share in the combined company, renamed Safran. Two years later, the French agency that manages state holdings failed to meet a regulatory deadline to disclose through France's stock market authority that it had breached a threshold for accumulating Safran shares, a reporting oversight that cost the state an opportunity to increase its holding to 40%.

Even if it remains the largest and only major shareholder, the state has limited powers over Safran, as was illustrated in 2012 when the company's board of directors was able to block a government-backed exchange of assets between Thales and Safran in the areas of optronics and avionics.

As the French state's ownership in and influence over its defense industry wanes, the court asserts the government would do well to borrow a page from U.S. industrial security policy, which since 1988 has allowed the president to decide, by executive fiat, to block all foreign investments in domestic strategic industries that could pose a threat to national security through the Exon-Florio amendment.

Such a move could draw negative attention from the EU, which the audit agency says views Exon-Florio as a protectionist measure. In its report, the agency notes only Italy has put in place a regulation that appears to borrow from U.S. law—a March 2012 decree that limits the government's veto power on ownership changes but provides special powers with respect to defense and national security interests.

The EU for years had pressured Italy to open its domestic markets to foreign ownership, though it remains unclear whether this limited measure, known as the “Golden Power” regulation, will run afoul of the union's rules.

“In the absence, at this juncture, of an Exon-Florio-type regulation, holding stock positions with a majority or blocking minority in these companies, either alone or in participation with other actors, is the favored route, given that state financial means are now limited,” the audit agency says, noting that the French government could reduce defense spending based on a new military strategy expected to be released in the coming weeks.

Short of regulatory reform, Gelain says, such budgetary pressure could induce the French state to reduce government interest in defense companies.

“A key step in triggering some level of industry consolidation in Europe is for the government to relinquish its shareholdings. There are other ways to preserve sovereignty over national security interests without the government being shareholder in these companies,” he says. “Not only would it make good business sense to reduce government ownership, but the state could raise money to sustain the military budget at a decent level . . . by selling these stakes in these companies.”