Private equity under the spotlight - ASIC cracks down on offers of stub-equity in proprietary companies

In brief 14 min read

ASIC is clamping down on the use of an offer of stub-equity in a proprietary company as an alternative form of consideration in public control transactions. This, and recent developments in the Capilano scheme, shows that ASIC is now looking at stub-equity consideration structures more closely and, in certain circumstances, will be prepared to challenge transactions. Partners Guy Alexander and Tom Story and Managing Associate Noah Obradovic report on the implications.

The ASIC clampdown

ASIC recently issued a media release announcing it was clamping down on the use of an offer of stub-equity in a proprietary company as an alternative form of consideration in public control transactions¹. An offer of stub-equity occurs where the bidder, in addition to offering the standard cash consideration, offers scrip consideration in the form of shares in the bid vehicle (or, more typically, the holding company of the bid vehicle (the Holdco)². The offer provides an opportunity for target shareholders to retain an economic exposure to the underlying business of the target company, through holding scrip in the Holdco³.

Stub-equity alternative consideration has been offered in a number of bids by private equity over the years, including KKR's acquisition of Pepper in 2017; PEP's acquisition of Patties in 2016, and Wattle Hill/Roc's acquisition of Capilano Honey this year. Although stub-equity consideration structures are more common in private equity-backed transactions, the structure has also been used in public control transactions involving corporate bidders (eg REA Group's acquisition of iProperty in 2016).

ASIC's main concern is where the Holdco is an Australian proprietary company, rather than an Australian public company (although, as discussed below, ASIC does have other issues with the stub-equity structure beyond the one specifically covered by their media release). Its concern is that the Corporations Act 2001 (Cth) (the Act) contains a number of disclosure and governance protections for shareholders in public companies, which do not apply to proprietary companies, and if a bidder can use a proprietary company to make a broad-based offer of shares to target shareholders, including retail shareholders, the 'intent' of the legislation would be defeated.

ASIC notes that, normally, proprietary companies are supposed to have no more than 50 non-employee shareholders and are prohibited from making offers that would require a prospectus. However, these provisions don't apply to stub-equity offers because there is a prospectus exemption for offers made under a scheme of arrangement; and recent stub-equity offers have been structured so that, if there would otherwise be more than 50 shareholders in the Holdco, the Holdco shares that would otherwise be issued to electing target shareholders are issued to a custodian, which holds the shares on behalf of all electing target shareholders.

The particular disclosure and governance protections that ASIC points to include the restrictions on related party transactions under chapter 2E, the restrictions on conflicted directors voting at board meetings under s195, and the requirement to hold an AGM under s250N, all of which only apply to public companies.

ASIC's media release follows its unsuccessful objection to the Capilano Honey scheme in the Federal Court (discussed further below). This was despite the fact that the same structure had been adopted in the PEP scheme for Patties, and the KKR scheme for Pepper, and there neither ASIC nor the court raised any issues with the structure.⁴

In the media release, ASIC states that it intends to issue a consultation paper in early 2019, seeking views on a proposed legislative instrument to prevent these offers of stub-equity in proprietary companies in control transactions, and that, in the interim, it will consider making individual instruments to prevent such offers.

At the moment at least, ASIC's position seems to be limited to a broad-based offer of shares in a proprietary company as part of a control transaction. That does raise the question, though, about management equity structures where shares have been issued in a proprietary company outside of a control transaction context, using a custodian/nominee structure. A number of these companies use a nominee structure in order to encourage management equity participation and not as a result of a control transaction.

What are the consequences of not being able to use a proprietary company as the Holdco?

We think that the ASIC position on this is misconceived – we don't believe that there is any 'intent' evinced in the Act that a public company has to be used to offer scrip to target shareholders. The Act does not mandate the use of a public company, so it is up to the bidder to choose the appropriate structure of the vehicle, provided there is adequate disclosure of the governance and disclosure regime which will apply. Section 708 provides an exception to the prospectus provisions, even where the Holdco is a proprietary company, and this was confirmed by the court in Capilano.

If ASIC is correct, does that mean that proprietary companies with more than 50 members (eg those with more than 50 employee shareholders) have to convert to a public company? Also, does it mean that other entities, such as foreign listed companies, which may be governed by foreign laws that do not provide governance and disclosure protections equivalent to Australian public companies, should not offer scrip consideration in Australia? If so, that would be a surprising and unwelcome development.

In any event, we don't think that ASIC's position in its media release will give rise to too many problems in practice for private equity bidders, because the bidder can still offer stub-equity using a public company as the Holdco or stub-equity in a foreign proprietary vehicle. We note that before the Patties scheme in 2016, the Holdco in stub-equity schemes had typically been a Cayman Islands company. Much of the reason for using a foreign company was to ensure that the takeover provisions of the Act (which apply to the acquisition of shares in Australian companies with more than 50 members) would not apply to acquisitions of shares in the Holdco (i.e. to allow the private equity shareholder to maintain maximum flexibility and control over their exit in Holdco). This was further refined in the Patties scheme, where an Australian proprietary Holdco was used, but with the custodian structure referred to above, to ensure that there would always be fewer than 50 registered shareholders in the Holdco. This was simpler, in that it avoided the need to use a foreign company, and the need to explain foreign corporations and securities laws to target shareholders, while still ensuring that the Australian takeover provisions would not apply.

Even though ASIC has now clamped down on the use of an Australian proprietary company Holdco, we think it will still be open for bidders to use an Australian public company Holdco, with the custodian structure to ensure that the 50-member threshold for application of the takeover laws is not exceeded. Yes, the restrictions on related party transactions under chapter 2E, and the restrictions on conflicted directors voting at board meetings under s195, would apply to the public company Holdco, but the shareholders deed for a Holdco offering stub-equity will often contain analogous provisions in any event, so that may not be a huge imposition.

Obviously, this depends on the bidder still using a custodian structure to keep the number of shareholders below 50. Interestingly, at the second court hearing on the Capilano Honey scheme, ASIC sought to attack the use of this structure, relying on s411(17) of the Act. That section provides that the court cannot approve a scheme unless it is satisfied that the scheme has not been proposed for the purpose of enabling any person to avoid the takeover provisions of the Act. ASIC argued that having a custodian to ensure that the total number of shares in Holdco did not exceed 50, with the purpose that the takeover laws did not apply to future acquisitions of shares in Holdco, meant that s411(17) applied. The court, quite correctly in our view, rejected this because s411(17) is plainly directed at the acquisition of shares in the target entity under the scheme, not at acquisitions in the Holdco that may or may not occur some time in the future, after the scheme has been implemented. Therefore, ASIC failed on that argument.

So, for the time being at least, it would be open for a bidder to use a public company Holdco for its stub-equity offer in the future.

What are ASIC's other issues with stub-equity schemes?

One of the major attractions of a stub-equity offer is that it can be used to allow a major shareholder to roll their shares in the target for shares in the Holdco, thereby giving them the ability to maintain an economic exposure to the underlying target business, and to get capital gains tax rollover relief. This can be important in getting the deal done, as the bidder will want to ensure that those major shareholders will support the deal.

Importantly, if the stub-equity offer was structured as an offer only to those major shareholders, they would not be able to vote on the deal. However, under the scheme, the stub-equity is offered to all shareholders on a one-for-one basis, so that the major shareholder is being treated the same as all other target shareholders, and therefore does not constitute a separate class for voting on the scheme. While the major shareholder may be subject to scale-back if other shareholders elect the stub-equity alternative consideration, small shareholders will usually not want to take shares in an illiquid vehicle where the bidder will have board control and special rights. This is particularly the case given that the target board's recommendation to vote in favour of the scheme is usually confined to the cash alternative consideration, not the stub-equity alternative, and the independent expert will usually apply a 30 per cent liquidity discount when assessing the value of the stub-equity.

For some time now, however, there has been a concern that ASIC and/or a court may take the view that the rights attached to the Holdco shares in the shareholders deed for Holdco have been structured in such a way as to, in practice, give a collateral benefit to the major shareholder at which the stub-equity alternative is targeted. It may be that, on their face, the special rights are available to anyone other than the bidder who happens to have more than, say, 10 per cent of the shares in Holdco, but if the only person who could end up with more than 10 per cent is the founder shareholder, have the rights been structured to give them a collateral benefit, and should this result in their votes being disregarded on the scheme?

This issue came up in the recent Capilano Honey scheme (in addition to the point in ASIC's media release about using a proprietary company Holdco). There, the shareholders deed setting out the rights attached to the Holdco shares gave the private equity bidder the usual board majority, drag-along rights, pre-emptive rights etc. The shareholders deed also gave certain rights to 'Non-Investor Parties' (original Capilano shareholders taking up shares in Holdco under the scheme) if they held more than a prescribed percentage of the shares in Holdco, in addition to the rights given to other Capilano shareholders taking Holdco shares. For example:

• a Non-Investor Party with 25 per cent or more of the Holdco shares (or, if there were no single Non-Investor Party with 25 per cent, the Non-Investor Parties together holding 10 per cent or more of the Holdco Shares) had the right to appoint one director to the Holdco board. This gave the relevant Non-Investor Parties veto rights over certain decisions, including material acquisitions or disposals, capital restructures, new issues of shares, and changes to the business.
• Except for any Non-Investor Party holding more than 5 per cent of Holdco shares, all Non-Investor Parties were required to hold their shares in Holdco through a custodian, in order to keep the number of registered shareholders below 50, thereby ensuring that the takeover provisions did not apply to future acquisitions of shares in Holdco. Previous stub-equity transactions had used this custodian structure for this purpose⁵, but those other transactions did not have the exception that allowed a former target shareholder with more than 5 per cent of the Holdco shares to hold their shares directly.
• Under the deed, any Holdco shareholders holding more than 5 per cent of Holdco shares had rights to participate in future capital raisings, and had pre-emptive rights regarding the sale of other shareholders' shares, but other former Capilano shareholders would not.

At the time of the announcement of the scheme, there was only one substantial shareholder in Capilano that would be able to benefit from the additional protections given to Non-Investor Parties under the shareholders deed if they held more than 5 per cent – Wroxby, which at that time held 20.6 per cent of the Capilano shares⁶. Capilano's announcement of the scheme included a statement that Wroxby had indicated, in the absence of a superior proposal, it intended to vote in favour of the scheme, and to elect to receive the scrip consideration rather than the cash consideration. This 'truth in takeovers' statement effectively satisfied the condition that shareholders holding at least 15 per cent of the total shares elect the stub-equity alternative consideration.

It appears that, before the first court hearing, ASIC was concerned that the rights attached to the stub-equity had been structured to favour the existing major shareholders in Capilano. Before the hearing, ASIC requested that the votes of significant shareholders in Capilano be tagged, so that any difference in interests between significant shareholders and other shareholders could be the subject of submissions at the second court hearing in relation to the fairness of the scheme. ASIC also required language in the scheme booklet that:

Significant shareholders who take up the Scrip Consideration will have additional rights under the Shareholders' Deed which other shareholders who take up the Scrip Consideration will not have.

The tagging of votes will permit the Court to know the extent to which shareholders who are not significant shareholders approved the scheme and to take that into account in considering whether it is appropriate for the Court to approve the scheme.

At the first court hearing, ASIC then opposed the scheme on a number of bases⁷, including whether the difference in terms attaching to the shares in Holdco depending on whether the holder held more than 5 per cent of Holdco shares was fair. The court ultimately granted orders to convene the scheme meeting, because Capilano had agreed to tag the votes of significant shareholders, and to disclose ASIC's concerns in the scheme booklet.

In the end, ASIC did not pursue this issue at the second court hearing, because at the scheme meeting, the scheme was approved by a sufficient number of votes that the resolution would have passed even without Wroxby's votes in favour. However, the case does indicate that ASIC will look more closely in the future to determine whether the rights attaching to the stub-equity shares have been structured to give rights to certain target shareholders who elect to receive stub-equity shares that are not being offered to other electing target shareholders.

What's next?

The use of stub-equity consideration structures has encouraged private equity bidders to seek out opportunities in the public space, and has therefore been a welcome development for public M&A activity more generally. However, the recent developments in the Capilano scheme are evidence of the fact that ASIC is now looking at these structures more closely and, in certain circumstances, is prepared to challenge the transaction on both legal and policy grounds.

Private equity sponsors considering using stub-equity structures in public control transactions should therefore ensure that any engagement with substantial shareholders electing scrip consideration (any discussions around the proposed equity terms in the Holdco) are structured carefully to minimise regulatory scrutiny and a potential court challenge. While we think that ASIC's arguments in Capilano were misguided, private equity sponsors considering using a stub-equity structure in a public control transaction should be mindful of the risks involved.