ASIC steps up its attack on the use of stub equity in control transactions

In brief 9 min read

ASIC has issued its promised consultation paper on the use of stub equity in control transactions, which will, if adopted, have the potential to make the use of stub equity as an alternative form of consideration in schemes and takeovers more difficult. In our update last December we flagged ASIC's intent to crack down on offers of stub equity in a proprietary Holdco. However, the consultation paper goes further, and proposes a ban on the use of custodian structures in stub equity schemes (ie the requirement that participating target shareholders hold their interests in the stub equity vehicle through a custodian). The custodian structure has the effect of keeping the number of registered shareholders in the Holdco below 50, with the result that the takeover provisions and disclosing entity provisions of the Corporations Act do not apply. Partners Guy Alexander and Tom Story and Managing Associate Noah Obradovic report on the implications.

A quick recap of stub equity consideration structures

Stub equity schemes involve the bidder, in addition to offering the standard cash consideration, offering scrip consideration in the form of shares in the bid vehicle (or, more typically, the holding company of the bid vehicle, the Holdco).¹ This provides an opportunity for target shareholders to retain an economic exposure to the underlying business of the target company, through holding scrip in the Holdco.

The stub equity shares are typically offered on a one-for-one basis, and the offer is subject to a cap, to ensure the bidder will ultimately control the target (eg if scrip elections are received for more than 49% of the shares in the target, the scrip elections are scaled back pro-rata and the electing target shareholders instead receive the cash consideration to the extent of the scale-back). The shareholders deed setting out the rights attached to the Holdco shares gives the private equity bidder the right to appoint a majority of the board, and will also typically confer drag-along rights, pre-emptive rights etc. on the private equity bidder, over the minority shareholders' shares.

Stub equity alternative consideration has been offered in a number of bids by private equity bidders 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 in 2018. The structure has also been used in control transactions involving corporate bidders (eg REA Group's acquisition of iProperty in 2016).

Use of an Australian proprietary company as the Holdco / use of a custodian structure to hold shares in the Holdco

When stub equity schemes were first introduced in the Australian market over ten years ago, the Holdco was typically a Cayman Islands or Bermudian company which, from a structural perspective, is typically not an issue for a private equity manager given the funds managed by the sponsor are usually established in one or more offshore jurisdictions. One of the reasons for using a Cayman or Bermudian vehicle was to ensure the takeover provisions of the Corporations 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, so that a private equity bidder could subsequently exit its controlling interest in the Holdco without requiring third party acquirers to go through the takeover provisions of the Corporations Act. Similarly, by using a foreign company, the unlisted disclosing entity provisions of the Corporations Act, which apply to an Australian entity with more than 100 members, would not apply to the Holdco.

Starting with the Patties scheme in 2017, this changed so that, instead of using a foreign company, an Australian proprietary company was used as the Holdco.² To ensure the number of registered members was kept below 50 so that the takeover provisions and the unlisted disclosing entity provisions of the Corporations Act did not apply, these transactions also required the former target shareholders accepting into the offer to hold their shares in the Holdco through a custodian or nominee structure. The use of the custodian structure was also important to ensure the 50 registered member limit for a proprietary company in the Corporations Act was not exceeded.

In the Capilano scheme late last year, ASIC raised concerns with the court about the use of an Australian proprietary company as the Holdco, rather than an Australian public company. ASIC expressed concern that the Corporations 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.³ 

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. Although a number of previous schemes, such as KKR's acquisition of Pepper and PEP's acquisition of Patties, had previously used this structure without complaint from ASIC, the Capilano scheme had the additional feature that, in addition to offering target shareholders (including retail shareholders) shares in the Holdco as scheme consideration, target shareholders were also invited to subscribe for additional shares in the Holdco for cash.

After the Capilano decision, ASIC issued a media release announcing it was clamping down on the use of an offer of stub equity in an Australian proprietary company as an alternative form of consideration in public control transactions. However, the focus of the media release was on the use of a proprietary company as the Holdco, not specifically on the use of a custodian structure to ensure there were not more than 50 registered shareholders. 

Having to use an Australian public company as the Holdco was not thought to be such a major issue.  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 was unlikely to be a huge imposition. Again, though, this assumed the bidder could still use a custodian structure to keep the number of shareholders in the public company below 50.

ASIC Consultation Paper now also objects to the use of a custodian structure

The interesting point arising from the ASIC consultation paper is that ASIC is now objecting to the use of the custodian structure, even where the Holdco is an Australian public company. ASIC argues it is not just the public company governance protections that are important, but that the takeover provisions and unlisted disclosing entity provisions also need to apply. This is despite the scheme booklet containing comprehensive disclosure around the fact that the takeover provisions will not apply to subsequent acquisitions of shares in the Holdco, and this is accepted by the target shareholders when they elect to receive the stub equity consideration, rather than the cash alternative.

Our view: an unwarranted proposal

We think ASIC's proposed ban on the use of custodian structures to hold shares in the stub equity Holdco is unwarranted, for the following reasons:

1. Provided there is appropriate disclosure in the scheme booklet, target shareholders who wish to take up the stub equity alternative consideration should be free to agree to hold through a structure which has the result that the takeover provisions and unlisted disclosing entity provisions of the Act do not apply. Even retail shareholders in the target who are offered a stub equity alternative can understand that, if they take shares in the Holdco and there is a subsequent sale by the private equity bidder of its shares in the Holdco, that can occur without a takeover bid on the same terms for all of the shares.
2. In every foreign scrip takeover bid or scheme, target shareholders are being offered shares in an entity which is not governed by the Corporations Act, and which may have fewer or none of its takeover protections. ASIC accepts that in those bids, there is no requirement for target shareholders to have the same protections as those provided under Australian law, provided adequate disclosure is made of the applicable rules, and target shareholders make an informed decision in deciding to accept the scrip bid. It is not clear why it is any different where the Holdco is an Australian company but the shareholders have elected to receive scrip in a company where the takeover protections do not apply.
3. One way for private equity bidders to deal with ASIC's proposed ban is to simply go back to using a foreign entity as the Holdco in a stub equity scheme. This would mean none of the other public company governance protections would apply, either, ultimately to the detriment of target shareholders taking up the stub equity. That seems nonsensical. 
4. Although the target board would typically recommend to shareholders that they accept the cash consideration only, a stub equity alternative gives the target board an opportunity to present an alternative to a cash only deal. This opportunity affords target shareholders with the opportunity to invest alongside a private equity sponsor and not pay any fees throughout the duration of the investment (albeit the lack of liquidity and lack of dividends are potential downsides). As such, if ASIC's proposed ban results in stub equity consideration structures becoming less prevalent in the Australian market (or withdrawn altogether), retail shareholders could ultimately be deprived of the opportunity to invest in this asset class.

Where to from here?

ASIC has asked for submissions on its proposed guidance and legislative instrument by 17 July 2019.  Even if ASIC does proceed with its proposed ban on the use of proprietary companies as the bidding vehicle, for the reasons given above we believe target shareholders should be allowed to invest in entities in the knowledge that future acquisitions of shares in those entities will not be governed by Australian takeover laws. ASIC has not in its consultation paper properly enunciated why this is necessary.