On 22 September 2020, ASIC released the ASIC Corporations (Stub Equity in Control Transactions) Instrument 2020/734, following a long-running consultation process in relation to the use of stub equity in control transactions (such as takeovers and schemes of arrangement).
ASIC had initially proposed to make major changes to these rules, but these changes were strongly opposed by many market commentators due to their potential to drive M&A structures offshore and to deprive shareholders of the potential upside offered by stub equity structures.
The final rule changes released by ASIC are less wide-ranging than those initially proposed. The changes are likely to bring to an end the practice of using proprietary company shares as stub equity, whilst leaving open the possibility of using unlisted public company shares.
What is stub equity?
‘Stub equity’ refers to the practice of a bidder in a control transaction offering a limited number of securities in an unlisted entity (usually the bidder itself or its holding company) (‘StubCo’) as part of the consideration mix for acquiring the target entity. If target shareholders elect to receive stub equity instead of cash (or a combination of the two), they have the ability to maintain some exposure to the bidder and target via holding shares in StubCo, and potentially to obtain scrip-for-scrip rollover relief.
Stub equity structures are particularly favoured by private equity bidders, and are often designed to appeal to the institutional and sophisticated shareholders of the target. However the Australian takeovers rules generally require equal treatment of all target shareholders, meaning that the target’s retail shareholders also need to be offered stub equity if it is made available to institutional and sophisticated shareholders.
Why did ASIC raise concerns with stub equity?
In December 2018, ASIC raised concerns with stub equity structures where retail shareholders were being offered shares in unlisted proprietary companies.
Proprietary companies are subject to lower disclosure and governance requirements than public companies. For example, public companies (including unlisted public companies) are subject to specific additional rules in relation to related party transactions, conflicted director voting, appointment and removal of directors, the requirement to hold AGMs and periodic financial reporting.
For this reason, the Corporations Act generally seeks to prevent proprietary companies from issuing their shares to a large number of retail shareholders. It does this in two main ways:
- proprietary companies are prohibited from making broad public offers of their shares which would require a disclosure document (i.e. prospectus); and
- proprietary companies must have no more than 50 non-employee shareholders.
However, bidders have in the past been able to structure around these restrictions when issuing stub equity by:
- taking advantage of existing exemptions in sections 708(17) and (18) of the Corporations Act which state that no prospectus is required for an issue of shares under a scheme of arrangement or takeover bid; and
- requiring certain target shareholders to direct that their StubCo shares be held by a nominee or custodian, meaning that the number of registered shareholders in StubCo can be kept below 50.
In relation to the second of these points, not only does this allow StubCo to comply with the proprietary company shareholder limit, it also has the effect that StubCo will not be subject to:
- the takeovers rules in Chapter 6 of the Corporations Act, which apply to listed entities, and also to any unlisted company with more than 50 shareholders; or
- the disclosing entity rules in Part 1.2A of the Corporations Act, which apply to companies that have issued securities under a takeover bid or scheme to 100 or more persons.
In June 2019, ASIC released Consultation Paper 312, which went even further than the concerns initially raised in December 2018. ASIC proposed to make legislative changes that would have had the effect of:
- preventing proprietary company shares from being issued under the prospectus exemptions in sections 708(17) and (18) of the Corporations Act (the ‘Prospectus Exemption Change’); and
- preventing takeovers and schemes of arrangement that require scrip consideration to be held by a custodian and/or subject to a security-holder agreement or similar arrangement, where doing so results in the issuer avoiding the application of the 50 non-employee member limit, or the takeovers rules, or the disclosing entity provisions (the ‘Mandatory Custody Change’).
The Mandatory Custody Change would have applied regardless of whether StubCo was a proprietary or public company.
What was the response to these proposed changes?
12 public submissions were made in response to ASIC’s consultation, the majority of which were strongly opposed to ASIC’s proposed changes.
Whilst many of the submissions were broadly against both the Prospectus Exemption Change and the Mandatory Custody Change, there was particular concern expressed that the Mandatory Custody Change went beyond merely preventing proprietary company stub equity structures, and would also restrict the use of public companies with a custodian structure. Questions were raised as to whether ASIC was even empowered to make such a change.
Concerns were also raised that ASIC’s proposed changes would prevent retail shareholders from having the ability to participate in stub equity structures, which could be a valuable investment opportunity. It was argued that as long as the risks of these structures were adequately disclosed then retail shareholders should be permitted to make an informed choice as to whether or not to participate.
There was also a particular concern raised that the changes would simply cause bidders to use a foreign domiciled StubCo, which would ultimately reduce the protections for retail investors by taking them outside Australian regulatory safeguards. It was noted that, prior to 2011, most stub equity deals used a non-Australian StubCo, usually incorporated in jurisdictions such as Bermuda or the Cayman Islands, and that ASIC’s changes would simply drive bidders back to using foreign issuers.
What are the final changes?
In the final legislative instrument, ASIC has proceeded to make the Prospectus Exemption Change, meaning that an issue of shares in a proprietary company will no longer be eligible for the prospectus exemptions in sections 708(17) and 708(18) of the Corporations Act.
However, ASIC has modified the Mandatory Custody Change. In summary, mandatory custodial arrangements will still be permitted in stub equity structures, but only if:
- the securities offered as consideration are public company securities (i.e. not shares in a proprietary company); and
- the custodial arrangements contain a provision whereby they will terminate if StubCo makes an application to convert from a public company to a proprietary company at a time when it has more than 50 non-employee beneficial shareholders, except if approved by a special resolution of the beneficial shareholders.
Due to these modifications, stub equity structures can still be used, as long as StubCo is a public company.
Bidders will still be able to use custodial arrangements to keep the number of StubCo shareholders below 50, thereby not triggering the application of the takeovers rules and the disclosing entity rules in relation to StubCo. However, these changes should effectively bring to an end the practice of issuing proprietary company shares as stub equity in the vast majority of cases.
For shareholders, this will mean that they have access to some increased protections, given that StubCo will be subject to the higher governance and reporting requirements which apply to public companies (including unlisted public companies), but they will not have the protection of the takeovers rules or the enhanced disclosure of the disclosing entity rules if the bidder decides to use a mandatory custodial structure to keep the number of StubCo shareholders below 50.
For bidders, the changes are likely to increase the compliance costs of stub equity structures (due to the requirement to use an unlisted public company, with associated compliance costs), but still preserve the ability to issue stub equity using an Australian entity, rather than being driven to use offshore company structures.
For more information or assistance with planning a takeover or scheme or arrangement, or responding to a bid approach, please contact James Burchnall.