- Related party M&A transactions have elements of risk for the company, its directors and management beyond the risks present in other M&A transactions.
- With careful planning and execution, these risks are all manageable for related party transactions which are in the best interests of the company concerned.
- Here are some tips for staying safe and keeping reputations intact in related party deals.
Since industry expertise and experience is highly valued in directors, it stands to reason that deal opportunities which arise for a company will sometimes involve directors wearing other hats. Similarly, there will often be synergy and other commercial benefits in deals between related companies. In uncertain times, related party assets may also be better understood by the company than other assets, potentially mitigating due diligence risk.
But with the risk of damaged reputations – or worse – if things go wrong in this high risk area, how can related party deals be done safely?
Here are six tips to achieve the benefits of deals between related parties while keeping the company (shareholders as a whole), directors and management and their respective reputations safe.
- Put separation protocols in place early – and be a stickler in sticking to them
The purpose of an Independent Board Committee (IBC) is to manage conflicts to give comfort to shareholders that the company has evaluated and managed the related party transaction in the same way as it would a transaction with an arm’s length party.
An IBC will stay safe if its touchstone is whether it is maximising value for the company. For example, if the particular transaction under consideration is one where there could be an auction or market-testing, the IBC should aim for a process which facilitates that.
Takeovers Panel policy (Guidance Note 19), ASIC policy (Regulatory Guide 76) and best practice to ensure conflicts are managed require protocols on matters such as:
- restricting information flow between directors and management who are used to dealing with one another on a regular basis
- requiring particular directors or managers to seek permission before engaging with other parties (e.g. potential deal counterparties or customers of the business) which they would usually be free to deal with in the ordinary course, and to report back on any such discussions to others to whom they do not usually report
- having key management or directors step aside from some or all of their usual duties, and
- the conduct of negotiations to achieve arm’s length terms – ASIC policy suggests that the ‘length and sincerity’ of the negotiating process, ‘whether there was ‘hard’ or ‘real’ bargaining’ with the parties having separate external advisers are some indicators of whether arm’s length terms have been reached.
It is not surprising that these deal conduct protocols make life uncomfortable for those involved in the transaction. Deal-doers are used to working quickly and seeking the shortest path between two points, and the protocols will inevitably feel restrictive and irritating. A person trying to enforce the protocols often feels pressured by others who are not sympathetic to what they see as unnecessary process and red tape. But try to keep the eye on the prize of getting a good deal done, and avoid, for example, email manifestations of exasperation – humorous or otherwise.
On one deal, at the end of a scheme of arrangement process, ASIC asked for confirmation from the party involved that the protocols had been complied with. The party had complied, with minutes evidencing the separation measures being observed throughout the process, so good evidence could be provided to ASIC. Where non-compliance could put such a transaction at risk and harm reputations, these protocol compliance measures are clearly important. It is safe and good practice to assume from day one that you will need to produce to a regulator at the end of the transaction evidence of compliance with the deal conduct protocols.
- Apply the sunlight principle
Typically, related party deals require shareholder approval and the extensive disclosure and voting exclusions that go with that. The usual sources of this are:
- For an ASX-listed company, listing rule 10.1, which requires shareholder approval for the acquisition or disposal of an asset worth more than 5% of the company’s equity interests involving either ‘classic’ related parties (such as directors, controlling companies and their associates) or a shareholder which holds more than 10% of the listed company. This approval requirement applies even if the transaction is on arm’s length terms.
- Corporations Act chapter 2E, which applies to transactions between public companies and their related parties. There is an exception – shareholder approval is not required if any benefits provided to related parties under the deal are on arm’s length terms.
The related party rules are quite technical, and each situation with a related party element needs to be analysed closely to determine whether shareholder approval is required, if so who can vote, and whether there are any exceptions that can be relied upon.
The safest path is to proceed on the basis that the transaction, its pros and cons and alternatives will need to be fully described in the sunlight – test it by reference to the front page of a daily newspaper. If there are aspects which parties would be reluctant to see in the sunlight due to the risk of criticism or embarrassment (as opposed to the disclosure concerns such as commercial sensitivity which can arise on any deal), that tends to be a sign of a risky related party deal.
- Obtain an independent expert report
For a related party approval required by the ASX listing rules, an independent expert report is required.
For some M&A transactions involving a related party, the Corporations Act 2001 (Cth) (Act) or ASIC policy also requires an independent expert report (e.g. the target statement for a takeover bid where the bidder starts with 30% of the target or has a common director with the target, or a control transaction approved by shareholders under section 611 item 7).
Technically, outside those cases, the Act does not require an independent expert report for a related party approval vote, but ASIC indicates in Regulatory Guide 76 that one may be necessary where:
- the financial benefits involved are difficult to value
- the transaction is significant for the company concerned, or
- the non-interested directors do not have the expertise or resources to provide independent advice to members about the value of the financial benefits involved.
Reflecting particularly on that last point, the company and its directors are generally significantly better protected if their recommendation is on the basis of an independent expert report. ASIC expects directors to apply their own judgement and not simply rely on an independent expert report without question, but where the independent directors consider the scope and content of the expert report carefully, along with their own business judgement and conclude that the transaction is in the best interests of the company, the expert report is a very significant factor in mitigating their risk.
Where a company seeks to rely on the ‘arm’s length terms’ exception to the Corporations Act related party approval requirement, one option can be to have an expert give a view on whether the terms of the arrangement are consistent with arm’s length terms. In the absence of readily available comparative market evidence, it may be high risk for the company and its directors to rely on the ‘arm’s length terms’ exception to shareholder approval without some compelling form of expert independent view.
- Engage proactively with regulators
Unsurprisingly, regulators tend to have their radar up in relation to related party deals. It is good practice to engage with regulators – even pre-announcement where feasible – to take them through the proposed transaction and flush out any areas of concern. For example, where a scheme of arrangement has related party aspects, it is ideal to engage with ASIC before lodgment of the draft scheme booklet to offer to step ASIC through the proposed transaction, its commercial rationale and the measures taken to manage the conflicts involved.
In a situation where what may be perceived publicly as a related party deal actually falls outside the shareholder approval categories, it is often a safer and smoother path to engage with the relevant regulator proactively, take them through the transaction and explain why it does not require approval, rather than go ahead with the deal and hope that the regulator does not ask questions, potentially under compulsion.
- Engage with proxy advisers and shareholders
Proxy advisers will often need convincing of the benefits of related party deals. If the IBC process has worked well and the ‘sunlight principle’ has been followed, there should be a compelling picture to present to proxy advisers and shareholders more broadly about the benefits of the deal and the care that has been taken to manage the conflicts in a way which protects the interests of shareholders.
It is helpful to prepare a public relations and engagement strategy, anticipating scepticism and taking an open approach in explaining the process and ‘pros’ of the deal, and how any ‘cons’ of doing the deal have been addressed.
- Bear in mind that conflicted directors still owe duties to the company
A director which has a material personal interest in the transaction obviously cannot participate in the IBC deliberations. But it is important to bear in mind that the conflicted director still owes duties to the company. The conflict does not ‘suspend’ those duties in respect of the transaction.
The Takeovers Panel and ASIC both give reminders of this in their respective policies.
The Takeovers Panel notes that:
- an IBC may need to obtain information from ‘participating insiders’, e.g. to assist with preparation of a target’s statement, and
- directors’ obligations regarding use of information may continue, and the board has the right to require assistance from ‘insiders’ during any period of absence.
ASIC notes (RG 76.56):
“In certain circumstances, conflicted directors may have a duty to take reasonable steps to protect a company from suffering serious harm by entering into a transaction in which they are interested. Notifying the board of an interest, abstaining from voting and not attending meetings may not always be sufficient.”
Exactly what a conflicted director must do depends on the circumstances of the transaction but the onus is particularly high if the conflicted director is aware that the transaction may cause serious harm to the company. By way of real examples considered by the courts:
Permanent Building Society (in liq) v Wheeler (1994) 11 WAR 187 – where PBS, which had no experience in land development, acquired land to embark on a land development transaction:
“It may be that, because of the conflict, he should not have spoken or voted in favour of the resolution. But as chief executive and managing director there was a responsibility on him to ensure that the other directors appreciated the potential harm inherent in the transaction, and to point out steps that could be taken to reduce the possibility of that harm. [The director] could not avoid that harm by, metaphorically speaking, burying his head in the sand while his co-directors discussed whether PBS should enter into such a potentially detrimental transaction.”
Fitzsimmons v R (1997) 23 ACSR 355 – which involved a common director of two companies. The director knew that one company was in a poor financial state but did not prevent the other company from taking on an exposure to that company. The court found that, despite the director’s duty of confidentiality to one company, he breached his duty to the other company by simply staying silent and allowing the transaction to proceed.
Where a potential deal is truly in the best interests of a company, the fact that there is a related party element does increase the risk in some respects – but that risk is manageable by careful planning and following the six tips above.