In this week’s update: the first part of our analysis of a claim by unhappy shareholders against the directors of a company following a recommended reverse takeover and a few other items.
Court rejects shareholder claim against directors for improper takeover recommendation (part 1/2)
The High Court has rejected a claim by a group of shareholders of a company against its directors for improperly recommending a reverse takeover and failing to disclose material information.
The case is fiercely complex. The judgment is very long (994 paragraphs) and fact-heavy (the first 609 paragraphs are a detailed explanation of the build-up to and aftermath of the takeover), but it is interesting reading for anyone keen to know more about how the transaction unfolded.
We have attempted to distil the key points below.
Sharp v Blank concerned the 2009 takeover of HBOS plc (formerly Halifax Bank of Scotland) by Lloyds TSB Group plc to create what would become the Lloyds Banking Group.
Lloyds and HBOS jointly announced the proposed takeover in mid-September 2008. The deal was structured as an all-share offer, with HBOS shareholders to receive 0.83 shares in Lloyds for each share they held in HBOS. This naturally had a dilutive effect on Lloyds’ existing shareholders.
The acquisition constituted a “reverse takeover” under the Listing Rules. This required (among other things) Lloyds to send a circular to its shareholders explaining the transaction and seeking shareholder approval for it.
The takeover arose during the tail end of the global financial crisis of 2007/2008. Lloyds and HBOS were both particularly affected by the crisis. They engaged with the Bank of England, Treasury and Financial Services Authority (as the FCA was then called) to discuss a series of recapitalisations to bolster their balance sheets.
The result was a decision that (assuming the takeover succeeded) the combined group would raise a further £17bn from recapitalisations, of which Lloyds would bear £5.5bn. Initially, Lloyds would raise £1bn through an issue of preference shares to the UK Government and a further £4.5bn through an open offer. There would be a further capitalisation round in 2009. Were Lloyds not to proceed with the takeover, it would need to recapitalise to the tune of £7bn.
The key point here is that capitalisations would further dilute existing Lloyds shareholders. However, having conducted due diligence on HBOS (particularly its loan book), Lloyds’ directors continued to view the takeover as a value-generative transaction for shareholders as a whole.
The directors issued a second announcement in mid-October 2008 confirming again that they intended to proceed with the takeover, albeit at a lower offer price, and setting out the recapitalisation proposals.
In early November 2008, the Lloyds board sent a circular to the company’s shareholders, unanimously recommending the takeover and inviting them to vote in favour. As required, the circular contained a significant amount of financial and non-financial information on Lloyds and HBOS.
Lloyds’ shareholders approved the takeover in mid-November 2008. 52.2% of shareholders (by value of shares held) attended the general meeting. 96% of those shareholders voted in favour. HBOS’ shareholders approved the takeover in mid-December. The acquisition completed in January 2009.
What was the claim?
Some years later, a group of 5,803 current and former shareholders of Lloyds (the “claimants”) launched a claim against most of the executive directors of Lloyds at the time of the takeover.
In a nutshell, the claimants alleged that the takeover had overvalued HBOS and that their shareholdings in Lloyds had been disproportionately diluted, in turn bringing their value down.
They put forward two separate but interlinked claims:
- The recommendation claim. By recommending the offer and providing advice on how to vote on it, the directors had assumed a duty of care to shareholders. That duty required them to use reasonable care and skill when deciding whether to make the recommendation.Based on what they knew, the directors should not have recommended the takeover, because it represented a “dangerous and value-destroying strategy which involved unacceptably risky decisions”. They said this applied not only when the directors sent the circular to shareholders, but also when they made the announcements to the market.
- The disclosure claim. The directors had included information in the circular on which they knew shareholders would rely and so were under a duty to ensure it was accurate. In addition, because the circular was published in connection with a shareholder meeting, the directors were obliged to ensure it contained sufficient information to help shareholders decide how to vote at that meeting.However, the circular had omitted material information. For example, it did not disclose emergency facilities to HBOS provided by Lloyds, the Bank of England and the US Federal Reserve. It did not explain that the level of HBOS’ losses would require the combined group to raise further capital in 2009. And it suggested there had been no significant change in HBOS’ financial or trading position in the four months prior to its publication.
Both of these errors artificially inflated the price of HBOS’ shares. Had the directors not recommended the offer and had the circular been accurate, the value of HBOS would have been clear to the market. The shareholders would have rejected the offer and the claimants would not have been unduly diluted.
These were both detailed claims that required a lot of analysis. We discuss the recommendation claim below. We will cover the disclosure claim next week.
Was there a duty of care, and when did it arise?
The directors had published the circular specifically to help Lloyds shareholders decide whether to approve the takeover. The circular contained a statement by each director that the information in it was “in accordance with the facts” and did not “omit anything likely to affect [its] import”. This placed the directors under a duty to shareholders to exercise reasonable care and skill when deciding whether to recommend the offer.
However, the directors had not been under a similar duty when making the announcements to the market. The purpose of those announcements was merely to comply with regulatory obligations, unlike the circular, which had been prepared specifically for the purpose of eliciting support for the offer. Moreover, the announcements had been made to the public generally, unlike the circular, which had been sent to specific intended recipients.
The judge thought it would be a “big leap” to make directors personally liable for an announcement to the market. To do that, the claimants would need to show that there had been something more than “routine involvement” by the directors in producing the announcements.
A regulatory announcement at the outset of a transaction was “distinctly and immediately recognisably different” from providing advice to shareholders about how to respond to the transaction. And the announcements in this case had specifically advised shareholders to read the formal documentation in due course before making a decision. They had not assumed any duty to shareholders.
Did the directors breach their duty to shareholders?
It is important to note at this point that the duty of care which the Lloyds directors owed to its shareholders was distinct from their “directors’ duties”, which they owed to Lloyds itself. The duties owed by the directors to Lloyds arose out of the Companies Act 2006 and applied at all times.
The duty they owed to shareholders, however, came about as a matter of common law solely because the directors voluntarily assumed responsibility for issuing advice to shareholders about the takeover.
However, the directors’ duty to shareholders to exercise reasonable care and skill was, in the judge’s view, “consonant” with the statutory duty they owed to the company under section 174, Companies Act 2006 to use exercise care, skill and diligence, and so he approached the issue in the same way.
The question also merged into the directors’ general duty to the company (Lloyds) to promote its success for the benefit of its shareholders as a whole. In exercising their duty to use reasonable care and skill, the directors needed to consider what was in the best interests of shareholders.
With this in mind, the judge made the following comments:
- Although the directors owed a duty of care to the company’s shareholders at the time the circular was sent, they had to discharge that duty by considering the interests of the company’s shareholders from time to time. That meant taking a long-term view of the benefit of the takeover to the company, rather than its short-term impact on the shareholders at the time.
- The directors had honestly to believe that the takeover was in the shareholders’ best interests (the “subjective test”). But that belief also had to be one that a reasonable director would hold (the “objective test”). If those tests were met, the directors would not be liable for “errors of judgment”.
- The fact that the directors obtained and acted on expert advice went a long way towards satisfying their duty to exercise reasonable care and skill, although it was not a complete substitute for it. Having obtained advice, the directors still needed to reach their own decision.
In the judge’s view, a reasonably competent chairman or executive director of a large bank could reasonably have reached the view that the takeover was beneficial to Lloyds’ shareholders. This was supported by various pieces of evidence:
- The Lloyds board – including its highly regarded and widely experienced senior non-executive directors – had unanimously approved the takeover.
- The acquisition was also supported by the UK Government and the IMF.
- There was no basis for assuming that HBOS was “worthless”. The fact that it had sought emergency funding did not deprive HBOS of “all value” (or else that funding would never have been forthcoming). Nor did it follow that HBOS’ shares had no value merely because it was hard to value its business. The question was whether HBOS held any value to Lloyds. There was a rational basis for believing that the takeover had an “upside” in the form of synergy value.
- There was no evidence that Lloyds had undertaken inadequate due diligence of HBOS.
- Severe impairments made by HBOS did not mean the transaction was unwise. They had to be considered in the context of the proposal as a whole. The board received working capital reports from two accounting firms and advice from three investment banks. It carefully reviewed them and a recent FSA analysis before reaching its decision. Nothing suggested there was so significant a risk of a dilutive capital raise that the acquisition was not beneficial to Lloyds’ shareholders. This detailed part of the judgment (paras 698-745) focusses on several technical regulatory issues and will be an interesting read for those working at financial institutions.
- Lloyds faced a choice of proceeding with the takeover and raising £5.5bn of capital, or abandoning it and raising £7bn. The directors had been advised that the former was “less dilutive”. The takeover entailed risks, and the judge saw a “strong case” that the directors had misjudged the decision, but there was no evidence they had weighed those risks up inadequately.
He therefore refused to find that the defendants had breached their duty when recommending the offer.
What does this mean for me?
For company directors, this decision is helpful and should be of great comfort. The backdrop to this case was a large, high-profile public takeover that took place at speed during a time of unprecedented economic turmoil.
But the principles the judge applied are no less relevant to any other public takeover, or (indeed) when reaching out to shareholders on a private company takeover. Courts will judge directors’ actions by a reasonable standard and will be reluctant to step in and re-evaluate their commercial decisions.
When recommending or commenting on the merits of a proposed transaction, the directors of a company may well incur obligations directly towards shareholders. It is therefore critical to fully evaluate the proposals before issuing advice. Steps boards can take include the following:
- Conduct extensive due diligence into a potential target or acquirer to understand fully the dynamics and effects of any potential proposal.
- Seek appropriate professional advice. Critically challenge and scrutinise that advice to ensure it accords with and supports the board’s views on the proposal.
- In deciding whether a transaction will benefit their company, consider the interests of the shareholders as a whole in the medium to long term.
- Document the reasons why a particular proposal is in the company’s interests. The board will need to be able to show that a reasonable director would have reached the same decision.
- Ensure that any communications or announcements make it clear whether advice or a recommendation is being given or is to follow separately.
- Corporate governance. The Quoted Companies Alliance (QCA) has published a new research report on corporate governance on AIM. The report studies how 900 AIM companies have adopted a corporate governance code for the first time. The study found that around 90% of companies chose to adopt the QCA Corporate Governance Code and around 10% chose the UK Corporate Governance Code. Most companies chose their code mainly after conducting a detailed assessment or seeking advice from their nominated adviser.
- Market abuse. The Financial Conduct Authority (FCA) has published Primary Market Bulletin 25. Among other things, the Bulletin contains a proposed best practice note aimed at assisting government departments, industry regulators and public bodies with complying with the Market Abuse Regulation. In particular, it contains guidance on identifying, controlling, handling and disclosing inside information, and dealing with leaks. The FCA has asked for comments on the note by 15 January 2020.