The Takeovers Code has been in force now for more than a decade. The "fundamental rule" is at the core of the Code's requirements, stopping anyone getting more than a 20% shareholding, unless every existing shareholder has the chance to sell into the offer or very specific procedures are followed. The Code's enactment has certainly regularised the takeover process for listed entities. It has created opportunities for all participants in the public markets space - target companies, bidders, cornerstone shareholders, and retail investors - to share in the benefits which flow from changes in corporate control. The Takeovers Panel has also done a fine job of vigilantly overseeing these processes and the proper application of the Code's regulatory requirements.
Despite these benefits, there remains one area where we think the Code's reach goes too far: in its jurisdiction over unlisted private companies which have more than 50 shareholders.
We are regularly confronted by the significant and adverse economic and opportunity costs of the Code's requirements in this area. It is the one area where we believe a fundamental reconsideration of the policy behind the Code's application is warranted.
What's the history?
Many of you will remember the history here. Our Code, from the outset, applied to private companies, with 50 or more shareholders, where the company also had more than $20 million in assets. The philosophy was to capture widely-held and significant private companies, to ensure the Code's fundamentals - equal treatment for all shareholders etc - applied across the spectrum. For the reasons noted here, we believe this philosophy was incorrect.
What's a private company?
Since the outset, the Code's private company net has been extended even further. The $20 million threshold test was abandoned, so that any widely-held private company was within the Code, irrespective of its asset base.
More recently, the Panel has expressed its view on how you count your shareholding base, for the purposes of determining whether or not you have 50 shareholders. (We believe the removal of the asset threshold was inappropriate, but we would still hold the views expressed here if it had remained - the Code should only apply to listed companies, unless the legislators can come up with a more meaningful alternative than the current Code company definition.)
Two people, holding one share parcel, are counted as two shareholders (although we do not share the Panel's view here and, in any event, there is a law change proposed to address this). Given the preponderance of trust structures for personal asset holdings, where two or more trustees typically appear on a share register, the net effect is that a financially modest company, with a few share parcels held through trusts, is as likely as not to be a Code company or at least treated as one by the Panel. The alternative is for these companies to seek out and pay for advice, and design artificial holding structures, to ensure that is not the case.
Where's the need?
Most investors in a private unlisted company, whether big or small, are often somehow connected into the activities, operations, or history of the company. They may be existing or former employees, the founder or following family generations, persons with whom the company has a significant trading connection, private equity investors who have taken board seats, and so on.
Generally they can be expected to understand that their investment is not particularly liquid. There is no ready market for their shares nor, in most cases, for the holdings of other co-shareholders. So there is some inherent protection that they will not end up co-investing with other parties they do not know or like, or that anyone else will get out of the company more easily or with a better deal than them.
Historically, private company investors have also been able to protect, or enhance, this base line co-investment position through a variety of mechanisms, including shareholders' agreements. One of the most standard mechanisms used which can be used is the pre-emptive rights arrangement. This arrangement requires that, if any shares are issued or transferred to anyone, existing investors have a pro-rata right of first refusal. This means they get a chance to buy up more stock ahead of anyone else. A right to sell out to any potential buyer that comes along, while not a stock-standard mechanism, is also something investors can seek, if they need it as a condition of their investment, when they invest. If they have got enough bargaining power, they can get these "tag-along" rights; if they don't, they don't - and they can decide whether this suits them or not before they put their money in.
So, we ask, why the need for the Code's application to private companies in the first place?
What about listed companies?
This is in stark contrast to the situation with listed company stocks. Here the basic proposition is that investors' stock is liquid, and certainly must be freely transferable to any person without any restriction. Minorities in a listed company are usually far more distant from the activities and operations of the listed company than those who have invested in private companies. They are along for the financial ride, but probably not much else.
So you can see, in a listed company context, the far greater likelihood of transactions occurring where the minorities are left out in the cold, and where they have had no ability to change or influence that position at any time in the investment cycle. Hence, in this context, the Code makes good sense.
The bite really comes when you get into capital raising for private companies.
If a private company needs cash, larger existing investors usually have the greatest capacity to pay in. (Of course, pre-emptive rights might often mean that minorities have a chance to put money in if they want. But, more often than not, they are not in a position to put in a meaningful or any contribution to the funding required.) In the ordinary course of events, directors have to act in the best interests of the company in deciding that they will seek money from an existing, or even a new, investor on a basis that dilutes others. Directors also have to be comfortable, and certify, that the amount that is paid in, and the extra shareholding given out, is a fair and reasonable deal - for both the company and the existing shareholders.
These seem to us to be appropriate protections. But the 20% Code shareholding limit looms large in these circumstances. These larger investors often simply cannot put in more money that the company sorely needs, without the expense of going to a shareholder vote, with independent expert reports obtained, and at which they cannot vote. And, even assuming minority shareholders are comfortable voting in the increased shareholding position of these investors this time (and any lack of comfort may be more contrived than real when shareholders realise they have disproportionate and unintended power), the shareholders putting their hands in their wallets now know that next time the company is strapped for cash, the company's fortunes effectively sit in the hands of other shareholders... Catch 22. So why would you put more money in? Perhaps you do, but you certainly price in this risk, which means you expect more shares for your cash, and more dilution for minorities.
Another strange twist in a private company context is the Code's compulsory acquisition rule. Once anyone gets a 90% shareholding in a private Code company, that shareholder must offer to buy out all of the others. And the others have to sell out. No matter how satisfied the shareholders were with their respective positions, the law says they cannot stay that way (unless, of course, you go back to the lawyers and pay for some artificial restructuring to save you from all this fuss).
What's more, more often than not you see this feature used as a device by large (90% or more) shareholders in private non-Code companies to suck out their co-investors. If all it takes is 50 shareholders to become a Code company, a large shareholder simply puts a handful of shares out to 49 nominees and, lo and behold, compulsory acquisition is at its doorstep. So where is the protection for the minorities here?
Where are the winners?
So let's get back to the core policy question. Why is it a good idea to place material regulatory constraints on the capital raising process for private unlisted companies that are looking to grow? If the rationale is to ensure minorities are treated fairly, the outcome is somewhat perverse.
There are one of two very likely side effects of the regulatory constraints. The first is that the capital cannot be raised. The growth it was to fund does not happen. Minority shareholders, and for that matter everyone, are undoubtedly worse off. The second is that the capital is raised, but, in our experience, at undoubtedly a significantly increased cost in every sense, which increase is attributable only to the regulatory regime required under the Code. So, ultimately, less free capital is then available to fund the growth, and minorities are more significantly diluted than need necessarily be the case. Yet again, minority shareholders are undoubtedly worse off. In fact, everyone is; there are no winners.
We believe this is a critical area, not only for the companies affected, but also for New Zealand and its economy. It would be a very simple matter to limit the operation of the Code to avoid these adverse conditions.