Guidance Note 17 - Rights Issues (GN 17) sets out the approach adopted by the Takeovers Panel (the Panel) in relation to rights issues that have the potential to affect control.
The recent decision by the Panel in Real Estate Capital Partners USA Property Trust  ATP 6 (Real Estate Capital Partners), in which a declaration of unacceptable circumstances was made, has confirmed the approach of the Panel as set out in GN 17 and reinforced the need for directors to take all reasonable steps to mitigate the potential control impact of a rights issue.
The Panel will pay close attention to a rights issue underwritten by a major shareholder or related party of the entity. While such an underwriting arrangement does not of itself constitute unacceptable circumstances, the failure of directors to properly gauge the interest of professional underwriters, seek out alternatives to a major shareholder or related party underwriter or adopt a structure which reduces the effect on control will increase the likelihood of a declaration of unacceptable circumstances being made.
The Real Estate Capital Partners decision
On 1 March 2012, the responsible entity (the RE) of Real Estate Capital Partners USA Property Trust (RCU) announced a 0.98 for 1 renounceable rights issue to raise approximately $20 million at $0.40 per unit. The rights issue was fully underwritten by Frost Holdings Pty Ltd (Frost).
A substantial unitholder of RCU made an application to the Panel on the basis that the rights issue had the potential to increase Frost's voting power in RCU from 19.82% to up to 59.51%, depending on the extent to which other unitholders took up their entitlement. It was also submitted that the RE did not thoroughly investigate ways to minimise the control effect of the rights issue.
The RE submitted that it had attempted to implement dispersion strategies but Frost had actively discouraged it from doing so, other than allowing the rights issue to be renounceable. Frost also warned RCU that any attempts to approach other unitholders as underwriters or sub-underwriters would jeopardise its commitment to the proposed underwriting arrangements.
The Panel considered that all reasonable steps to minimise the potential control impact of the rights issue had not been taken and made a declaration of unacceptable circumstances. In doing so, it gave orders requiring Frost to divest units it received as underwriter to enable unitholders to take up their full entitlement (presumably on the basis that unitholders may have been disinclined to subscribe with the underwriting arrangements in place) and apply for units in excess of their entitlement.
Need for funds
RCU had potential cash flow concerns as a result of an $88 million financing facility maturing in August 2012. The RE submitted that the capital raising was necessary to maintain RCU's ability to continue as a going concern.
The Panel reinforced its view that an entity's need for funds needs to be balanced against the potential control impact of a rights issue1. Despite accepting that RCU was in need of funds, the Panel noted that RE still had an obligation to ensure that the structure of the rights issue minimised any potential control impact.
Structure of the rights issue
Although RCU's rights issue was renounceable, renounceability alone is not necessarily sufficient to ensure that unacceptable circumstances will not arise. The RE claimed that it had attempted to implement dispersion strategies such as a shortfall facility, back-end book-build or sub-underwriting, but that each of these was discouraged by Frost.
The Panel noted that the implication of GN 17 was a standing item on the agenda of RCU's due diligence committee meetings relating to the rights issue. This showed that both Frost and the RE were aware the structure of the rights issue was important, particularly given that it was to be underwritten by a major unitholder, but there were no suitable strategies adopted to minimise the potential effect on control.
Effect of the rights issue
An underwriter or sub-underwriter is entitled to increase its voting power in an entity above 20% in reliance on items 10 and 13 of section 611 of the Corporations Act 2001 (Cth). However, the Panel remains concerned about ensuring those exceptions are not misused to acquire control. The Panel has acknowledged that where an issuer is financially distressed, it will be less likely to find an underwriter that is not a major shareholder2 and, for this reason, an underwriting by a major shareholder will not of itself constitute unacceptable circumstances3.
However, where a rights issue has the potential to effect control, the Panel will require directors to consider all reasonably available options to mitigate that effect.
The Panel found that all reasonable steps to minimise the potential control impact of the rights issue were not taken as:
- other than the rights issue being renounceable, there was no facility for unitholders to take up units in excess of their entitlement;
- there was no dispersion strategy implemented to deal with shortfall units, such as the appointment of sub-underwriters; and
- the directors had made only limited enquiries of professional underwriters and other major shareholders to identify alternatives to Frost as the single underwriter.
Motivations and intentions of the underwriter
The outcome was influenced by Frost's "manifest" desire to increase its unitholding in RCU as a result of the underwriting of the rights issue and its refusal to permit the RE to explore any dispersion strategies.
As noted in GN 17, a professional underwriter is generally focused on earning an underwriting fee rather than acquiring shares, so it is unlikely to have any interest in obtaining control of the issuer. In the Real Estate Capital Partners decision, the Panel pointed out that if Frost's primary intention was to ensure a successful capital raising, then it should not have been concerned by the proposed implementation of dispersion strategies.
What does this mean for companies proposing to undertake a rights issue underwritten by a major shareholder?
The Panel's decision reinforces the implications of GN 17 on rights issues with a potential effect on control and the importance of the structure of a rights issue, particularly where it is underwritten by a major shareholder or related party.
To minimise the potential control effects of an underwritten rights issue and reduce the likelihood of unacceptable circumstances, directors should consider:
- undertaking sufficient enquiries to source a professional underwriter or pursuing alternatives to appoint underwriters and sub-underwriters that are not related parties or major shareholders of the issuer. Options may include:
- appointing a number of underwriters or sub-underwriters; or
- approaching all major shareholders and offering them the opportunity to participate as underwriter or sub-underwriter. In Vesture Limited 02  ATP 15, the Panel indicated that where the proposed underwriter of a rights issue is a major shareholder, all major shareholders should be approached;
- implementing dispersion strategies such as sub-underwriting, a provision for oversubscriptions, a shortfall facility or back-end book-build; and
- seeking shareholder approval of the non-associated shareholders, particularly where the proposed structure of the rights issue does not minimise the potential control impact of the rights issue. There may be timing restrictions which prevent shareholder approval being obtained though.
While it may not always be possible to source an underwriter that is not a major shareholder of the company (particularly where smaller or financially distressed companies are involved), directors are still required to investigate all options reasonably available to minimise the potential control impact of a rights issue. Failing to do so will, as shown in Real Estate Capital Partners, likely lead to an adverse decision by the Panel, unwanted publicity and time and expense in rectifying the issue.