ASIC wants to take a tougher stance on related party transactions. A new policy proposal aims to reduce the use of the arm's length exception and force greater disclosure of related party arrangements in fundraising and takeovers documents.
The proposal follows an ASIC review of related party transactions involving both listed and unlisted companies. ASIC appears to have concluded that too many deals were being approved by boards rather than going to shareholders for approval.
ASIC has put its proposals on the table for discussion, with a view to publishing a final policy in March next year.
It has also proposed revising its existing policies on independent experts' reports. This includes new material on the "fair and reasonable" test.
In general terms, a company's related parties are its directors and the entity (if any) which controls it. The Corporations Act says that a public company must get shareholder approval before giving a financial benefit to a related party unless the deal is on arm's length terms.
ASIC appears to think that the arm's length exception is too often being relied on without adequate justification. In other words, some boards may have been using the exception without a proper examination of whether the deal really is on arm's length terms.
To address that, ASIC proposes a checklist of factors that boards should look at when evaluating the arm's length issue. If the board can't tick off each item on the checklist, they should, says ASIC, go to the members.
The checklist requires a board to look at
- how the terms of the overall transaction compare with those of any comparable transactions between parties dealing on an arm’s length basis in similar circumstances;
- whether the company followed "robust protocols" to ensure that conflicts of interest were appropriately managed in negotiating and structuring the transaction;
- the impact of the transaction on the company (including the financial position and performance of the company) and non-associated members;
- any other options available to the company; and
- any expert advice received by the company on the transaction.
Independent experts' reports
The Corporations Act does not require an independent experts' report when a company is seeking shareholder approval for a related party transaction, although many companies do provide them where they're required by the ASX Listing Rules or as a matter of good practice.
ASIC aims to regularise that good practice by providing guidance that a report should be provided if:
- the transaction is significant from the point of view of the company - apart from the amount of money involved, the deal may be significant because it changes the company's business or strategic direction, or involves the replacement of the board or significant dilution;
- the financial benefit is difficult to value;
- the non-interested directors do not have the expertise or resources to provide independent advice to members about the value of the financial benefit; or
- the transaction is a component of a control transaction for which the company is commissioning an expert report (such as member approval under item 7 of section 611).
ASIC has also issued proposed new policy on independent experts' reports generally: see below.
What should be in the meeting notice?
The Corporations Act lists, in outline form, the information that members must be given before voting on a related party transaction (eg. "the nature of the financial benefits").
ASIC wants to flesh out this list.
For example, it believes that, when detailing "the nature of the financial benefits", the company should disclose not only the nature and quantity of the benefits, but also the reason for giving the benefit and the basis for giving that particular benefit. As a practical example, ASIC spells out what this would entail where the benefit is a grant of options to a director:
"ASIC expects the following information to be disclosed:
- the number of options to be granted to the director;
- the terms of the options;
- an explanation as to why the options are to be granted, particularly where alternative forms of remuneration or incentive may be required to be expensed by the company in future years; and
- an explanation as to why the specified number of options is to be granted and why the specified value of the options was chosen.
A company should be careful to disclose the substantive effect of a transaction if necessary to explain the financial benefit. For example, if a company, instead of granting options, proposes to lend a director money to acquire shares in the company but the repayment terms of the loan effectively create an option-like situation, this should be disclosed."
Disclosure of existing related party arrangements
As well as new related party transactions, ASIC has looked at the extent of disclosure of existing related party arrangements in disclosure documents such as fundraising and scrip takeover documents.
It proposes two major changes:
- all such arrangements should be disclosed, even if the company believes that they are not material;
- disclosure should be made in scrip takeover documents and in both full and transaction-specific prospectuses and PDS.
ASIC's rationale is that you can tell a lot about a company by how it treats related party transactions: "it can be indicative of certain aspects of an entity’s business model, its attitude to related party transactions and how they are managed."
Independent experts' reports - "fair and reasonable"
In tandem with the proposals about related party benefits, ASIC has released draft policy changes on independent experts' reports.
This aims to address a number of concerns, again arising from a review of market practices. This revealed cases where experts:
- had accepted an engagement despite serious concerns about their independence;
- had adopted information provided by the commissioning company without conducting additional critical analysis;
- did not have a reasonable basis for their forecast financial information; and
- did not maintain sufficient working papers to demonstrate compliance with their obligations under ASIC's existing policies (Regulatory Guides 111 and 112).
Of particular significance to both related party transactions and takeovers is the "fair and reasonable" test.
Reports on related party transactions involving an asset acquisition or disposal often include a conclusion about whether they are fair and reasonable (eg. where such a report is required under ASX Listing Rule 10.10). Section 640 of the Corporations Act requires a similar report where a bidder is connected with the target.
ASIC already has a policy on "fair and reasonable" in the takeovers context. It proposes a number of changes to this:
- inclusion of a statement that a "not fair" offer may still be reasonable if the target is in financial distress and the alternatives to a bid are likely to be less attractive to target shareholders;
- inclusion of a requirement that, when describing the factors that make a "not fair" offer reasonable, the expert should generally only include the factors that are material to that conclusion (and value them, if possible).
In relation to related party transactions, it proposes a new set of guidelines that are based on the takeovers guidelines.
Where to now?
As indicated, ASIC hopes to have the new policy up and running by March next year. To that end, it is currently taking submissions on its proposals.
Directors will welcome ASIC's provision of a detailed explanation of the factors it considers relevant to determining whether a benefit is given on arm's length terms. This will take some uncertainty out of the current process.
However, it is to be hoped that the inclusion on that list of "any expert advice received by the company on the transaction" does not end up as a de facto expectation that an independent expert's report should become the norm.
Another concerning proposal is that every existing related party arrangement be included in fundraising documents, even if the company considers it to be non-material. The benefit to investors of non-material information will often be minimal, and would not necessarily justify the cost to the company of providing it.