In the first case of its kind, the High Court in England has prevented a shareholder from splitting its shareholding in an attempt to defeat the approval of a scheme of arrangement under section 895 of the Companies Act 2006 (Scheme) by way of manipulation of legislative requirements in relation to Schemes which require approval by a majority in number representing 75% in value of the voting class of shareholders.
The case raises some interesting questions in the context of debt restructuring Schemes and the strategies that those in favour or against a Scheme proposal might seek to employ in an attempt to support or frustrate a proposed Scheme.
In the matter of Dee Valley Group plc1
Dee Valley Group plc (Company) applied to the High Court in England for sanction of a Scheme between the Company and its members to allow Severn Trent Water Limited to acquire the entire issued share capital of the Company (Takeover).
Following the announcement of the class meeting directed by the court to vote on the Scheme (Court Meeting), a minority employee shareholder of the Company transferred one share each to 434 employees and other individuals opposed to the Takeover (Individual Shareholders) by way of gift. The Chairman at the Court Meeting disallowed the votes of the Individual Shareholders. Had the Chairman allowed these votes, the Scheme would have failed, as it would not have met the majority in number pre-condition of section 899(1) of the Companies Act 2006 (CA 2006).
Section 899(1) CA 2006 requires a majority in number (the Numerosity Requirement) representing 75% in value of the class of members present and voting at the Court Meeting to approve a Scheme before it can be presented to the court for its discretionary sanction.
The High Court held that the power to vote at a Court Meeting must be used for the purpose of benefiting the class as a whole, and not merely to support those specific interests of individual members if they are different from the interests of the class.
The court determined that the Chairman was justified in disallowing the votes of the Individual Shareholders. The court stated that their actions and the timing of those actions demonstrated that the Individual Shareholders could have given no consideration as to the interests of the class of members they had joined. The Individual Shareholders could only have joined with the pre-conceived notion of voting down the Scheme. The court was entitled to protect the integrity of the Court Meeting against manipulative practices such as share splitting that would frustrate its statutory purpose.
Wider ramifications for creditors' Schemes
Whilst Dee Valley was concerned with a members' Scheme, it is easy to see the analogies which could be drawn in relation to creditors' Schemes given that section 899(1) CA 2006 applies equally in respect of creditors' Schemes. The case could be applied as authority to preclude the ability to split debt into separate corporate vehicles for the purpose of manipulating the outcome of a class vote on a Scheme after a Court Meeting has been directed.
The timing of the transfer of the shares in Dee Valley appears to be critical to the outcome. The judge concluded that on the evidence the only possible explanation for the conduct of the Individual Shareholders in accepting the gift of a single share immediately after the Court Meeting had been directed was to further a share manipulation strategy to defeat the Scheme by use of the majority in number jurisdictional requirement. The judge stated that "There was no other reason to acquire one single share in the Company at that crucial time after the Court Meeting had been directed".
Questions remain as to whether it might be possible for a creditor to adopt a strategy of fragmenting the debt it holds across various corporate entities at an earlier point in time. There may be a variety of legitimate reasons why a creditor would adopt this approach, e.g. for tax structure purposes, risk diversification, internal policies, etc. Debt funds frequently use a number of sub-funds or affiliated funds to purchase debt for these and other reasons, even where a Scheme may not be in direct contemplation. In these circumstances, where split holdings of debt in the same debtor is customary, and even where there is a common investment manager (which might call into question why the split is required if the relevant exposure is managed in substantially the same way across sub-funds), it may be more difficult to conclude that "the only possible explanation" for the debt split was to manipulate voting, but at the same time the splitting of debt may seem obscure to the outside observer. The burden of proof of establishing that the debt was split for an "improper" purpose would seem to be on the person alleging the manipulation.
Practically therefore if a creditor is lending or purchasing debt in the secondary market where it has an inkling that a Scheme may be proposed in the future, or the debt is purchased in a capital structure which may lend itself to the use of a Scheme (e.g. a prospective bond restructuring where a dual consent solicitation and Scheme fall-back has been used successfully on a number of recent occasions2), it could decide to position itself in anticipation.
Clearly the impact of debt splitting in the way contemplated could be used by either majority principal debt holders or creditors holding small amounts of principal debt. We could postulate a situation where creditors hold a significant principal amount of debt in a class but where those creditors could be exposed by the Numerosity Requirement so seek to debt split to approve the Scheme. In the alternative there is a situation where a number of creditors holding a relatively small amount of principal debt in a class are against the Scheme and wish to use the Numerosity Requirement to seek to defeat the Scheme. The effects of debt splitting would arguably be less keenly felt if the tactic is adopted in the former case, as the Scheme still has to be presented to the court, which has the discretionary power as to whether to sanction it. At this point the court has to consider whether the approval of the Scheme is reasonable, whether each class was fairly represented by those attending the meeting and whether the statutory majority acted bona fide. In the alternative, where the Scheme is defeated through lack of majority in number, there is no power for the court to sanction the Scheme (a point which was approved in Dee Valley).
The need or temptation to resort to tactics such as debt or share splitting and its effect on the approval of a Scheme raises the question of whether the double majority requirement for approval of a Scheme (being the Numerosity Requirement and the 75% in value requirement) is necessary, especially when paired with the court's discretion at the sanction stage.
There has been some criticism of the Numerosity Requirement. Legislators in Hong Kong and Australia (who originally based their Scheme legislation on the English law model) have taken steps to minimise the impact of the Numerosity Requirement and to remove it in certain scenarios. These changes predominately relate to members' Schemes.
In Hong Kong, the case of Re PCCW3 brought the Numerosity Requirement to public attention. In this case, share splitting was used to support a Scheme. The court denounced the practice as improper and determined that it should be taken into account when the court exercises its sanction discretion.
Subsequently, the consultation stage for the New Companies Ordinance in Hong Kong outlined the concerns in relation to the Numerosity Requirement4 . These included that: (i) it is inconsistent with the "one share one vote" principle used in other provisions dealing with shareholders meetings in the legislation; (ii) there is a common reality that shares are often held by nominees and custodians; and (iii) the Numerosity Requirement attracts attempts to manipulate the outcome of the vote by share splitting.
The New Companies Ordinance came into operation on 3 March 2014 and replaced the Numerosity Requirement in relation to a Scheme involving a share buy-back offer or a takeover offer with a requirement that the votes cast against the Scheme must not exceed 10% of the voting rights attached to all disinterested shares. The court is also given discretion to dispense with the Numerosity Requirement in relation to members' Schemes for other purposes5.
In Australia, amendments were made to the relevant legislation in 2007 to give the court discretion to approve a members’ Scheme if it is approved by a 75% majority in value even if it does not pass the Numerosity Requirement6. The reasoning behind this was that "A members’ scheme could be defeated by parties opposed to the scheme engaging in ‘share splitting’[…]. By splitting shares to increase the number of members voting against the scheme, an individual or small group opposed to the scheme may cause the scheme to be defeated. This may occur even though a special majority is achieved in terms of voting rights attaching to share capital, and if the share split had not occurred, the majority of members were in favour of the scheme".7
Parliament in the UK resisted attempts to amend or remove the Numerosity Requirement in the drafting of the CA 2006 due to the persistent perceived risk of larger creditors and members imposing their will unfairly on smaller creditors and members8. However it is arguable, as a result of the Numerosity Requirement, that the current state of the law allows those creditors and members forming less than 25% in value of a class to have a disproportionately large impact on the outcome of the approval process of a Scheme as they are afforded the dual protection of (i) the right to reject a Scheme where they form the majority in number of the class; and (ii) the protection of court discretion even in the event that the majority in number approve the Scheme.
Although Dee Valley seems to put an end to reactive debt/share splitting following the proposal of a Scheme, the door may still be open for an earlier pre-emptive approach. Whilst the requirement of the majority in number remains part of the legislative framework for Schemes, creditors and shareholders may look more closely at using debt/share splitting tactics to either circumvent the legislative requirements or to use them to their advantage.