2013 saw a number of important legal developments for financial sponsors investing in Australia. In this edition of Bullseye we recap the key 2013 developments and the significant court decisions to watch out for as we head into 2014.
A drag-along right is an exit mechanism – not a minority buyout right
The NSW Supreme Court1 recently decided that in the absence of specific language to the contrary, a drag-along provision will not be interpreted to give a majority shareholder the right to buyout the other existing shareholders in the company. That is, the drag-along provision requires an offer from a third-party who is not an existing shareholder.
A drag-along right is a fairly typical provision in shareholder agreements which gives a majority shareholder the ability to require other shareholders to sell their shares, in the event of a third party offer for the majority shareholder’s shares. The Court’s decision was based on an objective interpretation of the terms of the relevant drag-along right which contemplated that the offeror and the offeree shareholders were different persons and which also referred to a sale of 100% of the company’s shares (and obviously, a shareholder cannot buy shares it already owns).
Financial sponsors subject to competition and anti-cartel laws
The first case on liability under the “bid rigging” cartel provisions of the Competition and Consumer Act 2010 (Cth) (CCA)2 - the March 2013 decision of the Federal Court of Australia (Gordon J) in Norcast S.á.r.L v Bradken Ltd (No 2) - set a somewhat concerning precedent regarding what could constitute bid rigging and misleading or deceptive conduct.
In a competitive auction, it is now even more important that financial sponsors carefully manage any dealings they have with other parties who could, even as a slight possibility, bid in the auction, irrespective of whether those dealings involve joint bidding agreements. This particularly includes situations where an on-sale of any assets is being contemplated.
Financial sponsors need to be mindful of the following when bidding in a competitive auction (or tender scenario):
- The anti-cartel and other restrictive trade practices provisions in Part IV of the CCA can apply to sponsors in an asset or share sale situation. A restriction on a party’s ability to bid in the sale of any asset or shares, whether by auction or tender, can be sufficient to enliven the cartel provisions.
- Arrangements or understandings between potential bidders in connection with a competitive auction process can be a breach of the cartel provisions even if they are unwritten, informal and unenforceable.
- An arrangement between people considered to be potential bidders may be inferred from surrounding circumstances. Commercial communications and arrangements (even very loose ones) between one or more financial sponsors and / or other potential bidders during the auction process (even if they are not actual bidders) can be sufficient for a Court to conclude there is a bid rigging arrangement.
- Parties can be in competition with each other as potential bidders (a requirement of the prohibition on bid rigging) even where the likelihood of such competition is, at best, a possibility which is not “remote”.
- The cartel and misleading or deceptive conduct provisions apply to conduct outside Australia by companies incorporated in Australia and entities carrying on business in Australia. It may be sufficient to meet the “carrying on business” test if a financial sponsor is a co-joint venturer with another party undertaking business activities in Australia. As such, joint and consortium bidding by financial sponsors anywhere in the world can be caught by Australia’s competition laws.
- Silence can in some circumstances constitute misleading or deceptive conduct, even where a party does not have any direct contact with the vendor, or when the vendor did not, or even could not, know of the collaboration or engagement between the financial sponsor and other party, notwithstanding that there is no positive duty on any party to disclose their engagement or collaboration. Taking steps to prevent disclosure of a back-to-back sale arrangement can amount to a misleading representation by silence that a party is not involved.
The key takeaways for financial sponsors are:
- think early about bringing yourself within the “joint venture” defence to bid rigging if there is any possibility of joining with anyone in an auction;
- and consider carefully:
- any representations being made in the sale process about any engagement or collaboration (and your ability to control representations being made by co-venturers); and
- what information, if any, you withhold about your dealings with others in the process.
Information memoranda risks
In February 2013, Japanese beer and beverage producer Asahi Group, commenced a court action against Pacific Equity Partners and Unitas Capital alleging that the two firms engaged in misleading and deceptive conduct when they sold Independent Liquor to Asahi in 2011.
The claims, in part, relate to the accuracy of the financial information contained in the Information Memorandum and the other diligence information provided to Asahi in connection with the sale process - the key point of significance being the claims are not just for breach of the actual warranties in the final sale agreement.
It is customary for Australian sale agreements to limit the scope of a vendor’s potential liability for breach of warranty by way of minimum and maximum claim thresholds and non-quantitative limitations. In addition, a vendor will usually spend time verifying in detail the precise warranties it gives, as well as the financial statements and other information being warranted. The Asahi claim attempts to side-step these limitations by claiming not just on the basis of breaches of the actual warranties in the sale agreement, but also on the basis of other preliminary information provided by the vendors.
If the Asahi claims relating to information disclosed in the Information Memorandum and the other diligence information are upheld by the Court, it will mean that vendors and their advisers have to be far more careful when presenting information to bidders in a sale process and not simply assume that a customary liability disclaimer will excuse them from responsibility for an Information Memorandum’s content.
Leaver arrangements - penalty considerations are now real
In the August 2013 edition of Bullseye we wrote about the High Court decision of Andrews v ANZ. In that case it was decided that an actual breach of contract was not required to enliven the “penalty doctrine” - thereby dramatically broadening the circumstances in which a court may find that a contractual provision, including a typical leaver buy-back provision in a shareholders agreement, is unenforceable. (Read the August 2013 edition of Bullseye here).
Throughout 2013, Courts continued to look at the penalty doctrine in light of the Andrews’ decision. One such decision was Re Pioneer Energy Holdings Pty Ltd. In the Pioneer decision the NSW Supreme Court found that an option in a shareholders agreement was an unenforceable penalty. The relevant option entitled one joint venture party to buy all the shares of the other joint venture party for a grand total of $1 if the other party defaulted on its further funding obligations.
Key factors in the Court’s reasoning were that the $1 purchase price was out of all proportion to the value of the shares sold and applied irrespective of when the default occurred and how much each party had contributed to the joint venture at the time of the default. The Court accepted that there were legitimate commercial justifications for the clause. The Court also recognised that the parties had expressly acknowledged in the shareholders agreement that the option (and related liquidated damages payment) represented a “genuine estimate of the loss and expense” which would be suffered by the non-defaulting party. However, notwithstanding these factors, the Court still decided that they were not sufficient to prevent the penalty doctrine applying.
MYOB sale - is a final offer letter really binding?
The litigation commenced by Archer Capital and the other former shareholders of MYOB against British software company, The Sage Group plc, has raised some interesting questions of contract law which will be of particular significance to financial sponsors.
Archer Capital and its fellow former shareholders claim that Sage’s final offer was a binding offer to acquire MYOB for the $1.35bn purchase price specified in the offer (notwithstanding that the definitive share sale agreement had not yet been executed by any of the parties) and that by withdrawing the final offer Sage had repudiated that legally enforceable contract. They are also alleging Sage engaged in misleading and deceptive conduct.
The contractual claim raises questions for parties bidding in auctions (including financial sponsors) about whether they can be contractually bound by a final form bid offer letter submitted as part of a formal auction process (and ahead of formal definitive documents being signed). If the Court ultimately determines that a contract can arise in such a scenario, bidders in auctions will need to pay far greater attention both to the terms of their bid offer letters (including their conditionality) and to the conduct of individuals involved in the auction process in relation to such offers ahead of final definitive documents being executed.
The MYOB litigation was largely heard before the Federal Court in late 2013. A decision is expected in the first quarter of this year.
Proposed tax changes
2013 saw a number of new and proposed tax changes which could impact financial sponsors investing in Australia:
- The thin capitalisation safe harbour for “general entities” (which may include financial sponsors) is proposed to be reduced from 75% to 60% for income years starting 1 July 2014. This effectively means that under the proposed new rules an entity may be funded with a maximum of 60% debt to 40% equity (compared with the current 75% / 25% split) before debt deductions may be denied under the thin capitalisation regime.
- From 1 July 2016, a 10% “non-final withholding tax” may be applied to sale proceeds paid to foreign investors. Under the proposed new rules, where a foreign resident disposes of certain taxable Australian property, the purchaser will be required to withhold and remit 10% of the sale proceeds to the Australian Taxation Office. This “non-final withholding tax” is intended to ensure that tax can be collected from foreign residents, so it is possible that the withholding tax obligation may not apply where the seller does not make a taxable gain. The proposed new withholding tax gives rise to a number of issues and questions for offshore financial sponsors, including the scope of transactions subject to the regime and the extent to which the tax position of the foreign seller will be taken into account in determining the withholding tax liability. These issues will hopefully be clarified once draft legislation is released.
- From 1 July 2014 it is proposed to limit the existing tax exemption for dividends paid by foreign subsidiaries to Australian parent companies to returns paid on equity interests. This means that the exemption will no longer be available in respect of dividends paid on shares that are “debt interests” or interests that are truly portfolio in nature. For Australian outbound investment, this means that the issue of redeemable preference shares by foreign subsidiaries to their Australian parent may be less attractive.
- The former Federal Government had announced that from 1 July 2014 the tax deduction for interest expenses incurred in deriving certain foreign exempt income (such as the exempt dividends referred to above) would be removed. In a positive move, the new Federal Government has announced that it will not proceed with this change. Instead, it will commence consultations on a targeted integrity rule to address certain conduit arrangements.
The Chinese offshore investment approval regime has been relaxed
In late 2013 the Chinese State Council made significant and widespread changes to the regulatory regime for overseas investment by Chinese investors, the “2013 Catalogue” – the first such revision since 2004. The changes have potentially profound ramifications for the future trends of Chinese outbound investments.
Generally speaking, certain Chinese investors must seek full governmental “verifications” (as opposed to a simple process of filing for records) from three key regulatory bodies for their outbound investments: the National Development and Reform Commission (NDRC), the Ministry of Commerce of the PRC (MOFCOM), and the State Administration of Foreign Exchange. NDRC verification is considered to be the most important approval and is essential to obtaining other approvals.
The 2013 Catalogue has significantly limited the categories of investments which are required to seek full verification from the NDRC and MOFCOM. “Special projects”, namely, proposed investments in certain “sensitive countries and regions” or “sensitive industries” or projects valued at over USD$1bn will continue to require full verification by the NDRC at the central level. However, except for those investments, all other investments by the centrally- administered state-owned enterprises and provincial enterprises (state-owned enterprises or otherwise) of USD$300m to USD$1bn will only be subject to an “after- the-fact” filing.
As the NDRC and MOFCOM have yet to release any revisionary or implementation rules in connection with the 2013 Catalogue, questions remain as to the alignment of the old approval regime and the changes under the 2013 Catalogue and how certain investments will be treated. That said, it is clear that the 2013 Catalogue should increase Chinese investors’ competitiveness and flexibility in cross-border M&A.
You can read more about the Chinese regulatory changes here.
The limits on break fees and other lock-up devices still apply in the case of financially distressed companies
The 2013 Takeovers Panel decision in Billabong confirmed that the limits on the acceptability of break fees and other lock-up devices apply irrespective of whether:
- the relevant target company is financially distressed;
- the break fee or other relevant lock-up device is found (as it traditionally would be) in an implementation agreement or sale agreement; and
- the break free or lock-up device is “cloaked” as some other type of financial return or penalty.
In the Billabong decision, the Takeovers Panel recognised that Billabong had an urgent need for funds and had been engaged in a protracted public sale / refinancing process. However, notwithstanding that, the Panel found:
- A bridge facility termination fee, which equated to 54% of Billabong’s equity value and was triggered by, amongst other things, a change of control of Billabong, was unacceptable. The Takeovers Panel reiterated that a break fee is “consideration however payable by a target if specified events occur which prevent a bid from proceeding or cause it to fail” (italics added). The bridge facility termination fee was a break fee in substance and greatly exceeded the Takeover Panel’s usual 1% of equity value guidance.
- A change of control trigger, which could have resulted in a make-whole premium in the proposed long term financing being payable, was likely to deter rival control proposals and was also an unacceptable lock-up device.
- An interest rate of 35% on a convertible tranche of the financing (if Billabong shareholder approval for the conversion of the tranche into redeemable preference shares and for the issue of certain options, was not been received) was also an unacceptable lock-up device. If shareholder approval had been received, the interest rate was to be 12% - an incremental difference in interest per annum of $10m. In this regard, the Takeovers Panel noted that “naked no vote” break fees are not prima facie unacceptable but may be so if the size or trigger is unreasonable.
Another interesting observation in the decision is the Panel’s ultimate acceptance of the amendment of the bridge facility termination fee to $6m, representing more than 1% of Billabong’s equity value but slightly less than 1% of its enterprise value. The Takeovers Panel noted that its Guidance Note 7 stated that enterprise value can be a more appropriate basis for assessment of a break fee when a company is highly geared.
Increase in non-bank senior / mezzanine debt providers and holdco PIK loans
The financing and re-financing of private equity deals in 2013 saw a number of non-bank debt providers establishing or expanding their presence in Australia and the increasing use of holdco payment-in-kind (Holdco PIK) loans.
What started in late 2012 and early 2013 as a rush to the US high-yield and term loan B markets for refinancings and dividend re- capitalisations, culminated in late 2013 with financial sponsors increasingly being able to obtain financing from specialist non-bank financiers for second ranking secured or structurally subordinated Holdco PIK loans as a means of financing the refinancings and dividend re-capitalisations.