John Elliot of Clayton Utz takes an in-depth look at the Australian M&A market, focusing on the significance of the association rules.
“The association rules are so broad that Australia’s corporate regulator once argued in court that two shareholders were associated with each other in relation to resources giant BHP because, among other things, they were both directors of the same football club in Melbourne.”
One of the quirks of acquiring an Australian company is that you may breach the law before you begin or even announce your bid.
That’s because Australia has strict controls on pre-bid warehousing, and even on pre-bid discussions. These provisions – called the association rules – are very significant for pre-bid planning: Clayton Utz’s annual M&A survey, “The Real Deal”, discloses that 56 per cent of bidders in 2012 had a pre-bid stake in the target company, often in the form of acceptance agreements with selected target shareholders.
The association rules are so broad that Australia’s corporate regulator once argued in court that two shareholders were associated with each other in relation to resources giant BHP because, among other things, they were both directors of the same football club in Melbourne. That argument was thrown out by the court, but the fact that the corporate regulator felt able to rely on it is a good indication of both the breadth and the fuzziness of the association rules.
The enforcement of those rules has recently been beefed up by an important court ruling. As a result, an understanding of the association provisions is now more important than ever.
Chapter 6 of the Corporations Act 2001 regulates takeovers of companies that are listed on Australian Securities Exchange (ASX) and unlisted companies that have more than 50 shareholders.
The basic rule is that one cannot acquire control of more than 20 per cent of voting shares in a company without making a formal takeover offer to all the shareholders. For these purposes, shareholders are deemed to control not only the shares that they own, but also the shares owned by their associates.
It will be immediately obvious that this prevents the deliberate warehousing of shares with friendly parties. In other words, you cannot exceed the 20 per cent threshold by acquiring shares in the names of friendly third parties.
What is less obvious, however, is that the association rules go a lot further than this. They can even restrict potential bidders’ ability to negotiate with third parties. To see why, it’s necessary to look at the definition of “associate”. The key part of the definition is in section 12 of the Act:
[A] person (the second person ) is an associate of the primary person if [...] (b) the second person is a person with whom the primary person has, or proposes to enter into, a relevant agreement for the purpose of controlling or influencing the composition of the designated body’s board or the conduct of the designated body’s affairs; (c) the second person is a person with whom the primary person is acting, or proposing to act, in concert in relation to the designated body’s affairs.
In plain English, you are associates if the two of you agree to control the company or if you act in concert in relation to its affairs. The breadth of this test is indicated by two factors:
the agreement to control the company need not be in writing and need not even be legally binding (or, as one judge put it, the rule applies to “wink and nod” agreements); and
the affairs of a company are defined to include (among other things), the company’s business, trading, transactions, dealings, property, liabilities, profits, income, receipts, losses, outgoings and expenditure.
What does this mean in practice?
Because it is so broad, the association test can have a significant effect on pre-bid planning.
For example, a putative bidder may want to acquire a company to obtain control of only some of its assets. The company already has a 20 per cent shareholder that may be interested in acquiring the rest of the assets. The putative bidder opens negotiations with the 20 per cent shareholder to discuss a possible bid for the company and a subsequent carve-up of its assets. There is no prohibition on carrying on those negotiations. However, once the bidder and the shareholder agree on a course of action, they become associates. The bidder is then deemed to control 20 per cent of the company, and cannot itself acquire any shares in the company without making a bid for the company.
The situation can be even more complicated if a putative bidder wants to have discussions with a shareholder who owns more than 20 per cent or even a majority of the company.
There are a number of ways to avoid going over 20 per cent in these situations. Typically, a bidder’s discussions with existing shareholders will be clearly delimited in regards to the number of shares under discussion, so that the 20 per cent threshold is never reached. There are also exceptions for agreements that are conditional on the approval of other shareholders and agreements to conduct joint bids.
In practice, it is relatively rare for someone to breach the 20 per cent threshold through an association (but see below). Much more common is a breach of the “substantial holding” notification requirements.
To ensure that the market is informed about significant changes in control of a company’s shares, the Act requires the public disclosure of all shareholdings of 5 per cent or more in a listed company (and of any changes in shareholdings above 5 per cent). That disclosure requirement extends to the shares of one’s associates. This means that even pre-bid agreements designed to stay below the 20 per cent threshold can result in a legal requirement to disclose the agreement if the relevant number of shares is 5 per cent or more. For those planning a bid, this can present something of a dilemma: non-disclosure is a breach of the Act that can lead to orders for divestment or the payment of monetary compensation (at best) or jail (at worst); public disclosure may prematurely alert the market that a takeover bid is imminent.
At this point, some readers may be wondering what all the fuss is about. After all, if secrecy is preserved, how would anyone else know that two people had a “wink and nod” agreement about a company? Even if someone suspected such an agreement existed, how could it be proved?
It is true that there may be little or no hard evidence of an association. That, however, is largely irrelevant: the law does not require “smoking gun” evidence before action can be taken against the associates.
This is because Australia significantly reduced the use of courts to police takeovers over a decade ago.
Before 2000, it had been found that, in a freewheeling M&A market, courts took too long to resolve legal issues and disputes about takeovers. Accordingly, the legislators established a Takeovers Panel as the primary forum for hearing and ruling on takeover disputes. It also moved the enforcement away from questions about the legality or otherwise of actions and placed more emphasis on whether those actions were unacceptable, given the policy underlying the takeovers provisions in chapter 6.
The Takeovers Panel is made up of business people, bankers and lawyers. It quickly established itself as a dispenser of fast justice, especially in relation to disputes about takeover offer documents. Before the advent of the panel, challenging a takeover offer document in court was guaranteed to slow down the bid as the court went through all the formalities associated with a full trial. By contrast, the panel can dispose of such disputes within a few days, relying as much upon the experience of its members as the submissions made by the disputing parties.
The panel was not so successful when it came to complaints that two or more parties were associates in relation to a company. A dispute about takeover bid documents can largely be resolved by reading the documents. An association, on the other hand, may not have any paper trail.
This put the panel in something of a dilemma. A full forensic investigation of an alleged association could be very time-consuming and beyond the panel’s resources, thus negating the policy that the panel should handle disputes with minimal delay. Conversely, hidden associations run directly contrary to the Act’s policy that takeovers “take place in an efficient, competitive and informed market”. The panel’s response was to insist that anyone who made allegations concerning an association had to come to the panel with some good evidence, even if it was not conclusive. The panel could then use its own evidence-gathering powers to supplement that evidence to some degree.
Recently, the panel has also started to rely upon its own internal expertise when evaluating association allegations. This reached a head in what has become known as the “Tinkerbell litigation”.
This involved an alleged association between Ms Leanne Catelan and her father, Mr Raymond Catelan. Mr Catelan owned 36 per cent of CMI Ltd and was its chief executive. Ms Catelan’s company, Tinkerbell, bought 9 per cent of CMI from a third party.
The panel held that Ms Catelan was an associate of her father. It ordered the compulsory sale of the 9 per cent that her company had acquired. Among the evidence relied upon by the panel was:
the negotiations leading up to the share purchase (which, in the view of the panel, involved Mr Catelan);
the funding of the purchase (Ms Catelan was in funds because of a gift from Mr Catelan);
the size of the purchase as a proportion of Ms Catelan’s portfolio (66 per cent, while the rest of her investments were in companies associated with her father);
the fact that the purchase took place when there was agitation for change on the board of CMI (“a very significant factor”, according to the panel);
the effect of such a large share transfer on control;
that fact that Ms Catelan worked for her father as an employee of CMI; and
the fact that the Catelan family and its legal adviser constituted the majority of the CMI board.
The panel made it clear that its evaluation of this evidence was strongly influenced by the business and professional expertise of the panel members:
Considering the whole of the material, based on our expertise and drawing appropriate inferences, we conclude that Ms Leanne Catelan and Mr Raymond Catelan are not acting independently in relation to the investment by Tinkerbell in CMI. Either there was an agreement, arrangement or understanding between them for the purpose of the ownership of the 9.22 per cent parcel of shares in CMI or they were acting in concert in relation to the ownership of that parcel or both.
Ms Catelan did not let things rest there. She took the relatively unusual step of appealing to the Federal Court (which has judicial oversight of the panel). On appeal, she argued that the evidence did not support the panel’s finding of an association and, more importantly, that the panel had breached the rules of natural justice by drawing inferences and reaching conclusions based on the collective experience of the panel members.
What the court said
The court held that the evidence relied upon by the panel did support a finding of an association. More importantly, it held that panel members could use their professional experience when drawing inferences and conclusions from the evidence in front of them:
[I]t is appropriate, in light of the nature of the Panel, that the Panel be entitled to draw on those factors in assessing evidence and drawing inferences [...]. To accept the applicant’s submission that the Panel should not be so entitled would be to strip the Panel in large part of its effectiveness as a specialist body established to resolve takeover disputes, as mandated by the legislation.
This was a crucial development for the panel. If it were unable to rely on its members’ experience in order to “join the dots” when evaluating evidence, its ability to enforce the association provisions would be significantly eroded.
Lesson for offshore buyers
Tinkerbell is especially important for overseas players contemplating a tilt at an Australian company. The fact that discussions and so on are taking place offshore may make it difficult for the panel to find conclusive, concrete evidence that associations are being formed. After Tinkerbell, the panel is effectively empowered to use its own knowledge of how the market works to fill in many of those evidentiary gaps.