Corporate Law Update
- The court examines whether a non-cash allotment of shares was exempt from the requirement for an independent valuation
- The FCA publishes proposals to adopt the ESMA prospectus disclosure guidelines in the UK
- The new Takeover Code and related documents, precedents and guidance have been published
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The High Court has held that shares in a public company were allotted improperly without a valuation and that a shareholder was liable to pay the shares up. It also decided that an exception to the requirement for a valuation, where the shares were issued in exchange for other shares, did not apply.
Zavarco UK Plc v Sidhu  EWHC 1526 (Ch) concerned a public company registered in the UK under the Companies Act 2006 (Zavarco) that had been incorporated to act as a listing vehicle to raise money for the development of a fibre optic telecommunications network in Malaysia. Earlier attempts to raise the necessary money through a Malaysian company had been unsuccessful.
Once incorporated, the Malaysian company’s shareholders would exchange their shareholding in that company for new shares in Zavarco, which would then be listed on the Frankfurt Stock Exchange. Under this arrangement, Mr Sidhu, one of the Malaysian company’s shareholders, would be allotted 840 million shares in Zavarco, each with a nominal value of €0.10.
Importantly, Zavarco would not be receiving cash in exchange for allotting the new shares. Rather, it would be acquiring the existing shares in the Malaysian company. As a result of this, Zavarco would be required by law to obtain a valuation of the existing shares in the Malaysian company, unless the arrangement was being put in place as part of a merger. See the box below for more information.
Under section 593 of the Companies Act 2006, a public limited company (or plc) must not allot shares in exchange for non-cash assets (non-cash consideration) unless an independent valuation of those assets is carried out within the preceding six months. The report must be made available to the company, and a copy must be provided to the person(s) to whom the shares are to be allotted.
However, section 594 provides an exception where the shares are allotted as part of an “arrangement” with another company. This means, broadly speaking, that, on a share-for-share exchange (such as on a merger or a takeover), a company can accept shares in another company (a target company) in exchange for allotting shares in itself without having to procure an independent valuation.
For the exception to apply, however, certain conditions must be satisfied:
- There must be an “arrangement” in place.
- That arrangement must be open to all the shareholders (or all the holders of a particular class of shares) of the target company.
There are various consequences of contravening section 593. Although the allotment remains effective, a person to whom the shares are allotted may be liable to pay an amount equal to the nominal value of the allotted shares, as well as any premium. The contravention may also amount to a breach of duty by the company’s directors and also amounts to a criminal offence.
Zavarco was incorporated and the arrangements were implemented. The share exchange agreement included a schedule designed to set out which shareholders would acquire shares in Zavarco. However, that schedule had been left blank. It was not clear who held what shares in the Malaysian company or, indeed, which shares were being transferred to Zavarco.
In addition, no valuation report was ever produced or provided to Zavarco’s shareholders.
Following the listing, Zavarco’s share price initially held up well. However, once shareholder lock-up arrangements had expired, the share price collapsed. Zavarco brought proceedings against Mr Sidhu. In particular, Zavarco claimed that there had been a breach of section 593 and that Mr Sidhu was required to pay a total of €84m in relation to the shares he had been allotted.
It was common ground that no valuation had been conducted and so the company had not complied with section 593. The key question for the court, therefore, was whether the share exchange was an “arrangement” that fell within the exception in section 594.
What did the court say?
The court said that there was no “arrangement” for the purpose of section 594.
To fall within that section, the proposed transaction needed a basic level of coherence. In particular, it needed to be clear who would be transferring their shares to Zavarco and how many shares in Zavarco each of those persons would receive in return. The same arrangement needed to deal with both the transfer by, and the subsequent allotment to, each shareholder of the Malaysian company.
However, the share exchange in this case did not comply with section 594 for a variety of reasons:
- It was unclear who owned the shares in the Malaysian company. The exchange therefore lacked the “requisite coherence” to claim that there was an arrangement under section 594.
- There was an additional shareholder who held shares in the Malaysian company with a different nominal value. That shareholder would be transferring their shares to Zavarco without receiving any shares in Zavarco in return, meaning the arrangement did not contemplate a subsequent allotment for this shareholder.
- The Malaysian company had also issued preference shares. However, although the preference shareholders had the option of transferring their shares to Zavarco in exchange for new ordinary shares, it was unclear whether all of those shareholders would in fact have the opportunity to do so.
As a result, the exception in section 594 did not apply and the arrangement contravened section 593. Mr Sidhu was liable to pay €84m for the shares he had received.
What does this mean for me?
The decision emphasises the importance for public companies and their shareholders of ensuring statutory requirements are complied with when allotting new shares. The requirements when allotting for non-cash consideration are exacting and failure to follow them can have significant consequences.
From the company’s perspective, failure to comply with section 593 is a criminal offence. In addition, without conducting a proper valuation of any non-cash assets, the company runs the risk of becoming undercapitalised and potentially unable to fulfil its debts.
From the directors’ perspective, authorising the allotment of shares without an independent valuation is likely to amount to a breach of statutory duty to the company. In particular, directors risk allegations of acting beyond their powers, without reasonable care, skill or diligence, or in a way that does not promote the success of the company for the benefit of its members. In addition, any director of the company who is “in default” will also be committing a criminal offence.
Finally, there are risks for shareholders. If the person subscribing for the shares knew or ought to have known that the company failed to procure a valuation, they will be liable to compensate the company by paying the aggregate nominal value of the shares, along with any agreed premium and interest.
This is not simply a problem for the subscribing shareholder. Anyone who subsequently acquires the shares in question will be jointly liable to compensate the company unless (broadly speaking) they are acting in good faith and are not aware of the contravention.
The so-called “merger” or “takeover” exemption in section 594 is used quite commonly in practice, including where a new holding company is being inserted above an existing business, or where a company is looking to raise financing through a cashbox placing.
If looking to take advantage of the merger exception in section 594, a company and any participating shareholders should ensure that the details of the arrangement are clearly set out, each class of shares in the target company is dealt with distinctly, and that each shareholder in the target company participates on the same terms.
The Financial Conduct Authority (FCA) has announced, in its Primary Market Bulletin 34 (PMB 34), that it is proposing to adopt, with modifications, European Union (EU) guidance on disclosures to be included within a prospectus.
Under EU and UK law, a prospectus is required where a person intends to offer transferable securities to the public or an application is made to admit transferable securities to trading on a regulated market.
Within the EU, prospectuses and their content are regulated by the EU Prospectus Regulation and delegated legislation. To supplement that legislation, the European Securities and Markets Authority (ESMA) has published guidelines on the disclosure requirements under the Prospectus Regulation (the ESMA Guidelines). Those guidelines replace previous guidance published by the Committee of European Securities Regulators (CESR) and previous guidance published by ESMA in relation to the EU Prospectus Directive (the forerunner to the EU Prospectus Regulation).
Following the UK’s withdrawal from the European Union, the EU Prospectus Regulation continues to apply within the UK by virtue of Brexit legislation, but in a modified form known informally as the “UK Prospectus Regulation”. However, the ESMA Guidelines do not automatically apply within the UK. Instead, the FCA has told UK issuers to apply the old CESR Recommendations for the time being.
The FCA is now proposing to adopt the ESMA Guidelines in a modified form for use within the UK. For this purpose, it has published a draft Technical Note TN 619.1, in which sets out the ESMA Guidelines in a form marked up to show the modified form that will apply within the UK.
The Technical Note also contains a mark-up of extracts from the CESR Recommendations dealing with “specialist issuers”, which would also apply in modified form within the UK. These will cover property companies, mineral companies, scientific research-based companies, start-up companies and shipping companies.
Broadly, the modified ESMA Recommendations mirror the existing EU version, with two notable exceptions:
- Pro forma financial information. Under its guidance that pre-date the ESMA Guidelines, ESMA had advised issuers that, where an issuer had undertaken one or more transactions that had not yet been reflected in the issuer’s latest financial statements, the issuer should include pro forma financial information in its prospectus for any of those transactions that were “significant”.
However, ESMA modified this approach when it published the ESMA Guidelines. Now, where an issuer has undertaken a series of transactions, and either one or more of them is significant or collectively they are significant, ESMA expects the issuer to publish pro forma financial information for all of the transactions. For these purposes, “significant” means a 25% variation from the issuer’s financial statements.
The FCA has decided not to replicate this modified approach. Consequently, the UK version of the ESMA Guidelines would continue the old approach that applied before ESMA published the ESMA Guidelines. PMB 34 sets out the FCA’s reasoning for this.
- Working capital statements for closed-ended funds. The FCA also intends to modify the ESMA Guidelines to reflect existing UK market practice for closed-ended funds when including a working capital statement in a prospectus. This will continue to allow closed-ended funds to include minimum net proceeds that are not underwritten and are yet to be raised in their working capital calculation.
The FCA is also proposing to make various technical amendments to its existing Technical Notes and to incorporate old ESMA Q&A on the EU Prospectus Directive into its Handbook. For more information, see PMB 34.
The Takeover Panel has published a revised edition of the Takeover Code reflecting the changes to the Code that are due to come into effect for offers announced on or after 5 July 2021. For more information on those changes, see our previous Corporate Law Update.
The Panel has also published new versions of its various checklists and supplementary forms to reflect those. The checklists and forms in question include those relating to possible offer (rule 2.4) announcements, firm offer (rule 2.7) announcements, offer documents and scheme circulars. The Panel has also retained the existing versions of its checklists and forms, will which continue to be relevant for offer periods commencing before 5 July 2021.
Separately, the Law Society and the City of London Law Society have together published new precedent documents to be used and adapted following the changes to the Takeover Code. The new precedents comprise:
- a revised set of offer conditions
- further terms of an offer
- wording for an acceleration statement
The documents have been published as illustrative examples. The Societies have clarified that the documents are not intended to be prescriptive or comprehensive and advise persons using the document to consider them in the context of their transaction and consult their advisers.
In addition, the Societies have published a memorandum describing potential approaches for addressing cash confirmation exercises in light of guidance by the Takeover Panel.