Shares issued on share-for-share exchange had to be paid up in cash
Zavarco plc v Sidhu  EWCA Civ 1040 concerns an appeal from a High Court decision on which we reported in July 2021. (See our previous Corporate Law Update.)
The case concerns a public company registered in England under the Companies Act 2006 (Zavarco plc) that had been incorporated to act as a listing vehicle to raise money to develop a telecommunications network in Malaysia following unsuccessful attempts to raise the money through a Malaysian company.
It was intended that the Malaysian company’s shareholders exchange their shareholdings in that company for new shares in Zavarco plc, which would then be listed on the Frankfurt Stock Exchange. As part of this, Mr Sidhu, one of the Malaysian company’s shareholders, would be allotted 840 million shares in Zavarco plc, each with a nominal value of €0.10.
Importantly, Zavarco plc would not receive cash in exchange for allotting the new shares. Rather, it would acquire the existing shares in the Malaysian company.
Under section 593 of the Companies Act 2006, an English public company cannot allot shares otherwise than for cash unless it obtains a valuation of the property it is receiving in return (a “non-cash valuation”). The consequence of contravening this rule is that the person to whom the shares are allotted must pay the full nominal value and any agreed share premium.
Under section 594, a public company does not need to obtain a valuation if the property it is receiving is shares under an arrangement put in place as part of a merger.
Zavarco plc did not obtain a non-cash valuation. Following the listing, its share price collapsed and it brought proceedings against Mr Sidhu, claiming 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.
Mr Sidhu argued in response that the shares had been allotted as part of a merger arrangement and so there had been no need for a valuation.
The High Court disagreed and found that there had been no merger arrangement. Mr Sidhu was therefore required to pay €84m to Zavarco plc for the shares he had received.
For more information on that decision and on the requirement for a valuation, see our previous Corporate Law Update.
Mr Sidhu appealed to the Court of Appeal.
What did the Court of Appeal say?
The Court of Appeal dismissed Mr Sidhu’s appeal and held that he remained liable to pay for his shares. However, interestingly, the court came to its conclusion via a different line of reasoning.
The judges found that Mr Sidhu had agreed to subscribe for the 840 million shares when Zavarco plc was incorporated, rather than take them in an allotment after incorporation. This made a critical difference.
Under section 584 of the Companies Act 2006, shares taken by a subscriber on incorporation must be paid up in cash. Unlike under section 593, a subscriber is not able to subscribe for shares by transferring non-cash assets and there is no option to obtain a non-cash valuation. There is also no exception for merger arrangements, as there is under section 594 for a post-incorporation allotment.
Mr Sidhu argued that the words “Each subscriber … agrees to become a member of [Zavarco plc] and to take at least one share” in the company’s memorandum (the document that establishes it is being incorporated) meant that he had meant to subscribe for only one share, with the remaining 839,999,999 being allotted after incorporation.
The judges rejected that argument. The words “at least one share” indicated that Mr Sidhu had potentially agreed to take more than one share and the company’s statement of capital and initial shareholdings showed that he had taken 840,000,000 shares on incorporation.
The court also clarified that shares taken by a subscriber on incorporation are not “allotted” and so cannot fall within sections 593 and 594. Rather, a subscriber comes into ownership of shares on incorporation purely as a result of the company being registered.
What does this mean for me?
Although the Court of Appeal reached its conclusion via a different route, it highlights the same key point. When implementing a share-for-share exchange, it is important to document and structure the arrangement properly.
If looking to take advantage of the merger exception in section 594 and allot shares without payment in cash or an independent valuation, a public company and any participating shareholders must 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.
Moreover, the public company must ensure that the shares it issues as part of the share-for-share exchange are allotted after it has been incorporated, and not as part of the incorporation process.
In any event, whether a person subscribes for shares after incorporation, it is important to ensure payment is made in cash, or that an exemption applies, for the following reasons.
- A public company that allots shares in contravention of section 593 commits a criminal offence. In addition, any director of the company who is “in default” will also commit a criminal offence.
- Authorising an allotment of shares without a non-cash valuation is likely to amount to a breach by the directors of their statutory duties to the company.
- Without conducting a proper valuation of any non-cash assets, a company runs the risk of becoming undercapitalised and potentially unable to fulfil its debts.
- A person who subscribes for shares in contravention of section 584 or 593 will be liable to pay the company the aggregate nominal value of the shares, along with any agreed premium and interest.
- Anyone who subsequently acquires the shares will be jointly liable to compensate the company unless (broadly speaking) they were acting in good faith and are not aware of the contravention.