Financial assistance: time to say ‘goodbye’

The modern restriction on a company providing financial assistance to acquire shares in the company or its holding company originates from a law based on the findings of 1926 Greene Committee in the United Kingdom.

The Greene Committee was particularly concerned with syndicates acquiring control of a company and then using the company's funds (often without providing security) to repay the syndicate’s acquisition debt. The Greene Committee felt that this practice ‘offended against the spirit (if not the letter) of the law which prohibits a company from trafficking in its own shares, and the practice is open to the gravest abuses’.^[3]

In Australia, legislated financial assistance provisions are traced back to section 129 of the Companies Act 1981 (Cth). That section expressly prohibited the direct or indirect giving of financial assistance for the purpose of, or in connection with, the acquisition of shares in a company or its holding company. The wording of the section was detailed and prescriptive, but included a number of exceptions (including, most relevantly and enduringly, where the company’s members resolved to approve the financial assistance).

The 1981 Act also provided that, if a court were satisfied the company or another person had suffered damage (or would be likely to suffer damage) as a result of the financial assistance, the transaction may be voided or unwound.

The regime was revised with the introduction of section 260A of the Act which permits the giving of financial assistance if it does not materially prejudice the company’s shareholders or the company’s ability to pay its creditors. If a company is found to have contravened section 260A, any person involved in the contravention is subject to civil penalties (and, indeed, criminal liability, if their conduct is found to be dishonest).^[4] However, in a major departure from the 1981 Act, any transaction involving financial assistance (and the financial assistance itself) is not invalid.

It is the risk of civil penalties in particular that has resulted in company officers adopting the practice (very often insisted upon by the banks in leveraged deals) of whitewashing anything that has the faintest hint of financial assistance about it. As many will appreciate, pretty much any financial benefit given by a company in the context of a transaction can be characterised as financial assistance.

While Australia was willing to follow the UK’s adoption of a financial assistance regime, she has not (yet) demonstrated the same enthusiasm as the UK in retreating from it. In 2008, the UK repealed financial assistance provisions for transactions involving private companies. The UK Department of Trade and Industry’s rationale was that it was ‘inappropriate for private companies to continue to carry the cost of complying with the rules on financial assistance, as abusive transactions could be controlled in other ways, eg through the provisions on directors duties’.^[5]

Let’s look again at the two principal ways around financial assistance.

The first is where the target company’s directors form the view that providing financial assistance is essentially immaterial and will not prejudice the company’s shareholders or its ability to pay creditors.

This is the approach typically adopted by entrepreneurs, often relying on instinct and an intimate understanding of their financial situation and prospects. If they have their wits about them, they can avoid falling into the trap of abstract safe thinking that any financial benefit given by a target company in a sale of its shares is financial assistance caught by the section.

However, as financial assistance is often judged in hindsight (and only after a business has failed or suffered some other distress), this short-circuiting approach is not without risk.

Less bullish directors and risk averse bankers (sometimes emboldened by strict internal policies) often baulk at this short-circuit approach. It is rare that banks and lawyers will support the view that financial assistance (once the section has been enlivened) is unlikely to be material. Moreover, lawyers tend to advise conservatively in this area because they do not like being called out by other lawyers on this point.

Which leads us to the second principal route to exemption, which is the ASIC lodgement a shareholder approval process commonly known as the whitewash procedure.

While many see the whitewash as a ‘free kick’, it can in reality be cumbersome and somewhat costly, requiring the preparation of shareholder notices and an explanatory statement containing all relevant information known to the company. The notice of shareholder meeting, explanatory statement and other documents must be lodged with ASIC. At least 14 days before giving financial assistance, the company must also lodge a notice stating that the assistance has been approved.

If the company will have a domestic holding company after the transaction in its shares has completed, the shareholders of the holding company must also approve the financial assistance. This clearly raises issues of practicality in the case of acquisitions by listed groups.

All of this needs to fit into the post-signing/pre-completion timetable, unless, in the case of a leveraged deal, the financier is prepared to ‘go naked’ (ie unsecured) until after completion (when the problem becomes the purchaser’s).

Banks and other financiers are generally happy to not insist on security over the target at completion where the transaction sponsor is a trustworthy acquirer with a borrowing track record and a future funding need. But this is not always the case, and target directors are often required to consider and assist in whitewashing security for purchaser debt over their companies.

The view of many is that the whitewash procedure is a blunt tool from a policy perspective. Its ineffectiveness is illustrated by the practical unsuitability of the process to protect creditors. While creditors could, theoretically, be alerted to the conduct of a whitewash via ASIC’s email alert system, it is doubtful that many creditors (particularly those who are unsecured) bother to set themselves up in advance to monitor debtors in this way.

Even if an unsecured creditor were to become aware of a debtor undertaking a whitewash, the hurdles to obtaining an injunction in appropriate cases are understandably high. It is a different story, of course, for secured creditors who typically have a variety of early warning and preventative measures at their disposal.

The disclosure requirements for the explanatory statement also suffer from a confusion of purpose. While the policy objective includes creditor protection, the disclosure requirement for the explanatory statement is directed solely at satisfying the needs of shareholders asked to vote on the whitewash resolution. In that regard, the requirement is that the explanatory statement discloses all information that is material to the decision on how to vote on the resolution.

However, the Act allows companies to take a shortcut by not having to disclose information which it would be unreasonable to disclose because the information has already been disclosed to shareholders.

This has led to the practice of separate ‘prior’ disclosure of sensitive information which avoids the need to include that information in the explanatory statement. This is handy for the company (wishing to keep certain information out of the public domain which would otherwise occur when the statement is lodged with ASIC), but less useful for creditors (assuming they are even paying attention – remember the practical inadequacy we discussed earlier).

Consequently, whitewash has become a ‘lip service’ practice and this has added to its frequent characterisation as a ‘free kick’.

 
In addition to protecting creditors, the financial assistance provisions purportedly restrict corporate controllers exercising powers to benefit themselves at the expense of the company as a whole.

However, we say that this objective is already promoted by other parts of the Act and by the general law, both of which impose a range of obligations on directors, including the duty to act with care and diligence, and the duty to act in the best interests of the company and free from conflict. These overarching duties do not evaporate simply because shareholder approval is obtained in conducting the whitewash.^[6]

Shareholder approval does not wave a magic wand and provide a blanket protection for directors. The existing directors’ duties, along with the duty to prevent insolvent trading,^[7] act as a strong deterrent against abuse by controlling shareholders and directors who are their instruments. This has been recognised in the UK where, as noted, the financial assistance regime was repealed for private companies.

The major shortcoming of the current statutory framework is that it causes lenders and companies to default to a somewhat costly and pointless shareholder approval process (with inbuilt lodgement and disclosure requirements which invariably fail to achieve purpose). The whitewash is only a thing because an implied prohibition on financial assistance (complete with civil penalties for non-compliance) has been enacted. But, as noted, the restriction is superfluous.

If the restrictions on financial assistance (including the whitewash provisions) were repealed, then directors would still have to observe good governance practices (as they do in every aspect of their office), and lenders would still need to observe good and prudent lending practices (as most currently do). At risk of stating the obvious, lenders are generally not in the business of lending to lose money.

The Global Financial Crisis, enhanced regulatory intervention (including increased capital requirements) and numerous enquiries and Royal Commissions have brought responsible lending to the fore. While not fool proof, lender restraint plays an important role in moderating debt in the system and in the hands of borrowers. The practical usefulness afforded by this is not generally recognised or given credit.

Instead, due to the financial assistance provisions, the responsibility rests entirely with the company’s directors, and funding is often conditional on conducting the whitewash procedure to insulate the bank and others from any involvement in a contravention of these, frankly, pointless provisions. While not advocating in any way to increase the legal burden on banks and other financiers, we consider the existing statutory and general law duties of directors, when coupled with prudent lending practices, to be adequate protection for shareholders and creditors.

One situation where the whitewash procedure in its current form may still have a role to play is in protecting minority shareholders who might otherwise find themselves left behind after a controller sells their shares to a highly geared acquirer. Not only would those minority shareholders miss out on any control premium, but they would also find themselves as investors in someone else’s debt.

Under the existing regime, assuming the target’s directors initiated the whitewash (which they ought to as things currently stand), the minority would effectively have a veto over the transaction. The protection afforded by the legislation remains relevant in this situation.