Companies seeking to raise funds to stave off financial crisis may often find it difficult to attract a cornerstone investor or third party underwriter. For such companies, fundraising by way of a rights issue, which may include a shareholder underwriting, may be the only viable option.
The takeovers provisions of the Corporations Act provide some flexibility in this respect. In particular, the exemptions to the takeover prohibition in section 611 of the Corporations Act permit a shareholder to cross the 20 per cent takeover threshold (or increase its holding between 20 per cent and 90 per cent) by exercising rights acquired under a pro rata issue (item 10) or by acquiring shares in the capacity of underwriter (item 13).
ASIC has taken a vigilant approach to shareholder underwritings in the past. The recent decision in Re QR Sciences Limited  ATP 37 also shows that both it and the Takeovers Panel are keen to ensure that rights issues are not structured to achieve control outcomes outside the protections of Chapter 6.
The relevant exemptions
Item 10 of section 611 provides an exemption from the takeover prohibition for an acquisition of shares under a rights issue, provided that the same offer is made to every shareholder under the rights issue, and each shareholder has an equal opportunity to avoid dilution of their holding by participating in the offer. The item 10 exemption specifically includes the acquisition of shares by an underwriter to the rights issue.
Item 13 of section 611 of the Corporations Act provides another exemption from the takeover prohibition where the acquisition arises from the shareholder underwriting an issue under a disclosure document (whether or not pro rata), provided the disclosure document discloses the effect that the underwriting would have on the person's voting power in the company.
In various public releases, ASIC has acknowledged the reality facing many companies in need of additional capital: that a rights issue is often the most favourable means of raising capital, that the success of the issue can often only be assured by way of an underwriting, and that a controlling or significant shareholder is often the only person willing to underwrite the issue.
However, ASIC has indicated that it will closely examine the terms of, and circumstances surrounding, an underwriting by a person who already controls, or is likely after the transaction to control, the company, to ensure the transaction is in fact a bona fide underwriting and not an attempt to circumvent the takeover protections in Chapter 6.
The Takeovers Panel adopted a similar position in its decisions in Re Anaconda Nos (2–5) and Re Phosphate Resources, which both involved rights issues underwritten by the issuer's major shareholder. In these decisions the Panel, after considering at length the terms of the transaction and its commercial context, upheld the validity of the rights issue and associated underwriting arrangement.
The rationale for this approach seems clear enough. Provided there is appropriate disclosure of the potential control effects of a fundraising, and that the terms of the raising are arms length in nature, then the fact that an underwriter may acquire a controlling position should not be contrary to the Eggleston Principle of equality of opportunity. In effect, the control consequence is a quid pro quo for the commercial risk assumed by the underwriter, which can be all the more compelling when the issuer is in a genuine position of financial distress.
However, where there is a rights issue but no underwriting, and the shareholder does not, as a result, assume the commercial risk of the issuance, the Panel is likely to very closely examine the structure of the issue to ensure compliance with item 10 of section 611, as the decision of the Takeovers Panel in Re QR Sciences Limited demonstrates.
The QRSciences rights issue
QRSciences, an unlisted public company, had two major shareholders, QRSciences Holdings and SecQR. QRSciences Holdings, a listed company, held 51 per cent of the ordinary shares in QRSciences and had a $5 million convertible debt owed to it by QRSciences. SecQR was the other major shareholder of QRSciences, with a shareholding of 23 per cent of the company.
In September 2003, QRSciences sought to raise about $5 million through a non-renounceable rights issue. The primary purpose of the rights issue was to raise funds to repay the majority of the $5 million convertible debt to QRSciences Holdings. Had QRSciences Holdings wished to convert the debt to equity, it would have required the majority approval of non-associated shareholders to do so, under the exemption in item 7 of section 611. If SecQR opposed conversion, that was unlikely to be achievable.
The rights issue was made on a two-for-three basis. If all QRSciences shareholders exercised their full entitlement to the new shares, the rights issue would have raised almost $10 million. However, the rights issue was capped at about $5 million, so that the number of new shares issued under the offer was limited to about one third of the issued share capital of the company at the time of the offer.
In the event of an oversubscription for the new shares, a 'scale-back' mechanism was activated whereby the number of new shares received by each applicant would be proportionately reduced, so that the aggregate number of shares applied for equalled the maximum shares to be issued. The scale-back mechanism altered the proportionality of the rights issue so that the number of shares each applicant would not receive (as a result of the uniform reduction) was proportional, rather than the number of shares each applicant received being proportional. Importantly, the way the scale back worked meant that it was impossible for any shareholder to determine in advance the number of shares they must apply for, in order to maintain their desired voting interest in the issuer.
QRSciences, in the offer information statement (OIS) accompanying the rights issue, acknowledged that it could not stipulate with any certainty the number of new shares a participating shareholder would ultimately be issued other than that, under the terms of the offer, shareholders who subscribed for their full entitlement of new shares would receive between one and two new shares for every three existing shares.
The Panel application
SecQR made an application to the Panel for a declaration of unacceptable circumstances alleging that:
- the rights issue did not comply with any of the exemptions to section 606, particularly item 10, and so contravened section 606. The rights issue was not exempt under item 10 because it allowed QRSciences Holdings to disproportionately increase its shareholding in QRSciences
The Panel decision
The Panel was highly critical of the structure of the rights issue and the content of the OIS. However, it was not required to make a declaration of unacceptable circumstances because QRSciences undertook to withdraw the rights issue.
The Panel found that the rights issue did not comply with the item 10 exemption—the only exemption applicable to the rights issue—because it did not offer shareholders the same percentage of securities to be issued as the percentage they held before the rights issue. In other words, the rights issue was not a proportional offer to shareholders.
The Panel clearly indicated that the section 611 exemptions should be strictly interpreted:
'We consider that the exceptions to section 606 in section 611 can only properly be relied on where conduct clearly falls within their terms … the exceptions in section 611 and 655A are a definitive statement of the gateways through which transactions may pass without contravening section 606'.
The Panel gave this advice to parties engaging in transactions that do not comply with the requirements of a section 611 exemption:
'If a party believes that proposed conduct complies with the policy of Chapter 6 set out in section 602 but would not satisfy the technical requirements of an exemption in section 611, the proper course is for that party to seek relevant modifications from the Australian Securities and Investments Commission'.
In addition to its findings regarding the application of section 611, the Panel also held that the fact shareholders were unable to predict the number of shares they would need to apply for to preserve their proportionate holding was unacceptable.
The Panel found other deficiencies in the OIS, both in terms of its failure to disclose the intentions of QRSciences Holdings in relation to the rights issue, and its failure to explain the effect of the rights issue on the convertible debt.
The Panel held that, in the particular circumstances, the OIS should have contained a clear statement of the intention and ability of QRSciences Holdings to subscribe for shares under the rights issue. However, the Panel clearly restricted this finding to the facts of the application saying:
'Generally the issuer of an OIS is not required to comment on the intentions of substantial shareholders unless those intentions are specifically known to the issuer'.
The Panel also found that the OIS should have contained a clear explanation of the current position of the convertible debt and the effect the rights issue would have on the terms of the debt, with particular reference to the conversion price of the issue compared to the conversion price under the debt.
Implications of the Panel's decision
The facts in QRSciences made for a particularly compelling argument of unacceptable circumstances. To that extent, the Panel's decision was unsurprising. However, there are potentially a number of more general implications of the Panel's decision for companies seeking to raise additional capital from their shareholders.
First, parties must be mindful of the fact that many transactions of a capital raising nature may also fall within the scope of Chapter 6, particularly where there is a controlling or substantial shareholder that is either near or above the 20 per cent takeover threshold. Careful consideration needs to be given in such cases to the availability of the relevant exemption in section 611, be it item 10 (rights issues), item 11 (dividend reinvestment), item 12 (IPO fundraising) or item 13 (underwriting). If there is not strict compliance, appropriate relief should be sought from ASIC. If that is not available, a shareholder resolution under item 7 may be required.
Second, from a disclosure perspective, the Panel clearly stated that such transactions must comply with both the regulatory requirements associated with the capital raising and those associated with Chapter 6 of the Corporations Act. The Panel said:
'… we consider that where capital raising transactions also constitute circumstances raising issues under Chapter 6, it may lead to unacceptable circumstances if the offer document does not comply with the information principles in section 602 as well as complying with the disclosure obligations directly applicable to the relevant capital raising transaction (for example under Chapter 6D or Part 7.9.)'.
This may be particularly important if a shareholder could move to a position of control as a result of underwriting the issue. In those circumstances, information on the shareholder's source of finance for the underwriting, and intentions on matters such as dividend policy and capital management, may be acutely relevant to the issuer's existing shareholders. Because the underwriter's knowledge is relevant in deciding what must be included in a prospectus or product disclosure statement (as opposed to an OIS), in these cases the issuer may have a positive obligation of disclosure under the Re QR Sciences Limited principle.
Third, particular attention needs to be paid to offer structure. Chapter 6 principles may again be attracted, in addition to the disclosure document requirements of Chapter 6D. In the event of under-subscription, the issuer can ensure that the desired amount is raised by either procuring the services of an underwriter to mop up any unexercised rights, or by giving all shareholders the option to participate proportionately in any resulting shortfall. Companies wishing to limit the funds raised under a pro rata rights issue should not adopt a scale back mechanism like the one utilised by QRSciences, of which the Panel was so highly critical, but should adopt a scale back that results in a reduction of subscriptions that is proportional to shareholders' existing holdings. All of these capital raising structures fall within the scope of the item 10 exemption and, provided the structure of the transaction and the surrounding circumstances do not suggest that the transaction is designed to circumvent Chapter 6, are acceptable means through which companies can raise discrete amounts through a rights issue.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.