The recent decision of the Supreme Court of New South Wales in Re Capel Finance Ltd [2005] NSWSC 286 serves as a salient reminder to those involved in the preparation of members’ schemes of arrangement that the discretion of the court under section 411(1) of the Corporations Act is real—and not to be taken lightly.
Background
The applicant in that case applied for orders for the convening of a meeting of its shareholders to consider a proposed arrangement between the company and its shareholders.
The proposed arrangement involved a specific capital reduction through the cancellation of all existing ordinary shares other than those held by two nominated members. The ordinary shares other than the excluded shares of the two named shareholders were referred to as the ‘scheme shares’ and the holders of those shares as the ‘scheme shareholders’.
It was envisaged that, before the scheme became binding, scheme shareholders would be able to deliver election forms to the company which would determine how the part of the liberated capital referrable to the particular holder’s shares would be applied.
The three possible elections were:
- the sum referrable to the particular holder’s shares would be applied in paying up new ‘redeemable preference shares’ in the company, to be issued to the holder on the basis of one new share for each cancelled share, or
- the sum would be paid to the holder in cash, or
- the sum would be applied partly in one of these ways and partly in the other.
In the case of a failure to elect, the default position was the allocation of new shares.
Justice Barrett refused to make an order for the convening of the meeting under section 411(1) for the proposed scheme as it then stood. His Honour had three major objections to the scheme materials.
Inadequate disclosure of cash position
Justice Barrett noted that, in respect of the three elections available to shareholders subject to the capital reduction, if all scheme shareholders elected for cash, the company would be required to pay out about $1.2 million. The proposed explanatory statement stated that if this maximum cash outlay became payable, it would be funded from the company’s ‘cash resources’. However, there was no further explanation of the source of the funds.
While acknowledging the unlikelihood that all scheme shareholders would elect to receive cash, Justice Barrett’s opinion was that the explanatory statement for the scheme needed to be amplified to clearly identify the arrangements in place to ensure the availability of the maximum cash requirement. He drew an analogy with the disclosure requirements of a company making a takeover bid, which must make detailed disclosures about the availability and source of necessary cash consideration under section 636(1)(f) of the Corporations Act. He concluded that a company embarking upon an analogous transaction in relation to shares in itself should be required to make the same disclosure.
Improper classification of new shares as ‘redeemable preference shares’
The new shares that were to be made available to members in substitution for their scheme shares were described in the scheme materials as ‘redeemable preference shares’. Several flaws in the terms of issue of these shares were highlighted by Justice Barrett.
First, the terms stated that the holders of the redeemable preference shares ‘can redeem’ those shares. Justice Barrett pointed out that this was a basic misconception, as it is the company that redeems a redeemable share—the company literally buys the share back from the holder. He stated that if, as was the case here, the redemption is at the shareholder’s option, the terms of issue must be clearly framed as such.
Second, and fundamentally, a share issued on the terms set out in the scheme materials would not actually be a redeemable preference share. The terms explicitly stated that the shares would not be entitled to receive any priority as against the holders of any existing or future classes of shares in relation to repayment of capital or during winding up, that no right to participate in profits was attached to the shares, and that the redeemable preference shareholders would not have any right to vote or attend and speak at meetings.
A share issued on these terms would not, in Justice Barrett’s view, satisfy the definition of a redeemable preference share as outlined in section 9 of the Corporations Act, which requires the shares to have a preference or priority over ordinary or common stock. The terms failed to attach any preferential right or priority to the supposed ‘redeemable preference shares’.
It should be noted that Justice Barrett rejected the suggestion that the right of the holder to require redemption by the company made the shares ‘preference’ shares. Although this made the share redeemable, the characteristics that make a share a redeemable share are distinct from the characteristics that make it a preference share.
Disclosure of risks and uncertainties relating to redemption of shares
If the shares were redeemable preference shares, section 254K(b) of the Corporations Act would preclude redemption, except out of profits or the proceeds of a new issue of shares made for the purposes of redemption. The proposed explanatory statement made only a brief comment with respect to this rule, stating that ‘there is a risk that there may be no available profits when a scheme shareholder elects to redeem any Capel Finance Preference Share that they hold’.
Justice Barrett pointed out that this statement was made in a context where the company stated that it is not carrying on business, had no plan to commence any new business, did not have any past years’ profits to which it might resort for the purposes of redemption, and had a balance sheet with accumulated losses of more than $48 million. With regard to these factors, it seemed that the prospect of profits being able to cover the redemption of redeemable preference shares in the foreseeable future was highly doubtful.
Justice Barrett stated that shareholders invited to take up redeemable preference shares in a context such as this, where the profits to cover redemption are not presently available and may never become available, deserve a proper explanation of the consequences of their taking those shares. Accordingly, Justice Barrett found the explanatory statement to be defective in fully explaining the risks and uncertainties attaching to the acceptance of the redeemable preference shares.
Conclusion
The matters on which Justice Barrett based his decision were to be the subject of attention by the company with a view to amendment. It will be interesting to see whether the applicant is able to put forward a revised proposal that meets with his Honour’s approval.
Although the decision is fact-specific, it does evidence the important role that the court plays in exercising a genuinely supervisory jurisdiction over schemes of arrangement. It also demonstrates the continuing trend towards functional equivalence between the scheme and takeover provisions of the Corporations Act, particularly in the field of disclosure.
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.
