UK: Updating the City Code: Dual Listed Company Transactions and Frustrating Action

While mergers and acquisitions may be off the agenda for most companies at the moment, the Takeover Panel continues to amend and update the Code in response to changing business practices. Following public consultation, the Code Committee has issued Response Statement 11 (27th August 2002) which:

1. amends the definition of an ‘offer’ in the Code to include Dual Listed Company Transactions; and
2. clarifies the nature of certain ‘frustrating actions’ contained in Rule 21.2.

• Applies to any listed or unlisted plc resident in the UK which is the subject of a ‘change of control’ (generally a merger or takeover offer)
• Change of control is defined as a holding of 30% or more of shares carrying voting rights in a company
• The Code is designed principally to ensure the fair and equal treatment of all shareholders in relation to take-overs (General Principles)
• The Code does not have the force of law but regulatory bodies have held that all parties should adhere to the Code as it is in accordance with high business standards.
• The Code applies to all parties involved in such transactions including professional advisors.

A DLC structure involves two listed companies combining their operations into a single economic unit, while retaining their separate legal identity and existing Stock Exchange listings in their own countries. Unlike a conventional merger or takeover involving two companies, under a DLC arrangement neither set of shareholders need dispose of their shareholding and the companies need not transfer assets between each other. Although the two companies have a unified management structure and operate as one company, they are still separately owned. This ‘virtual merger’ of the two companies is held in place by contractual obligations. The aim of the DLC is that investors should treat the shares of each company as if they were interchangeable. Both sets of shareholders have a share in the risks and rewards of the combined enterprise.

Both companies’ shareholders in a DLC structure usually elect a common board of directors to govern the two companies. The companies form a ‘joint electorate’ by changing their constitutions to allow shareholders to vote at each other’s meetings. Where the companies have a different numbers of shareholders, special voting shares can be issued so that the company with the largest number of shareholders does not dominate the entity.

Dividend payments or repayments of capital are usually paid out equally to each of the companies’ shareholders. The DLC contract will provide for ‘equalisation arrangements’ that allow each company to effectively underwrite the other’s agreed dividend payment by arranging to make up the difference should the other company not have sufficient profits itself.

Examples of DLC: Reed Elsevier; BHP Billiton

Benefits of a DLC:

• Economies of scale and merger synergies without the need for a disposal or transfer of shares
• Tax advantages: no disposal of shares so no CGT or Stamp Duty to pay
• No (or minimal loss) of national identity and corporate status
• Avoids investor ‘flowback’ in cross-border mergers, where shareholders sell the shares in the post-merger entity, as they are now foreign scrip, for reasons such as portfolio investment restrictions. This can cause the share price of the new entity to sharply fall.

Disadvantages: The difficulties of determining ‘equalisation’ between the two companies; divergent share prices; the complexity of the structure.

The Panel previously regarded DLC transactions as falling outside the scope of the City Code. It was felt that a DLC transaction did not involve a ‘change of control’ in a company as no person had acquired 30% or more of a company’s shares carrying voting rights through it. Also shareholders have no choice as to whether they should retain or dispose of their shares as they would in a conventional offer. In short, a DLC transaction was regarded as a dilution of shareholders’ rights rather than a change of control.

However it is now felt that although technically there is no change of control in a DLC transaction, DLCs are in reality a means of effecting a merger between two companies which would otherwise be structured as a Code regulated offer. Therefore shareholders should be entitled to the protections given by the Code which is designed to ensure that all shareholders are treated equally and fairly and that there is an orderly framework for the transaction.

The definition of offer therefore now reads:

The Code uses the term ‘holding’ instead of ‘listed’ to prevent confusion as the Code itself applies to both listed and unlisted companies. In practice, though, only listed companies are usually involved in DLCs.

So from now on the Code’s protection for shareholders will apply to DLC transactions as it would for any Code offer. A firm announcement of the DLC transaction will trigger the Code timetable (Rule 2.5), although parts of the timetable will be applied flexibly to reflect the fact that this is not an offer for shares.

DLCs involving listed companies will also continue to be regulated by the UKLA Listing Rules.

2. Frustrating Actions

One of the fundamental objectives of the Code is to prevent boards of companies from taking any action that would frustrate an offer against the wishes of shareholders. This is encapsulated in General Principle 7 and Rule 21 of the Code. Rule 21.1 seeks to prevent the Board of an offeree company from using ‘poison pill tactics’ to thwart a hostile bid (eg. by allotting extra shares to shareholders unfavourable to the offer or disposing of those company assets which the offeror is keen on obtaining). The Rule therefore requires the offeree to either obtain the consent of its shareholders for such actions or in effect obtain the offeror’s consent to them.

Rule 21.2, on the other hand, deals with the situation where the offeror and the offeree seek to frustrate any potential or actual offers made by a third party. In other words, rather than the offeree company seeking to prevent the offer going ahead, it instead tries to make sure a particular offer succeeds and prevent any others from making a successful bid. R21.2 governs arrangements made between an offeror and an offeree in a Code transaction. In particular, it limits the amounts that the offeree can pay as an inducement fee to a bidder. Inducement fees (also known as break fees) are arrangements where one party (typically the offeree in an agreed takeover situation) agrees to indemnify another party (i.e. the offeror) against the other party’s costs in relation to the offer where the offer fails to proceed for certain specified reasons. An example of such reason might be a recommendation by the offeree company board in favour of a high rival bid.

The effect of the inducement fee is therefore to lessen the costs and risks to the offeror of a failed bid and encourage its bid. As this would be prejudicial to other offers, Rule 21.2 limits inducement fees to no more than 1% of the value of the offer made. The offeree board and its financial advisors must also confirm to the Panel that they believe it to be in the best interests of the shareholders and the fee must be fully disclosed. The notes to the Rule also state that it applies in the same way to other ‘favourable arrangements’ between the offeror and offeree.

Until recently it has not been entirely clear what these ‘favourable arrangements’ constituted. The Code committee has now amended Rule 21.2 to clarify the scope of these other ‘arrangements’. The new notes to R21.1 state that they include:

Under the amended rule, then, the 1% limit will apply not just to inducement fees but also to these other arrangements, even if they are of an ordinary commercial nature. The consultation paper notes that the amended Rule could cover a situation where two companies enter into a joint commercial venture which allows for company B to acquire company A’s interest in the joint venture at a discount in the event of a change of control in company A. The effect of R21.2 would be to limit the discount that company A could offer to B in the same way as with inducement fees. The new Rule 21.2, therefore both clarifies the nature of the arrangements it covers and widens its scope.

These recent amendments to the City Code reflect the flexible approach the Panel takes to updating and adjusting its rules on takeovers and mergers. The changes, which bring DLC transactions into the remit of the Panel’s supervision and clarify the Rules on frustrating actions represent the Panel’s ongoing concern for the fair and equal treatment of all shareholders during a change of control in a company.

Both these changes came into effect on the 27^th August 2002.