UK: Public to Private Takeovers - solutions to the legal problems

Last Updated: 15 December 1998
Public to Private Takeovers - solutions to the legal problems

1 Break-up fees: how they can be given

- Introduction

It is becoming increasingly common for potential bidders at the outset of a proposed recommended takeover to seek fees from a potential target company, to be paid if the proposed transaction is not completed. These fees have long been a feature of the US market but have (with a few limited exceptions) only relatively recently been used in the UK. The break-up fee might, for example, be payable by the target company to the bidder if a higher third party offer is announced (and not matched by the first bidder), if the target board withdraws its recommendation, or if the offer fails to become unconditional for other specified reasons.

Break-up fees can be particularly appropriate in public to private transactions to provide a degree of comfort in relation to the risks and liabilities associated with a public transaction. Great care, however, needs to be taken by the boards of both the bidder and the target in structuring a break-up fee so as to ensure that it can lawfully be paid.

- Fiduciary duties

The directors of the target cannot agree to a break-up fee which is not agreed in good faith and in the interests of the target, its shareholders and (to a limited extent) employees. Further, they cannot "fetter their discretion". In practice, the decision usually comes down to balancing the desirability of inducing the MBO team and their bidding vehicle to make an offer, against the costs to the target and the likelihood of blocking (or dissuading) a higher third party bidder.

- Financial assistance

A break-up fee potentially falls foul of the Companies Act restrictions on a company giving financial assistance for the acquisition of its shares. Any obligation on the part of the target which contravenes section 151 CA85 would be unenforceable by the potential bidder and would also constitute a criminal offence on the part of the target and its officers.

In summary, a break-up fee will not constitute unlawful financial assistance if it does not result in a material diminution of the target's net assets. One-half to one percent of the net assets (calculated by reference to the proposed offer price, not book values as shown in the accounts) will be material.

For these purposes, the net asset value should be a reasonable and informed estimate by the directors of the target of its net asset value. As a rule of thumb, this can be most easily ascertained by attributing the proposed offer price to a hypothetical sale of all the business and assets of the target (including its investments in its subsidiaries and in other companies), less all liabilities (including debt, provided for liabilities and the target directors' estimate of the tax payable by the target on the hypothetical proceeds of sale).

It is important, however, that the break-up fee is not explicitly or implicitly structured in the form of an indemnity or a gift. Words like "reimbursement of fees" should be avoided as being too close to an indemnity, the parties should not use the likely fees as a starting point for the negotiations and the undertaking should expressly make reference to the purpose of the fee (an inducement to the potential bidder) so as to avoid any suggestion of a gratuity.

- Takeover Code

Rule 21 ("Restrictions on Frustrating Action") imposes limitations on the ability of a potential target amongst other things, to enter into contracts outside the ordinary course of business, but is capable of waiver by the Takeover Panel with the consent of the target. It is our experience that the Panel generally permit break-up fees of the type and extent discussed in this note.

- Listing Rules

The size of the proposed fee relative to the target must be analysed - for targets with low profitability in relation to their assets, the agreement to pay a fee could constitute a Super Class 1 transaction. Any break-up fee should be carefully structured so that no director or former director of the target or any of its subsidiaries (or an "associated party" of any such person) is a party to the relevant agreement - Chapter 11 "Transactions with related parties".

2 How to do due diligence and get information

- Information to competing bidders and to potential financiers: Rule 20.2 and 20.3

Put simply, under Rule 20.2, any non-public information generated by the target and provided to the management team/bidding vehicle/equity house must, on request, be provided by the target to other bona fide competing bidders.

Rule 20.3 is similar, but in practice very different - any information generated by the MBO team (or the equity house) and provided to potential financiers must be provided to the target's independent directors if they so request.

It is thus very important (and in practice surprisingly difficult) to manage the information flow, due diligence process and preparation of the MBO team's business plan so that Rule 20.2 type information can be easily distinguished.

The scope for avoiding providing the independent directors with the MBO team's projections and analyses in accordance with Rule 20.3 is more limited, but we have seen a number of techniques used.

- Housekeeping

In public to private offers, information typically flows to the bidding team from a wide range of sources - after all, the key members of the bidding team are usually on the target's board. If at all possible, ensure that all information is passed via the target's lawyers or financial advisers. Very great care needs to be taken to ensure that, at no time, can the MBO team be accused of disclosing confidential information without authority (remember the Co-op bid!). Ensure that the MBO team's activities (in terms of time spent and information disclosed) are authorised by waiver of the provisions of their service agreements.

- "Widening the circle" of knowledge: Rule 4.3

The Takeover Panel sets strict limits on the numbers of third parties who can be contacted whilst the proposed transaction remains non-public. For this purpose third parties include banks and shareholders who may be willing to give the irrevocable undertakings, but exclude the private equity house, the directors of the target, the MBO team and advisers. The Takeover Panel must be consulted before private shareholders are approached. In the past, the Takeover Panel has permitted up to five or six different parties in total to be approached. This is highly restrictive where a deal leader will want to obtain financing on competitive terms and have a high degree of certainty in relation to acceptance levels.

- Negotiations and channels of communication

Confusion will ensue unless, at an early stage of contact, it is clear to all parties exactly who is speaking for the target and who for the MBO team/the bidding vehicle. A committee of the board, comprising the independent directors, should be set up promptly. Great care needs to be taken to avoid a member of the MBO team emerging as the spokesman, negotiator or conduit of information for the target.

3 Satisfying the Banks' security requirements: Getting to 100 per cent

- Importance in leveraged transactions

Where a bid relies on bank finance secured on the assets of the target group, the debt provider will be reluctant to permit the offer to be declared unconditional unless it is reasonably certain that the bidding vehicle will be entitled compulsorily to acquire any shares not assented to the offer (under section 429 et sec CA85 requiring, essentially, a 90 per cent acceptance threshold to be met). This is because the security for the acquisition finance (as opposed to refinancing existing target debt) can only be given by the target group once the financial assistance "whitewash" procedure has been completed - a process requiring the passing of two special resolutions of the target, which necessitate 75 per cent majorities.

Worse, both the "privatisation" and the "whitewash" resolutions can be challenged in Court by objectors holding 5 per cent and 10 per cent, respectively, of the issued shares of any class. Even if a challenge were ultimately unsuccessful, there would be an inevitable delay in the target group giving the bank security. Note: in "public to private" transactions, the usual arrangements with members of the MBO team often make it more difficult to satisfy the 90 per cent requirement of entitling the bidder compulsorily to acquire non-assented shares (see below).

- Irrevocable undertakings: Rule 4.3

Although obtaining irrevocable undertakings from substantial shareholders of the target will provide considerable comfort that the 90 per cent threshold will be reached, note the limits the Takeover Panel is likely to set on the numbers who may be approached (Rule 4.3 of the Takeover Code and paragraph 2 above). It is possible to include warranties in irrevocable undertakings, although the MBO team will almost invariably be entering into separate agreements with the private equity house - an appropriate place for detailed, commercial and "investment agreement" type warranties and indemnities.

- Purchases after offer made: conditionality

Purchases of target shares (either on- or off- market and whether conditional or not) before the offer is formally made (ie. the offer document is posted) will not count towards the 90 per cent threshold for compulsory acquisition purposes. Purchases after the offer documents have been dispatched will count, and can be a useful way of speeding up, and making more certain, the process of reaching 90 per cent.

In practice, such purchases will need to be conditional on the offer becoming wholly unconditional; the bidding vehicle and the MBO team are unlikely to be able to afford, nor want to own, the shares if the bid does not succeed. Rule 4.3 does not apply to approaches to shareholders after the offer has been made. The advantage of irrevocable undertakings is that they can be obtained before an offer is made and acceptances made pursuant to them will count towards the 90 per cent acceptance condition.

- Schemes of arrangement

In some public to private transactions, a bid by way of a court approved scheme of arrangements under section 425 CA85 should be carefully considered:

Advantages:

  • lower threshold (where there is no active opposition): 75 per cent of those who vote (90 per cent of all shareholders under an offer) from more than 50 per cent by number of shareholders voting.
  • if approved by the requisite shareholder vote and by the Court, the acquisition binds all shareholders, not just those who vote in favour.
  • no stamp duty (although this is out-weighed in part by the extra cost of the Court process) under most circumstances.
  • suitable where the bank or other financier is adamant that the finance will not be provided unless 90/100 per cent control is obtained.

Disadvantages:

  • in practice, no irrevocable undertakings can be obtained without negating the voting threshold advantages of a scheme. Certainty is therefore reduced.
  • more complicated, at least to those unfamiliar with schemes.
  • the process is controlled by the target (although this can to some extent be mitigated by agreement between the parties).
  • can take longer (much less so than is perceived), but can be quicker to achieve 100 per cent. control.
  • ultimately subject to the sanction of the High Court which gives objectors a forum in which to complain.

4 Different classes of share: overcoming the problems

Where the target has more than one class of share, the Takeover Code requires separate offers to be made for each. For each class, the compulsory acquisition procedure will be available only if 90 per cent acceptances are received for that class. Although the Takeover Code does not require a bidder to offer for non-equity shares (principally, for these purposes, non-convertible preference shares), in a public to private transaction, leaving a class of shares of shares in the hands of third parties is seldom a viable option, if only because of the necessity to re-register the target as a private company and to "whitewash" the giving of financial assistance.

A major concern in such circumstances is that a stake in the preference shares - of a relatively small size and of little value in relation to the value of the target and its ordinary shares - will entitle a party with a small economic stake to hold the bidder to ransom and to demand a disproportionately high price to be paid for preference shares. Indeed, there are several well-known investors who acquire preference shares largely with this in mind.

Depending on the particular rights of the preference shares concerned and the distributable reserve position of the target, it may be possible for the class of share in question to be cancelled as part of a Court-approved reduction with the target paying preference shareholders no more than they would be entitled to on a solvent winding up.

5 Enabling the MBO Team to invest in the Bidding Vehicle

- Effect on the 90 per cent compulsory acquisition threshold

Almost invariably members of the MBO team will be investing in shares in the bidding vehicle whilst the consideration under the offer will be cash. The compulsory acquisition procedure is not open to bidders where the terms of the offer are not the same for all the shares of the same class. There are technical methods for ensuring that the MBO team's shareholding in the target is treated separately so that compulsory acquisition is a possibility in relation to target shares held by the outside shareholders. (This can be achieved, for example, by the grant to the bidding vehicle of voting rights over the MBO team's shares in the target). However, to the extent that they are so treated, inevitably the acquisition of their shares will not count towards the 90 per cent threshold.

- "Special arrangements": Rule 16

Treating the MBO team differently will also contravene a general principle (and specific rule) of the Takeover Code - all shareholders of a particular class must be treated similarly by the bidder (General Principle 1 and Rule 16). In practice the Takeover Panel will consent to separate treatment of, and special arrangements with, the MBO team in relation to their shares provided that:

  • the independent financial adviser to the target states in the offer document that it considers the arrangements to be fair and reasonable;
  • (sometimes, although less so recently) independent target shareholders' approval is obtained at an EGM;
  • the arrangements, whilst providing the MBO team with the potential for greater benefits than other shareholders (who received only cash), expose the MBO team to the risks associated with their investment in the bidding vehicle. (eg. there can be no exit price guaranteed for the members of the MBO team);
  • the MBO team is not offered consideration of a higher value for their shares than other shareholders. This can usually be justified by reference to the price being paid (in cash) by the private equity house subscribing for, shares in the bidding vehicle.

- Rollover relief for the MBO team

At its most simple, the special arrangement would constitute an agreement by members of the MBO team to invest some/all of the cash received by them on acceptance of the offer by way of subscription for bidding vehicle shares. This would result in their incurring a CGT charge on any gain on sale to the bidding vehicle of their target shares at a time when the proceeds (or some of them) had been re-invested in the bidding vehicle's equity. Typically therefore, the acquisition by the bidding vehicle of their target shares is structured as a share for share transaction separate from the offer, but conditional on the offer becoming unconditional in all respects. This is capable of providing rollover relief for the MBO team.

The special arrangements will need to be fully explained to the target's financial adviser, and to the Takeover Panel, and clearly summarised in the offer document. There is every advantage in keeping the arrangement as straightforward and easily understood as possible.

- Permission to deal

Usually, members of the MBO team will be subject to the Stock Exchange Model Takeover Code for transactions in securities by directors, and any agreement in relation to their shares with the bidding vehicle may technically constitute a prohibited dealing. In such circumstances, clearance from the Stock Exchange should be sought.

6 Dealing with technical Takeover Code Issues

- Cash confirmation - Rule 24.7

Rule 24.7 places an obligation on the bidder's financial adviser to state in the offer document that the bidder has sufficient resources available to it to satisfy acceptance of the offer. Since, in a public to private transaction, the bidder is usually newly incorporated with no assets at all at the time the offer document is dispatched, the financial adviser will be relying on the commitments by the bank and the private equity house to subscribe/lend.

Should the cash confirmation statement on the part of the bidder's financial adviser prove to have been unreasonably given, it could ultimately be required by the Takeover Panel to advance the monies itself. The finance and investment documents are always very carefully examined by the financial adviser and its advisers.

Conditions to funding

The bidding vehicle's financial advisers will therefore require that, immediately upon the target shareholders' being entitled to receive their consideration (up to 14 days after the offer is wholly unconditional), the entirety of the debt and equity finance is available to the bidding vehicle. In practice, this means that:

  • the management's equity is subscribed upon the offer becoming wholly unconditional;
  • the private equity house subscriptions can be conditional only as above and on management's subscriptions having been made;
  • for a certain funds period, mezzanine and senior acquisition debt finance can be conditional only as above, no serious ("black-hole") insolvency event, and all share capital having been subscribed.

Almost invariably, agreements in relation to the finance for the offer have to be in final form and executed before the offer is announced.

Conditional confirmation

In exceptional circumstances, the Takeover Panel will consent to the Rule 24.7 cash confirmation being expressed to be subject to the satisfaction of specified circumstances. This is rare, and is typically strongly resisted by the target's independent directors and advisers. In any case, given the greater number of "public to private" transactions recently, it is becoming harder to justify by reference to exceptional circumstances.

- Rule 3: target adviser

Note that the Takeover Code stresses that, in an MBO takeover transaction, the adviser to the target and the directors not participating in the bidding process must be truly independent. It is important to ensure that the Rule 3 adviser is appointed, properly briefed and becomes involved at the earliest opportunity.

- Rule 4: dealings; insider dealing

The Takeover Code sets out very detailed restrictions on the ability of the bidder, and parties linked with it, to deal in the target's shares. As with the disclosure requirements of the Takeover Code, this is a most problematic area, as on a strict reading of the Rule, the restrictions apply to the securities division of banking groups of which the private equity house forms part. As before, the answer is to consult the Takeover Panel who, if presented a persuasive case, will be prepared to apply the Rules flexibly.

Very great care needs also to be taken to avoid breach of the insider dealing legislation, since at most relevant times in a public transaction, the bidding team and vehicle will be in possession of price sensitive information, which relates not only to the bid itself, but also to the financial and business condition of the target.

- Rule 19.2: responsibility for offer document

The Takeover Code requires that the directors of the bidder should take responsibility for all the information contained in documents issued by or on behalf of the bidder and, where the bidder is controlled by another party, also by the directors of the controlling individual or the directors of the ultimate holding company. In public to private transactions, the question arises as to the extent to which the bidding vehicle's financial backers will be required to take responsibility. Where the backers are banks and/or private equity arms of banking groups, the question becomes even more acute.

In such circumstances it is important at an early stage to consult the Takeover Panel whose response will vary depending on the particular circumstances of the transaction and its financing. It would be unusual for debt providers to be drawn into the responsibility net and often it is possible to limit the private equity house directors' responsibility to that information relating to the institution and themselves.

- Rule 24.2 and 24.3: information about the bidder

The Takeover Code requires inclusion in the offer document of a great deal of information in relation to the bidder and parties associated with the bidder (for example a summary of three years' accounts, material contracts, holdings and dealings in target shares etc). As with Rule 19.1, the Takeover Code extends this disclosure requirement to the ultimate owners and controllers of the bidder.

Clearly there will be very little to disclose in relation to the newly incorporated bidder, but the Takeover Panel needs to be consulted as to how much information must be given in relation to the financial backers of the transaction. In the past, the Takeover Panel has permitted a relatively low level of disclosure of financial and other information about the backers of an MBO offer. By contrast, the Takeover Panel is likely to require full disclosure of holdings of, and dealings in, target shares by the financiers of the offer (Rule 24.3).

This article was first published by Marcfarlanes in December 1998.

This note is believed to be correct at the time of publication. It is not, however, intended to be exhaustive nor to provide legal advice in relation to any particular situation and should not be acted or relied upon without taking specific advice.

If you would like any further information or specific advice, please contact Charles Martin or Tim Oldridge.

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