Company Law Review Act - Financial Assistance

By Leigh Brown

1. Introduction

1.1 Repealed section 205(1) of the Corporations Law prohibited the giving of 'financial assistance' by a company for the purchase of its own shares (or units in shares) or those of its holding company unless the company complied with an extensive shareholder-approval procedure. It also prohibited a company from acquiring, or lending money on the security of, its own shares (or units of shares) or those of its holding company. The provisions of this section was prominent on corporate lawyers' checklists for advising their clients, largely because of the serious consequences which may have resulted if the prohibitions were contravened.

1.2 For example, officers of the company involved were guilty of an offence (section 205(5), section 1311(1)) and, if convicted, could be ordered to pay compensation (section 205(6)) and, if convicted, could be ordered to pay compensation (section 205(b)) and a contract under which the company contravened the prohibition was voidable at the option of the company (section 206(1)(a), 206(2)).

1.3 Amendments to the Corporations Law under the Company Law Review Act 1998 ('CLRA') include significant changes to the 'financial assistance' provisions which:

• remove a potentially major technical obstacle to many normal commercial transactions; and
• streamline the shareholder approval process.

1.4 The introduction of a 'no material prejudice' approach under section 260A reduces the difficulties that section 205(1) caused for ordinary commercial transactions. As stated in the Company Law Review Bill's Explanatory Memorandum, for transactions which do not involve material prejudice, the new rules under section 260A make it unnecessary to decide whether the transaction really involves the giving of financial assistance (no matter how minimal). This is because the real focus has become whether or not the transaction involves material prejudice.

2. Self acquisition and control of shares

Prohibition on direct self-acquisitions and taking security (sections 259A, 259B)

2.1 The prohibitions under the repealed section 205(1)(b) and (c) against a company:

• acquiring its own shares (or units of its shares); or
• lending money on the security of those shares,

have been retained in sections 259A and 259B.

Extension of prohibition to controlling company

2.2 However, the prohibition against a company taking security over shares (or units of shares) has been extended to shares (or units of shares) in a company that controls it (section 259B(1)).

2.3 Section 259E(1) provides that a company controls an entity if the company has the capacity to determine the outcome of decisions about the entity's financial and operating policies.

2.4 In determining whether a company has this capacity:

• the practical influence the company can exert, rather than the rights it can enforce, is the issue to be addressed; and
• any practice or pattern of behaviour affecting the entity's financial or operating policies is to be taken into account (even if it involves a breach of an agreement or a breach of trust) (section 259E(2)).

2.5 Control does not need to be actively exercised. Under section 259E(2)(a), what is relevant is the practical influence the company can assert.

Exceptions to the prohibition

2.6 Many of the previous exceptions to the prohibitions against direct self-acquisitions and taking security have been retained with amendments, including:

• court orders: the acquisition of a share or unit of a share under a court order (section 259A(c));
• acquisitions for no consideration: the acquisition of an interest (other than a legal interest) in fully paid shares in the company if no consideration is given for the acquisition by the company or an entity it controls (section 259A(b));
• buy-backs: the acquisition of a share (or unit of a share) under a buy back under section 257A (section 259A(a));
• employee share schemes: a company taking security over shares in itself under an employee share scheme that has been approved by:
• - resolution passed at a general meeting of the company;
• - if the company is a subsidiary of a listed Australian company, a resolution passed a general meeting of that listed Australian company; and
• - if the above paragraph does not apply but the company has a holding company that is an Australian company and that is not itself a subsidiary of an Australian company, a resolution passed at a general meeting of that holding company (section 259B(2);
• financial institutions: a company taking security over shares or units of shares in itself or in a company which controls it if:
• - the company's ordinary business includes 'providing finance' and
• - the security is taken in the ordinary course of that business and on ordinary commercial terms (section 259B(3)).

'Providing finance' is defined in section 9 to mean lending money, giving guarantees or security for loans made by someone else, or drawing, accepting, endorsing, negotiating or discounting a bill of exchange, cheque, payment order or promissory note so that someone can obtain funds.

12 month limit on holding certain shares

2.7 Section 259B(4) and (5) contain new provisions under which a company that acquires shares (or units of shares) in itself because it exercises rights under a permitted security, must within the following 12 months cease to hold those shares (or units of shares). The voting rights attached to the shares (or units of shares) cannot be exercised while the company continues to hold them.

2.8 If, at the end of the 12 months (or extended period), the company still holds any of the shares (or units of shares), the company will commit an offence for each day while that situation continues (section 259B(6)).

Consequences of contravention

2.9 If a company contravenes section 259A or section 259B(1) by directly acquiring its own shares (or units of shares) or taking security over its own shares (or units of shares) or those in a company that controls it, under section 259F:

• the contravention does not affect the validity of the acquisition or security or of any contract or transaction connected with it; and
• the company is not guilty of an offence;
• however, any person who is involved in the company's contravention commits an offence and will be subject to the civil penalty provisions (criminal proceedings may also be taken) (section 1317DA).

Issuing or transferring shares to a controlled entity (section 259C)

2.10 The acquisition by a company of shares (or units of shares) in a holding company was previously regulated by sections 185 and 205(1)(b)(ii). Under section 259C, the issue or transfer of shares (or units of shares) of a company to an entity it controls is void except in certain specified circumstances, including where:

• the issue to the entity is made as a result of an offer to all of the members of the company who hold shares of the class being issued and is made on a basis that does not discriminate unfairly (either directly or indirectly) in favour of the entity; or
• the transfer to the entity is by a wholly-owned subsidiary of a body corporate and the entity is also a wholly-owned subsidiary of that body corporate (section 259C(1)).

2.11 Both of these circumstances have been introduced under the CLRA and, in each case, the acquiring entity will be required to dispose of the shares within 12 months (or extended period) after the acquisition (sections 259C(3), 259D(1)).

2.12 ASIC has the power to exempt a company from the operation of section 259C(1) (section 259C(2)).

Company controlling entity that holds shares in it (section 259D)

2.13 New provisions have been introduced in section 259D which, the Explanatory Memorandum states, are intended to allow companies to take some steps preparatory to the unwinding of a 'controlled member' relationship.

2.14 Under section 259D(1), it is permitted for:

• a company to obtain control of an entity that holds shares (or units of shares) in the company;
• a company's control over an entity that holds shares (or units of shares) in the company to increase; and
• a company to issue shares (or units of shares) to an entity it controls in either of the circumstances referred to in paragraph 2.8 above,

provided that the entity ceases to hold the shares (or units of shares), or the company ceases to control the entity, within 12 months (or extended period) after it occurs.

2.15 Any voting rights attached to the shares (or units of shares) cannot be exercised while the company continues to control the entity (section 259D(3)).

2.16 If at the end of the 12 months (or extended period) the company still controls the entity and the entity still holds the shares (or units of shares), the company commits an offence for each day while that situation continues (section 259D(4)), although the validity of the transaction is not affected (section 259D(6)).

3. Permissible financial assistance

3.1 Under the new section 260A of the Corporations Law, a company is permitted to give financial assistance for the acquisition of shares (or units in shares) in the company or a holding company of the company only if:

• giving the assistance does not materially prejudice:
• - the interests of the company or its shareholders; or
• - the company's ability to pay its creditors; or
• the assistance is approved by a special resolution of shareholders under section 260B; or
• the assistance is exempted under section 260C.

3.2 Therefore the company must:

• firstly consider whether a proposal involves it financially assisting a purchase of its shares (or units of shares); and
• then, assuming the proposal does, secondly decide whether one of the three exemptions are available.

4. What is 'financial assistance'?

4.1 The first question is whether a proposal involves a company financially assisting an acquisition of its shares. The wording of section 260A allows a very broad interpretation of what can constitute financial assistance.

4.2 Unlike the repealed section 205, the new section 260A does not provide any aid in interpreting the concept of 'financial assistance'. Section 205(2) previously provided that financial assistance included a reference to the giving of financial assistance by means of making a loan, giving a guarantee, providing security, releasing an obligation or forgiving a debt or otherwise. It may be safely assumed that each of these activities will continue to constitute financial assistance under the new section 260A.

4.3 Case law which examined the meaning of the phrase in the context of the previous section 205(1) of the Corporations Law, provides some assistance in determining the meaning of financial assistance. However, there is no settled judicial interpretation of what the phrase means.

4.4 Reported cases on the provisions of section 205 provide a wide variety of transactions which may be caught by the legislation. Examples include:

• a company granting a charge or mortgage over assets in favour of a person who has financed an acquisition of the company's shares (Re National Mutual Royal Bank Ltd (1990) 3 ACSR 94; 8 ACLC 1057, SC(Qld)); and
• a subsidiary company agreeing to pay vendors of shares in its holding company a percentage of its annual turnover beyond a specified threshold (Independent Steels Pty Ltd v Ryan (1989) 15 ACLR 518; 7 ACLC 804, SC(Vic) Full Ct).

4.5 Each case seemed to extend the concept of 'financial assistance'. It really involves any transaction under which the company incurs a liability which otherwise would have been undertaken by a purchaser or vendor of the company's shares.

No longer 'For the purpose of, or in connection with'

4.6 Section 205(1)(a) prohibited the giving of financial assistance directly or indirectly 'for the purpose of, or in connection with' the acquisition of shares or units of shares. These words have been removed under the new section 260A, which simply refers to financial assistance to a person to acquire shares (or units of shares).

Timing of financial assistance

4.7 As was the case under section 205, the time at which the financial assistance is provided is not relevant. Section 260A(2) specifically provides that financial assistance may be given before or after the acquisition of shares (or units of shares).

Mode of acquisition

4.8 Again, as was the case under the provisions of section 205, the mode of acquisition of shares (or units of shares) is not relevant. Section 260A(3) specifically provides that the shares (or units of shares) can be acquired by issue, transfer or any other means.

Dividends

4.9 Dividend payments made by a company in good faith and in the ordinary course of commercial dealing were not prohibited by section 205(1) (section 205(8)(a)).

4.10 Under the new section 260A(2)(b), financial assistance may take the form of paying a dividend. If the payment of a dividend materially prejudices the interests of the company or its shareholders or the company's ability to pay its creditors, the company will not be able to pay the dividend unless shareholder approval is obtained under section 260B.

5. First exemption - 'no material prejudice'

5.1 In determining whether or not financial assistance can be given under section 260A(1)(a), each of the following three questions must be considered separately:

• does the giving of financial assistance materially prejudice the interests of the company as an entity?
• does the giving of financial assistance materially prejudice the interests of the shareholders as a whole? and
• does the giving of financial assistance materially prejudice the company's ability to pay its creditors?

5.2 If the answer to each of these three questions is 'No', the company may give the financial assistance without obtaining any further approvals. It will also be unnecessary to decide conclusively whether the transaction in fact involves the giving of financial assistance.

What is 'material prejudice'?

5.3 The Explanatory Memorandum to the Company Law Review Bill indicates that whether a transaction causes material prejudice to a company is a question of fact to be answered in light of the circumstances of each case. In other words, the question of whether or not there is material prejudice will be answered in the context of all the relevant circumstances of the transaction, and by determining its likely effects in relation to each of the three subjects of the test (ie. the company, shareholders and creditors). Accordingly, it will be relevant to compare the likely effects of the transaction to the likely effects of other courses of action available to the company, including the effects of doing nothing.

5.4 However, the Explanatory Memorandum makes it clear that it will not be possible to determine whether a transaction involves material prejudice merely by reference to arbitrary rules, such as the percentage impact the transaction will have on the company's profit.

5.5 The following examples of circumstances in which material prejudice may occur are given in the Explanatory Memorandum:

• if a company withdraws a large amount of money from its bank and lends it to a company that is bordering on insolvency; and
• if a company guarantees a company which is likely to default.

Australian Accounting Standard 5

5.6 Reference to Australian Accounting Standard 5 may be of some assistance in determining whether or not there is, or whether there is likely to be, material prejudice, as it sets out guidelines for determining quantitative materiality. The guidelines are as follows:

• an amount which is equal to or greater than 10% of the appropriate base amount, ought to be presumed to be material unless there is evidence to the contrary;
• an amount which is equal to or less than 5% of the appropriate base amount, ought to be presumed to be immaterial unless there is evidence, or convincing argument to the contrary; and
• no presumption ought to be made as to the materiality of an amount which lies between 5% and 10% of the appropriate base amount prior to consideration of the nature of the item.

What should the base amount be?

5.7 If the material prejudice relates to the company and shareholders, the impact of the transaction on profits, future earnings and return to shareholders should be considered.

5.8 If the material prejudice relates to creditors, the company's balance sheet and the company's ability to pay its creditors should be considered.

6. Second exemption - shareholder approval

6.1 If the company is unable to reach the conclusion that the giving of financial assistance does not cause material prejudice in respect of the interests of the company or its shareholders or the company's ability to pay its creditors, the company can still give financial assistance if it is authorised to do so by shareholders (section 260B).

Listed Australian holding company or ultimate Australian holding company

6.2 If the company proposing to give financial assistance will, after the relevant acquisition:

• be a subsidiary of a listed Australian company; or
• have an Australian holding company (which itself is not a subsidiary of an Australian company),

then the shareholders of the listed company/holding company must also pass a special resolution to authorise the financial assistance (sections 260B(2) and (3)).

6.3 The underlying reason for such extra approval being required, is to ensure that the transaction is approved by the shareholders who will have to bear any burden associated with the transaction once it is completed. The need to seek shareholder approval is confined to the Australian corporations just referred to, in order to avoid unnecessary expense where the listed company or holding company is a foreign corporation.

Procedure

6.4 The shareholder approval process procedure has been streamlined by removing the previous 21 day objection period and the need to publish details of the proposal to give financial assistance in a newspaper and to notify debenture holders.

6.5 The new procedure under section 260B requires the company to take the following steps (and, if applicable, the company's Australian listed parent or ultimate holding company to take each of the following steps except step 5(a)):

1.Prepare notice of meeting (section 260B(4))

• The company must prepare a notice of meeting to shareholders, advising them of the proposed resolution.
• The notice must include a statement setting out all the information known to the company that is material to the decision on how to vote on the resolution, except that the statement need not repeat information if it would be unreasonable to require the company to do so because the company has already provided the information to shareholders.
• Given that a company does not require shareholder approval unless the giving of assistance materially prejudices the interests of the company, the shareholders, or the ability of the company to pay its creditors, the statement should set out which of those interests is prejudiced and how.

2. Lodge notice with ASIC (section 260B(5))

Before the company sends the notice of meeting to shareholders, the company must lodge it with ASIC together with any other document which the company will send to shareholders.

3. Further notice of meeting (sections 249H)(i), 249HA(i))

The notice (including the statement) must be sent to shareholders so that it will arrive at least 21 days (28 days in the case of a listed Australian company) before the date of the meeting.

Companies will need to check their constitutions to determine how the 21 day (or 28) period is calculated.

4. Hold meeting (section 260B(1))

The resolution must be passed either:

• as a special resolution by a majority of 75% or more of votes cast at the meeting, with no votes being cast in favour of the resolution by the person acquiring the shares (or units of shares) or by their associates; or
• by all ordinary shareholders (section 260B(1)).

The alternative procedure for approval by resolution agreed to by all ordinary shareholders was apparently added to avoid a situation where all shareholders are prohibited from voting in favour of a resolution to approve the financial assistance.

5. Notices to ASIC (section 260B(6) & (7))

Following the passing of the resolution, the company must provide ASIC with two further notices:

(a) a notice in the prescribed form stating that assistance has been approved in accordance with section 260B, which must be given to ASIC at least 14 days before the financial assistance is actually given; and

(b) a notice in the prescribed form providing ASIC with a copy of the special resolution, which must be given to ASIC within 14 days of the special resolution being passed.

7. Third exemption - exempt financial assistance under Section 260C

7.1 There are 'general', 'special' and 'other' exemptions from section 260A. However, generally the exceptions simply preserve the exceptions which previously existed pre-1 July 1998.

General exemptions

7.2 These generally are based on financial assistance given in the ordinary course of commercial dealing and consist of:

• acquiring or creating a lien on partly-paid shares for amounts payable to the company on the shares; and
• entering into an agreement with a person under which the person may make payments to the company on shares by instalments (section 260C(1)).

Special exemptions

7.3 Special exemptions exist for:

• financial institutions, where the company's ordinary business includes 'providing finance' (as defined in section 9) and the financial assistance is given in the ordinary course of that business and on ordinary commercial terms (section 260C(2));
• subsidiaries of borrowing corporations if :
• - the company is a subsidiary of a borrowing corporation;
• - the financial assistance is a guarantee or other security given by the company for the repayment by the borrowing corporation of money that is or will be liable to repay;
• - the borrowing corporation is such because it is or will be liable to repay the money; and
• - the guarantee or security is given by the company in the ordinary course of commercial dealing (section 260C(3));
• employee share schemes, if the financial assistance is given under an employee share scheme that has been approved by:
• - a resolution passed at a general meeting of the company;
• - if the company is a subsidiary of a listed domestic corporation -a resolution passed at a general meeting of the listed domestic corporation; and
• - if the paragraph above does not apply but the company is a holding company that is a domestic corporation and that is not itself a subsidiary of a domestic corporation -a resolution passed at a general meeting of that holding company (section 260C(4))
• Other exemptions

7.4 The following other types of financial assistance are also exempted from section 260A:

• a reduction of share capital in accordance with Division 1 of Part 2J.1;
• a share buy-back in accordance with Division 2 of Part 2J.1;
• assistance given under a court order; and
• a discharge on ordinary commercial terms of a liability that the company incurred as a result of a transaction entered into on ordinary commercial terms.

8. Consequences of failing to comply

8.1 Changes to the financial assistance provisions of the Corporations Law have also been made in relation to the consequences of contravention.

Pre 1 July 1998

8.2 The consequences of a breach of the prohibition in section 205(1) of the Corporations Law were serious and included:

• any contract in breach of section 205(1) was voidable at the option of the company: section 206(1), 206(2);
• officers of the company who were involved in the contravention were guilty of an offence (although the company was not): section 205(5);
• officers of the company who were convicted of an offence for contravention of the section could be ordered to pay compensation to the company or to any person who had suffered loss: section 205(6);
• where the company made or performed a contract in contravention of the section and the company or any other person suffered or was likely to suffer loss or damage, the court was able to make such order or orders as it thought just and equitable against any party to the contract or against the company, or against any person who, among other things, aided or abetted the contravention: section 206(4).

Post 1 July 1998

8.3 Under the changes made to the Corporations Law under the Company Law Review Act, if a company proceeds to provide financial assistance in contravention of section 260A:

• The contravention does not affect the validity of the financial assistance or of any contract or transaction connected with it.

It is stated in the Explanatory Memorandum to the Company Law Review Bill that these changes have been made to promote certainty and protect the interests of third parties.

• The company is not guilty of an offence (section 260D(1)).

8.4 However, any person who is involved in the company's contravention will have contravened a civil penalty provision (section 260D(2)). Contravention of a civil penalty provision may be a criminal offence if the person contravenes the provision knowingly, intentionally or recklessly and either dishonestly and intending to gain, whether directly or indirectly, an advantage for that or any other person, or intending to deceive or defraud someone (section 1317FA(1)) (although criminal proceedings for an offence constituted by a contravention of a civil penalty provision cannot be begun if a person has already applied for a civil penalty order in relation to the same contravention: section 1317FB.

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The information contained in this article has been prepared by the Minter Ellison Legal Group.Professional advice should be sought before applying the information to particular circumstances.