Corporate - Financial Assistance Update

The law on financial assistance has long been regarded as one of the most complex and uncertain areas of modern company law. This complexity has important practical implications for structuring transactions.

Two recent Court of Appeal decisions and one first instance case have highlighted the lack of certainty in this area and the potential pitfalls in three commonplace scenarios:

• the payment of fees by a target company;

• restructuring post-acquisition indebtedness; and

• operating the "whitewash" procedure under section 155 of the Companies Act.

Section 151 of the Companies Act 1985 (the Act) prohibits a company or any of its subsidiaries from providing financial assistance where a person is acquiring, proposing to acquire or has acquired, shares in that company. Financial assistance should not be provided, directly or indirectly, for the purpose of:

• the acquisition of shares; or

• reducing or discharging a liability incurred for the purpose of an acquisition of shares.

The Act lists the types of financial assistance which are caught by the restriction. It also provides a list of certain activities where the provision of financial assistance will not be unlawful. The box on page 2 summarises the types of financial assistance that are prohibited and what is permitted.

The key objective of the financial assistance provisions in the Act is the protection of the assets of the target company or group from the perspective of their creditors and non-assenting shareholders.

Many commentators have, for a long time, felt that these concerns are already adequately provided for in the laws relating to directors’ duties, unfair prejudice, unlawful dividends, reductions of capital and the provisions of the Insolvency Act 1986 regarding transactions at a preference or those intended to defraud creditors. There have been a series of reviews recommending change and liberalisation, including proposals from the Company Law Steering Group for the planned Companies Bill. However, at present, the current prohibitions remain on the statute book and there is no imminent sign of new legislation. In addition, the restrictions are entrenched in European law in so far as they relate to PLCs and so any reform for PLCs would also have to be agreed at a European level.

The consequences of a breach of the financial assistance provisions can be severe:

• It is a criminal offence. The company providing the financial assistance may be liable to a fine and the officers of the company in default may be liable for imprisonment and/or a fine.

• The company and its officers can be required to compensate any person who suffers a loss as a consequence of their unlawful actions.

• Breach of the prohibition is a breach of a director’s fiduciary duty for which the company can seek damages.

A subsidiary of a target company paid fees incurred by its own auditor in the preparation and provision of financial information to be included in the purchaser’s long form report. The long form report was required in the preparation of a prospectus for an equity fundraising to be carried out by the purchaser to finance the acquisition.

Following completion of the acquisition, the purchaser brought proceedings against Robert Chaston, who was a director of the subsidiary and a shareholder of the target company. The claim was for damages by virtue of the director having breached his fiduciary duty by having procured or connived in the provision of unlawful financial assistance by the payment by the subsidiary of the auditor’s fees. The purchaser had taken an assignment of the benefit of the right of the subsidiary to sue its former director for breach of fiduciary duty.

The Court of Appeal overturned the decision of the first instance court and found that the payment of the auditor’s fees by the subsidiary did constitute unlawful financial assistance.

Arden LJ (giving the leading judgment) stated that what was important in reviewing whether the transaction involved the provision of financial assistance was whether "as a matter of commercial reality, the fees in question smoothed the path to the acquisition of shares". In the circumstances, the payment of the auditor’s fees relieved both the purchaser and the vendor from incurring their own costs in the preparation of the financial information in the long form report. The payment reduced the net assets of the subsidiary to a material extent and was therefore financial assistance.

The other key points arising from the Court of Appeal decision were:

• It was irrelevant whether the financial assistance was incurred prior to or at the same time as the completion of the acquisition of the shares. The legislation contemplates that unlawful financial assistance can be provided where a person is only "proposing" to acquire the shares. Preparatory work that acts only as an inducement to enter into a transaction can therefore be unlawful financial assistance for the purposes of that transaction.

• It was acknowledged in the Court of Appeal that the purchaser did not regard the acquisition as a success: part of the motivation behind bringing the action against the director was the recovery of part of the purchaser’s overall loss resulting from the transaction. However, the merits of the purchaser’s case were not relevant in deciding the financial assistance issue.

• A transaction can constitute financial assistance whether the assistance is provided to the purchaser or the vendor or to the target itself.

• A transaction which constitutes financial assistance does not need to be to the detriment of the company’s interests. For example, it is possible for there to be unlawful financial assistance where a company provides a loan on terms that are better than usual commercial terms.

• The fact that the director had acted honestly in the best interests of the company did not prevent the director from being found liable for proving the provision of unlawful financial assistance, which was a breach of his fiduciary duty.

• Each case must be judged on its own facts and having regard to the commercial substance of the arrangements.

Does the Chaston case have consequences for the following similar business scenarios involving the payment of fees?

• The payment of advisory fees by a target company which is the subject of a bid governed by the Takeover Code.

• The payment of fees incurred in the preparation of an information memorandum where a company is put up for sale by way of auction.

• The payment of fees by a target company where its group is reorganised simultaneously with the completion of an acquisition of shares.

In each of the above scenarios, Chaston has taught us that the courts will look to the commercial objectives behind the facts. If, in paying for advisory services on a bid, the target is primarily concerned with fulfilling its duties to inform and protect shareholders, it is unlikely that a court would find, on that basis alone, unlawful financial assistance. Similarly, if a group reorganisation is largely conducted for the business purposes of that group even though it was necessitated by or helped the completion of the acquisition, those fees would be properly incurred by the group for its own purposes.

In an auction scenario, caution should be exercised if it is proposed that the target should pay any fees incurred as part of the sale process. When there is no prospective purchaser in the frame, there may be no financial assistance as no one will be proposing to acquire any shares. However, as soon as potential purchasers have been contacted (or have come forward), this will no longer be the case.

The Chaston case also raised questions about the role of financial assistance in a purchase of own shares. Arden LJ in her judgment gave the purchase of own shares as an example of assistance being provided to the company itself. There has, for a long time, been a contrary view that a purchase of own shares does not involve financial assistance because a logical reading of section 151 cannot be stretched to make a "person" acquiring shares refer to the company itself. Arden LJ’s remarks in Chaston were not, strictly speaking, part of her judgment but her comments have added to the lack of certainty surrounding financial assistance in the context of a purchase of own shares.

The target company, MT Realisations, was dependent upon its parent, the vendor, for intra-group loans amounting, in aggregate, to some £8 million. The loans were repayable on demand and security was provided by MT Realisations to the vendor. MT Realisations was sold for £1 to a purchaser, who also agreed to pay the vendor £6.5 million for an assignment of the benefit of the intra-group loans. The £6.5 million consideration for the loan assignment was payable in instalments.

The purchaser ran into financial difficulties and became unable to pay the remaining instalments of the purchase price for the loan assignment. The debt was rescheduled such that other separate commercial debts owed by the vendor or any of its group companies to MT Realisations were not paid. Instead they were offset against the purchaser’s liability to the vendor to pay the purchase price for the loan assignment. MT Realisations’ liability to the purchaser under the inter-company loan was reduced by the same amount.

MT Realisations later went into liquidation and the liquidator claimed that unlawful financial assistance had been provided by MT Realisations in discharging the purchaser’s obligation to the vendor to pay the purchase price for the loan assignment. The liquidator sought to have the rescheduling of the debt set aside as unlawful in order to claim the commercial debts due to MT Realisations from the vendor and its group.

The court at first instance held that there was no breach of section 151 of the Act. The reasoning behind the decision was that the rescheduling of the indebtedness related to the payment of the purchase price for the loan assignment, not for the acquisition of the shares. As such, the financial assistance provided to the purchaser by MT Realisations was not "for the purposes of the acquisition" of its shares.

Decision of the Court of Appeal The Court of Appeal applied the "commercial realities" test used in the Chaston case. It found that the purchaser, as a secured creditor of MT Realisations, was entitled to exercise its security rights over MT Realisations’ book debts and apply them for its own purposes.

The set off of the amounts due to MT Realisations from the vendor against the instalments due to the vendor from the purchaser and the reduction of the amount owed by MT Realisations to the purchaser under the inter-company loan, simply short circuited the commercial position. Therefore, there was no "assistance" provided by MT Realisations because assistance must "involve something in the nature of aid or help. It cannot exist in a vacuum; it must be given to someone".

Mummery LJ emphasised the fact that each case of potential financial assistance must be examined in its commercial context: "each case is a matter of applying the commercial concepts expressed in non-technical language to the particular facts. The authorities provide useful illustrations of the variety of fact situations in which the issue can arise, but it is rare to find an authority on section 151 which requires a particular result to be reached on different facts."

As the Court of Appeal decided that there had been no assistance by the target, it did not need to decide whether any assistance that there might have been could be said to be for the "purposes" of the acquisition of shares. However, Mummery LJ did state that he found the judgment of the court of first instance on this point, which had held that any assistance that there was had been for the purpose of the acquisition of debt rather than shares, "less persuasive".

The purchaser of In a Flap Envelope Company Limited acquired its shares for a purchase price payable in instalments.

The purchaser defaulted on the purchase price instalments. It was then agreed that the target company would lend the purchaser the necessary amount. It was recognised that this constituted financial assistance and so the whitewash provisions in sections 155 to 158 of the Act were used (see box containing a summary of the whitewash procedure on this page).

A statutory declaration was sworn by an overseas director of the purchaser who was appointed as a director of the target company on the day that the statutory declaration was sworn. Up to that point, the overseas director had had little to do with the day-to-day operation of the target company.

Mr Jenkin was the previous sole director of the target company and had been a director for some time. He was also one of the vendors of the target company to whom the purchase price was owed. He resigned at the same time as the overseas director was appointed. Immediately following the swearing of the statutory declaration, Mr Jenkin was reappointed and the overseas director resigned. There was a suggestion by the judge in the case that the paperwork in relation to the appointments and resignation may have been signed at one sitting.

The target company later went into liquidation and the liquidator claimed that the provision of financial assistance was unlawful because the provisions of the whitewash procedure had not been complied with.

The court held that:

• The whitewash procedure had not been properly implemented and consequently the loan by the target company to the purchaser constituted unlawful financial assistance.

• Mr Jenkin had not ceased to be a director of the target company at the time the statutory declaration was sworn; he continued as de facto director.

• Neither Mr Jenkin nor the overseas director had made proper investigation of the affairs of the target company for the purpose of the statutory declaration.

• The liquidator was entitled to claim the monies received by the vendors under the agreement on the basis that it was received pursuant to an illegal contract.

• Although Mr Jerkin had received legal and accounting advice, he was not entitled to use the receipt of that advice as a defence under section 727 of the Act in order to obtain relief from breach of his fiduciary duties (see box containing a summary of section 727 on this page). The receipt of professional advice does not discharge a director from his duty to consider whether the transaction is in the best interests of the company and Mr Jenkin had failed to make those considerations. He had acted otherwise than in the best interests of the company in providing the loan because the purchaser was unlikely to be able to repay it.

The overriding impression of the decisions in the three recent cases is that there is little legal certainty on the interpretation of the financial assistance provisions. The two Court of Appeal cases point to differences in opinion between the High Court and Court of Appeal judges on the meaning of the legislation.

There are many clear cut instances where the provision of financial assistance is unlawful. However, it is clear that there are other instances where an element of judgement is required. Consequently, it remains difficult for directors and advisers to reach a definite conclusion on whether certain actions are lawful. For example, we cannot be certain whether the Court of Appeal in MT Realisations would have reached a different decision if the inter-company loan due from the target to the vendor had not been secured by a fixed and floating charge.

Each of the three cases shows a growing tendency for the courts to apply the "commercial realities" test to the facts of each case. There are some elements of the financial assistance provisions that must be interpreted in a strict legal sense. These can normally be analysed with certainty, even if sometimes the result can appear to be incongruous. For example, it is clear that a loan by a target to a purchaser can be unlawful financial assistance even if it is in the best interests of the target and on commercial terms that are better than otherwise available to the target.

However, there are other elements where the courts will look to impose their own assessment of the commercial realities, for example, when looking to establish whether, as a matter of fact, the target has provided any assistance to "smooth the path of the transaction" and when looking to determine the principal purpose of any such assistance. As such, in deciding whether a transaction involves the provision of unlawful financial assistance, the views of the directors driving the commercial deal and, on occasions, the auditors in determining the level of net assets and distributable reserves of the company, will need to be taken into account. Unfortunately, though, the courts will have the final say on all these matters and the parties will need to take this into account when reaching their own decision.

Although the recent cases have not made substantive changes to the law, they have shown that an allegation of financial assistance can be a useful litigation tool. The purchaser in the Chaston case used financial assistance proceedings as a method of recovering a loss incurred from an unprofitable transaction. This was despite the fact that it was the purchaser who benefited from the payment of the fees. It will be interesting to see whether other purchasers follow the Chaston route. If this trend does develop, this will be another cause for concern for directors who will not only face criminal liability but also significant personal financial consequences if they are involved in any transactions that constitute unlawful financial assistance.

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