CODEWORD

Introduction

It is not unusual for arrangements between shareholders of smaller Code companies, particularly for those that sit near the fringe of the definition of “Code company”, to result in inadvertent breaches of the Code.

This article sets out the Panel’s experiences with inadvertent breaches involving smaller Code companies, what these companies can do to mitigate these issues, and what the Panel is doing, or can do, to assist these shareholders and companies.

Code companies

The Code applies only to “Code companies”. A company is a Code company if it is a New Zealand registered company that:

(a) is a party to a listing agreement with a registered exchange and has securities that confer voting rights quoted on the registered exchange’s securities market; or

(b) was within paragraph (a) at any time during the period of 12 months before a date or the occurrence of an event referred to in the Code; or

(c) has 50 or more shareholders.

Relevantly for the purposes of this article, the Code applies to unlisted companies with 50 or more shareholders. In calculating the numbers of shareholders, the number of shareholders is key, not the number of parcels recorded on the Register.

Why do small Code companies often run into difficulty with the Code?

Shareholders in a smaller Code company are often involved in the activities and operations of the company, or are connected to the history of the company in some way. The shareholders may be family members, existing or former employees, or persons with whom the company has a significant trading connection.

Also, many shareholders in smaller companies choose to protect their investment position through instruments like shareholders’ agreements, or insist on mechanisms like pre-emptive rights to ensure some control over the shareholder profile of the company.

The relationships between the shareholders in small companies, and the instruments and mechanisms used to protect their investment position, have the potential to trigger the “associate” provisions of the Code and as a consequence to restrict the ability to aggregate shares in excess of 20%.

Associates

Rule 4 of the Code states that, for the purposes of the Code, a person is an associate of another person if:

(a) the persons are acting jointly or in concert; or

(b) the first person acts, or is accustomed to act, in accordance with the wishes of the other person; or

(c) the persons are related companies; or

(d) the persons have a business relationship, personal relationship, or an ownership relationship such that they should, under the circumstances, be regarded as associates; or

(e) the first person is an associate of a third person who is an associate of the other person (in both cases under any of paragraphs (a) to (d)) and the nature of the relationships between the first person, the third person, and the other person (or any of them) is such that, under the circumstances, the first person should be regarded as an associate of the other person.

It is not uncommon for the nature of the relationships between the shareholders in small Code companies to be such that they fall within the types of relationships described in paragraph (d) above. This means that, due to the relationships or agreements made between shareholders in a small company, the shareholders may be considered to be associates of one another under rule 4 of the Code.

Shareholders being associates of one another is not necessarily problematic in itself; that is if the fundamental rule of the Code is adhered to (i.e., no person, together with their associates, increases their shareholding over 20%) and the compliance options in rule 7 of the Code are followed (i.e., takeover offers are made to all shareholders or by obtaining shareholder approval for an increase in shareholding).

However, if all or a majority of existing shareholders are associates then they will not be able to buy or transfer shares between themselves (because each shareholder, together with its associates, would together hold or control more than 20% of the voting rights in the company), and if shareholder approval is sought for any acquisition or allotment of shares the acquirer, the disposer, the allottee and their respective associates would be excluded from voting on the question by rule 17. This means that if all of the shareholders are associated, then under the Code there is no one to vote on the resolutions required by rule 7 in order to move ahead with a proposed transaction.

Shareholders’ agreements

A shareholders’ agreement is a contractual arrangement between shareholders governing many aspects of their relationship, the conduct of the affairs of the company, aspirations, business plans, and the like. The agreement can deal with any number of matters or just one or two major issues which the shareholders regard as important.

Generally, a shareholders’ agreement is broken down into a number of parts, including:

(a) Entry into the company and the terms on which a person becomes a shareholder;

(b) Governance and control of the company;

(c) Arrangements regarding the appointment of directors by individual shareholders or by groups of shareholders;

(d) Transfers of shares, including pre-emptive rights; and

(e) Exit arrangements.

The Panel has in the past found that shareholders may be associates of one another by virtue of being parties to a shareholders’ agreement. In those cases, in the absence of an exemption from the Code, shareholders may therefore not be able to increase their percentage of shares in the company or vote on resolutions to approve proposed acquisitions or allotments by other shareholders.

What are we doing about it?

The Panel acknowledges that it is sometimes difficult for the shareholders in these smaller Code companies, because of the way these companies are traditionally structured, to comply with the provisions of the Code and that this fact can result in inadvertent breaches of the Code. A recent exemption granted to an unlisted Code company highlights these difficulties.

The Panel has in the past found that shareholders may be associates of one another by virtue of being parties to a shareholders’ agreement.  In those cases, in the absence of an exemption from the Code, shareholders may therefore not be able to increase their percentage of shares in the company or vote on resolutions to approve proposed acquisitions or allotments by other shareholders.

Ormiston Exemption

In June 2011, the Panel granted an exemption to all the minority shareholders in Ormiston Surgical & Endoscopy Limited (“Ormiston”) (Takeovers Code (Ormiston Surgical & Endoscopy Limited) Exemption Notice 2011).  Ormiston was a Code company by virtue of having more than 50 shareholders.

Ormiston was proposing to issue voting securities to Southern Cross Hospitals Limited (“Southern Cross”). As Southern Cross already held and controlled more than 20% of the voting rights in Ormiston, it could only increase its voting control in Ormiston if shareholders first approved the proposed allotment by an ordinary resolution in accordance with rule 7(d) of the Code.

However, rule 17(2) of the Code prohibits the allottee and its associates from voting on a resolution for the approval of an allotment. The Panel considered that Ormiston’s shareholders may all have been associates of Southern Cross by virtue of being parties to a shareholders’ agreement, which, amongst other things, contained clauses concerning voting on board representation and pre-emptive rights. The shareholders of Ormiston therefore needed an exemption from compliance with rule 17(2) of the Code to enable them to vote on the resolution to approve the proposed allotment to Southern Cross.

The Panel granted the exemption to the shareholders on the understanding that they would unwind the shareholders’ agreement and that they would vote on the resolution in any manner they thought fit. In other words, that they would “disassociate” themselves from the requirements or influence of the shareholders’ agreement.

The Panel considered that the exemption was appropriate and consistent with the objectives of the Code because:

(a) all of the current shareholders of Ormiston, being party to the shareholders’ agreement, may have been associates for the purposes of the Code and, as such, the mechanisms provided in the Code for the approval of Southern Cross’s proposed increase of voting securities in Ormiston through the proposed allotment were unworkable; and

(b) Ormiston provided a detailed enforceable undertaking under section 31T of the Takeovers Act 1993 to use all reasonable endeavours to seek the effective termination of the agreement as soon as practicable after the proposed allotment had taken place; and

(c) the exemption provided Ormiston with the opportunity to make a reasonable transition to full compliance with the Code; and

(d) Ormiston’s shareholders had the opportunity to vote (on a fully informed basis) to approve Southern Cross’s voting control increase; and

(e) the exemption maintained a proper relationship between the costs of complying with the Code and the benefits resulting from it.

In line with the Ormiston exemption, the Panel may only grant such an exemption to a company if the company agrees to unwind the elements of association between the shareholders. For example, Ormiston undertook to use all reasonable endeavours to seek the effective termination of the shareholders’ agreement as soon as practicable after the proposed allotment had taken place. Ormiston later confirmed to the Panel that the agreement had been terminated.

Regulatory Reform Bill 2010

When the Regulatory Reform Bill is passed, it will clarify and narrow the definition of “Code company”.

Clarifying “50 or more shareholders”

As set out at the beginning of this note, the Code currently defines a “Code company” as including companies that have “50 or more shareholders”.

After the Bill is enacted, a “Code company” will be defined as including companies that have “50 or more shareholders and 50 or more share parcels”. This amendment will reduce the scope of the Code and result in the Code compliance burdens (but also the shareholder protections) residing with more widely-held companies.

Definition of a “Code company” – shareholders holding voting securities

In 2006 the Takeovers Act was amended to remove from the purview of the Code those listed companies with only debt securities quoted on an NZX market. This was on the basis that the Code is concerned with voting rights. However, there are unlisted companies that have large numbers of shareholders whose shares do not confer voting rights, but that have fewer than 50 shareholders who do have voting rights.

After the Bill is enacted, the Code will apply more evenly as between listed and unlisted companies, because a definition of “shareholder” will be added for the purposes of interpreting “50 or more shareholders”. The new definition defines a “shareholder” as “a shareholder holding a security that confers a voting right”.

By stipulating that the Code applies to shareholders with voting rights, the amendment will reduce the scope of the Code, and will correspondingly reduce the compliance costs for companies that are no longer subject to the Code.

What can shareholders do about it?

As described above, shareholders of smaller companies that are subject to the Code need to consider whether shareholders’ agreements and other such instruments are necessary in the context of their company. If shareholders decide that such agreements are necessary they must be aware that these instruments may result in a possibility, or even a likelihood depending on the nature of the instrument, of there being an “association” between shareholders. This may consequently mean that there is no viable way for any shareholder in the company to increase their voting control in compliance with rules 7(c) and 7(d) of the Code.

For companies teetering on the edge of the definition of “Code company”, the Panel is not averse to the shareholders deciding that they want to restructure themselves, in a manner that complies with the Code, so that they do not fall under the definition.

The Panel executive is here to help

If you are reading this and you are wondering about its implication for you (or your clients, if you are a financial or legal adviser) the Panel will welcome your enquiry. We are here to help and can explain the implications of the Code, whether an exemption might be necessary, and the issues which the Panel may consider for granting an exemption.

For companies teetering on the edge of the definition of “Code company” the Panel is not averse to the shareholders deciding that they want to restructure themselves in a manner that complies with the Code so that they do not fall under the definition.