How the Code applies to lock-up agreements
Published 1 March 2004
Lock-up agreements are permitted by the Code and the policies that underpin it. These include lock-up agreements which occur before a bid is made (pre-bid lock-ups) and agreements made during the offer process (intra-bid lock-ups).
A pre-bid lock-up agreement is an agreement between a shareholder and a potential bidder that if the bidder makes a takeover offer for the company on agreed terms then the shareholder will accept that bid.
There is no doubt that such an agreement is permitted by the Code. The fundamental rule contained in rule 6(1) deals with increases in the holding or controlling of voting rights in a Code company. Consequently, if the pre-bid agreement does not have the effect that the potential bidder becomes the holder or controller of the voting rights attaching to the shares then no breach will occur.
Clause 8 of Schedule 1 of the Code recognises this position. Under this clause all that is required is that in the offer the bidder must give details of any party that has agreed conditionally or unconditionally to accept the offer and the material terms of the agreement.
Acceptance of the legality of pre-bid agreements is not an oversight in the Code but flows directly from the way the Code has been constructed. The key provisions controlling the content of pre-bid contracts are the fundamental rule as mentioned above, and also rule 20 which requires that an offer must be made on the same terms and provide the same consideration for all securities of the same class. The same rule has the effect also of preventing collateral arrangements which are intended to enhance the effective price received by a shareholder.
It has been suggested that a loophole exists because a party can obtain a number of pre-bid agreements and hence at the time the offer is made the bidder may be in a strong position to achieve a successful outcome. In addition of course, the bidder can acquire outright up to 20% of the voting rights of the target company before a bid is made.
The Code deals with this situation in a number of ways. First, the potential bidder may not actually acquire and control more than 20% of the voting rights in the target company. Second, rule 23 of the Code requires that the bid be conditional upon the bidder obtaining control over more than 50% of the voting rights in the target company. Third, as mentioned above, under rule 20 the offer must be made on the same terms and conditions to all holders of securities of the same class. Furthermore, it can be expected that parties to pre-bid agreements will want to achieve the best possible price for their shares.
If the bid proceeds and is successful the Code will have achieved the desired outcome. The process will be conducted in accordance with the provisions of the Code, including the obligation to provide independent advice, so that all shareholders will be fully informed. Pre-bid agreements may have contributed to the success of the bid, but is this a criticism?
In formulating the Code, the Panel was required by the terms of the Takeovers Act 1993 to consider a number of objectives. These objectives include:
- encouraging the efficient allocation of resources;
- encouraging competition for control of companies; and
- assisting in ensuring the fair treatment of shareholders. Fair treatment of shareholders, which the Panel has equated with equal treatment of shareholders, is a fundamental objective of the Code.
This objective is always satisfied in the case of a pre-bid lock-up agreement because other shareholders must be offered the same price as that provided for in the lock-up agreement.
The only issue which needs to be addressed is whether the potential for pre-bid contracts to limit the development of an auction between competing bidders is desirable.
There are good reasons for the Code’s approach in allowing prebid agreements. This is the subject of considerable discussion in Australia as it considers whether it should move from its present takeovers Code to a mandatory bid Code, more in line with the City of London Code.
The Australian Code focuses much more directly on the auction principle. In broad terms, pre-bid agreements are not permitted as they may inhibit the auction between competing bidders. However, this does have important consequences in the operation of the takeovers market.
An example of the flexibility that exists under the New Zealand Code was the sale by the controlling shareholder of its stake in United Networks to Vector. In effect, the seller and the company in conjunction with their financial advisers undertook a competitive process to achieve the best price for the controlling shareholder. This was possible because under the New Zealand Code the preferred bidder had the certainty through a pre-bid agreement with the seller that when the formal bid was ultimately made to all shareholders the controlling shareholder would sell into that bid. Equal treatment was achieved in that all shareholders received that same price. It is argued by many in the commercial world that the ability to undertake a commercial auction in this manner is efficient and also achieves the best outcome.
It is the inability under the Australian Code to undertake the same process that has led to pressure to adopt the mandatory bid system. Under this system there would be no constraints whatsoever in undertaking the commercial auction to find the highest bidder for the controlling shareholder’s stake in the target company. In fact, a pre-bid agreement is not necessary as there is no restriction on a sale contract being entered into and completed. All that is necessary is for the bidder to subsequently make an offer to all remaining shareholders on the same terms and conditions. This is why the mandatory bid system is often referred to as being based on an exit principle whereby shareholders must be given the opportunity to exit the company, once the threshold has been passed, on terms no less favourable than those enjoyed by the initial sellers.
It can be seen from the above that strict adherence to the auction principle can inhibit commercial transactions which many would regard as efficient business practice. The approach to the New Zealand Code was to try to restrict as far as possible regulation inhibiting normal commercial activity except where this was necessary to ensure that the fundamental policy objectives of the Code were fulfilled. The United Networks takeover is a good example of the flexibility of the New Zealand Code and the balance achieved between its various objectives.
The issue has also arisen recently as to whether during a bid a lock-up agreement can be entered into whereby a shareholder agrees that it will accept the offer as soon as the price has been increased to an agreed figure. Such an agreement is permitted by the Code subject to similar constraints that apply to pre-bid agreements. Just as the original bid must first be made before it can be accepted, so with a variation the variation must first take place in accordance with the provisions of the Code before the offer as varied can be accepted. Rule 20 requiring equal treatment ensures that all shareholders will receive the same price. It is not possible for the “pre-variation” agreement to actually effect a variation as this will result in the bid being varied in a manner which does not comply with the Code. This was the issue that arose in the Otago Power case. The only exception is where the purchase complies with the requirements of rule 36 which is most likely to arise when an offer has become unconditional. Rule 37 then deals with the variation of the offer that flows from any such acquisition at a price in excess of the price contained in the offer.
The important point with lock-up agreements is that the terms must be constrained to ensure that they do not breach the fundamental rule contained in rule 6(1) or rule 20 requiring equal treatment of all shareholders.