“Financial Assistance”: A Fatal Flaw in Cross-Border Acquisition Financings
By Denis Petkovic
A challenge in many corporate acquisitions is how to finance the acquisition without violating local company law prohibitions against the target providing “financial assistance” for the purchase of its own shares by third parties.
Examples of financial assistance are where the target’s assets serve as security for the acquisition debt or where the target agrees to sell off assets after the acquisition to help pay down the debt.
Refinancings after the acquisition can also be a problem.
Prohibitions against financial assistance are littered throughout company law in jurisdictions within the British Commonwealth ranging from England to Australia, Hong Kong, Singapore and Nigeria. Because the rules have as their foundation prohibitions against unauthorized returns of capital to shareholders — prohibitions that are found in civil law countries also — it is prudent to inquire into similar restrictions in civil law jurisdictions as well. An example is Italy.
The English law prohibition is in section 151 of the Companies Act, 1985. Section 151 prohibits two types of transactions. First, it provides that where a person is acquiring or proposing to acquire any shares in a company, it is unlawful for the company or any of its subsidiaries to give financial assistance, directly or indirectly, for the purpose of that acquisition before or at the same time as the acquisition takes place.
Second, after a person has acquired any shares in a company and any liability has been incurred by that person or any other person for the purpose of the acquisition, it is unlawful for the company or any of its subsidiaries to give financial assistance, directly or indirectly, to reduce or discharge the liability incurred.
If a company acts in contravention of section 151, then it is liable to a fine and every officer who was involved is liable to imprisonment or a fine or both.
The financial assistance prohibition dates to 1929 and reflected a view that companies ordinarily ought not to buy back their own shares because this would constitute an unauthorized reduction of share capital. The underlying policy went further, however, and was intended to prevent asset stripping — the process whereby potential bidders borrowed money to acquire a company and then used the assets of that company to finance their borrowings. The concern extended to prohibiting bidders from securing their borrowings against the assets of the target, thereby putting at risk the interests of minority shareholders of the target company and creditors of that company.
There was a general feeling by the 1980s that the law went too far. The statute was amended in 1981 to define more accurately what constituted “financial assistance” and to relax the prohibition so that it did not affect honest transactions.
The prevailing feeling in the United Kingdom is that the present rules still do not work very well, in particular in relation to fundamentally honest transactions. Moreover, companies now can buy back stock, and the era of highly leveraged buyouts often premised on strong economic efficiency grounds lays a valid philosophical challenge to the notion that company law should discourage “asset stripping.” For this reason, further changes to the law are proposed from time to time, particularly as the prevailing rules are a minefield of technicalities that can create a fatal flaw in fundamentally honest deals.
A good example of the tripwires created by the financial assistance rules is found in section 151(2). This section prohibits absolutely the target company or any of its subsidiaries after an acquisition is completed from giving financial assistance, directly or indirectly, for the purpose of reducing or discharging the liability incurred. The prohibition lasts indefinitely and catches refinancings.
As discovered in the United Kingdom during the last recession and which one must be mindful of in the light of prevailing economic storm clouds, the prohibition can be particularly problematic when a restructuring is required for a group of companies, one of whom may have been acquired previously, as it continues to be impossible for security to be taken from that company to support the refinancing.
One of the consequences of prohibited financial assistance taking place — even inadvertent — is that any security taken will be void. Thus, lenders are potentially at risk. It is for this reason that calls have been made in the United Kingdom to subject section 151(2) to a time limit so that, for example, nothing done by a target company after a lapse of two years from the date of acquisition of its shares will constitute a breach of the section. To date, these calls have fallen on deaf ears.
What Is Financial Assistance?
Section 152 defines what financial assistance is. It is a wide definition. It covers:
- guarantees, securities or indemnities, releases and waivers;
- loans or other agreements under which any of the obligations of the person giving the assistance are to be fulfilled at a time when, in accordance with the agreement, any obligation of any other party to the agreement remains unfulfilled, or by way of the novation of, or the assignment of rights arising under, a loan or such other agreement;
- any other financial assistance given by a company, the net assets of which are thereby reduced to a material extent or which has no net assets.
A House of Lords decision in 1989 held that the definition is to be interpreted widely.
Are there any transactions that would not come within the parameters of financial assistance?
There are some. The grant by the target of irrevocable negative pledges under seal in favor of a financier does not constitute financial assistance. This is so for two reasons. First, section 151(2) provides that where a person has acquired shares in a company, then it is not lawful for the target or any of its subsidiaries to give financial assistance for the purpose of reducing or discharging the liabilities so incurred. The grant of a negative pledge will not actually reduce or discharge liabilities of a target at all nor of any of its subsidiaries. It is arguably not assistance having a “financial” character.
Second, the grant of a negative pledge in favor of a bank does not actually fall within the definition of financial assistance in section 152.
A further area of concern is whether section 151 prohibits a foreign subsidiary of an English company from providing financial assistance for the acquisition of shares in its English parent company, and secondly, whether it applies to an acquisition of shares in a foreign company.
These issues were touched upon in Arab Bank plc v. Mercantile Holdings Limited (1994) by Millett J who issued some troubling comments. He was concerned principally with the first issue, whether section 151 prohibits a foreign subsidiary of an English company from providing financial assistance for the acquisition of shares in its English parent.
Millett J concluded that subsidiaries for the purposes of section 151 of the Companies Act had to be construed as limited to subsidiary English companies.
There is a view that Millet J’s conclusion is correct, but that his reasoning is perhaps wrong. The view that supports Millett J’s interpretation relies on the context of the financial assistance prohibition and asserts that the context requires limiting the reference to “subsidiaries” to locally incorporated subsidiaries rather than foreign subsidiaries. Why is the context so important? It is because section 151 is concerned essentially with capital reduction, protection of shareholders’ rights and creditors’ rights — matters that are generally dealt with under the law of the place of incorporation of the relevant company. On this view, it is not for English law to legislate whether foreign subsidiaries may give financial assistance for the purchase of shares in their parent companies, but rather it is for the government of the place the foreign subsidiary is incorporated to do so. Indeed, in some jurisdictions, there is no prohibition on giving financial assistance at all. For example, an international business company incorporated under the law of the British Virgin Islands is not restrained by any such prohibition.
On this basis, it should be lawful for an English company to give financial assistance for the purpose of assisting the purchase of shares in its foreign parent company — the foreign parent after all is not a “company” for the purposes of the Companies Act and is not thereby caught within the prohibition. It should also be lawful for a foreign subsidiary to give financial assistance in connection with the purchase of shares in its English parent. However, the Department of Trade and Industry proposes to change the law on this topic to prevent a British company from providing financial assistance for the acquisition of its own shares or those of any British or foreign parent company. Financial assistance by foreign subsidiaries for the acquisition of the shares of a British parent company would continue to be permitted.
Another question about the ambit of the financial assistance prohibition concerns transaction fees. Quite often, the parties may agree that a target will bear the cost associated with the acquisition of its shares, such as valuation fees for auditors. Some lawyers take the view that such costs may be met by the company because they fall outside the rules if the net assets of the company are not reduced to a material extent. The Department of Trade and Industry proposes to legislate to introduce a specific exemption for lawful fees and indemnities.
Section 153 of the Companies Act and subsequent provisions provide several bases that one might use to argue a scheme is not prohibited.
Sections 153(1) and (2) permit financial assistance if the company’s principal purpose is not to give it for the purpose of the acquisition or to discharge a liability incurred by a person for the acquisition and the financial assistance is given incidentally as part of some larger purpose of the company and in good faith in the interests of the company. These provisions are designed to loosen up the operation of section 151 so as not to catch honest transactions that incidentally involve financial assistance. The problem with the sections is the use of the word “purpose” and the mingling of concepts such as “principal purpose,” “larger purpose” and something being an “incidental part of some larger purpose.” As far as drafting goes, this wording is truly appalling. Those familiar with the use of “purpose” tests in tax legislation will know that they are difficult to apply. This has been the experience of sections 153(1) and (2).
In the context of a refinancing where only a small portion of indebtedness from an initial takeover remains, it could be said that the “larger purpose” is to obtain new finance rather than to discharge an old acquisition borrowing. Perhaps where the new money was £9,999,000.00 and the amount of old acquisition borrowings remaining was £1,000.00, one could rely on these provisions, but where the split is perhaps £5 million for each, it would be a brave lawyer who would say that the principal purpose exemption was available.
The Department of Trade and Industry proposes — possibly during the next parliament — to recast the exemption so that financial assistance would not be prohibited where the company’s “predominant reason” for entering into the deal was not to give financial assistance. When applying this new test, the reason for a transaction should be assessed from the company’s perspective — making board minutes of very great importance — and the fact that the transaction or its manner of implementation constituted financial assistance would be disregarded.
Dividends and Other Exemptions
Section 153 also contains numerous other exemptions. The most important is the ability to provide financial assistance by way of dividend, which is one method in which operating profits may be distributed to shareholders. Also, reductions of capital confirmed by the court, redemptions or purchases by the target of its own shares and schemes of arrangement approved by the court are exempted. In practice — apart from the relaxation procedure discussed below — the “dividending up” exemption is the most important exemption used by companies.
Section 155 of the Companies Act establishes an exemption or relaxation from the prohibitions set out in section 151 that is often applied in highly leveraged deals.
The section permits a private company to give financial assistance where the acquisition of shares in question is or was an acquisition of shares in the company or, if it is a subsidiary of another private company, in that other company if certain legal tripwires are avoided. This section does not apply if one of the intermediate holding companies is a public company.
One condition for section 155 to apply is that the company giving assistance must have net assets that are not reduced, or to the extent that they are reduced, the financial assistance is provided out of distributable profits.
This condition is difficult to comply with in practice. If the target company grants a guarantee and charge in respect of its assets to secure a debt, then are the net assets thereby “reduced”? How is the contingent liability associated with the guarantee to be treated? Current accounting treatment looks at whether the guarantee is likely to be called having regard to the viability of the borrower’s group and cash flow and other projections relevant to the indebtedness in question. If, on the basis of this examination, it is not foreseeable that the guarantee will be called over say two to three years, then the amount of the contingent liability represented by the guarantee will be discounted completely. On this basis, there is no reduction in net assets. These are judgmental considerations and here lies one of the problems associated with section 155(2); judgment brings with it a lack of certainty.
The relaxation provisions are full of other technical requirements, like the need for an auditor’s report and company declarations.
The Department of Trade and Industry has previously proposed to revamp the relaxation provisions significantly. Under the DTI’s preferred approach, private companies will be allowed to provide financial assistance if that assistance is not “materially prejudicial” to the company or if the members approved the transaction in advance.
In what circumstances would a transaction not be “materially prejudicial”? The DTI proposed that if the assistance is out of distributable profits and results in a reduction of less than 3% in the company’s net assets — assuming in the case of contingent liabilities that they were enforced — that the transaction will not be materially prejudicial.
For banks, the major concern associated with section 151 is that they will be punished unduly: the consequence of providing financial assistance in contravention of the statute is, among other things, illegality of any contract (such as a guarantee or security) given in respect of that assistance. Criminal sanctions also apply as mentioned previously. The DTI has previously proposed to change the law in the United Kingdom so that a transaction would not be void solely on the grounds it constituted unlawful financial assistance. Other civil law remedies (constructive trust breaches, etc.) would continue to be available.
The financial assistance prohibition in the statutory form used in the United Kingdom is full of technical tripwires for the unwary and must be approached with caution. The prohibition appears in many permutations around the world. However, these are in no way uniform and each jurisdiction in which a “cousin” to the UK prohibition is to be found should be subject to separate scrutiny.
The issues raised by the prohibition are not peculiar to British Commonwealth or ex-British Commonwealth jurisdictions. Given that the original concerns of the prohibition were to stop unauthorized reductions of capital, civil law jurisdictions may throw up similar issues when target company support is required as a condition to the financing or refinancing of an acquisition of a target’s shares by an investor. Indeed, in some recent transactions in continental Europe involving refinancing of acquisition debt, similar concerns have surfaced.