Effecting a takeover by scheme of arrangement has long offered one key attraction over a traditional contractual offer – a lower threshold to enable the purchaser to compulsorily acquire the entire issued share capital of the target. However, this advantage hides a potential trap for bidders which has long been identified as a risk but which, until recently, target shareholders opposed to a takeover had not sought to exploit.
What is a scheme of arrangement?
A scheme of arrangement is a statutory process set out in the Companies Act 2006 under which a company can agree to an arrangement with its members or creditors, which becomes binding on all relevant members or creditors once approved at a specially convened meeting (known as a court meeting) and then approved by the court. The “arrangement” can take any number of forms. On a takeover scheme, all of the existing shares in the target are mandatorily transferred to the bidder in exchange for the agreed purchase price.
The risk for bidders: the “majority in number” requirement
Under a takeover scheme, the court is able to order the transfer of the target’s entire issued share capital to the purchaser once the scheme consent threshold has been met – a majority in number of voting target shareholders between them holding not less than 75% in value of the shares voting on the scheme (this contrasts with the 90% acceptance threshold at which the statutory squeeze out is triggered on a contractual takeover offer).
It is the first element of the test where the risk for bidders lies. For a court meeting attended (in person or by proxy) by 400 shareholders, if 200 or more vote against the scheme (irrespective of how many shares they hold) the scheme would be defeated. So, for example, those 200 shareholders could hold a single share each and prevent the other 200 shareholders (who could hold, say, 10 million shares between them) from being able to approve the scheme.
It is precisely this aspect of the approval threshold that some employees of Dee Valley, a water utility company and the target of a recent takeover bid by Severn Trent, sought to exploit.
“Share-splitting”: the intended spoiling tactic
A number of shareholders opposed the Dee Valley scheme from the outset. One of these shareholders, Mr C (also an employee of Dee Valley), bought 443 new shares in the company following court hearing being convened, each of which were transferred by way of gift to a separate individual employee. Just a few days later, proxies for many of these shareholders were lodged against the scheme.
At the court meeting, 466 out of 828 members present in person or by proxy voted against the resolution to approve the scheme, but more than 75% of votes cast were in favour of the scheme.
Prior to the scheme, the company obtained an order from the court permitting the chairman of the meeting to reject the votes of any person deriving their shareholding from a transfer by Mr C. The purpose of the order was to allow the chairman to discount the votes and report the result of the meeting to the court on both bases (i.e. with or without the votes of the new single-share members), and then enable the legitimacy of that discounting to be argued before the court at the hearing to approve the scheme. The chairman duly discounted the votes of the 443 new members, which meant, by a majority of 363 to 32, that the majority in number test was satisfied.
What the court had to decide
In the words of the judge:
“It appears that this is the first case in which a share-splitting exercise has been undertaken with the apparent object of defeating a scheme of arrangement between its shareholders…”
And so the question before the court was whether, given the apparent clarity of the statutory requirements, the chairman was able to legitimately discount the votes of those members who had received their shares through the split. At face value, the strict consent requirements of the Companies Act looked to favour the opponents of the scheme (and leading textbooks quoted by counsel for the opponents went so far as to say the court was “powerless” in the face of share-splitting tactics to defeat a scheme).
The court’s decision: the votes of the new, single-share, members could be discounted
The court found that the chairman was entitled to discount the votes exercised by the new single-share members. The court found that on a scheme, the shareholders must vote in a way they consider benefits the class as a whole (a new rule which parallels the common law restrictions on the power of a majority to alter articles of association, which must be exercised in the interests of the company as a whole) – here they had joined the class purely with the intention of defeating the scheme.
The court said (with emphasis added):
“… the actions of the Individual Shareholders in accepting the gift of a single share in the circumstances I have described demonstrated that they could have given no consideration to the interests of the class of members which they had joined. They can only have joined that class with the pre-conceived notion of voting down the Scheme. There was no other reason to acquire one single share in the Company at that crucial time after the Court Meeting had been directed. Both the Chairman and the court could and should, in my judgment, take these matters into account in considering whether the votes of the Individual Shareholders were valid. In my judgment, they were not. The Chairman was entitled to protect the integrity of the Court Meeting against manipulative practices such as share-splitting that would frustrate its statutory purpose.”
Whilst leave to appeal the decision was granted, the opponents of the scheme subsequently decided against further legal action.
A dangerous precedent, or a principled view from the court?
The case is another example of where the English courts use established legal principles to develop a new rule to get to what might be objectively considered the “right” result – certainly as far as the majority shareholders of the company were concerned.
However, the court clearly grappled with the difficulties that could easily flow from principle underlying the judgment – that the state of mind of a particular shareholder is of legal significance and could result in their vote being discounted at the chairman’s (or the court’s) discretion if not deemed to have been exercised to benefit the class.
More fundamentally, the decision also represents an encroachment on the principle of legal certainty between parties that makes English law so attractive to international business, and a further restriction on the general principle that shareholders are entitled to exercise their voting rights as they wish.
With this in mind, in its judgment the court tried very hard to limit the scope of this rule to clearly abusive transactions:
“… The thought processes of members are likely to be complex and intertwined and, unless it can be shown… that the members were motivated by their own interests in a quite different capacity, it will, I think, be hard to reject votes by looking into their minds.”
In our view, the court did as well as it could in developing a limited rule to avoid situations where, given the particular nature of the statutory approval threshold, the majority could be held to ransom by new shareholders holding a (potentially) vanishingly small percentage of the company’s overall share capital.
Whilst those new shareholders opposed the scheme on very principled grounds, the disenfranchisement of the majority of existing shareholders holding a much larger number of shares was, in the circumstances, always likely to be successfully challenged. But instances where the court is willing to exercise that power are likely to be limited to clearly artificial situations involving incoming shareholders intent on defeating a scheme by “flooding” the court meeting.
Of course, had the judgment gone the other way, the bidder would not have been powerless and could have switched to a contractual takeover offer, where each shareholder would have been free to accept the offer. With that in mind, and with the stamp duty saving for takeover schemes having been removed a few years ago (eliminating another key advantage of a scheme over a contractual takeover offer), in the future bidders and their advisers might look a little more closely at the make-up of the target’s shareholder register to see whether a contractual offer might afford greater certainty from the outset.