After two years of market uncertainty, ASIC has settled its position on the use of stub equity in public markets control transactions. The final position, which will permit the continued use of custodian arrangements in stub equity structures, is a positive outcome for private equity and a sensible compromise from the regulator.
Stub equity gives shareholders the option of retaining a stake in the target business by swapping their shares in the target for shares in the bid vehicle, rather than cashing out. It is a structure that is particularly favoured by private equity bidders, who may be looking for ways to encourage certain institutional shareholders to support the bid and/or to bridge a gap in value expectations.
The challenge with such structures is that the stub equity must be offered to all target shareholders on an equal basis. That means that the bid promoter faces the theoretical risk that acceptances into the stub equity could mean that the bid vehicle is ultimately populated by a large number of shareholders. If the number of shareholders who accept the sub equity exceeds 50, then the bid vehicle will become subject to Australian takeover laws. This would complicate an exit and diminish the benefits of the take private transaction.
To avoid this unwanted outcome, the stub equity is usually issued to a custodian who holds legal title to the stub equity on behalf of the accepting shareholders. This ensures that the number of registered shareholders in the bid vehicle remains below the limits at which the takeovers provisions of the Corporations Act are triggered. As an additional benefit, this approach also ensures that the continuous disclosure requirements do not apply to the stub equity vehicle.
Controversially, some issuers of stub equity have gone further, by structuring their investment vehicles as proprietary companies, so as to step around the enhanced reporting requirements and investor protections that apply to public companies.
Since the Capilano Honey scheme in late 2018, ASIC has expressed its concern that retail investors who take up stub equity do not benefit from an appropriate level of disclosure and reporting in respect of their shareholding in the stub equity vehicle. Successive public statements placed the market on notice that the use of stub equity ran a real risk of regulatory intervention, unless those concerns were addressed to ASIC's satisfaction.
In June 2019, ASIC invited submissions on a proposal to modify the Corporations Act so as to:
- prevent stub equity offers of scrip in a propriety company; and
- prohibit the use of custodian structures to hold stub equity scrip.
The proposal received a significant market response. In our article from August 2019, we expressed the view that ASIC's proposal was an overreaction. While we agreed that there was a case for prohibiting stub equity being offered in proprietary companies, we argued that removing the right to use a custodian could only result in either:
- private equity looking for other jurisdictions in which to deploy capital; or
- stub equity being offered in offshore vehicles which are both beyond ASIC's regulatory reach and which may in fact provide even lesser protection to investors.
More than 12 months after commencing consultations, ASIC has now released its final position. In summary, ASIC has modified the Corporations Act to prohibit the issue of stub equity in proprietary companies without a prospectus. Importantly however, ASIC has decided not to ban the use of custodian agreements. The modified law contains anti-avoidance mechanisms to ensure that public company structures are not converted to a proprietary company at a later stage, except by way of a special resolution of the underlying beneficiaries.
The final outcome is a sensible decision, and strikes an appropriate balance between maintaining investor protections, while ensuring that take private transactions remain a feature of this market. With the boundaries having now been clearly marked, private equity can again deploy stub equity structures with confidence. Accepting shareholders will retain the investor protections afforded to them by a public company structure, without interfering in the commercial drivers that gave rise to the deal in the first place. Given the uncertainties that the market has dealt with during 2020, any outcome that offers greater flexibility in deal making will be warmly welcomed.
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