Underwriting: another warning from the Takeovers Panel

By Will Moncrieff.

Key Points:
Underwriting agreements may need to take account of recent Panel pronouncements.

Underwriting - especially by existing shareholders - continues to attract the attention of the Takeovers Panel.

By itself, using a shareholder as an underwriter isn't illegal. Nor is the possibility that an underwriter may secure a major stake in the company. However, both ASIC and the Panel are concerned about underwriting agreements which:

• unfairly allow the underwriter to gain control (or increase its control) of the company;
• don't offer an equal opportunity to all shareholders; and/or
• confer an unreasonable financial benefit on an underwriter who is a director or controlling shareholder.

The Panel's recent examination of two underwriting arrangements provides a checklist of warning signs that may signal trouble for an underwriting.

InvestorInfo

InvestorInfo (INV) had $1.44 million in the bank. It announced a rights issue to raise $3.6 million to "fund future acquisitions or investment opportunities consistent with INV's growth and diversification strategy"

The exercise price was at a 4%-6% discount to market price.

The issue was fully underwritten by a director (Mr Young) who controlled 26% of the company. If no-one took up the offer, Mr Young would go to 59% control of the company.

What the Panel didn't like

The Panel and ASIC both jumped on the issue.

A company may find itself in the position where handing control to an underwriter is the only way to raise much-needed cash.

This is not an insurmountable problem. Both ASIC and the Panel recognise that, in certain circumstances, handing control to an underwriter may be the unavoidable price of raising much-needed funds.

However, it's clear that the Panel wasn't convinced that InvestorInfo had got to that point. Key factors here were:

• unsatisfactory efforts by the board to find an unrelated underwriter who was not an existing substantial shareholder
• InvestorInfo's failure to obtain external advice on the terms and conditions of the rights issue
• the small discount to market price represented by the rights offer price, which reduced the attractiveness to shareholders of the rights offer
• the fact that the underwriting shareholder would have a chance to increase its shareholding (through the underwriting agreement) that wasn't available to other shareholders
• the company’s relatively secure financial position and the lack of an explained and compelling need for urgent capital raising
• the board’s failure to seek shareholder approval for the underwriting agreement with Mr Young. The Panel acknowledged that as a matter of law the company may not be required to obtain shareholder approval, but noted that if a company takes the step of obtaining shareholder approval then the Panel would be less likely to consider the underwriting would constitute unacceptable circumstances.

As a result of the concerns raised by the Panel and ASIC, the issue and underwriting were revised. Under the revised terms:

• there would be a secondary round of offers to shareholders other than Mr Young
• Mr Young would sell off any post-issue shares above 28.3% (ie, he would only retain what he could have bought under a creep acquisition).

In addition, there would be additional disclosure of the purpose of the rights issue, and shareholders who had already lodged applications would be allowed to withdraw them.

Unrelated underwriter

The InvestorInfo case was followed by the Data & Commerce Limited rights issue. The issue involved an underwriter who was not a current shareholder. However, the underwriter could possibly end up with 40% of the company.

A shareholder complained to the Panel about this. The Panel did not take any action on the complaint because the company took action to change the terms of the rights issue and to provide shareholders with more information. Among other things, the company offered existing shareholders a second-round opportunity to take up rights before the underwriting agreement kicked in (this appears to be similar to the second round offer in InvestorInfo).

Reality check

From these cases emerge some "reality check" questions for any board that's considering an underwriting that could impact on the control of the company:

• how urgently do we need this money?
• what other avenues of fundraising are open to us?
• should we get external advice on the terms and conditions of the fundraising?
• would existing shareholders subscribe if the discount was attractive enough?
• is there an external underwriter willing to take us on?
• should we call a general meeting to get shareholder approval?[1]

For its part, the Panel's recent actions suggest that, if a company does decide on a related-party underwriting, there should be safeguard mechanisms such as:

• a secondary round of offers to shareholders, before the underwriting; and/or
• an agreement by the underwriter to sell down within a specified timeframe.

Another point to remember is that the Panel isn't the only "watchdog" in this area. Even if no shareholders complain about an underwritten issue, ASIC can still take the matter to the Panel or issue a stop order on the prospectus.

[1] The Panel's decision in InvestorInfo provides a more detailed list of relevant factors that may betaken into account when determining whether the issue is unacceptable. This is based on both the Panel's own decisions and the factors listed in ASIC Policy Statement 159:

(a) whether the issuing company received advice from securities advisers – if advice from professional financial advisers (for example, investment banks, and other corporate advisers such as stockbrokers and accountants) is received concerning the various means by which funding could be raised and their respective advantages and disadvantages, it becomes clearer why the issuer chose to raise funds by a rights issue and, potentially, for the commercial terms of the rights issue (for example, amount to be raised, price per share and issue ratio)

(b) whether the issuing company made attempts to find unrelated underwriters and sub-underwriters – this indicates that someone who has no collateral involvement is prepared to take the risk of a shortfall; such a person will seek to reduce that risk by seeking to increase the likelihood of shareholders taking up their rights and by attempting to lay off their risk to other investors through sub-underwriting

(c) the attractiveness of the pricing of the rights issue – a significant discount to market will indicate that the issuer is seeking to attract shareholders to exercise their rights

(d) whether the rights issue is renounceable – renounceability, especially when combined with an attractive issue price, indicates that the issuer wants the rights exercised and that, given that there is no relevant exception from section 606 for the buyers of rights who then exercise them, that the exercise of rights should have the least effect possible on proportionate interests of existing shareholders

(e) market factors during the rights issue – these may incline or disincline shareholders to participate

(f) what disclosures are made or not made by the issuing company before and during the rights issue – full and meaningful disclosure ensures that shareholders and other investors have a clear understanding of the issuer’s business, financial performance, plans and prospects and the effect on them of the issue and will enable shareholders and investors to make a better informed decision in relation to investing in the issuer

(g) the ratio of the rights issue (although the Panel acknowledges that once a company has determined the total amount that needs to be raised, and has settled on a price that will be sufficiently attractive, the ratio offered under the rights issue is a pre-determined result)

(h) the financial situation of the company (ie whether it has a need or use for the funds in the near term) – this may indicate that a rights issue, particularly one underwritten by a related underwriter, is the only rational means by which necessary funds may be raised

(i) whether there is an adequate explanation of the purpose of the issue and the company's prospects in the disclosure document – by explaining the use of funds in some detail the issuer helps to show that there is a genuine need for the funds and makes the issue more attractive to shareholders by showing a commercial justification rather than just asking investors to trust the directors

(j) whether the underwriter has entered into the underwriting in the ordinary course of its business – as with (b);

(k) whether the company has explored other capital-raising alternatives – as with (a)

(l) the terms of the underwriting – unusual terms may suggest that the issuer or the underwriter do not expect the shareholders to take up the rights or an intention that control of the issuer pass to the underwriter

(m) the shareholding structure of the company - if a substantial shareholder is close to control and is also involved in the underwriting this may indicate the matters discussed in (l)

(n) the response of the substantial shareholders to the rights issue – this may indicate whether there is likely to be a large shortfall

(o) recent variations of the company’s capital, such as a buy-back – this can indicate whether there is a genuine need for the funding

(p) whether the identities of any sub-underwriters have been disclosed to shareholders – if the likely control scenarios are disclosed, including the identities of those who may end up owning any shortfall, the future shareholding pattern of the issuer is being frankly discussed, which suggests that shareholders are being openly invited into the rights issue

(q) dealings by an underwriter or sub-underwriter in securities or renounceable rights before or during the rights issue – this may suggest an attempt to build up a base from which control may be obtained and evidence that the issue is not genuinely accessible to shareholders

(r) if the underwriter or sub-underwriter is associated with any directors or substantial shareholders and the role of the underwriter (if any) in the making of the offer under the rights issue – as in (a), (b) and (i)