31 Mar 2011

ASIC's new stand on related party transactions and experts' reports

Following a review of related party transactions, ASIC has issued a new policy.

It has also revised its existing policies on independent experts' reports. This includes new material on the "fair and reasonable" test.

Shareholder approval

In general terms, a company's related parties are its directors and the entity (if any) which controls it. The Corporations Act says that a public company must get shareholder approval before giving a financial benefit to a related party unless the deal is on arm's length terms.

Similarly, a registered scheme must get member approval before giving a financial benefit out of scheme property to the responsible entity or a related party unless the deal is on arm's length terms. (This doesn't stop the responsible entity's paying itself fees or exercising rights to an indemnity provided for in the scheme constitution.)

ASIC's new policy aims to improve disclosure about related party transactions. It addresses five issues:

  • the circumstances in which ASIC will allow directors to vote at a board meeting on a matter in which they have a material personal interest;
  • how to determine what are "arm's length" terms;
  • what information needs to be given to members before they vote on a related party transaction;
  • who can vote on a related party transaction at a general meeting;
  • disclosure of related party transactions in transaction disclosure documents such as prospectuses and bidder's or target's statements.

When can a director with a material personal interest vote?

The Corporations Act prevents a director of a public company from voting on a matter in which he or she has a material personal interest which is required to be disclosed, unless:

  • the other board members allow the director to vote; or
  • ASIC allows the director to vote.

ASIC can allow a director to vote if his or her presence is necessary to ensure that the board meeting has a quorum and there is some compelling reason why the matter can't just be considered at a general meeting.

The Act says that urgency is one reason why relief can be granted. ASIC is coy on what else it considers to be "compelling" reasons, but suggests that they might include:

  • a general meeting has already approved the deal and the directors are just working on implementing it;
  • the matter will ultimately go to a general meeting for approval (by itself or as part of a larger deal);
  • the matter has to be kept confidential;
  • the director only has the material personal interest because it is a prerequisite for the job; or
  • a general meeting might be too expensive.

Do we have arm's length terms?

ASIC sets out a checklist of factors that boards should look at when evaluating the arm's length issue.

  • how do the terms of the overall transaction compare with those of any comparable transactions between parties dealing on an arm’s length basis in similar circumstances?
  • did the company follow "robust protocols" to ensure that conflicts of interest were appropriately managed in negotiating and structuring the transaction?
  • how does the transaction impact on the company (including its financial position and performance) and non-associated members?
  • other options that were available to the company, and
  • any expert advice that was received by the company on the transaction.

The Commission warns that directors need a high degree of certainty before relying on the arm's length exception:

"Directors should only rely on the exception when they are persuaded that the exception does apply, rather than it being merely arguable that it applies.

Accordingly, if after taking into account all the factors in [the above list] and any other relevant factors, it is not clear that the transaction falls within the arm’s length exception (or any other exception in Ch 2E), member approval should be sought."

What should be in the meeting notice?

The Corporations Act lists, in outline form, the information that members must be given before voting on a related party transaction (eg. "the nature of the financial benefits").

ASIC wants to flesh out this list.

For example, it believes that, when detailing "the nature of the financial benefits", the company should disclose not only the nature and quantity of the benefits, but also the reason for giving the benefit and the basis for giving that particular benefit. As a practical example, ASIC spells out what this would entail where the benefit is a grant of options to a director:

"we expect the following information, at a minimum, to be disclosed:

  • the number of options to be granted to the director;
  • the terms of the options;
  • an explanation as to why the options are to be granted, particularly where alternative forms of remuneration or incentive may be required to be expensed by the entity in future years; and
  • an explanation as to why the specified number of options is to be granted and why the specified value of the options was chosen.

Entities should be careful to disclose the substantive effect of a transaction if necessary in order to explain the financial benefit. For example, if a company, instead of granting options, proposes to lend a director money to acquire shares in the company but the repayment terms of the loan effectively create an option-like situation, this should be disclosed."

Meeting materials must also adequately value the financial benefit (preferably in dollar terms) and disclose the basis of the valuation, together with the principal assumptions behind the valuation. In some circumstances, an independent expert's valuation may be necessary (see below). ASIC believes that an adequate valuation is especially relevant where the financial benefit is equity securities in the company or scheme, or involves the sale or purchase of an asset.

The Corporations Act requires the meeting materials to be submitted to ASIC before the meeting. ASIC can then make comments on the materials. Those comments are given to the members. ASIC says that, when deciding whether to comment, it will, among other things, have reference to this new policy.

Independent experts' reports

The Corporations Act generally doesn't require an independent experts' report when a company is seeking shareholder approval for a related party transaction, although many companies do provide them where they're required by the ASX Listing Rules or as a matter of good practice.

ASIC aims to regularise that good practice, through a policy that a report should be provided if:

  • the financial benefit is difficult to value;
  • the transaction is significant from the point of view of the company - apart from the amount of money involved, the deal may be significant because it changes the company's business or strategic direction, or involves the replacement of the board or significant dilution of the existing members;
  • the non-interested directors do not have the expertise or resources to provide independent advice to members about the value of the financial benefit; or
  • the transaction is a component of a control transaction for which the company is commissioning an expert report (such as member approval under item 7 of section 611).

(ASIC has also issued new policy on independent experts' reports generally: see below.)

Who can vote on a related party transaction at a general meeting?

Generally speaking, a related party who is receiving a benefit cannot vote at the shareholders' approval meeting.

ASIC can grant an exemption but, with very limited exceptions, the new policy is almost Please do not ask, as a refusal may offend:

"It is unlikely that we will often make such a declaration. However, since the definition of related party in the Corporations Act is so broad, a declaration may be made, for example, if the applicant can show:

(a) that the association between the parties is strictly technical; and

(b) no real conflict of interest exists (e.g. an associate has no interest in the outcome of the transaction, the interests of the related party are the same as that of the company, or where all the parties are related parties).

In granting this relief, we will consider the effect of relief on the interests of members, other investors and creditors."

Disclosure of existing related party arrangements

As well as new related party transactions, ASIC has looked at the disclosure of existing related party arrangements in disclosure documents such as fundraising and scrip takeover documents (as part of the general statutory duty to provide investors with information relevant to their investment decisions).

Late last year, it considered adopting a policy that all such arrangements should be disclosed, even if the company believed that they are not material. The new policy does not go quite so far:

"We expect entities to disclose information about existing related party transactions in disclosure documents except to the extent that:

(a) such disclosure may confuse investors by dealing with inconsequential matters; or

(b) investors already have adequate information about the related party transactions as a result of past disclosures so it is not reasonable for the information to be repeated in full."

Independent experts' reports - "fair and reasonable"

In tandem with the new policy on related party benefits, ASIC has revised its policy on independent experts' reports.

This aims to address a number of concerns, arising from the Commission's review of market practices. This revealed cases where experts:

  • had accepted an engagement despite serious concerns about their independence;
  • had adopted information provided by the commissioning company without conducting additional critical analysis;
  • did not have a reasonable basis for their forecast financial information; and
  • did not maintain sufficient working papers to demonstrate compliance with their obligations under ASIC's existing policies.

Of particular significance to both related party transactions and takeovers is the "fair and reasonable" test.

ASIC's existing policy on "fair and reasonable" in the takeovers context has been amended to include statements that:

  • a "not fair" offer may still be reasonable if the target is in financial distress and the alternatives to a bid are likely to be less attractive to target shareholders;
  • the expert should quantify the "the reasonableness factors" he or she considers to be material.

ASIC provides two examples of quantification of "reasonableness factors":

"(a) if the expert comments that the share price may fall if the bid is unsuccessful, the expert should consider providing quantitative information such as the pre-announcement share price (or volume weighted average price) and the liquidity profile of the target’s shares; and

(b) if the bidder controls the target, the expert should consider quantifying the size of the minority discount."

Reports on related party transactions involving an asset acquisition or disposal often include a conclusion about whether they are fair and reasonable (eg, where such a report is required under ASX Listing Rule 10.10). Section 640 of the Corporations Act requires a similar report where a bidder is connected with the target. In relation to related party transactions, the new policy sets out guidelines along similar lines to those for takeovers.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.