Focus: Even more on amending scheme constitutions
6 September 2012
In brief: A recent Victorian decision has added to the somewhat confusing case law on when a responsible entity can amend a scheme's constitution. Partner Marc Kemp (view CV), Consultant Derek Heath (view CV) and Lawyer Dora Chan report on the case and compare it to previous decisions.
- Background and the 360 Capital decision
- Where the case law agrees
- Where the case law diverges
- What next?
How does it affect you?
- The decision in 360 Capital1 adds to the uncertainty about when a responsible entity can make amendments to a managed investment scheme's constitution without investor approval. There are now two distinct groups of cases.
- From a practical perspective, there is now a higher risk that unilateral amendments will be challenged and declared invalid, at least in the Victorian Supreme Court.
- The decision has again confirmed that, before approving any unilateral amendments, the board of a responsible entity needs to undertake an exhaustive analysis of the proposed amendments and itself conclude that members' rights are not adversely affected.
- We understand that the 360 Capital responsible entity has appealed. If so, the current uncertainties may be resolved in one way or the other.
Section 601GC(1)(b) of the Corporations Act 2001 (Cth) allows the constitution of a registered managed investment scheme to be amended 'by the responsible entity if the responsible entity reasonably considers the change will not adversely affect members' rights.' Otherwise, the constitution may be amended only by a special resolution of the members of the scheme.
As we have previously reported, a responsible entity's power of amendment has recently been the subject of much dispute and consideration (See our previous articles on the subject: Getting your constitutional amendment right – the Centro decision, Amending scheme constitutions – the most recent Federal Court decision on section 601GC, Amending scheme constitutions – the latest on section 601GC, Amending registered scheme constitutions).
In summary, 360 Capital follows the more restrictive approach of the Federal Court decision in Wellington2, by holding that amendments relating to the issue of new securities affected members rights, and could not be made without investor approval if those changes were adverse.
In 360 Capital, investors in the 360 Capital Industrial Fund challenged the validity of two separate sets of amendments to the fund's constitution made by the responsible entity in May and July respectively.
The May amendments made changes to allow the issue of redeemable unsecured convertible notes. The amendments included changes to various clauses of the constitution that would have prevented the notes being issued, such as: a prohibition on issuing options unless the trust was listed (which it wasn't); and limits on the issue of units, including the price at which the units could be issued. At the time the challenge was heard the offer of the notes was well underway, with the institutional offer complete.
The July amendments introduced restrictions on convening and conduct of meetings of members of the fund and the manner in which members could appoint proxies.
The plaintiffs challenged both sets of amendments on the same grounds: that the responsible entity of the fund could not have reasonably considered that the amendments did not adversely affect members' rights and therefore it had no power to make the amendments under s601GC(1)(b). The judge agreed and declared all the amendments ineffective. His Honour declined to consider the position of the placement and the rights of the institutional investors who had already taken up notes.
The 360 Capital decision and the previous case law appear to agree that 'members' rights' means the members' contractual and equitable rights under the constitution.3 A distinction is drawn between the rights of members and the enjoyment of rights or their value. Matters relating to the economic value of the units should be considered instead under the broader question of whether the responsible entity is acting in the best interests of members (as it is required to do under s601FC(1)(c)).
Justice Sifris, the judge in 360 Capital, seemed to accept the distinction between rights and (commercial) interests. However, in a footnote late in his judgment, he questioned the theoretical underpinning of that distinction.4 He seemed to do so in support of his more expansive view of 'rights' (discussed below).
The three-step approach
The three-step approach first articulated by Justice Barrett in ING has been approved in every case since. This approach involves:
- first, an assessment of how the responsible entity viewed members' rights before the modification and whether those rights – as distinct from the enjoyment of them or their value – would be changed or impinged upon by the modification;
- second, the responsible entity must demonstrate that, based on a comparison of members' rights before the modification with the changed rights that would exist after the modification, the responsible entity considered that those rights would not be adversely affected; and
- third, the opinion of the responsible entity as to the absence of adverse affectation must be seen to be something that the responsible entity reasonably considers.
Justice Sifris in 360 Capital described the 'three-step approach' as a 'sound' one 'that has consistently been followed in subsequent cases' (at para 41).
Subsequent cases support Justice Barrett's formulation that 'the responsible entity must decide whether the change will remove, curtail or impair existing rights in a way that is disadvantageous to the person whose degree of affectation is contemplated by the legislation...Any adverse affectation, however slight, is sufficient to deny the responsible entity the modification power.'5
Justice Barrett added:
The question is not a general question whether members will be 'worse off' if the change is made...Nor is it a general question of prejudice or disadvantage. It is a specific question that goes wholly and exclusively to the much narrower matter of members' rights. Their interests are, as stated, another thing altogether. So is the value of their rights.6
Despite this, several decisions appear to have taken the commercial context of the amendments into account when assessing whether an amendment will have an adverse effect. For example, in Timbercorp,7 amendments that were perhaps adverse on their face were permitted in light of the broader commercial consideration that the value of the rights was, in any event, negligible. In addition, the formulation of the test in ING ('whether the change will remove, curtail or impair existing rights in a way that is disadvantageous to the persons whose holdings of units cause them to possess and enjoy the rights' (our emphasis)) itself implies a broader test. Ordinarily the removal, curtailment or impairment of a right would be adverse without more. However, the courts appear to require something more: that the removal, curtailment or impairment also be disadvantageous. This is at odds with the stated principle in ING, that is a question of adverse affectation of rights, not commercial interests.
A narrower rights-based approach is supported by the fact that it is difficult to distinguish the broader approach from the separate 'best interests' test under s601FC(1)(c) of the Corporations Act. This section requires a responsible entity to act in the best interests of members and, if there is a conflict between the interests of the members and the interests of the responsible entity, to give priority to the interests of the members. The 'adverse effect' test risks losing its meaning as a separate test if it takes account of commercial considerations. That said, in Centro the court appears not to have considered this a problem, saying (at ) that the 'analysis and conclusion [in relation to the effect of changes on an assumed right of members] are equally applicable to the matter of benefit to members [ie, members' best interest]'.
In summary, the responsible entity must actually consider that the amendments are not adverse and that conclusion must be reasonable in the circumstances.8
A theme that has emerged from the cases is that the responsible entity must give due and proper consideration as to whether and to what extent members' rights would be affected. The board of the responsibility entity must have turned their minds to these matters. The minutes of the board meeting play a central role in evidencing the decision-making process of the directors of the responsible entity.
In 360 Capital, only the board minutes themselves were provided as evidence of the board's consideration of the issues (for example, there were no affidavits in support from board members). His Honour noted this. While adding that he was not criticising the decision to rely on the minutes alone (paragraph 56) the consequences proved significant.
His Honour also noted that the board minutes did 'not disclose any relevant or adequate consideration of precisely what the rights were before the proposed modification, how the modification would change those rights and, in particular, why such change would not be adverse' (paragraph 61). It did not matter that the board had received and tabled extensive legal advice and an expert's report, or that it was minuted that the board considered the issues and the advice received. Clearly, a very high standard of documentation is now required in these situations.
In summary, though, as we have suggested previously, essentially what is required is to:
- carefully and clearly document in board minutes the three step decision-making process outlined above;
- not restrict the analysis to a 'shopping list' of members' rights, but think expansively about the rights conferred on members under the scheme constitution;
- if there is any uncertainty in the distinction between rights and interests, as is now more likely, and if the RE concludes that an interest is affected, conduct an 'even if' analysis: even if members' rights were affected, would they be adversely affected? and
- always ask 'does the amendment benefit members?'.
Despite agreeing on the process to be followed by responsible entities that are considering whether an amendment to the scheme constitution adversely affects the rights of members, the case law has yielded different results on amendments relating to issuing and pricing interests in the scheme.
In Wellington, Justice Gordon held that a change to the constitution that altered the price at which new units could be issued affected members' rights and that the affectation, in that case, was adverse. Her Honour noted that the responsible entity properly conceded it had not considered whether the change in issue price calculation adversely affected members' rights and then added (at  and ):
Here, each unitholder had the right to have any new units issued in the PIF Scheme issued on the terms that were fixed by the PIF Scheme Constitution and not otherwise.
Her Honour then added:
Furthermore, in my view, it is apparent that given the modification on 9 May 2011 and also on 16 May 2011, it cannot be said that the change would not adversely affect members' rights. It removed or impaired existing rights in a way that was disadvantageous to unitholders. The affectation was adverse to them and, accordingly, that adverse affectation was sufficient to deny Wellington the modification power absent a special resolution of the members of the PIF Scheme.
The pricing provision of the constitution was seen as the source of a contractual right of every existing member to insist that no new unit be issued except at the price specified in the constitution, to allow existing members to maintain a proportionate interest in the scheme based on the existing issue pricing formula, and not to suffer any dilution from the new issues of units priced according to that formula.
In Centro, while stating that it was not ultimately the basis for her decision, Justice Barrett rejected Justice Gordon's conclusion in Wellington that the provisions of a constitution setting the issue price for new units were the source of a contractual right on the part of existing members to insist that no new units be issued except at that price:
the provision prescribing the price at which units may be issued is a provision that qualifies the power of the responsible entity to issue new units. Proper and valid exercise of the power entails issue at the prescribed price and at no other price. The responsible entity has discretion whether to accept an application for units but no discretion as to the issue price. To say that modification of the constitution to change the prescribed issue price affects the 'rights' of existing members is therefore to accept the proposition that members have a 'right to have the scheme administered and operated in accordance with the constitution that, in my opinion, is not a 'right' of members in the relevant sense.
The absence of any such "right" to have the scheme administered and operated in accordance with the constitution and the distinction drawn in the company cases between something that "affects" members' "rights" as such and something that affects enjoyment or value of members' rights or their capacity to turn them to account leads me to the conclusion that, despite what was said in the Premium case, it is open to the applicant, as responsible entity, to form, on reasonable grounds, the opinion that no "right" of members will be affected by the proposed addition to the constitution of the provision allowing a single issue of units at the particular asset value price and not at the market-based price prescribed by the existing provisions...9
Justice Barrett suggested that this issue goes to the heart of the purpose of s601GC(1)(b):
It is possible to argue that "members' rights" include a right to have the managed investment scheme operated and administered according to the constitution as it stands. If that is so, any modification of the constitution involves an invasion of that right that is arguably adverse. I am not persuaded that this is a correct approach. It denies all efficacy to s 601GC(1)(b) and must, for that reason, be rejected. Because the power to modify is concerned with the constitution, the focus is on rights created or secured by the constitution itself.
This contrasts with the view taken by Justice Sifris in 360 Capital:
In my opinion, the plaintiffs [members] did have and do have rights which have purportedly been modified by the May Amendments...
Section 601GB of the Corporations Act requires the constitution of a registered scheme to be "legally enforceable as between members and the responsible entity". Prior to the May Amendments, the constitution provided that New Units were required to be issued in accordance with clause 5 [of the Constitution] and at a price determined in accordance with clause 5.4. Further, clause 5.2(a) prohibited "the Trustee" from granting options "unless the Trust was Listed" and in any event, any option would "not confer on the Optionholder any interest in the Fund" (clause 13.5(a)).
In my opinion, each unitholder or member had a right to ensure that no options were issued unless the Trust was listed and that an optionholder would not have any interest in the Fund. Further, each unitholder had a right to ensure that new units were issued on the terms and at an issue price calculated in accordance with clause 5.4. These rights were and remain accrued and enforceable rights. They are important substantive rights. The modification of these rights in the manner contemplated goes well beyond the enjoyment of such rights or the value of the rights. Rather, the modification affects the characteristics and nature of the rights.
In other words, his Honour held a provision of the constitution of the fund that specifies an issue price or formula, confers rights on members to ensure that no new securities are issued except in accordance with that price or formula, and that an amendment to these provisions may be an amendment that affect members' rights. This follows the more restrictive reading of the constitutional amendment power in Wellington.
Justice Sifris sought to distinguish Centro by noting: the more extensive nature of the rights being considered in Wellington and 360 Capital; the absence of any provision in the Centro constitution prohibiting the issue of options; the uniform application of a new pricing structure in Centro; and the due consideration given to the amendments by the responsible entity in Centro (at  to ).
Despite this, it is somewhat difficult to reconcile the reasoning in 360 Capital and Wellington on the one hand and Centro on the other.
Furthermore, there are elements of the 360 Capital decision that suggest Justice Sifris generally takes a wider view as to what constitutes 'rights':
- As noted above, his Honour questioned some of the underlying reasoning regarding the scope of 'rights':
In my opinion, it is necessary to consider the rights of members in the context of a trustee and beneficiary relationship and excessive reliance should not [as was done in Centro] be placed on the suggested comparable rights of shareholders, particularly in relation to the concept of enjoyment of rights being distinguished from the alteration of rights (Footnote 14.)
- His Honour also sought to narrow the principle that members do not have a right to have the scheme administered in accordance with the constitution without any change. He suggests that this is correct as far as it goes but adds:
Unless and until there is a change in a permitted way, members have a right to have the managed investment scheme operated according to the constitution as it stands. Again not all change is adverse...A change may be entirely beneficial or more accurately a responsible entity may, after due deliberation and analysis consider that such change is beneficial and does not adversely affect members' rights. (Paragraph 55.).
- While not completely clear, it seems his Honour considered that the July amendments relating to meeting procedures and proxies also affected rights (paragraph 70). He did not feel it necessary even to consider the argument that these amendments related to matters of 'a procedural and administrative nature in relation to meetings of 360 Capital RE, not members' rights' (paragraph 68).
All the relevant decisions were by a single judge at first instance and therefore, broadly speaking, have equal weight. It will take either legislative change or the decision of a higher court to clarify the scope of the responsible entity's amendment powers.
We understand that the 360 Capital responsible entity has appealed against Justice Sifris's decision. If so, some of the current uncertainties may be resolved.
- In the matter of 360 Capital Industrial Fund  VSC 320.
- Premium Income Fund Action Group Inc v Wellington Capital Ltd  FCA 698.
- ING Funds Management Limited v ANZ Nominees Limited  (ING) NSW 243 at  to ; Smith v Permanent Trustee Australia Ltd (1992) 10 ACLC 906 at 913-14; Eagle Star Trustees Ltd v Heine Management Ltd (1990) 3 ACSR 232.
- Footnote 14 in paragraph 63.
- ING at paragraph .
- ING at .
- Re Timbercorp Securities Ltd (in liq)  VSC 050.
- ING at .
- At  – .
- Marc KempPartner,
Ph: +61 2 9230 4991
- Derek HeathConsultant,
Ph: +61 2 9230 4233
- Penny NikoloudisPartner,
Ph: +61 2 9230 4805