INSIGHT

If in doubt, get the whitewash out

By Phillip Cornwell, Joshua Storey
Banking & Finance Corporate Governance Financial Services Mergers & Acquisitions Private Equity

In brief 3 min read

The High Court's first decision on the financial assistance prohibition in section 260A of the Corporations Act supports a conservative approach to the prohibition, and in particular highlights the danger of 'taking a view' on the no material prejudice exception. The taking of legal proceedings by a company, at its own expense and risk, to enforce a pre-emptive rights provision for the benefit of majority shareholders, was found to be financial assistance for the acquisition of shares and the company had failed to discharge its onus of showing there was no material prejudice.

Key takeaways

  • The term 'financial assistance' has a broad commercial meaning and can even extend to a company relieving certain shareholders of the financial burden of taking legal proceedings to enforce a pre-emptive rights provision in its constitution.
  • The necessary connection between the assistance and an acquisition or proposed acquisition can be indirect and contingent.
  • At least in injunction proceedings, 'no material prejudice' must be affirmatively established by the company giving the financial assistance.
  • If it is not clear that the company, its shareholders and its ability to pay creditors are in no worse position after the giving of the financial assistance, then a 'whitewash' under the shareholder approval procedure in s260B is prudent.

The High Court's decision in Connective Services Pty Ltd v Slea Pty Ltd [2019] HCA 33

Background – what happened here?

Slea Pty Ltd (Slea) held a 33.3% interest in the company Connective Services Pty Ltd (Connective), along with two other shareholders. Connective conducted a mortgage aggregation business. Its constitution contained a pre-emption clause requiring each shareholder to offer those shares to existing shareholders before those shares could be transferred to another party.

The sole director and shareholder of Slea had had a falling out with the other principals of Connective, and no longer took an active part in the business. It was alleged Slea intended to transfer its shares without complying with this pre-emptive rights provision. Connective took proceedings for an order compelling Slea to offer its shares in Connective to the other shareholders. Slea countered by seeking an injunction restraining those proceedings as unlawful financial assistance.

A little history

The High Court observed that the origins of the financial assistance prohibition lay in a concern with the maintenance of corporate capital, and in particular with the view that the funds of the company should not be used by shareholders 'for the purpose of getting rid of a troublesome partner'. The current version of the prohibition is wider, but these origins did seem to colour the High Court's approach.

What constitutes 'financial assistance'

The High Court confirmed that 'financial assistance' should be given a broad commercial meaning and that there was no need to impose additional tests such as whether the company had been 'impoverished'. The financial assistance in this case was the commencement and funding of legal proceedings against one shareholder to enforce a pre-emptive rights provision for the benefit, in effect, of the other shareholders. The commencement of these proceedings by the company, at its expense, constituted the giving of financial assistance as this eased the financial burden in the process of any acquisition of shares by those other shareholders, who were relieved of having to take the proceedings themselves.

What 'to acquire' means

The words 'to acquire' in s260A extend to all conduct in connection with the process of acquiring the shares or units of shares. The acquisition can be by issue, transfer or any other means. The High Court also confirmed that, despite the change in language that occurred when s260A replaced its predecessor, the section still captures indirect financial assistance and proposed acquisitions.

How to determine whether there is 'material prejudice'

The High Court adopted a simple approach in determining whether there was material prejudice: after the giving of financial assistance will the company or its shareholders or its ability to pay its creditors be in a worse position?

The High Court discounted the value of arbitrary rules (such as percentage impact on profit) and of considering whether there was a 'net transfer of value' for determining 'material prejudice', stating it 'does not assist to gloss the concept of material prejudice by the introduction of further concepts'. In this case the legal costs involved were estimated at between $525,000 and $755,000. The court found that Connective had not shown there was no material prejudice.

The danger in forming a view on 'no material prejudice'

This case illustrates the risk of forming a view that there is no relevant material prejudice under s260A(1)(a) since:

  1. the court seemed to set a low bar for assessing material prejudice; and
  2. the onus, at least in injunction proceedings, will be on the company alleged to have given the financial assistance to disprove material prejudice.

Actions you can take now

  • A conservative approach should always be adopted when considering whether there has been a contravention of s260A(1)(a), and the performing of a 'whitewash' procedure by obtaining shareholder approval under s260B remains an effective way to avoid the consequences of the financial assistance prohibition.
  • At least in cases where the target company becomes a wholly-owned subsidiary of its acquirer, this whitewash procedure is a mere, and otherwise costly but pointless, formality. Reform of the prohibition is called for.