Corporate - Financial Assistance Update

The law on financial assistance has long been regarded as one of the most complex and uncertain areas of modern company law. This complexity has important practical implications for structuring transactions.

Two recent Court of Appeal decisions and one first instance case have highlighted the lack of certainty in this area and the potential pitfalls in three commonplace scenarios:

the payment of fees by a target company;

restructuring post-acquisition indebtedness; and

operating the "whitewash" procedure under section 155 of the Companies Act.

OVERVIEW OF THE LAW OF FINANCIAL ASSISTANCE

The prohibition

Section 151 of the Companies Act 1985 (the Act) prohibits a company or any of its subsidiaries from providing financial assistance where a person is acquiring, proposing to acquire or has acquired, shares in that company. Financial assistance should not be provided, directly or indirectly, for the purpose of:

the acquisition of shares; or

reducing or discharging a liability incurred for the purpose of an acquisition of shares.

The Act lists the types of financial assistance which are caught by the restriction. It also provides a list of certain activities where the provision of financial assistance will not be unlawful. The box on page 2 summarises the types of financial assistance that are prohibited and what is permitted.

The key objective of the financial assistance provisions in the Act is the protection of the assets of the target company or group from the perspective of their creditors and non-assenting shareholders.

Many commentators have, for a long time, felt that these concerns are already adequately provided for in the laws relating to directors' duties, unfair prejudice, unlawful dividends, reductions of capital and the provisions of the Insolvency Act 1986 regarding transactions at a preference or those intended to defraud creditors. There have been a series of reviews recommending change and liberalisation, including proposals from the Company Law Steering Group for the planned Companies Bill. However, at present, the current prohibitions remain on the statute book and there is no imminent sign of new legislation. In addition, the restrictions are entrenched in European law in so far as they relate to PLCs and so any reform for PLCs would also have to be agreed at a European level.

Sanctions for breach

The consequences of a breach of the financial assistance provisions can be severe:

It is a criminal offence. The company providing the financial assistance may be liable to a fine and the officers of the company in default may be liable for imprisonment and/or a fine.

The company and its officers can be required to compensate any person who suffers a loss as a consequence of their unlawful actions.

Breach of the prohibition is a breach of a director's fiduciary duty for which the company can seek damages.

PAYMENT OF FEES BY THE TARGET: THE CHASTON CASE

Chaston v SWP Group Plc [2003] B.C.C. 140

Facts

A subsidiary of a target company paid fees incurred by its own auditor in the preparation and provision of financial information to be included in the purchaser's long form report. The long form report was required in the preparation of a prospectus for an equity fundraising to be carried out by the purchaser to finance the acquisition.

Following completion of the acquisition, the purchaser brought proceedings against Robert Chaston, who was a director of the subsidiary and a shareholder of the target company. The claim was for damages by virtue of the director having breached his fiduciary duty by having procured or connived in the provision of unlawful financial assistance by the payment by the subsidiary of the auditor's fees. The purchaser had taken an assignment of the benefit of the right of the subsidiary to sue its former director for breach of fiduciary duty.

Decision of the Court of Appeal

The Court of Appeal overturned the decision of the first instance court and found that the payment of the auditor's fees by the subsidiary did constitute unlawful financial assistance.

Arden LJ (giving the leading judgment) stated that what was important in reviewing whether the transaction involved the provision of financial assistance was whether "as a matter of commercial reality, the fees in question smoothed the path to the acquisition of shares". In the circumstances, the payment of the auditor's fees relieved both the purchaser and the vendor from incurring their own costs in the preparation of the financial information in the long form report. The payment reduced the net assets of the subsidiary to a material extent and was therefore financial assistance.

The other key points arising from the Court of Appeal decision were:

It was irrelevant whether the financial assistance was incurred prior to or at the same time as the completion of the acquisition of the shares. The legislation contemplates that unlawful financial assistance can be provided where a person is only "proposing" to acquire the shares. Preparatory work that acts only as an inducement to enter into a transaction can therefore be unlawful financial assistance for the purposes of that transaction.

It was acknowledged in the Court of Appeal that the purchaser did not regard the acquisition as a success: part of the motivation behind bringing the action against the director was the recovery of part of the purchaser's overall loss resulting from the transaction. However, the merits of the purchaser's case were not relevant in deciding the financial assistance issue.

A transaction can constitute financial assistance whether the assistance is provided to the purchaser or the vendor or to the target itself.

A transaction which constitutes financial assistance does not need to be to the detriment of the company's interests. For example, it is possible for there to be unlawful financial assistance where a company provides a loan on terms that are better than usual commercial terms.

The fact that the director had acted honestly in the best interests of the company did not prevent the director from being found liable for proving the...

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