Insights + Resources

October 18, 2019

Corporate Law Update: High Court Sounds a Warning to Directors Providing Financial Assistance to Shareholders

Following a recent High Court case, companies should be aware of adopting too narrow an interpretation of the “financial assistance” provisions of the Corporations Act 2001 (Cth) (‘Act’). Not fully apprehending the scope of interpretation of “financial assistance” can result in breaches of the Act, with dishonest breaches attracting fines of up to $220,000 and/or imprisonment.

Background to the prohibition on financial assistance

The philosophy behind the prohibition on a company financially assisting persons to acquire its shares was explained in the nineteenth century by Lord Macnaghten:

‘…if shareholders think it worthwhile to spend money for the purpose of getting rid of a troublesome partner who is willing to sell, they may put their hands in their own pockets and buy him out, though they cannot draw on a fund in which others as well as themselves are interested’. [1]

Following concerns about a ‘highly improper’ practice of companies providing funds for the purchase of their own shares, the prohibition was given statutory effect in the English Companies Act 1929. The legislative provision prohibited companies directly or indirectly providing financial assistance in connection with a purchase of their own shares, whether such assistance takes the form of loan, guarantee, provision of security, or otherwise.

In Australia, the modern incarnation of this rule is contained in section 260A of the Act, introduced in 1998. This provision only allows a company to financially assist a person to acquire shares in the company if:

• Giving the assistance does not materially prejudice the interests of the company or its’ shareholders or the company’s ability to pay its creditors; or

• Giving the assistance is prior approved by a special (75%) resolution of shareholders under section 260B; or

• An exemption applies under section 260C.

The prohibition initially took statutory effect as a blanket prohibition. The material prejudice and shareholder approval exceptions were introduced into the corporations law in 1998 to address difficulties the rule had been causing for ordinary commercial transactions.

High Court judgment in October 2019

In a unanimous judgment of five judges of the High Court of Australia on 9 October 2019, the bounds of the meaning of “financial assistance” under section 260A was explained.

In Connective Services Pty Ltd v Slea Pty Ltd [2019] HCA 33 (‘Connective Case’), at the instigation of its’ two majority shareholders (Millsave and Mr Haron), Connective Services Pty Ltd and its’ related entity (together, ‘Companies’) had at their own expense pursued proceedings against a minority shareholder (Slea) for failing to observe the pre-emptive rights provisions of the constitution. Slea sought to sell its shares in the Company to a third party (Minerva) without first offering those shares to the other two shareholders (Millsave and Haron).

Under the pre-emptive rights provisions in the constitution each shareholder was required to offer those shares to existing shareholders before those shares could be transferred to a third party. (Such pre-emptive provisions are fairly common in the constitutions of Australian companies, and even more so if there is a shareholder agreement between the parties. They are designed to protect the vested interests of existing shareholders against outsiders).

Slea and Minerva applied to have the Company’s proceedings against Slea dismissed or stayed and sought an injunction under section 1324 of the Act to restrain the Company on the basis that this contravened section 260A, as it amounted to ‘financial assistance’ to the majority shareholders who coveted the shares sold to Minerva. The assistance to the majority shareholders had not been approved by shareholders under section 260B and it was not exempt under section 260C.

What was the court’s view about ‘financial assistance’

In the Connective Case, the High Court unanimously observed that:

‘The financial assistance need not involve a money payment by the company to the person acquiring the shares. Any action by the company can be financial assistance if it eases the financial burden that would be involved in the process of acquisition or if it improves the person’s “net balance of financial advantage” in relation to the acquisition. For instance, the assistance might involve the company paying a dividend by means other than by payment of cash, issuing a debenture, granting security, or agreeing to pay consultancy fees.’

The High Court held that the commencement of the pre-emptive rights proceeding by the Companies was financial assistance within the meaning of section 260A(1), and that the Companies did not discharge their onus of proving that there was no material prejudice to the Connective companies or their shareholders. By doing so, the Companies eased a financial burden in the process of any acquisition of shares by the majority shareholders.

The Court’s view was that the legal proceedings against Slea for the vindication of the pre-emptive rights of Millsave and Haron could have been commenced by Millsave and Haron. If they had been so commenced, then it would plainly have been financial assistance for the Companies to funds the proceedings just as it would have been financial assistance to provide funds for stamp duty, valuation costs, or due diligence costs. By bringing the proceedings at the expense of the Companies, a financial burden in the process of any acquisition of shares by Millsave and Haron was eased.

What is ‘no material prejudice’?

With respect to material prejudice, the Court’s construction was simply whether the companies will be in a worse position after providing the financial assistance. As the legal costs of the proceedings were in the order of $525,000 to $755,000, the Court found that the Companies had not discharged the onus of establishing no material prejudice occurred.

Some observations

The Connective Case makes it clear that the concept of financial assistance is not confined to direct contributions to the share acquisition price. The relevant question is whether the relevant assistance involves the reduction of the financial burden of acquisition for the relevant purchaser. Anything which ‘smooths the path to the acquisition of shares’ may be required to be financial assistance.

Directors of companies should take note of this case when approving share transfers, and must think carefully before instigating any proceedings to protect the rights of shareholders aggrieved by such transfers. To do so they either need authority of shareholders by special resolution, or must be confident that the interests of the Company, shareholders or creditors are not materially prejudiced.

Interestingly, under recently introduced crowd sourced funding regulations, a similar financial prohibition applies for CSF funding (section 738ZE of the Act). However, unlike section 260A, there are no exceptions for shareholder consent or where the grant of assistance does not materially prejudice the company, shareholder or creditors.

Concluding remarks

The Connective Case demonstrates that it is fraught with risk to take a permissive view as what constitutes financial assistance or ‘no material prejudice’. Directors are well advised to seek proper legal advice before forming such views in connection with acquisitions of the company’s shares.

This article provides information that is general in nature. If you have questions or concerns involving questions of corporate law, including the financial assistance provisions of the Act, please contact us below.

[1] Trevor v Whitworth (1887) 12 App Cas 409, 436.

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