CODEWORD

The Fundamental Rule

Except as permitted by rule 7, fundamental rule 6(1) generally prohibits a person becoming the holder or controller of an increased percentage of the voting rights in a Code company where that interest would be greater than 20%. Taken together, rules 6 and 7 allow a person to become the holder or controller of an increased percentage only by specific methods. The permissible methods vary according to the person’s position before and after the increase.

Fundamental rule 6(1) was formulated with a view to possible avoidance strategies as found in local and overseas practice. Of particular significance in this regard are the control limb of rule 6(1), the aggregation of associates’ holding under rule 6(1)(a), as well as the definitions of control and associates.

The Control Limb

The fundamental rule is concerned with transactions that cause a person to become the holder or controller of an increased percentage of the voting rights in a Code company. If the fundamental rule were triggered solely by changes in a person’s holding, this could be easily avoided by property-based arrangements (e.g. by using nominees) or contractual ones (e.g. by voting agreements). Accordingly, the control limb of rule 6(1) is appropriately viewed as the threshold anti-avoidance measure. It ensures that changes in control of a Code company cannot be hidden behind ownership or contractual arrangements.

Example 1

Pedro holds 15% of the shares in Code company Trojan Limited. Pedro proposes to acquire an option over Victoria’s 10% holding in Trojan Limited. Victoria agrees to vote her shares in accordance with Pedro’s instruction. [Note: In all diagrams Trojan Limited is a Code company. Shaded boxes or circles signal non-compliance with the Code.

Example 2

Victoria holds all the shares in Nautilus Limited that, in turn, owns 25% of the shares in Code company Trojan Limited. Pedro proposes to purchase Victoria’s shares in Nautilus Limited.

As the Victoria/Pedro transaction will not alter the holdings in Trojan Limited, it does not cause Pedro to become the holder of an increased percentage of voting rights in the Code company. However, the transaction will provide Pedro with absolute control over Nautilus Limited and thus with control over the 25% parcel in Trojan Limited. By reason of the transaction, Pedro will become the controller of an increased percentage (moving from 0% to 25%) of voting rights in Trojan Limited. As Pedro will control more than 20% of the voting rights after the transaction, Pedro will breach rule 6(1)(a).

Broad definition of control

The net cast by the control limb of fundamental rule 6(1) is a wide one, as rule 2(1) defines control, in relation to a voting right, as having directly or indirectly, effective control of the voting right.

When applied to arrangements involving indirect control of a voting right, the fundamental rule will apply to a variety of potential avoidance strategies, subject only to the constraint that the indirect control of voting rights be effective.

Example 3

Victoria holds 40% of the shares in listed company Nautilus Limited that in turn owns 25% of the shares in Code company Trojan Limited. Pedro proposes to purchase Victoria’s holding in Nautilus Limited.

As Nautilus Limited is a listed company, it qualifies as a Code company under rule 3(1). Accordingly, the proposed transaction implicates fundamental rule 6(1) in relation to the shares in both Nautilus Limited and Trojan Limited. Of interest in the present context is its application to control of the shares in downstream Trojan Limited.

Assume, for the purposes of the example, that Nautilus Limited’s shareholders will approve Pedro’s purchase of Victoria’s holding in Nautilus Limited pursuant to rule 7(c). Now consider the proposed transaction as it bears upon the holding and controlling of shares in Trojan Limited. The transaction will not increase the percentage of voting rights that Pedro holds in Trojan Limited. Both before and after the transaction, Pedro will hold no voting rights in that Code company.

However, assuming that Victoria’s 40% holding in listed company Nautilus Limited gives Victoria effective control of that company, then, in turn, Victoria will have effective control over Nautilus’s 25% holding in Code company Trojan Limited. The proposed transaction will enable Pedro to accede to that control position. Accordingly, as the proposed transaction will increase from 0% to 25%, the percentage of voting rights in Trojan Limited that is controlled by Pedro, Pedro will contravene rule 6(1)(a) in relation to Trojan Limited.

Note that it is not sufficient for compliance with the Code that the shareholders of Nautilus Limited approved Pedro’s acquisition of Victoria’s shares in Nautilus Limited. The acquisition of control of voting rights in Trojan Limited is one for the shareholders of Trojan Limited to approve.

Associates

The Code is concerned with regulating changes of control of Code companies. The Code would be ineffectual if it concentrated only on voting rights held or controlled by a particular company or individual. It was essential to include in the Code the concept of “association” so that when two or more associated parties acquire ownership of, or control of, voting rights above 20% in a Code company the fundamental rule is triggered.

The concept of associates appears in fundamental rule 6(1)(a) as well as in two of the deeming provisions in rule 6(2). In all three instances, the concept serves as an anti-avoidance measure.

Example 4

Associates Pedro and Quentin hold respectively 8% and 10% of the shares in Code company Trojan Limited. Pedro proposes to increase his holding by 7% to 15% through on market purchases. Pedro’s purchase will not make him the holder or controller of more than 20% in Trojan Limited. The transaction will, nevertheless, contravene rule 6(1)(a). For the purposes of the 20% threshold, Pedro’s post-transaction holding must be aggregated with the holding of associate Quentin. As the proposed transaction increases the combined holding of Pedro and Quentin from 18% to 25%, it will exceed the 20% threshold in rule 6(1)(a). Associate arrangements will also aggregate holdings in upstream companies.

Example 5

Associates Pedro, Quentin and Rodrigo each hold one third of the shares in Nautilus Limited that in turn owns 19% of the shares in Code company Trojan Limited. Pedro proposes to acquire on his own account a 2% holding in Trojan Limited through on-market purchases.

Viewed in isolation, the proposed acquisition will not cross any of the thresholds set by the fundamental rule. However, the combined holdings of Pedro, Quentin and Rodrigo give them effective control over the affairs of Nautilus Limited and thus control over the 19% holding in Trojan Limited. This control position must be aggregated with the proposed on-market 2% purchase by Pedro. As the aggregated post-transaction control position of Pedro, Quentin and Rodrigo involves more than 20% of the shares in Trojan Limited, the proposed acquisition will cause Pedro to breach rule 6(1)(a).

Broad Definition of Associate

“Associate” is defined in the Code as follows:

Meaning of associate

(1) For the purposes of this Code, a person is an associate of another person if

(a) the persons are acting jointly or in concert; or

(b) the first person acts, or is accustomed to act, in accordance with the wishes of the other person; or

(c) the persons are related companies; or

(d) the persons have a business relationship, personal relationship, or an ownership relationship such that they should, under the circumstances, be regarded as associates; or

(e) the first person is an associate of a third person who is an associate of the other person (in both cases under any of paragraphs (a) to (d)) and the nature of the relationships between the first person, the third person, and the other person (or any of them) is such that, under the circumstances, the first person should be regarded as an associate of the other person.

(2) A director of a company or other body corporate is not an associate of that company or body corporate merely because he or she is a director of that company or body corporate.

The definition of associate has two features that significantly extend the anti-avoidance scope of the fundamental rule.

First, associate status does not presuppose control of the associate’s voting rights. For instance, under rule 4(1)(a), two persons qualify as associates if they act jointly or in concert, even though neither has positive control over the actions of the other. Under rule 4(1)(b), two persons qualify as associates if the one person is accustomed to act (as opposed to required to act) in accordance with the wishes of the other

Secondly, the definition of associate is, in all five limbs, an open-ended one that turns on the facts of the particular situation. This is expressly obvious in relation to rule 4(1)(d) and rule 4(1)(e) which define associate by reference to the term itself under the circumstances. However, fact-based analysis is also anticipated by the element acting jointly or in concert in rule 4(1)(a) and by the element accustomed to act in rule 4(1)(b).

Fact-based analysis even enters into the operation of rule 4(1)(c) under which two related companies qualify as associates. Rule 3 provides that related company has the same meaning as in section 2(3) of the Companies Act l993. Under that section, two companies qualify as related if one company is the subsidiary of the other under section 5. A subsidiary relationship exists under section 5(1), if the one company controls the composition of the board of the other, which will usually depend on the circumstances of the case.

Cumulative scope of the limbs in rule 4(1)

The five limbs of the associate definition apply singularly and cumulatively.

Example 6

Handy Limited holds 25% of the shares in Superior Limited, the remainder of the shares being widely held. Superior Limited is the exclusive distributor of one of the products manufactured by Handy Limited. Handy Limited and Superior Limited each hold 9% of the shares in Code company Trojan Limited and each has a right of first refusal over the other’s holding. Superior Limited acquires on-market another 2% in Trojan Limited. Shortly thereafter, Handy Limited acquires another 1% in Trojan Limited on-market.

If Handy Limited and Superior Limited qualify as associates, then the 1% acquisition by Handy Limited would breach rule 6(1)(a). The two companies possibly qualify as associates under any of the first four limbs in rule 4(1). The facts relevant to any one particular limb might leave some doubt whether the two companies qualify as associates under that particular limb. However, the Panel can also take into account the cumulative significance of possible qualification under the other limbs.

Combined effect of the control and associate elements

The combined effect of the control and associate elements, in view of their open-ended definitions, significantly expands the potential scope of the fundamental rule.

Example 7

Xavier Limited holds 40% of the shares in closely held investment company Nautilus Limited that in turn holds 19% of the shares in Code company Trojan Limited. Xavier Limited is also the principal lender to highly leveraged Prospect Limited (a closely-held venture capital firm). Prospect Limited proposes to purchase on-market a 5% stake in Trojan Limited.

Prospect Limited’s acquisition will trigger rule 6(1)(a) if: a) Xavier Limited and Prospect Limited qualify as associates, i.e. by reason of their debtor/creditor relationship; and b) Xavier Limited has effective control over Nautilus Limited’s shares in Trojan Limited.