The Federal Court has cast doubt on whether a director can recommend to shareholders that they vote in favour of a scheme of arrangement where that director will receive a benefit in connection with the scheme’s implementation. This has called into question the common practice of scheme implementation agreements requiring unanimous recommendations from target boards and containing corresponding walk-away rights, leaving market participants wondering when disclosure of a director’s interest in the scheme booklet will not be sufficient such that the director should decline to provide a recommendation.
Unanimous recommendation requirement the norm
It is common for scheme implementation agreements to require the board of the target to unanimously recommend that shareholders vote in favour of the scheme (subject to limited qualifications such as the absence of a superior proposal and the expert concluding the scheme is in the best interest of shareholders), and for bidders to have a corresponding walk-away right if a director does not provide or withdraws that recommendation.
In most cases, this is the expectation of bidders when transacting via scheme and is not a contentious issue for targets, given a scheme is implemented by (and therefore requires the support of) the target in any case.
What about the recommendation of interested directors?
Up until now, the fact that a director would receive a benefit in connection with the success of a scheme did not, generally, change the above position. That is, bidders have still expected, and targets have still agreed to, a requirement for a unanimous positive recommendation and corresponding walk away right in scheme implementation agreements. The benefit to be received by the director has been considered a disclosure issue to be addressed in the scheme booklet.
This approach was recently endorsed by the Supreme Court of Victoria in SMS Management & Technology Ltd  VSC 257, where the managing director was to receive a cash ‘incentive payment’ in connection with the implementation of the scheme. In this case, Justice Robson considered it important that shareholders know the recommendation of the managing director (being the “main moving force behind the company” (at )) and believed the disclosure of the managing director’s interest in a footnote to the chairman’s letter to be sufficient.
Justice Farrell has, however, taken a different approach in two recent Federal Court decisions:
Gazal Corporation Limited  FCA 701
Justice Farrell disagreed with Justice Robson in SMS Management & Technology and said it was not necessary for an interested director to provide a recommendation (even if they are the managing director). Here, the managing director was to receive a cash payment as a ‘bonus’ if the scheme was implemented.
The Court ultimately allowed the scheme booklet to be sent to shareholders containing the recommendation of the interested director, but only after the ‘Letter from the Independent Director’ was amended to include (in the body) disclosure of the benefit to be received by the managing director (in addition to the disclosures of that interest that already appeared in a number of places in the scheme booklet).
Her Honour ended her reasons with a warning that disclosure may not always be sufficient and that scheme proponents cannot always count on the Court making orders approving despatch of the scheme booklet or the scheme where an interested director elects to make a recommendation. Her Honour also made it clear what, in her view, such interested directors should do (at ):
“… directors who are interested in the outcome of the scheme because they stand to receive a bonus or benefit (other than as a shareholder) only if the scheme proceeds should exercise caution in making recommendations and, in my view, generally should not do so.”
Ruralco Holdings Limited  FCA 878
A similar approach was taken by Justice Farrell in Ruralco, where the managing director was to receive cash payments in connection with the scheme’s implementation in lieu of existing entitlements and as part of retention arrangements.
The Court emphasised the importance of disclosing the interest of the managing director in the Chairman’s Letter and in every other instance in the scheme booklet where the directors’ unanimous recommendation is mentioned, so shareholders could decide what weight to give to the recommendation. The Court approved the despatch of the booklet to shareholders, but only on the basis that it contained such disclosure.
Like in Gazal, the Court expressed a preference that only the independent directors provide a recommendation and observed that the additional disclosure and issues associated with having an interested director provide a recommendation could have been avoided if the managing director had declined to provide a recommendation.
The Federal Court’s comments in these cases do not apply to voting intention statements by directors in relation to their own shareholdings, which the Court acknowledged was appropriate (see Gazal at ).
Q&A script and other communications with shareholders
In Gazal, after making the disclosure in the scheme booklet of the managing director’s benefit more prominent to address the Court’s comments at the first Court hearing, the script used for telephone canvassing of shareholders referred to the directors’ unanimous recommendation without mentioning the bonus to be received by the managing director.
This was not subject to specific comment by Justice Farrell in Gazal, but it was taken up in Ruralco, where Her Honour noted (at ):
“The bare statement of the directors’ recommendation (without reference to [the managing director’s] interest) in other communications with shareholders, such as in telephone canvassing, might be a circumstance which might lead a Court at the second court hearing to decline to approve the scheme because the Court could not be assured of the integrity of the outcome of the shareholder vote.”
Accordingly, parties should not only focus on the shareholder communications approved by the Court but must be vigilant of how the recommendation of an interested director (and other matters relevant to the Court) is being represented in all communications with shareholders, regardless of whether such communications are scrutinised during the first Court hearing.
Benefits to directors that have an ‘incentive effect’
The ‘benefits’ the focus of this note are pecuniary interests in the outcome of the scheme different to those of other shareholders. It seems reasonable to expect that the required disclosure, and the appropriateness of an interested director making a recommendation, will in each case be informed by the ‘materiality’ of the pecuniary interest in question. While quantum will presumably inform materiality, what about the purpose or characterisation of the benefit?
In SMS Management & Technology and Gazal, the benefit in question was a cash payment that was described as an ‘incentive’ and ‘bonus’ (respectively) and had as its purpose incentivising implementation of the transaction and recognising the directors’ conduct in relation to the implementation of the scheme.
In Ruralco, on the other hand, the cash payments to be made to the managing director were designed to satisfy existing entitlements and were part of legitimate retention arrangements. Nevertheless, the Court focussed on the fact that the proposed payments were dependent on shareholders voting in favour of the scheme and decided that – even though the purpose of the payments was not to incentivise implementation of the scheme – “[t]here is, nonetheless, an incentive effect supportive of the scheme” (at ).
Accordingly, it would seem the purpose and characterisation of the payment will be of little influence if, as a matter of fact, the payment is dependent on the scheme being implemented, such that it may have an incentive effect. If this is the case, whether the director should provide a recommendation and, if so, how disclosure will be approached, should be carefully considered.
Where to from here?
It is unclear from the above decisions when disclosure in the scheme booklet will be sufficient – put differently, when will a Court decline to approve a scheme booklet for despatch on account of it containing the recommendation of an interested director? Parties may seek to address this uncertainty in implementation agreements (specifically the risk of a bidder’s termination right being triggered by a director withdrawing their recommendation, so the Court will approve a booklet for despatch) by, for example:
- qualifying the requirement for a unanimous recommendation (or the corresponding walk away right) where it is determined that it is not appropriate for the interested director to provide a recommendation (whether based on the directors’ determination alone or requiring a supporting legal opinion); or
- only requiring a unanimous recommendation of the independent directors (rather than the full board).
Indeed, in Gazal, the Court said “the question of whether it is appropriate for all directors to make a voting recommendation should be considered at the time a scheme implementation agreement is executed and conditions crafted appropriately” (at ).
What is clearer after Gazal and Ruralco is the Federal Court’s expectations in relation to the disclosure of a material benefit to be received by an interested director in connection with a scheme. In short, the benefit to be received by the interested director must be disclosed in the chairman’s letter and wherever else the unanimous recommendation is provided in the scheme booklet (and other shareholder communications).
This heightened disclosure guidance will assist parties weigh up whether an interested director should provide a recommendation. That is, if an interested director considers it appropriate and would like to provide a recommendation, they must do so in full knowledge that the benefit they stand to receive will require more prominent and frequent disclosure in the scheme booklet and all other communications with shareholders than would otherwise be the case.
Gilbert + Tobin is acting for Ruralco in relation to its proposed scheme of arrangement.