No smoothing the path: financial assistance by a company for acquisition of its own shares

Section 151 of the Companies Act 1985 prohibits a company or any of its subsidiaries, where a person is acquiring or proposing to acquire shares in the company, from giving direct or indirect financial assistance before or at the time of the acquisition (section 151(1)); or, once the acquisition has occurred, from directly or indirectly giving financial assistance in order to reduce or discharge any liability incurred for the purpose of the acquisition by the acquirer or any other person (section 151(2)). In other words, the section is there to ensure that the resources of the target company and its subsidiaries are not used to help finance the acquisition, whether it is a share subscription or a sale of shares.

While this may seem a relatively straightforward concept, financial assistance is widely regarded as one of the most difficult areas of company law. This is partly due to the complexity of the provisions, which contain a number of exemptions, and partly to the large and sophisticated body of interpretation (by judges and by counsel) that has grown up. Breach of section 151 is a criminal offence and a breach of fiduciary duty, and may also give rise to liability for the tort of conspiracy. The arrangement that constitutes the assistance (such as security over the company's assets or a guarantee) will be unenforceable by the recipient.

Chaston v SWP

Judicial comment on section 151 is always significant, but the Court of Appeal's decision in Chaston v SWP Group plc [2003] BCC 140 is especially so because the leading judgment is by Lady Justice Arden who, as Mary Arden QC, was one of the foremost company law experts at the Bar and often advised on the section.

SWP was a listed company. It financed a share acquisition by means of a placing, in connection with which it commissioned a long- and a short-form report on the target group by reporting accountants. Deloitte & Touche worked on both reports, and their fees were paid by a subsidiary of the target company. The fees were approximately £20,000 and the subsidiary's net assets were approximately £100,000. It was uncertain as to whether the payments were made before or after the shares were purchased, so both sections 151(1) and (2) potentially applied. Mr Chaston was a director and a major shareholder of the subsidiary, and was largely responsible for negotiating the sale.

Categories of financial assistance

The categories of financial assistance are set out in section 152(1)(a). The first three of the four categories broadly comprise assistance by way of gift, by way of guarantee, security or indemnity or by way of loan. All these forms of assistance are prohibited whether or not they diminish the company's net assets. None of them appears strictly to apply to payment of the Deloitte fees if one takes the situation at face value - in other words, officially Deloitte's services were provided to the target subsidiary, which was therefore not technically in the position of giving away its money for nothing, or assuming an indemnity obligation in relation to another person's liability. On the other hand, instructing Deloitte meant (in the words of one of the judges) that the purchaser "was helped by not having to put its hand in its pocket for part of the fees that would otherwise be incurred in the due diligence exercise". In any event, the Court of Appeal did not have to resort to a full analysis of these categories.

The fourth category (sub-paragraph (iv) of sub-section (1)(a))) is "any other financial assistance given by a company the net assets of which are thereby reduced to a material extent or which has no net assets". Of course, it is sub-paragraph (iv) that makes the definition so open-ended, potentially bringing a multitude of forms of assistance (including some not yet devised) within the prohibition. In Chaston v SWP, the company had net assets but the fees equated to 20 per cent, which meant that there was no scope for claiming that the amount was not material (as a rule of thumb, under 1 per cent is often taken as non-material, but there is nothing to support this figure in the Companies Act or in case law). There was no attempt to argue that, since services were provided to the company in consideration of the payments, the effect on net assets was neutral: Mr Chaston's counsel conceded that sub-paragraph (iv) would apply if payment of the fees was indeed financial assistance.

Arden LJ's judgment

The Court of Appeal unanimously held that the liability to pay the fees was unlawful financial assistance and was clearly incurred for the purpose of the acquisition of shares in the parent company. Mr Chaston was liable for breach of fiduciary duty for having procured, or connived in, the offence.

Arden LJ's judgment traces the history of the prohibition and makes a number of points of general application.

• The prohibition applies even if the assistance is not given to the purchaser. Counsel for Mr Chaston had argued that the assistance must be given to the purchaser, or at least to the purchaser as well as to the seller, but Arden LJ said that there was no reason why assistance paid to a subsidiary or associated company or other person nominated by one of the parties to the transaction should not be assistance contrary to section 151. As a matter of commercial reality, payment of the fees "smoothed the path to the acquisition of shares". It made no difference that the assistance had no effect on the price of the shares, because the policy of section 151 extends beyond assistance given to enable the price for the shares to be paid.
• The prohibition also catches assistance given in connection with the company's purchase of shares in itself. The case did not actually involve a purchase of own shares, but one of the arguments turned on whether the wording of section 151 presupposes an acquisition of shares by someone other than the company itself. Arden LJ categorically stated that it does not, and gave as an example of financial assistance the granting by a company of security over its assets to secure a borrowing raised to purchase its shares itself. There is an exemption for purchase of own shares, but it covers only the actual payment for the shares. Some counsel, and at least one of the leading textbooks, have previously taken the view that section 151 simply does not apply if there is no separate purchaser, but this must now be treated as unsafe.
• Section 151 prohibits financial assistance given "directly or indirectly" and those words are sufficiently wide to cover pre-transactional assistance. Moreover, section 151(1) applies even though a person is only proposing to acquire shares. Mr Chaston's counsel had argued that any assistance fell outside the scope of section 151 because it had preceded the transaction. It is not clear whether Arden LJ meant that pre-transaction assistance is caught even if there is no person proposing to acquire shares at the time, but the wording of section 151(1) seems to indicate that it does not apply unless a person is proposing to acquire shares.
• Financial assistance need not always be detrimental - for example, a loan made on terms that are highly beneficial to the company. This would fall within the loan category of financial assistance, which, like the first two categories, is prohibited whether or not there is any diminution in the company's net assets (unless an exemption applies). Detriment is, of course, required in relation to assistance falling within sub-paragraph (iv) unless the company has no net assets (in which case all financial assistance, detrimental or not, is prohibited).
• Due performance of fiduciary duties is not itself enough to avoid a breach of section 151. If it were, a loan on terms beneficial to the company would not be caught (see above).

The MT Realisations case

Arden LJ also commented on the recent High Court decision in MT Realisations Ltd v Digital Equipment Co Ltd [2002] EWHC 1628 (Ch), which took a novel approach both to the scope of matters caught by section 151 and to the interpretation of sub-paragraph (iv).

In that case, the purchaser was initially willing to pay £6.5m for the target, which owed £8m to the seller. The deal was ultimately structured as a sale of the shares for £1 and the seller assigned the loan to the purchaser for £6.5m payable in instalments. The financial assistance issues arose from the fact that, after the sale, certain debts due from the seller's group to the target were set off against the purchaser's outstanding liability for the loan assignment instead of being paid to the target.

The judge held that:

• although the loan agreement was connected with the sale of shares, that did not mean that it was necessarily for the purpose of the sale, because a distinction must be drawn between incentives to enter an agreement or concurrent benefits and the acquisition of shares; and
• even a company with no or negative net assets would not fall within sub-paragraph (iv) as long as the assistance did not reduce its assets even by the smallest amount.

Separating out the loan as a "concurrent benefit" meant that the financial assistance aspects were limited to the £1 consideration- an amount for which no assistance was conceivably required. The decision was cautiously welcomed, although the interpretation of sub-paragraph (iv) was difficult to reconcile with the wording. Neither of these points required decision in Chaston v SWP, but Arden LJ nevertheless made it clear that she disagreed on both.

Ramifications

One can speculate whether section 151 would have been invoked if the subsidiary's net assets had been greater than £2m, so that the fees equated to less than 1 per cent. It is not certain that the payments would have been beyond challenge as gifts or indemnities - in substance if not in form.

Particularly in the context of the payment by the target of professional fees in connection with due diligence, sales of shares have always been regarded as more problematical than subscriptions - for example, the possibility of gift or indemnity is more salient where the company or its parent is not even receiving the consideration paid for the shares. Some take the view that the increase in the company's funds resulting from a subscription means that any assistance cannot be a gift, and should also be set off against any diminution in net assets for the purposes of the test under paragraph (iv), but there is no consensus on this.

While Chaston v SWP does not provide comfort, neither does it cause fresh alarm in this respect, because the amounts in question represented such a large proportion of the company's net assets that the case does not call the 1 per cent rule of thumb into question. It is principally in the context of purchase of own shares that avenues have been closed off - to say nothing of any hopes raised by MT Realisations.

For further information, please contact Simon Howley at [email protected] or on +44 (0)20 7367 3566.