CAPITAL STRUCTURE MANAGEMENT FOR PROPRIETARY COMPANIES

The Corporations Act 2001 (Cth) (“Act”) prohibits a proprietary company from having 50 or more non-employee shareholders. The exclusion of employee shareholders provides proprietary companies with an ability to incentivise employees through the issue of securities in the company usually under an employee share scheme, without the concern of exceeding the 50-shareholder limit and being forced to convert to a public company and as a result, incurring the additional time and expense associated with complying with the additional obligations of being a public company (such as holding annual general meetings and satisfying audit requirements).

While the Act specifically excludes employee shareholders for the purposes of section 113 of the Act, the exemption afforded to employee shareholders does not apply to Chapter 6 of the Act which governs acquisitions of voting shares in, and takeovers of, Australian companies.

Relevantly, being subject to Chapter 6 of the Act attracts the prohibition set out in section 606 of the Act which provides that a person must not acquire a relevant interest in issued voting shares in a company that has more than 50 shareholders if as a result of that acquisition, the person’s voting power in the company or that of another person (whether alone, or collectively with their associates) increases either from 20% or below to more than 20%, or from a point that is above 20% and below 90% (“General Prohibition”).

There are various exceptions to the General Prohibition which are set out in section 611 of the Act, including (but not limited to) where the relevant acquisition is approved by shareholders of the company, but this generally requires an independent expert report to accompany the resolution put forward to shareholders and hence is expensive and unwieldy for proprietary companies. However, the majority of the exceptions are targeted towards public companies such as acquisitions of shares through a rights issue, underwriting arrangements or a takeover bid or under an initial public offering fundraising. As proprietary companies are generally prohibited under the Act from making an offer under a disclosure document and accordingly, prohibited from raising money from the public in circumstances that would require a disclosure document, exemptions relating to fundraising aren’t generally relevant to proprietary companies and accordingly provide little, if any, relief from the General Prohibition.

One of the key consequences of the application of Chapter 6 of the Act to proprietary companies is that typical features of shareholders agreements that deal with transfers of shares – such as drag along and tag along rights – as well as provisions dealing with compulsory disposals arising from breaches of that agreement, would have the effect that each shareholder of the entity has a “relevant interest” in the securities of each other shareholder by virtue of their rights to control a power of sale over the shareholders’ shares in certain circumstances. For proprietary companies which have 50 or more shareholders, that relevant interest results in a breach of the General Prohibition in Chapter 6 of the Act, unless an exemption applies.

To address these concerns, proprietary companies who wish to ensure that they do not inadvertently become subject to the General Prohibition should take steps to limit the number of shareholders on their register, which may be done in a number of ways (such as structuring incentive plans to restrict the exercise of options to particular liquidity events, or establishing an employee share trust or custodian structure under which the shares of employees who exercise their options once vested are held).

If you are invested in or involved in the operation of a proprietary company and have any concerns in relation to the above issues, please contact Mark Burchnall (mburchnall@mphlawyers.com.au) or Taila Childs (tchilds@mphlawyers.com.au) to discuss.