Independent expert reports (IERs) are so common in schemes of arrangement, that the market has come to expect that directors who recommend a scheme will do so “subject to the expert concluding that the scheme is in the best interests of scheme participants”.
It might be asked why, under that common formulation, the directors’ views are subrogated to those of the expert. After all, the Corporations Act specifically requires directors to express their view, but only requires an IER to be provided in specific circumstances.
The Federal Court’s decision in Security Matters Limited (Security Matters) provides an important reminder that the IER is only one piece of information available to target shareholders and ought not, of itself, be considered determinative.
The decision was a win for the directors of Security Matters who continued to recommend the deal notwithstanding that the IER concluded that the schemes were not fair or reasonable and were not in the best interests of the security holders.
Security Matters proposed two interdependent schemes of arrangement (Schemes) whereby the company would merge with a NASDAQ-listed “special purpose acquisition company” (SPAC).
The IER for the Schemes was originally prepared in October 2022. It concluded that the Schemes were fair and reasonable and in the best interests of the scheme members.
For reasons that are not clear from the judgement, the scheme booklet was not distributed to security holders until January 2023. Given the significant passage of time since the IER was first prepared, the expert was asked to prepare an updated report. That report also concluded that the Schemes were fair and reasonable and in the best interests of scheme members. However, this time the expert assumed a maximum redemption rate in the SPAC of 85%. The supplementary report further noted that if the redemption rate was higher than 85%, the expert’s views may change. The expert was concerned in this regard that the SPAC may need to raise new (and potentially expensive) money to fund the growth plans of the merged company if redemptions exceeded the 85% threshold.
The SPAC subsequently announced that the redemption rate was 99.5%. As a result, the expert issued a further supplementary IER, which concluded that the Schemes were not fair and not reasonable, and accordingly, were not in the best interests of scheme members.
The directors of Security Matters disagreed with the expert’s conclusion. They issued their own critique of the expert’s findings and explained why the directors continued to recommend the deal. In doing so, the directors relied on advice obtained from international finance experts about the valuation methodology in the IER (in particular, the value attributed to a Nasdaq listing) and the availability and cost of funding necessary to meet redemptions.
Scheme members subsequently voted overwhelmingly in favour of the Schemes.
At the second court hearing, ASIC opposed court orders approving the Schemes on the basis (among others) that:
- no Australian court had approved a scheme where the IER found that the scheme was not fair and not reasonable and was not in the best interests of scheme members;
- ASIC was not aware of any previous scheme where the proponent had challenged the IER;
- the opinions obtained by the board to support their critique of the IER were not independent expert reports, did not comply with ASIC policy for such reports and were not provided by persons licensed to give financial advice in Australia; and
- as a result, the directors’ critique may have been misleading or deceptive.
What did the court say?
In a resounding victory for the directors, the Federal Court had little trouble in dismissing ASIC’s objections and approved the Schemes.
O’Callaghan J noted that scheme members are generally the best judges of whether an arrangement is to their commercial advantage and suggested that the court will be “reluctant to make decisions contrary to the views of security holders expressed at meetings”. He stated that it is “emphatically” not the court’s role to second guess the decision of security holders in circumstances where they have received adequate disclosure in relation to the Schemes. In this regard, the court noted that the final IER had been made available to security holders in full.
The court acknowledged that directors were entitled to take and consider advice from industry experts in responding to the IER. Those experts did not need to be licensed or to comply with ASIC policy on the production of IERs, as their advice was being provided to the board and not to security holders.
The court accepted that the IER is not “holy writ” and that the directors, having formed the view that the expert was not correct, were bound by law to convey that view to security holders. There was no suggestion that the directors’ view was not genuinely held. The court saw no reason to assume that the critique was misleading purely from the fact that it was at odds with the IER.
Why is this significant?
The Security Matters decision tells us something about the nature of IERs, but also shines a light on the respective roles of target directors, ASIC and security holders in schemes of arrangement.
The case is a timely reminder that the IER is just one piece of information and ought not be the sole source of truth as to the merits of a transaction.
The case was also a victory for strong leadership. Many boards would have changed their recommendation following the adverse conclusions in the IER. To do so here would have denied security holders the benefit of a deal which was clearly heavily supported.
Going forward, boards can be confident that it is entirely within their authority to make their own recommendations on value or to provide further context or detail surrounding the expert’s conclusions. The court has made it clear that it has a high regard for security holders’ capability to assess information and act in their own best interests.