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Financing MBOs: the legal issues Back  
A manager getting involved in an MBO is faced with issues - negotiating, legal, financial - that may never have come across the desk before. The learning curve can be steep according to David O’Donnell.
Management buy-outs (MBOs) tend to be highly geared transactions. Members of management involved will generally not have the financial resources required to go it alone. Even when they do have these assets, they will be naturally pre-disposed to seek to limit the extent of personal assets to be risked in a venture. Accordingly, finance needs to be located. This will boil down to equity finance and loan finance and in certain cases, maybe hybrid types of finance such as mezzanine loan finance or convertible loans.

Historically, an MBO would involve the management team joining with institutional investors who would take an equity stake in Newco which was the acquisition vehicle. However, recently, with reducing interest rates, debt finance has become a more attractive option for MBO teams. The legal issues which arise in the event of such equity investment are:

• what is the stake of the investor?
• what options to increase shareholding are to be made available to the investor or to management ?
• what sort of rights are to be attached to shares
• in the event of an offer being accepted by, say, more than 50% of the shareholders in the company to sell out, will that majority be able to drag along the 50% minus minority, or will the statutory 80% rule apply?
• will there be contingent premiums payable on the shares by the investors?
• control and conduct of business issues.

Impediments to leveraging assets
Leveraging on a target company’s assets to raise finance for the acquisition may pose legal issues for the MBO team.

A loan financier will obviously look for security for the money it lends. As stated at the outset, the MBO team may have few assets of their own (or few assets of their own that they are willing to risk in the MBO) and this will have two consequences. The first is that to the extent possible, management will seek to avoid personal guarantees. Secondly, the acquisition vehicle is unlikely to be sufficiently strong and asset-backed to be a satisfactory mark for the loan financier. Ideally, what the financier will want is the target company to guarantee the obligations of the MBO team and for the assets of the target to be put up as security.

The two strands of law that one comes up against are:
• the law regulating financial assistance; and
• the law regulating loans to directors and to persons connected with directors.

Irish financial assistance law is based on UK financial assistance law, which has its germs in a number of perceived scandals in the 1920s and the 1940s. However, the law as introduced is a blunt instrument. It was correctly summed up in 1962 by a UK royal commission as constituting ‘an occasional embarrassment to the honest without being a serious disincentive to the unscrupulous’. In principle, the law provides, as now set out in Section 60 of the Companies Act 1963, that a company cannot provide financial assistance directly or indirectly for the purpose of, or in connection with, a purchase of shares or subscription for shares in itself or in its holding company. There is a let-out for private companies where such financial assistance may be authorised by special resolution of the company. Prior to so doing, the directors of the company are obliged to make a statutory declaration of solvency - that is a statement made as though under oath - to the effect that the company will be able to pay its debts in full as they fall due. To provide this financial assistance without the procedure being followed or to make the declaration knowing it to be untrue is a criminal offence, punishment by imprisonment and fines.

Over-zealous law on loans
The second line of law which impedes MBOs is to be found in Part III of the Companies Act 1990. As Ireland has frequently done, we enacted a law to be found in Britain but extended it beyond the areas in which it applied in its home jurisdiction.

In this case a law applying to plcs and holding companies and subsidiaries of plcs has been applied in Ireland to all companies - even unlimited companies. Section 31 of the Companies Act 1990 prohibits the giving by a company of a loan to a director or a person connected with a director. It goes on to prohibit the giving by a company of a guarantee of a loan made to a director or to a person connected with a director. Typically, an MBO Newco would be a person connected with a director or directors. So what is the solution? The answer is an Irish solution to an Irish problem - lock the doors!

When a management buy-out is being completed, what one does is to arrange for the transaction to be completed, with the purchaser registered as holder of the shares prior to the purchase money being paid. Due to an exemption that exists for loans/guarantees between subsidiary companies and their holding companies, this means that the target company, having become Newco’s subsidiary can then freely lend to Newco and/or guarantee the borrowings of Newco.

Whilst one can appreciate the undoubted good thoughts behind these two strands of legislation which interfere with MBOs, it is worth mentioning that in other countries with an enterprise culture, e.g. the United States, they do not have laws like this. The question of use of company’s assets might well be dealt with by dealing with directors’ duties rather than with creating technical offences which serve only to fascinate lawyers and irritate business people.

Scheme of arrangement
One of the methods of acquiring companies in Ireland is a scheme of arrangement. The principal advantage with respect to financing would appear to be (although the matter is not free from doubt) that the financial assistance law is thereby by-passed. What is happening is not a purchase of shares or a subscription for shares, but rather a cancellation of shares and an issue of shares to a bidder. As such, the assisted transaction is not one which is mentioned in Section 60 of the Companies Act 1963.

It would appear also possible for financial assistance to be given in connection with an acquisition structured in such a way even where a public company is concerned. Section 201 of the Companies Act 1963 contains the relevant law. What happens is that the company being acquired makes an application to the court for approval of a scheme whereby the shares held by the existing owners are cancelled and the amount of the share capital thereby cancelled is applied in payment up of new shares in the name of the bidding company. Then, subject to a majority in number and three quarters in value of shareholders voting at a general meeting specially called for the purpose to vote in favour, the court can approve the scheme. Once it is approved, it is binding on all persons.

Despite the two strands of law which effect MBOs - financial assistance and loans to directors - it does not prove in practice to be an impediment to transactions. MBOs happen, and MBOs involving public companies happen, notwithstanding the legal environment. This being the case one can ask, ‘why have the law at all?’. That as they say would be another story.

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