House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Parliamentary Secretary to the Treasurer, the Hon Chris Pearce MP)

Chapter 10 Regulation impact statement: rights issues and employee share schemes

Background

10.1 The issues contained in this Regulatory Impact Statement (RIS) relate to the fundraising provisions in the Corporations Act 2001 (the Corporations Act). These provisions are contained in Chapter 6D 'Fundraising' of the Act.

10.2 Chapter 6D was inserted in the Corporations Act through the Corporate Law Economic Reform Program Act 1999 . It builds on the previous general prospectus disclosure rules, but includes a number of additional provisions relating to the use of new instruments such as short form prospectuses and offer information statements, clarification of the persons liable for contraventions of the provisions, a new definition of sophisticated investors and others.

10.3 The Chapter 6D provisions have on the whole worked well and have supported a strong market in fundraisings since they were introduced. According to a recent survey conducted by KPMG, total equity fundraisings in Australia in 2005/06 amounted to A$42.5 billion, which represents an increase of 42 per cent since 2000/01. Over time, however, it has become apparent that there are some shortcomings in the practical application of the provisions. Some of these affect the smooth operation of market processes, while others are more substantial in their effects, resulting in the skewing of market outcomes in ways that may not accord with Government policy.

10.4 The proposals examined in this RIS relate to those shortcomings which have a more substantial distorting effect on the market.

Problem identification

Rights Issues

10.5 Rights issues are a method of fundraising in which existing shareholders in a listed entity are given the opportunity to purchase new shares in proportion to their holdings at specified terms. The current legislation requires that rights issues must be accompanied by a prospectus (or a Product Disclosure Statement (PDS) in the case of a listed managed investment scheme). As a result, the use of rights issues as a fundraising instrument has, to some extent, been superseded by other forms of fundraising with less onerous disclosure requirements. An example is a placement of shares to large institutional investors, which can be accomplished without a prospectus. One of the consequences of such placements is that existing shareholders and fund members may be disadvantaged. Small shareholders, for example, are generally not able to participate in these placements and therefore cannot acquire shares at the discount typically offered in such placements.

10.6 Further, rights issues often occur in circumstances where speed of execution is an important factor. The requirement to produce a prospectus or PDS may give rise to delays which may cause issuers difficulties in the circumstances and may lead to some other, faster form of fundraising being favoured, with consequences for existing shareholders similar to those set out above.

10.7 The impact of easing disclosure requirements may be illustrated using the placements market as an example in comparison to the rights issue market. The ability to raise funds through a placement of shares without full prospectus disclosure was made possible through the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 which inserted section 708A in Chapter 6D of the Corporations Act. The relevant provisions formally commenced on 1 July 2004, so that any impact they had on the fundraising market would have become apparent in the statistics for the 2004/05 financial year. The statistics shown in the table below demonstrate a marked increase in funds raised through placements in that and the following year. Amounts raised through rights issues have, in contrast, stayed at a similar level in those two years and have lagged behind funds raised through placements.

Source: KPMG, survey of Australian capital markets 2005-06.

Employee shareholder schemes

10.1 Employee Shareholder Schemes (ESSs) are held to improve the productivity of the economy by aligning the interests of employees with those of their employer. The Australian Government's established policy therefore supports the introduction of ESSs in companies, with a variety of measures being put in place to give effect to the Government's policy.

10.2 The offer and issue of shares to employees constitute actions that fall within the scope of the investor protection provisions of the Corporations Act. The consequences are that under the law, companies establishing ESSs must comply with the fundraising requirements in Chapter 6D as well as the licensing and disclosure requirements in Chapter 7 of that Act. In addition, the current law relating to the self-acquisition of shares by companies creates difficulties for the practical implementation of ESSs. The cumulative effect is to discourage the wider establishment of ESSs, especially among unlisted companies.

10.3 Relief from the full provisions of the law is provided by the Australian Securities and Investments Commission (ASIC) for listed companies, based on the consideration that ongoing disclosure of all price-sensitive information is required as a condition of maintaining a listing. Unlisted companies, however, do not benefit from this relief. The ultimate consequence is that employees of unlisted companies generally have fewer opportunities to participate in the ownership of their employers than in the case of listed companies.

Policy objective

Rights issues

10.4 The objective is to create an environment in which companies make decisions on fundraising methods based on comparative merits and characteristics rather than on regulatory requirements. This would be achieved by creating a level playing field for all comparable fundraising methods.

10.5 The solutions identified should impose the lowest possible costs on companies wishing to raise funds, in order to encourage an active market in fundraisings of all descriptions. It is, however, important at the same time to ensure that investors are provided with all the information they require to make an informed decision about whether to participate in the fundraising or not.

Employee share schemes

10.6 The discouragement of ESSs in unlisted companies through the impact of the investor protection provisions of the Corporations Act does not accord with the general policy of supporting the introduction of ESSs. The objective is to minimise the impact of these investor protection provisions on the formation of ESSs in unlisted companies, while ensuring that employees who are offered a chance to participate in an unlisted company ESSs are provided with sufficient information to make an informed decision on whether to participate or not.

10.7 The Australian Government's policy supporting ESSs in general is based on a number of benefits that may accrue to companies and the wider economy through the establishment of ESSs. The Nelson Report into employee share ownership in Australia (tabled in 2000) identified the main benefits as follows:

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better alignment of the interests of general employees and employers, leading to more productive enterprises;

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an increase in national savings;

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facilitation of the development of certain small and medium-sized companies, especially in certain sunrise industries such as information technology and biotechnology; and

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facilitation of employee buyouts and succession planning in small businesses.

10.8 The Government's response to the Nelson Report reaffirmed its policy approach to ESSs, which balances promoting benefits that may accrue as a result of aligning the interests of employees and employers and limiting opportunities for overuse. In 2004, the Government set a target to increase the proportion of employees with shares in their company to 11 per cent by 2009, compared to 5.9 per cent in 2004.

10.9 To further encourage the growth of ESSs in Australia, the Government has established an Employee Share Ownership Development Unit within the Department of Employment and Workplace Relations (DEWR). The unit's activities include:

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providing information and raising awareness about the potential benefits of employee share ownership through information materials and seminars;

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assisting employers and employees with design and implementation of schemes; and

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collecting information about the barriers to the uptake of employee share ownership and informing developments to overcome these barriers.

10.10 Information on the Government's policies in relation to ESSs and specific measures to encourage their wider use is available through the units website, which may be accessed through the DEWR website at www.dewr.gov.au.

10.11 The Australian Government has also provided a range of tax benefits to encourage the wider establishment of ESSs. However, the amendments examined in this RIS do not address the tax treatment of ESSs and do not propose any changes in this respect.

Implementation options

Rights issues

Option A: Do nothing:

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Under this option listed entities raising funds through a rights issue would have to produce a prospectus or PDS. Certain other forms of fundraising such as institutional placements would not require a prospectus, as provided for in the current law.

Option B: Require a prospectus for all fundraisings:

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Under this option all forms of fundraising would require a prospectus or PDS, in order to ensure that all investors, including retail investors, were able to participate in these fundraisings. This would address the disadvantage suffered by small members of listed entities in institutional placements where they are not able to participate because of the lack of adequate disclosure.

Option C: Remove the prospectus requirement for rights issues subject to the obligation to provide certain defined information to the market:

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Under this option the requirement to issue a prospectus or PDS for rights issues would be removed in the case of listed entities. The scope of the exemption would be limited to listed entities on the grounds that the combination of an original prospectus on listing and the continuous disclosure rules would ensure the provision of an appropriate flow of information to members necessary for informed decision-making.

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However, under certain circumstances as defined in the Australian Securities Exchange Listing Rules price-sensitive information may be withheld from the market. It would be necessary to provide that such information must be disclosed before a rights issue can proceed. This could be achieved by requiring that a 'cleansing' notice, modelled on the provisions of section 708A of the Corporations Act, be provided.

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Cleansing notices as required under section 708A are limited to the provision of any information withheld from the market under the Australian Securities Exchange Listing Rules. They are therefore far more restricted in scope than a prospectus or other disclosure document as defined in Chapter 6D of the Corporations Act, and therefore impose a much lower compliance burden on issuers.

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Under this option a new section would be inserted in the Corporations Act deALIGN with the exemption of rights issues from the disclosure requirements, including the requirement to provide a cleansing notice. The exemption would extend to the issuer only, since any on-sales by third parties (such as an underwriter to the issue) could take advantage of the existing disclosure exemption in section 708A. Such on-sales would have to be covered by the issue of another cleansing notice, as required under section 708A.

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Further, in certain circumstances rights issues may potentially lead to a shareholder or underwriter acquiring control or obtaining or significantly increasing voting power above the 20 per cent takeover threshold. It is vital to ensure that members are provided with full information on the potential effects of the rights issue before they decide whether or not to take up their rights. The contents requirements for the cleansing notice would therefore be worded in such a way that issuers would have to provide information on the effects of the rights issue on the control of the company, as well as the consequences of any potential effects on control.

Employee share schemes

Option A: Do nothing:

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Under this option unlisted company ESSs would continue to have to comply with the disclosure and licensing provisions of the Corporations Act. The main requirement in this respect is the provision of a prospectus including audited financial statements. Certain licensing requirements would also apply to the sponsoring company or related entities established for the operation of the ESS. An example would be the requirement for trustees managing the scheme on behalf of employees to hold a licence for the provision of custodial and depository services. Listed companies, as mentioned above, would continue to receive relief from most of these requirements.

Option B: Provide extensive relief for unlisted company ESSs from the relevant provisions of the Corporations Act

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The main relief would be to remove the requirement to provide a prospectus including audited financial statements, and substitute a specific ESS document tailored to the needs of employees in these situations.

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The requirements in relation to the proposed ESS document would differ from the prospectus requirements by providing a specific list of items to be included. The items would mainly relate to the nature of the securities to be offered, the working of the plan under which employees would participate in the ESS, amounts payable by employees for shares acquired, the tax implications for participating employees and an explanation of how the plan would be administered and managed. Small proprietary companies as defined in the Corporations Act would be released from the requirement to provide audited financial statements. In addition a statement would have to be included that the document was not a prospectus, and provided a lower level of disclosure than a prospectus.

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The general disclosure test applying to a prospectus, that it must contain all information that an investor and their professional adviser would reasonably require to make an informed assessment of the offer, would not apply to the ESS disclosure document. The specific items that are required to be included in a prospectus would not apply. This would result in a lower level of disclosure of information to employees, and would significantly reduce the cost of compliance to companies in producing these documents.

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Extensive licensing relief would also be provided, which would free companies from the need to submit relevant applications to ASIC and comply with the initial and ongoing licensing requirements.

Option C: Provide limited relief for unlisted company ESSs from the relevant provisions of the Corporations Act

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Under this option the licensing and disclosure requirements would be reduced to a level that would remain consistent with providing an adequate level of investor protection for employees considering participating in unlisted company ESSs. Specific proposals under this option include:

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Facilitate the use of Offer Information Statements as defined in the Corporations Act for unlisted company ESSs. The content requirements for prospectuses are defined on a very high level in the Corporations Act as encompassing all the information that an investor would reasonably require to assess the offer made. As a consequence, substantial due diligence by legal advisers is required to ensure compliance with the law. The content requirements for an Offer Information Statement, on the other hand, are expressed in narrower terms that do not require extensive due diligence exercises.

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Audited financial statements would continue to be required. The reason is that reliable financial statements are held to be essential for assessing the condition and prospects of a company.

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Partial licensing relief would be granted where it would not impact on the interests of employees. Certain critical functions, such as offering advice to employees considering participation in the scheme, would continue to require an appropriate licence.

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Relief from the provisions of the law relating to the prohibition of the self-acquisition of shares by a company or related entity would be granted to facilitate the daily operation of ESSs.

Assessment of impacts

10.12 Impacts are divided between three impact groups (consumers, business and government). Typical impacts of an option on consumers might be changes in access to a market, the level of information and disclosure provided, or prices of goods or services. Typical impacts of an option on business would be the changes in the costs of compliance with a regulatory requirement. Typical impacts on government might be the costs of administering a regulatory requirement. Some impacts, such as changes in overall confidence in a market, may impact on more than one impact group.

10.13 The assessment of impacts in this regulation statement is based on a seven-point scale (-3 to +3). The impacts of each option are compared with the equivalent impact of the 'do nothing' option. If an impact on the impact group would, relative to doing nothing, be beneficial, the impact is allocated a positive rating of +1 to +3, depending on the magnitude of the relative benefit. On the other hand, if the impact imposes an additional cost on the impact group relative to the status quo, the impact is allocated a negative rating of -1 to -3, depending on the magnitude of the relative cost. If the impact is the same as that imposed under the current situation, a zero score would be given (although usually the impact would not be listed in such a case).

10.14 The magnitude of the rating of a particular impact associated with an option has been assigned taking into account the overall potential impact on the impact group. The reference point is always the status quo (or 'do nothing' option). Whether the cost or benefit is one-off or recurring, and whether it would fall on a small or large proportion of the impact group (in the case of business and consumers), is factored into the rating. For example, a cost or benefit, even though large for the persons concerned, may not result in the maximum rating (+/-3) if it is a one-off event that only falls on a few individuals. Conversely, a small increase in costs or benefits might be given a moderate or high rating if it would be likely to recur or if it falls on a large proportion of the impact group. The rating scale for individual impacts is explained in the table below.

10.1 The ratings for the individual impacts compared to the status quo are then tallied to produce an overall outcome for the option. If it is positive, it indicates that the option is likely to produce a more favourable cost/benefit ratio than the status quo. If it is zero there would be no overall benefit from adopting the option, and if negative the option would provide overall a less favourable cost/benefit ratio than the 'do nothing' option. Ordinarily, options that have the highest positive score would be the favoured courses of action.

10.2 What is classed as a 'large', 'moderate' or 'small' cost or benefit depends on the nature of the problem and options being considered. Of course, the costs and benefits associated with options to address a problem costing billions of dollars per year are likely to be of a much greater absolute magnitude than the costs and benefits of options for deALIGN with a rather modest issue that effects only a handful of persons. However, as all the ratings are made relative to the status quo/ do nothing option for a particular problem, the absolute value of 'large' or 'moderate' or 'small' is not really important. All that matters is that within a problem assessment, the impacts of each option are given appropriate ratings relative to the status quo and each other. If that occurs, it will be sufficient for the methodology to yield an overall rating that assists in assessing the relative merits of options, from a cost/benefit perspective, to address the particular problem.

10.3 An example of the rating calculation for an option, using the seven-point scale ratings of impacts, is in the table below. The example is based on a purely hypothetical scenario that a new type of long-wearing vehicle tyre is being sold and marketed, but it has become apparent that the new tyres have a higher risk of exploding while in motion than conventional tyres. The example is designed merely to illustrate how the rating scale might be used to compare a proposal's costs and benefits option to the 'do nothing' option - it is not intended to be a comprehensive or realistic assessment of options to address such a problem.

10.4 Illustrative ratings for the problem of a long-wearing tyre that may fail are provided in the table below:

Option A: Do nothing

Option B: Ban on sale of the new tyre

Option C: Industry-developed quality control standards

10.1 In the above hypothetical example, Option C appears to have a better impact for consumers and a better overall cost/benefit rating than Option B. Although Option B appears to offer a slightly better impact for consumers, it appears to be less effective from an overall cost/benefit perspective than Option C.

Analysis of costs/benefits

Rights issues

10.2 The analysis of the costs and benefits of the options associated with this measure are summarised in the tables below.

Option A: Do nothing

Option B: Require a prospectus for all fundraisings

Option B: Require a prospectus for all fundraisings (continued)

Option C: Remove the prospectus requirement for rights issues subject to the obligation to provide certain defined information to the market

Option C: Remove the prospectus requirement for rights issues subject to the obligation to provide certain defined information to the market (continued)

Employee shareholder schemes

10.1 The analysis of the costs and benefits of the options associated with this measure are summarised in the tables below.

Option A: Do nothing

Option B: Provide extensive relief for unlisted company ESS from the provisions of the Corporations Act

Option C: Exempt unlisted company ESSs from certain provisions of the Corporations Act, while maintaining an adequate level of investor protection for employees considering participation in such schemes

Business cost calculator

10.1 This section presents the results of the analysis of the cost impact on business of the various options. In all cases it was assumed that the status quo option would not impose additional costs on business.

10.2 For rights issues, the option to require a disclosure document for all fundraisings including rights issues was assumed to affect 1350 fundraisings in total, based on previous year information on fundraisings in the Australian capital markets. Assumptions were made on the average cost of producing a prospectus, including the cost of legal advice and the preparation of audited financial statements. The analysis results in a per business cost of $145,000 and a total cost of $195.75 million. A similar analysis was then performed for Option C, abolishing the requirement for a prospectus to be provided for rights issues and substituting instead a requirement for a cleansing notice to be released to the market. Due to the less onerous legal requirements applying to cleansing notices the per business cost for this option is estimated to be approximately $14,000. This option would also only apply to rights issues and not affect any other forms of fundraisings, resulting in a lower total cost to industry of $10.2 million.

10.3 With respects to unlisted company ESSs, the main difficulty lies in estimating the number of companies that could be affected by the various options. Statistics provided by an industry association indicate that there are a total of 42,100 unlisted companies that could be affected, of which about 2,500 are assumed to already have an ESS based on Australian Bureau of Statistics information. Option B would result in extensive relief from the current disclosure and licensing requirements, and is therefore assumed to lead to a doubling in the number of companies with an ESS to 5,000. This results in total industry costs of $267.9 million based on an annual cost per business of approximately $53,580 to set up and run an ESS over 25 years. Option C, which provides limited relief from the current requirements, the corresponding figures are $260 million based on an annual cost per business of $69,333. Because of the more restrictive nature of the relief provided, the number of businesses with an ESS is assumed to grow by 50% to 3,750. The smaller number of businesses assumed to establish an ESS under Option C results in a lower total cost to industry. However, the annual cost per business is higher than under Option B, reflecting the more stringent disclosure requirements of this option.

Consultation

10.4 Preliminary consultation on these measures was undertaken as part of the April 2006 Corporate and Financial Services Regulation Review Consultation Paper. Comments received in response to the consultation paper have been taken into consideration in identifying and examining the options outlined in this RIS.

10.5 The majority of the submissions received in relation to rights issues supported the removal of the obligation to produce a prospectus or PDS for rights issues of listed entities. The argument generally put forward was that listed companies are obliged to keep the market informed about significant developments on an ongoing basis, so that there is little need to require additional disclosure for a rights issue. One submission from a major accounting firm proposed that rights issues involving material acquisitions should not be allowed relief from the obligation to provide a prospectus or PDS. One submission from an individual stakeholder suggested extending the relief provided to cover rights issues by overseas listed companies offered into Australia.

10.6 In addition to the Corporate and Financial Services Regulation Review, the problems in relation to unlisted company ESSs were considered by a consultation group originally established by Treasury's Revenue Group to discuss taxation aspects of ESSs. Two sessions were held with this group to discuss the impact of the Corporations Act provisions on unlisted company ESSs. In addition, the group provided a submission specifying in detail the relief requested in relation to Corporations Act provisions. Feedback received following the consultation paper, as well as the views expressed by the consultation group, were taken into account in identifying and examining the options outlined in this RIS.

10.7 The consultation group, which consists mainly of law firms, accounting firms and specialised consultants that offer advice to companies interested in establishing an ESS, proposed wide-ranging relief for unlisted companies from the relevant provisions of the Corporations Act. The submissions responding to the consultation paper generally expressed some caution with respect to this proposal. While acknowledging the merits of ESSs they also mentioned factors such as the level of risk involved in unlisted companies, the difficulty of obtaining relevant information and the comparatively low level of financial sophistication of most employees. While there was some support for providing relief for unlisted company ESSs, there was also considerable concern that an appropriate level of investor protection should be maintained.

10.8 A second round of consultation was held through the release of a Proposals Paper in November 2006. The proposal for abolishing the requirement for a prospectus or PDS for rights issues by listed entities was supported by all 14 submissions which commented on this proposal. One submission wanted to maintain the prospectus or PDS requirement where the rights issue was conducted in connection with a material acquisition. This suggestion is not supported since this information will have to be disclosed under the continuous disclosure requirements in any case. Other submissions wanted to extend the relief in a number of ways, including raising the current limit applying to share purchase plans ($5,000). This suggestion will be brought to the attention of ASIC, as the current relief in relation to share purchase plans was provided through an ASIC class order.

10.9 Eleven submissions were received on the proposals relating to ESSs. All the submissions supported the proposals, which reflected Option C as set out above. Several submissions argued that the proposed relief did not go far enough, and made a variety of suggestions on how they could be extended. It is unlikely that these suggestions will be accepted, due to the need to maintain an appropriate balance between providing relief to industry and maintaining an adequate level of protection for the potential participants in these schemes. A number of technical suggestions were made to facilitate the operation of the proposals. Due to time pressure these suggestions will not be able to be considered for implementation at this stage, but may be considered during further consultations with industry in the future.

10.10 Consultation on the draft legislation has been limited in scope due to insufficient time available prior to introduction of the legislation.

Conclusion and recommended option

Rights issues

10.11 With respect to the problem relating to rights issues in comparison to other fundraising methods with reduced disclosure requirements, the conclusion is to recommend Option C.

10.12 Compared to Option A (the 'do nothing' option), Option B imposes heavy additional costs without contributing sufficient benefits to justify them. These costs are quantified in the Business Cost Calculator (BCC) analysis provided in section 5.4 and arise from requiring a prospectus for placements, for which there is no commensurate benefit. While the measure would achieve the stated objective in removing the bias inherent in the regulations against rights issues, it would only do so at an excessive cost which could have serious implications for the development of the equity market.

10.13 Option C achieves the desired objective of removing the bias against rights issues without imposing excessive costs on industry and other stakeholders, as can be seen in the BCC analysis in section 5.4. This is done by requiring an appropriate level of information to be given to investors, allowing them to make an informed decision on the merits of the offer, while providing for an efficient way for companies to make the information available. In the overall impact assessment provided in section 5.2, Option C is superior to Option B, but also provides a net benefit compared to Option A, and is therefore the preferred option.

ESSs for unlisted companies

10.14 In relation to ESSs for unlisted companies, the conclusion is to recommend Option C.

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