APM Human Services International Limited: further developments for stub equity schemes

In recent months, the landscape surrounding stub equity schemes has continued to develop, particularly following two Court decisions that raise questions regarding the circumstances in which a stub equity structure will cause class or fairness issues, which could ultimately determine whether or not the scheme will be successful.

In brief

• The Millennium decision allowed stub equity to be offered on a basis that excluded a large number of “small” shareholders from participating, but did not elaborate on the potential implications for issues of class and fairness.
• In APM Human Services, the Court affirmed that a conventional stub equity structure (which did not exclude small shareholders) does not typically create class or fairness problems, but highlighted potential concerns over the influence of "rolling shareholders" on scheme approval.
• Increasingly, bidders must consider a range of potential issues when structuring a stub equity scheme. Until there is further judicial guidance as to the boundaries of class and fairness in the context of stub equity schemes, bidders may need to be confident that shareholders who are not expected to receive stub equity are supportive of the scheme

Stub equity schemes recap

Earlier this year, we wrote about the implications of the decision in Re Millennium Services Group Limited [2024] NSWSC 307 for stub equity structures used in schemes of arrangement.

To briefly recap, a stub equity scheme involves a bidder — often a private equity bidder or other financial sponsor — offering shares in an unlisted bidder entity (the "stub equity vehicle") to company shareholders in a scheme of arrangement. The stub equity is typically offered as an alternative to cash consideration and, while (generally) available to all target shareholders, it is usually aimed at a specific subset, such as founders, key management, or larger shareholders.

Bidders offer stub equity because it allows them to maintain alignment with founders or key management who are essential to the future success of the target. It also enables target shareholders to retain economic exposure to the target business (by owning shares in the stub equity vehicle) and thus benefit from any future upside of the target business.

Although stub equity is generally offered to all target shareholders on the same terms, the governance arrangements for the stub equity vehicle may provide that shareholders with a certain percentage in the vehicle receive special rights, such as appointing a director to the stub equity vehicle board, approving certain fundamental business matters, and receiving information. The scheme is often conditional on a minimum take-up of the stub equity or a more specific condition requiring certain key “rolling shareholders” to elect the stub equity. Additionally, stub equity vehicle arrangements typically provide that smaller shareholders (say, holding less than $10,000 worth) may be subject to compulsory acquisition, allowing the bidder to ultimately buy out their holdings in the stub equity vehicle at a future point in time.

The Millennium case represented a departure from previous structures, as the Court allowed stub equity to be offered in a way that excluded small shareholders from participating from the outset. Specifically, "small" shareholders holding a parcel of less than $345,000 in target shares (a vastly larger parcel than the traditional concept of a $500 unmarketable parcel) were excluded from the stub equity election, meaning only approximately 30 out of more than 1,250 target shareholders were eligible to take the stub equity. The Court permitted this structure without requiring target shareholders to vote on the scheme in two separate classes — those eligible for stub equity and those who were not — and all shareholders voted together as one class. Similarly, the Court did not express any concerns about the overall fairness of the structure.

Although the Millennium structure was permitted, the Court's reasoning did not address the issues of class or fairness arising from excluding small shareholders in any detail. It is therefore difficult to assert that Millennium represents a clear endorsement for bidders to drastically limit the offer of stub equity to a subset of target shareholders where it is proposed that there be only a single class of target shareholders voting on the scheme.

APM Human Services

Subsequent to the Millennium decision, another stub equity scheme was recently considered by the same Court in Re APM Human Services International Limited [2024] NSWSC 1095. While the stub equity structure in this case was more conventional — there was no exclusion of shareholders based on holding size — the Court provided additional commentary related to the issues of class and fairness.

In APM Human Services, the bidder offered target shareholders the option of all cash consideration, all stub equity consideration, or a mix of both. A condition of the scheme was that certain "key rolling shareholders" elected to receive all stub equity consideration. These key rolling shareholders included the founder (who was also the largest shareholder in the target, holding approximately 35% of shares) and key members of management. Consistent with the usual practice, shareholders in the stub equity vehicle above certain thresholds would hold additional rights, including the ability to appoint directors and approve specific business decisions.

In considering the structure at the first Court hearing, the Court affirmed that an offer of stub equity does not, in itself, prevent the scheme meeting from being convened by the Court, provided the appropriate disclosures are included in the scheme booklet. Similarly, the Court accepted that differential rights related to the governance of the stub equity vehicle do not necessarily create separate classes or imply that the scheme is unfair.

However, the Court made the following observations regarding the impact that "rolling shareholders" (i.e., shareholders who elect to receive the stub equity) may have on the Court's decision to approve the scheme at the second Court hearing:

… this matter highlights an emerging need for the Court to be alert to the impact of a stub equity structure on voting majorities at the second Court hearing, where it has the consequence that rolling shareholders are … permitted to vote on the scheme, although they will retain a continuing indirect shareholding or at least a continuing economic interest in the scheme company following the transaction. A Court may well need to assess, at the second Court hearing, whether a scheme which provides for the exit of other shareholders in exchange for cash has been approved at the scheme meeting largely or entirely by the votes of larger rolling shareholders who retain their economic interest in the scheme company, and target companies may need or wish to tag such votes in order to ensure that sufficient evidence as to that matter is available at that hearing.

The Court also noted that the target had "rightly offered" to tag the votes of the 35% founder shareholder (though it appears not for other shareholders) so that the impact of those votes on the resolution to approve the scheme could be considered at the second Court hearing.

Implications for bidders

Although APM Human Services affirms that a conventionally structured stub equity scheme will not typically raise class or fairness issues, the observations above leave open the possibility that a Court may nevertheless decline to approve a scheme at a second Court hearing if the resolution has been passed "largely or entirely" by rolling shareholders.

This presents another factor for bidders to carefully evaluate when structuring an offer of stub equity.

On one hand, if stub equity is offered to only some target shareholders, there remains a risk that the Court will require shareholders to vote in separate classes. (That was the approach in the scheme for PSC Insurance Ltd recently where rolling shareholders, all of whom were part of management, were put in a separate class.)

The key implication of having separate classes is that minority shareholders can have a larger say on the outcome and potentially cause the scheme to be voted down. While the Millennium decision is helpful in this regard, there is no clear line on where a seemingly permissible exclusion of "small" shareholders (however defined) might tip over into a class-creating situation.

On the other hand, if stub equity is offered to all shareholders, although the risk of requiring separate voting classes may be significantly lower, this must now be balanced against the possibility that the Court could decline to approve the scheme at the second Court hearing where the vote has been carried by rolling shareholders. In other words, if absent the rolling shareholders voting in favour of the scheme, the scheme vote would have failed, the Court may decline to approve the scheme. While the circumstances in which that may occur are not yet clear, the scenario in which this is most likely to be tested is where a target shareholder objects to the scheme at the second Court hearing on this basis.

Regardless of whether stub equity is offered to some or all target shareholders, until there is further guidance from the Court as to when a separate class will arise or the structure will create fairness issues, bidders may need to be confident that the shareholders who are not being offered or receiving stub equity will be supportive of the scheme.