PROPOSED EXEMPTION FOR EMPLOYEE SHARE PURCHASE SCHEMES OF UNLISTED COMPANIES

A DISCUSSION PAPER

SECURITIES COMMISSION

17 August 2004

Contents:

Introduction
The existing class exemptions

Listed issuers
Specified unlisted issuers
Individual exemptions

Proposed class exemption
Extent and method of disclosure
Eligible persons
Exit mechanisms
Cap on shares allotted
Request for comments

Introduction

1.

The Securities Commission seeks comments on a proposed extension of its class exemption for employee share purchase schemes. We would like comments by the end of Tuesday 31 August 2004.

2.

The extension would include employee share schemes operated by unlisted New Zealand companies in the class exemption. We propose that the exemption for these schemes will be subject to certain additional conditions, to reflect the lesser amount of information provided to shareholders of unlisted companies. We seek comments on this proposal, and on the terms and conditions of the proposed exemptions.

3.

The proposed exemption will not affect the exemption employee share purchase schemes of NZX listed issuers.

The existing class exemptions

Listed Issuers

4.

There have been Commission exemptions for employee share schemes of listed issuers since 1986. The current exemption is the Securities Act (Employee Share Purchase Schemes) Exemption Notice 2002 (the "class exemption"). This exemption applies to listed companies who offer shares to "eligible persons", ie:

(a)

employees or directors of the company or its subsidiaries; or

(b)

people who provide personal services (other than as an employee) principally to that company or its subsidiaries.

5.

The notice exempts listed issuers from the following parts of the law:

(a)

section 37A(1)(c) of the Securities Act - the effect of this is the registered prospectus has no fixed lifespan - it is an "evergreen" prospectus;

(b)

section 37A(2) of the Securities Act (now redundant, as section 37A(2) was repealed in April 2004);

(c)

clauses 4 to 20, 22 to 38, and 40 to 42 of the First Schedule of the Regulations - these provisions set out information that must be in a registered prospectus for shares. The effect of this exemption is that the only information that must appear in the prospectus is:

(i)

main terms of the offer - name of issuer, a brief description of the shares, the number of securities being offered, and the price;

(ii)

name and address of any offeror other than the issuer;

(iii)

details of incorporation of the issuer;

(iv)

all terms of the offer, and of the shares themselves, not otherwise in the prospectus, except those implied by law or set out in some other publicly registered document (in which case the document must be identified); and

(v)

the place where the constitution of the issuer can be inspected.

6.

The exemption is subject to a condition that the securities are allotted only to eligible persons.

Specified unlisted issuers

7.

The class exemption also applies to specified unlisted issuers, who can be added to a schedule of the notice. The Commission's policy has been to include unlisted issuers only if they have:

(a)

at least 500 shareholders, holding a minimum of 25% of the total voting shares on issue (equivalent to NZX Listing Rule 5.2.3); and

(b)

an available market for the securities (either on SEATS or some other equivalent trading system) to facilitate negotiability and liquidity in the securities, with an undertaking from the company that the securities would continue to be traded on such a market.

8.

The exemption for specified unlisted issuers is subject to additional conditions intended to give potential investors extra information, and to warn them that it may not be easy to accurately price, or to deal in, the shares. There is only one specified unlisted issuer, New Zealand Wool Services International Limited.

Individual exemptions

9.

The Commission has granted 3 individual exemptions for New Zealand companies who operate employee share purchase schemes but who do not fit the above criteria as "specified unlisted issuers".¹

10.

These exemptions are similar to the class exemption, in that they allow the use of an evergreen, short form prospectus. One of these exemptions also permits the company to include personalised information in a document accompanying the investment statement. There are extra conditions to these exemptions. Each company must put certain extra information in their annual reports. In addition, each company must describe in their investment statement any arrangements under which shareholders can sell their shares.

1

These exemptions are the Securities Act (Fulton Hogan Limited) Exemption Notice 2000 (SR 2000/164), the Securities Act (Opus International Consultants Limited) Exemption Notice 2002 (SR 2002/80), and the Securities Act (The New Zealand Wine Company Limited) Exemption Notice 2002 (SR 2002/421).

Proposed class exemption

11.

The Commission wishes to extend the ambit of its class exemption so that smaller companies who wish to use employee share schemes as part of their remuneration plan do not have to seek individual exemptions. The Commission understands that these schemes are relatively common, but often operate without a registered prospectus. In some cases, the shares will be offered to people who are not "members of the public", and so no prospectus will be needed. However, under the Securities Act the fact that a person is an employee does not, of itself, make that person not a "member of the public" in relation to any offer of securities by their employer. We think that most employee share schemes should have a prospectus and investment statement. The primary purpose of these documents is to give information about the benefits, costs, and risks of the investment to people who may buy shares.

12.

If shares are offered to employees in circumstances where a prospectus is required there are serious consequences for the employer (issuer) if the scheme does not have a prospectus. Under the Securities Act any allotment of shares in these circumstances is void and of no effect. The issuer, and any directors of the issuer, are liable to repay subscriptions. If this is not done within 2 months of the allotment then the subscriber is also entitled to 10% per annum interest on their subscription money. For example, if shares are allotted without a prospectus and then some years later an employee is unable to sell the shares, or to get as much as was paid for them, the employee could claim the allotment was void, and require the company or its directors to repay the full subscription price plus 10% per annum interest. It is important from the point of view of the issuer's liability to have a prospectus.

13.

Many employee share schemes operate on an ongoing basis. The Commission recognises that the compliance costs involved in preparing and registering a full prospectus every year could be prohibitive for a small enterprise.

14.

Exemptions for employee share schemes recognise the value of companies encouraging employee participation in the company through share ownership plans. The exemptions strive to strike a balance between lowering compliance costs for the company and providing employees with sufficient information to make an informed decision about joining the scheme.

15.

Taking this as a starting point, there are four policy considerations on which the Commission seeks comment prior to settling any further exemption. These are:

(a)

extent and method of disclosure;

(b)

eligible persons;

(c)

exit mechanisms;

(d)

whether to cap the number of shares that can be allotted under the exemption.

Extent and method of disclosure

16.

The Commission considers that registering a prospectus is an important discipline for any company that intends to issue shares to the public. However, once this is done, and the company is an issuer, there are arguments in favour of limiting the ongoing compliance costs of renewals. Employee share schemes tend to operate over a long period of time and there can be significant costs when prospectuses must be renewed every year.

17.

For this reason the Commission proposes a class exemption that allows unlisted companies to offer shares to employees through an established scheme using an evergreen prospectus and an investment statement. This is the same basic level of disclosure as is required of listed companies under the class exemption.

18.

The Commission considers that the conditions of any exemption should require unlisted companies to provide more information than listed companies are required to provide. This is because companies listed on NZX have six-monthly financial reporting obligations, and must also comply with the continuous disclosure provisions of the listing rules. This means that shareholders of listed companies can easily obtain information about their company, and get an accurate idea of the value of its shares from the current market price. Unlisted companies in general do not offer these advantages.

19.

Compliance costs can be limited if the additional disclosures can be made in the issuer's financial statements and by additional information in the annual report. This avoids the costs of a new disclosure document every year, but still gives investors the information they need.

20.

The Commission proposes that unlisted companies using this exemption should provide employees with:

(a)

the company's most recent audited financial statements;

(b)

if any allotment is to be made more than 9 months after the most recent balance date, a set of interim financial statements that comply with FRS-24;

(c)

additional information about the company, shareholdings, and current activities in their annual reports, similar to that already required in the Commission's individual exemptions. This comprises:

(i)

particulars of entries in the directors' interests register; and

(ii)

information about material contracts; and

(iii)

information about any pending legal proceedings or arbitrations that might have a material adverse effect; and

(iv)

a statement by 2 directors of the company as to whether, in their opinion after due inquiry, there have arisen since the last balance date any circumstances that materially adversely affect—

A

trading or profitability; or

B

asset value; or

C

ability to pay liabilities due within the next 12 months.

21.

The Commission does not propose any exemption from the requirement to have an investment statement. However, given the small amount of information required in the prospectus, and the fact that it, like the investment statement, will be an evergreen document, it could be sensible for issuers to combine the two documents. The goal would be to provide concise and clear information for employees about the benefits of joining the share scheme, the cost of doing so, and the risks associated with being a shareholder of the company.

22.

The Commission proposes to require that investment statements for these offers describe any arrangements the company has in place for shareholders to sell their shares, or to facilitate the sale of shares. For more on this, see the section headed "exit mechanisms", below.

23.

Because companies may wish to offer individual terms to various employees, the Commission also proposes that companies using the exemption could include personalised information for employees in a document accompanying the investment statement. The Commission would grant an exemption from the requirement that the investment statement set out all the terms of the offer to the extent required to allow this.

Questions

a.

Would the proposed exemptions and disclosure conditions relating to the prospectus and investment statement provide the right balance between compliance cost savings and adequate disclosure for employees?

b.

Are any other disclosure exemptions needed to make the exemption more workable?

Eligible persons

24.

The Commission proposes that the exemption should apply in respect of shares allotted to people who are "eligible persons" as defined in the existing class exemption. These are people who are:

(a)

employees or directors of the company or any subsidiary; or

(b)

persons who provide personal services (other than as employees) principally to that company or any subsidiary.

25.

Including people who provide personal services is intended to cover those who do not have employment agreements, but whose working relationship with the company makes them equivalent to an employee. The Commission has not previously defined at what point a person provides services "principally" to any given company. We do not consider it necessary to do so now.

26.

It is not clear whether the class exemption would currently apply to offers of shares made to employees where the employees will hold the shares through a trust arrangement. It is our initial view that the manner in which the employee wishes to hold shares should not affect the exemptions available. We propose to clarify that the exemption will apply where beneficial ownership of the share is offered to the eligible person even if the share is allotted to the trustee of a trust of which the eligible person is either a beneficiary, either alone or with family members or with other eligible persons.

Questions

c.

Is the present definition of "eligible persons" appropriate for an extended class exemption?

d.

Should the exemption apply where shares are offered to employees, but held through a trust where the employee is a beneficial owner of the shares?

Exit mechanisms

27.

Exemptions for employee share schemes are based largely on an assumption that employees of a company have a closer relationship with the company than do other members of the public. Usually issuers offer shares under such schemes to enhance employee relations and as a performance incentive, rather than to acquire significant capital. Often employees are in a better position to acquire information about the company than other members of the public.

28.

However, the Commission has been concerned that shareholders in smaller companies have only a limited ability to exit their investment, or to obtain sufficient information to gauge the appropriate price for their shares should they wish to sell. The impact of this can be particularly great for employee shareholders who depend on the company for most or all of their income. For these people, if the company performs badly, both the value of their investment and the security of their principal income can be adversely affected.

29.

For this reason, the individual exemptions granted to companies whose shares were not traded on an established market have involved close scrutiny of procedures that the companies have in place for investors to sell their shares. The exemptions have been granted on conditions that require the employer to repurchase the shares or to assist employees to find a buyer, at prices that are either clearly beneficial to employees or that are set by an independent valuation.

30.

The Commission considers that any extended class exemption should include a condition requiring an unlisted company to repurchase shares from employees who leave their employment. As the exemption allows limited disclosure because of the relationship between employers and employees, we consider the employer should be obliged to reduce the liquidity risk of the investment by assisting employees to exit their shareholdings when they leave the company. Any such repurchase would need to follow the procedures set out in sections 60 to 62 of the Companies Act 1993.

31.

The Commission does not consider that the commitment to repurchase shares should be required where there is an established market for trading the shares. However, this option will not be available to most smaller companies.

32.

Accordingly we propose that the new class exemption be subject to a condition that either:

(a)

There is an established market for the shares; or

(b)

The company has offered to repurchase shares under the Companies Act from employees who are shareholders, when their employment ceases.

33.

Some smaller companies seek to limit the scope of their shareholding, and may wish to require that shares be repurchased when employment ceases. The Commission has no objection to this.

34.

In either case the Commission considers that the investment statement should clearly describe the options available to employees who wish to exit their shareholding, either during their employment or when they leave the company.

Questions

e.

Should the class exemption be subject to a condition requiring companies to repurchase shares upon termination of employment?

f.

Is this necessary where there is an established market for the shares?

g.

Is the proposed disclosure about ability to sell shares sufficient?

Cap on shares allotted

35.

The Commission does not intend that exemptions for employee share schemes be used as avenues for companies to raise significant capital with only limited disclosure. Where we have received requests for exemptions to allow companies to undertake substantial capital raising from employees the Commission has been concerned that the interests of the company, in securing significant capital, might not be aligned with the long term welfare of its employees.

36.

For this reason the Commission proposes to cap the number of shares that can be allotted to eligible persons under any class exemption for unlisted issuers. As these schemes are likely to operate over long periods it may be appropriate to have both an annual and an overall cap.

37.

The Commission proposes that the exemption should be available only

(a)

where the number of shares allotted to eligible persons who are members of the public in any one year does not amount to more than 5% of the share capital of the company at the beginning of the year; and

(b)

where the total number of shares held by eligible persons who are members of the public does not at any time amount to more than 15% of the share capital of the company.

We have chosen the 5% annual limit because this is the percentage of the share capital of a company that is a substantial holding in terms of securities law. The 15% overall cap is sufficiently low, we think, that the exemption is unlikely to be seen as a preferred way for a company to raise significant capital funding.

38.

Directors of many smaller companies have significant shareholdings. The Commission proposes that the limits described above would apply only to shares allotted to and held by eligible persons who must receive a prospectus before any shares are allotted. It is not intended that directors' (or some employees') shareholdings be counted in the total if these people are not "members of the public", or are "wealthy or experienced" investors in terms of section 5(2CA) of the Securities Act.

Questions

h.

Should any class exemption include a cap on the quantity of shares that can be allotted to eligible persons under the exemption?

i.

If so, are the proposed caps set at the right levels?

Request for comments

39.

The Commission welcomes comments on the questions set out in this paper, and any other comments on the proposed exemption.

40.

After considering comments received the Commission will decide whether or not to grant a new class exemption, and the terms and conditions of the exemption. An exemption notice will then be drafted. We will send a draft notice for comment to anyone who would like to be consulted on the drafting of the exemption. Please indicate in your comments on this paper if you would like to be consulted on the drafting of any exemption notice.

41.

We seek comments before the end of Tuesday 31 August 2004.

42.

Please send comments in electronic format to liam.mason@seccom.govt.nz. Comments can also be sent by post to: Securities Commission
PO Box 1179
Wellington
Attn: Liam Mason

or by facsimile to (04) 472 8076.