Lawmakers at both the European and national levels have taken on the ambitious task of improving the attractiveness of public capital markets in Europe for equity financing. Their initiatives aim to improve the legal framework for start-ups and emerging companies. In Germany, this topic has gained momentum not least because Germany-based businesses considering an initial public offering (“IPO”) have developed an increasing interest in non-German (in particular US) listing venues and exploring the use of (more flexible) non-German corporate entities. In light of this debate, the European Commission recently presented a draft for the EU Listing Act, which includes provisions to simplify European prospectus law.
In Germany, the federal government in 2022 announced its intention to introduce a so-called “German Future Financing Act” (Zukunftsfinanzierungsgesetz), and in April 2023 the first draft of this act was published (the “Draft Act”). It contains numerous proposals to modernise rules relevant for the German capital market and suggests amendments in financial market, corporate, takeover and tax laws. It also proposes changes to facilitate and expedite equity raising transactions by German issuers. Whether the proposed law will actually enter into force as proposed is uncertain. The legislative process is not expected to be completed until the end of Q2 2023 at the earliest.
This post provides a brief summary of the existing legal framework for capital increases in Germany (see 1.) and outlines the key proposals of the Draft Act relevant for these transactions (see 2.). It further identifies shortfalls of the Draft Act and anticipates how the suggested proposals might be received in practice (see 3.).
1. Status Quo: Capital increases in Germany – a tedious venture?
While an IPO is a significant milestone for every company and may yield new equity, one of the key drivers for companies to go public is the ability to tap further external financing sources on the capital markets. This is because the need for capital raising does not end with an IPO. A listed company may have to raise capital by issuing shares for a variety of reasons, such as for funding of expansion or growth plans, reducing debt and to improve its financing profile, financing research and development to develop new products or services, or infrastructure investments to improve efficiency and reduce its cost base. Hence, the legal framework applicable for capital raisings is an important factor for a company considering the legal form of its IPO vehicle and the trading venue.
Preventing dilution: The role of mandatory subscription rights
A key feature for capital raising transactions in Germany is that – in principle – existing shareholders mandatorily receive rights to subscribe to new shares (so-called “subscription rights”). Once subscription rights have been allocated, shareholders may exercise them during the so-called “subscription period” to avoid being diluted. Any subscription period must be open for at least two weeks. Hence, transactions involving subscription rights expose companies to extended market risk during execution. This in turn forces issuers to set the issue price for the new shares at a steep discount to prevailing market prices, resulting in significant dilution of shareholders not participating in the capital raise.
Moreover, subscription offers are often perceived as burdensome as they constitute public offers under the EU prospectus regulation (Regulation (EU) 2017/1129 of the European Parliament and of the Council of 14 June 2017 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/71/EC, “Prospectus Regulation”) and hence require the preparation of equity prospectuses. Preparing a prospectus and getting it approved for publication by BaFin is also a costly and time-consuming process that delays execution even before the issuer gets to the two-week subscription period. Because of the prospectus requirement and the subscription period, “over-night” placements are not available for German issuers that seek to execute a large transaction.
Accelerating cash raisings by setting aside subscription rights
However, an “over-night” cash capital raise by way of so-called accelerated book-building (“ABB”) is possible where subscription rights can be set aside. This always requires shareholder involvement and, technically, there are two ways to achieve this:
- Direct resolution: In theory, shareholders may directly resolve on a specific transaction, and in this context resolve to exclude subscription rights for the transaction.
- Authorising a future transaction: Practically more relevant, shareholders may resolve to authorise the management board to exclude subscription rights for any future cash capital raise (creating a so-called “authorised capital”). This structure is used for ABB transactions.
In each case, a vote by 75% of shareholders present at a general shareholder meeting is required. Once such 75% vote is passed, dissenting shareholders may file a contestation claim. Until a court has resolved on such claim, the direct resolution/authorised capital may not become effective. Hence, contestation claims, if not settled, may have the effect of blocking major corporate transactions.
General rules for setting aside subscription rights
Setting aside subscription rights might be needed from a practical perspective:
- In a capital increase involving a contribution in kind excluding subscription rights is typically required as this structure is used to acquire certain assets from third parties or selected shareholders only, i.e., not all shareholders should participate in this transaction. In particular for a listed company, an in-kind transaction is relevant for share-for-share offers or debt-to-equity swaps.
- For a cash capital increase, excluding subscription rights might be preferred to swiftly conduct a transaction priced at around the prevailing market price, or to facilitate an investment into the company by a certain party only.
However, an authorised capital does not give management a “carte blanche” to exclude subscription rights whenever deemed fit.
For both cash and in-kind transactions, the general rule is that subscription rights may be excluded only if the transaction is in the interest of the company, and if diluting existing shareholders is both appropriate and necessary in light of the intended transaction. Furthermore, excluding subscription rights must be proportionate (i.e., the company’s interests must outweigh the interests of the shareholders). Given these requirements, a decision to exclude subscription rights requires careful consideration and involves legal risks.
Special rule to facilitate ABBs
It is significantly easier to set aside subscription rights when executing an ABB though. It requires that (i) the cash raise does not exceed 10% of the share capital in place at the time the authorised capital was resolved or prior to launch of the transaction (whichever is the lower), and (ii) an issue price of the new shares set at a level that is not “significantly below” the then-prevailing market price of the shares already in issue. It is important to note that these rules are not available for in-kind transactions.
When it comes to determining an attractive discount that is not “significantly below” the market price, a 5% discount to the prevailing market price is regarded as legally permissible. Hence, the downside of an ABB is that it does typically not allow for a more deeply discounted offer (even if the market may require it) and is subject to the 10% volume limit. Both may be showstoppers for companies in need of raising high amounts of equity.
2. Key proposed changes for capital raisings in Germany
The Draft Act proposes several changes to the current regime. First, shareholder meetings should going forward – at least in principle – be able to raise the 10% limit restricting the issue volume for an ABB to up to 20%. But it also suggests that shareholders should be able to challenge the placement discount determined applied in any capital increase transaction (which would entail significant consequences for ABBs as well as for share-for-share deals and debt-to-equity swaps).
Raising the roof: Doubling the 10% limit for ABBs
As described above, ABBs currently are subject to the 10% limit. Critics have argued for a long time that this 10% limit was too restrictive. As a reaction, the Draft Act proposes to raise the limit from 10% to 20%, and it will be interesting to see how companies and shareholders will receive this additional flexibility in practice.
Permitting ABBs with an issue volume of up to 20% of the issued share capital would bring the following consequences:
- Increase in “firepower”: Obviously, the increased issuance volume would provide additional equity financing flexibility for companies. When making use of this increased ABB “firepower”, companies would no longer be forced to conduct a two-week “public offer” requiring an approved EU Prospectus Regulation-compliant prospectus (which would otherwise require significant lead-time, incur preparation costs, and expose a company to market volatility risks). As customary for private placements, shares would be placed with qualified investors only, thereby protecting the less sophisticated investor base.
- Harmonisation with European prospectus law: Under the Prospectus Regulation, no prospectus is required for the admission to trading of newly issued shares provided these shares represent less than 20% of the number of shares already admitted to trading. Because a capital increase exceeding the 10% limit requires a public offer/admission prospectus under the current German legal framework, this means in practice that German issuers can never fully utilise the 20% Prospectus Regulation exemption already in place. Raising the ABB volume limit from up to 10% to up to 20% would harmonise German corporate law with the European legal framework.
Introducing a notable shareholder protection mechanism
As a somewhat revolutionary step, the Draft Act proposes that shareholders shall no longer be entitled to file contestation claims against capital increase resolutions of shareholder meetings. The positive effect from this is that it would take away the blocking potential for shareholders and thereby drastically increase transaction certainty for companies and other stakeholders.
To ensure shareholder protection, the Draft Act suggests that shareholders shall be able to apply for a court review of the discount instead of filing a contestation claim against the resolution as a whole (so-called “appraisal proceedings”). It should be noted that appraisal proceedings often last for multiple years. In these proceedings, dissenting shareholders would demand for a compensation payment by the company should the applied discount have been excessive. Accordingly, this mechanism would alter – rather than eliminate – shareholder protection.
In this context, the Draft Act proposes that the company may ask for an indemnity from the shareholder who is receiving newly issued shares at the discount. Such indemnity would be relevant should the company be ordered by a court to make such a compensation payment. This mechanism would economically allocate the “discount risk” to the new shareholder (rather than to the company and hence effectively to all post-transaction shareholders). To comply with its fiduciary duties, a management board would generally always ask for such indemnity.
3. Practical questions and potential shortcomings
As outlined in the following, some of the provisions of the Draft Act could lead to challenges in practice, and the legislator might address those aspects in the course of the legislative process.
20% limit: Headwinds by proxy advisors ahead?
Creating an authorised capital for a 20% cash capital increase would still require 75% of shareholders present at a general shareholder meeting to vote in favour of it. Should shareholders conclude that this increased 20% limit is not appropriate, they will vote against such proposal.
Currently, various prominent international and domestic proxy advisors and investment managers have voting guidelines in place that recommend voting against authorisations for share issuances without subscription rights where a 10% threshold may be exceeded. Given the significant interest of issuers to flexibly and quickly exploit market opportunities to raise equity and the significant protections for shareholders that will remain in place (see below), it is to be hoped that the proxy advisors’ recommendations will not in practice prevent companies from using the additional flexibility.
Protection mechanism should not apply to ABBs, share-for-share deals and debt-to-equity swaps
Even though the proposed approach may seem equitable at first glance, the introduction of this mechanism would likely bring significant consequences for ABBs, share-for-share deals and debt-to-equity swaps. In fact, the proposed rules may even make these transactions impossible from a practical perspective. This would be in stark contrast to the Draft Act’s goal of facilitating capital measures.
In an ABB, technically the underwriting banks subscribe for the new shares when placing them with qualified investors. Hence, in practice banks would need to get comfortable with giving an indemnification to the company. This seems odd because economically the new (ultimate) investors – and not the underwriters – should be exposed to this risk.
The background of this is as follows: At present, there is no agreement among practitioners and German legal scholars as to whether the special rule facilitating ABBs at the same time blocks the application of the shareholder protection mechanism. There are very good reasons at hand why this should in fact be the case. Even though there may be comprehensible technical arguments for applying this shareholder protection mechanism: It seems somewhat contradictory to facilitate ABBs on the one hand provided that the discount applied does not exceed 5%, and then open this pricing question again for judicial review.
Should this provision enter into force as suggested, we believe that there is a tangible risk of exposing the ABB market to significant legal uncertainties (thereby potentially “freezing” it). This cannot be in the interest of any party. Hence, the legislator should expressly clarify that the newly devised protection mechanism does not apply for cash capital increases for which subscription rights have been excluded based on the simplified regime (i.e., for example for ABBs).
In a share-for-share deal, this provision would ask the seller of the target company to effectively bear the risk of a “mispriced premium”. Furthermore, the seller would be exposed to potential long-lasting appraisal proceedings. The same applies to a lender contributing a loan receivable against issuance of new shares. It can be expected that these parties would not be willing to be exposed to this risk as it has the potential to severely alter the transaction economics. This could also threaten to make these deals unattractive.
Pricing an ABB – even more uncertainty ahead?
To make things even worse, the Draft Act also brings about additional uncertainty when it comes to pricing an ABB. As outlined, a 5% discount is currently regarded as legally permissible in general, and this discount is applied to the market price prevailing at around launch of the ABB.
As just outlined, there are convincing reasons to exclude ABBs from the proposed protection mechanism. A further reason for this point of view is that the proposed rules refer to the three-months volume weighted average price for the period up until the day before launch of an ABB for determining the relevant market price to which the discount would be applied. So, an ABB would become impossible if the share price falls during the three-months period because the placement price of the new shares would have to be set above the share price at launch. Hence, investors would be better off buying shares on the market than participating in the cash raise. And in rising markets the proposed mechanism would allow companies to price an ABB at a discount (potentially significantly) exceeding 5%.
Again, this underscores the necessity to clarify that ABBs should be exempt from the proposed protection mechanism. In this context, it should also be considered to address the “5%-dogma” in the new legislation. Rather than focussing on an inflexible and uniformly applicable defined maximum percentage when pricing an ABB, management should be authorised to consider factors such as the urgency and magnitude of the capital raising needs of the company, prevailing market conditions and the strategic context of the capital raise to determine whether the specific discount is in the company’s best interest and therefore permissible.
For example, issuers in financial distress who may not have the time to prepare deeply discounted rights issues may require higher discounts to ensure their continued existence. As a further practical example, the US capital markets generally requires higher than 5% discounts in follow-on shares issuances, currently making the 5%-requirement a key driver for German-based businesses wishing to list in the US to drop the German corporate legal form in favour of more flexible regimes (such as the Dutch).
4. Conclusion: Some fine-tuning needed to balance good intentions with practical realities
The Draft Act contains some helpful suggestions for the reform of corporate law governing equity capital raises by listed German companies. Directionally, this is to be welcomed. It is encouraging to see that the national legislator is initiating measures intended to keep capital raising (and ultimately also IPOs) in Germany attractive.
However, the Draft Act currently contains elements that are counterproductive to the legislator’s stated intentions as they would likely seriously hamper ABBs and share-for-share transactions in particular.
As regards ABBs, raising the 10% limit to 20% should be welcomed as it addresses a company’s desire to swiftly raise more capital than currently permitted. As a nice side effect, it would also lead to a harmonisation of German corporate law with the European Prospectus Regulation. From a practical perspective, it remains to be seen whether companies will be able to make use of this additional flexibility.
Taking away the ability for shareholders to file contestation claims when a shareholder meeting resolves upon a capital increase with exclusion of subscription rights seems to be a “game changer”: This could indeed significantly increase deal certainty. However, introducing appraisal proceedings allowing shareholders to initiate a court review of the discount price in an ABB seems highly questionable from a practical perspective. The legislator should exempt ABBs from these rules in the revised draft. This would at the same time fix the “drafting glitch” with regard to determining the market price when pricing a discount in an ABB.
Furthermore, the proposed amendments would also make share-for-share deals and debt-to-equity swaps significantly less attractive. While some of the proposed changes were certainly borne of good intentions, these implications may make capital raises even more difficult.