A very messy Spotless spill?

The disgruntled institutional shareholders in Spotless are apparently very close to moving to requisition an extraordinary meeting to get rid of what they perceive to the biggest obstacle to their receiving a bid from Pacific Equity Partners – Spotless' chairman Peter Smedley. It is an open question, and one that would raise a lot more questions, whether a successful dumping of Smedley would allow them to achieve their objective.

The institutions – the most visible of which are Orbis Investment Management, Lazard and Investors Mutual – apparently believe they have the support of shareholders, including Spotless' founders, the McMullin family, who speak for about 56 per cent of the group's capital. If that is correct, there is no doubt they could get rid of Smedley.

The problem with that as a strategy is that there are five other non-executive directors, and Spotless chief executive Josef Farnik, on a board that was hand-picked by Smedley to try to oversee the reconstruction of the perennially under-performing group.

Simply forcing Smedley out would provide no guarantee that the board, which has said very clearly that it won't engage with PEP or allow it to conduct due diligence unless it is prepared to lift its indicative and very conditional 'offer' from $2.68 a share to at least $2.80 a share, would suddenly surrender and usher PEP through the door.

Making the position of the incumbents even more complicated is that there is, apparently, voluminous documentation of analysis of Spotless' value by KPMG. The directors might have to compromise their convictions, and skirt around the edges of their fiduciary obligations, to abruptly change their stance. Certainly, it would be uncomfortable for them to be seen to be succumbing to pressure.

That suggests that the institutions would need to contemplate a complete displacement of the board, which would be a far more controversial and difficult process. Finding a new chairman might not be that difficult for a group with their connections but finding an entire board willing to volunteer to jump into the middle of such a contentious situation would be more difficult.

The problem for Spotless is that it is apparent a majority of its shareholders want – and it is a very legitimate desire – to exit the register and are prepared to do so at PEP's indicative level of $2.68 a share. Indeed, they are so keen to get out that they are willing to take dramatic action to facilitate a PEP bid.

The bigger institutions on the register are situational investors that would make very solid profits at PEP's indicative price.

That puts the board in an invidious position.

The directors owe a fiduciary responsibility to the company and all of its shareholders. Where the institutions, in the midst of volatile and performance-destroying market conditions, are keen to book some profits, other shareholders – albeit apparently a minority – might share the board's conviction that the restructuring of the company will eventually produce a structural leap in profitability and value.

The position of the Spotless directors is further complicated by the fact that PEP isn't proposing a formal takeover offer but is trying to pressure the board into supporting and promoting a scheme of arrangement.

Given the numbers would almost certainly ensure a scheme would be voted through, if the institutions stick together and can navigate some of the trickier Corporations Act issues relating to the nature of any associations they create, the minorities would be disenfranchised in a scheme relative to their potential leverage in a conventional takeover process with its higher thresholds for success.

Private equity needs to pursue schemes, rather than takeovers, because generally their lenders won't fund them unless they can conduct due diligence and create certainty that they will achieve 100 per cent ownership.

While the Corporations Act makes it quite clear that schemes are only supposed to be used for the exceptional transaction which can't be easily prosecuted with a conventional offer, schemes have become the norm and formal takeover offers rare. The takeovers provisions of the law could be excised and no one would notice.

That means target company boards have to deal with offers that aren't actually offers – they are always indicative and conditional – and which require them to not just embrace but actively promote the takeover to all their shareholders.

In effect, they are being asked, generally with associated pressure from their institutional shareholders, to give the private equity firms something of real value – their endorsement and active support – in exchange for nothing of any certain value. They are 'asked' to give the potential bidder a free look and a free option over control.

Smedley chose not to do that and at least has been successful in getting PEP to add five cents a share to its indicative price. He is trying to get another 12 cents a share in exchange for opening the door to PEP and committing to support a scheme at $2.80 a share.

Because his major shareholders have decided they want out, he and his fellow directors are in the grip of a prolonged and tightening bear hug that is unlikely to end well for the incumbents unless they can drum up an alternate bidder at $2.80-plus a share, in which case their stance towards PEP would be vindicated.

The Australian Securities and Investments Commission has shown no interest in the now ubiquitous use of schemes rather than takeover offers, despite the clear direction in the Corporations Act that schemes are the option of last resort. Nor has it indicated any interest in promoting a discussion as to whether the Australian takeover law regime should import the 'put up or shut up' rule from the UK to end the lengthy and distracting stalking of companies that the ‘bear-hug followed by a scheme' strategy can lead to.

The PEP attempt to acquire Spotless is unusual. It is overtly hostile and an attempt to force a scheme on an uncooperative board.

Whatever the outcome – and it is possible that, confronted with a near-inevitable outcome if the institutions do go ahead and requisition a meeting, some face-saving compromise might be developed – it will ensure that private equity bids and the use of schemes in lieu of takeover offers will remain controversial.