November 12, 2007
Fun and Games Arbitraging DLCs
A full-fledged BHP Billiton bid for Rio Tinto plc raises some interesting legal issues. The reason is that both companies are dual listed ones. A DLC structure is a virtual merger structure utilized in cross-border transactions. The companies do not actually effect an acquisition of one another, but instead enter into an unbelievably complex set of agreements in which they agree to equalize their shares, run their operations collectively and share equally in profits, losses, dividends and any liquidation. In the case of BHP Billiton, this structure involves Billiton, an English company, and BHP, an Australian company. In the case of Rio Tinto the structure involves Rio Tinto plc, an English Company, and Rio Tinto Ltd, an Australian company.
The key to the relationship between the two companies is their equalisation agreement (this link accesses RT's equalisation agreement). This sets an equalisation ratio between the shares for purposes of liquidation, dividends and takeovers. In the equalisation agreement for Rio Tinto it is set at 1:1 initially. In addition, the agreement requires that major decisions of the parties be made by joint decision of the shareholders and boards, the the parties have an identical board. Most importantly, the equalisation agreement enforces each company's constitutional documents which require that any bidder must make a bid for both companies and the consideration must be equal as set out in the equalisation ratio converted for currency fluctuations (see RT plc Article s. 64 here and RT LTD constitution s. 145 here for their relevant provision).
So, the first point is that in the case of RT, these agreements likely make it impossible for a third party bidder to come in and bid only for one of the two companies. This is a nice takeover defense for each. And because of this, it may run into the U.K. and Australian prohibitions against company's "taking frustrating actions" to inhibit hostile bids. This prohibition generally prohibits companies from adopting any takeover defensive measures. Whether the takeover panels of each company considering RTP's "defense" here would overturn it, is unknown, though i suspect it is unlikely given the uniqueness of this structure.
More importantly, the shares of DLC companies trade outside the DLC equalisation ratio. Once, I saw someone put up a chart of BHP's English shares and Billiton's Australian shares and showed how they had a 5-10% differential outside the equalization ratio. The professor highlighted this as evidence of an inefficient market. The shares should ideally trade at the equalization ratio. But they don't -- whether this is irrational or due to different legal and tax regimes is yet to be determined. For more on this see The Limits of Arbitrage: Evidence from Dual-Listed Companies. Page 21 and 22 of this chart show that Rio Tinto and BHP Billiton have traded up to 10-15% off their equalisation ratio.
Arbitrage opportunities on this disparity are usually limited though because the shares are not interchangeable. But here, to the extent this disparity still exists there is a classic arbitrage strategy available if a bid is made. For the lawyers, though it is a headache. If Billiton offers shares, it will presumably be BHP shares for the English entity and Billiton shares for the Australian. But the BHP shares are worth less on the market than Billiton shares (about 7% below the equalisation ratio). So, in order to meet the test they will have to offer higher consideration in BHP shares than Billiton shares. This is feasible I think, but likely obligates Billiton to make an equalisation payment to BHP. Alternatively, BHP Billiton may be able to give RT shareholders a choice between the shares but this would be ill-advised for tax reasons -- the U.K. is likely to treat this as a taxable exchange (remember the problems with UK holders of the Dutch leg of Royal Dutch Shell when it was collapsed?).
In any event, I'm intrigued to see how BHP Billiton's lawyers deal with this issue.
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