EXIT STRATEGIES: Planning for and Managing the Liquidity Event

Transcription

1 W. Ian Palm (416) January 26, 2005

2 Introduction * There is a life cycle to most private equity and venture capital investments. As some point, usually within five and seven years, the investors will be seeking a means to dispose of all or a portion of their investment hopefully earning a substantial return. Such a disposition is often referred to as a liquidity event and can take the form of a number of different types of transactions including: a sale of the company by way of asset sale, share sale, amalgamation or some other sort of transaction, an initial public offering of the company s shares, 1 rolling the assets of the company into an income trust, or a secondary sale of the investor s interest to another private equity or venture capital investor. Through careful advance planning on behalf of the company s shareholders, directors and management there are likely many opportunities to significantly boost the value of such a transaction. At the same time, these types of transactions give rise to significant risks on the part of all such parties involved. With some vigilance on the part of shareholders, directors and management it should be possible to prepare for and mitigate against these risks. The discussion in this publication is limited to a liquidity events resulting from an initial public offering or a sale transaction. In each case the process involved is outlined, the roles of and some of the advance planning that various parties may undertake and some recommended practices that parties should consider in managing such a process in order to have a better chance for maximizing value. Plan Ahead for the Liquidity Event A well-positioned company will often have a choice between a sale transaction, a public offering or a further private equity financing. With some planning the board of directors should be in a good position to assess the options. There are a number of things that a company can undertake at an early stage before the company has decided to pursue a sale transaction, a public offering or some other option for that matter. With some of these steps addressed more fully in advance the company should be better positioned to react quickly when an opportunity arises. These include the following: * Thank you to Vernita Tsang, Student-at-law at for assistance. 1 Other variations on the theme may be a reverse takeover of an existing public company shell or undertaking a qualifying transaction with a capital pool company. The net effect in each case will be the resulting company being public, offering some liquidity to shareholders. These types of transactions are outside the scope of this publication. Page 1

3 1. Business Planning: considerable time should be spent developing a detailed business plan. It will not only draw attention to areas of possible concern, but will provide the reader with a description of the important elements of the company and its future direction. A well developed business plan will form the basis for the company s prospectus or confidential information memorandum in the context of a sale transaction. 2. Collecting and Organizing a Due Diligence Record: in the context of a sale transaction potential bidders will want access to a broad range of documentation related to the company and the selling shareholders will need to conduct due diligence to protect against a potential claim for breach of representations and warranties. In the context of a public offering the company, its directors, officers who sign the prospectus and the company s underwriters will need to conduct due diligence to ensure they are able to meet their due diligence defense to a statutory claim of misrepresentation. While the purpose may be different, regardless of the type of liquidity event, the relevant parties will still want to review much the same documentation. By anticipating the variety of documentation required and spending the time early to collect, review and carefully catalog the information, a company can avoid delays in the process of a liquidity transaction. By being organized, a company may also be able to foresee potential issues early and find solutions before they have a negative impact on the success of the liquidity event. 3. Update Minute Books and Shareholder Records: corporate records in a private company are often out of date and director and shareholder meetings are often not well documented. Bidders in a sale transaction will be looking to confirm shareholdings and will typically require back up opinions or support from legal counsel and the company s auditor. Similarly, in a public offering it is essential to determine the number of outstanding shares. This information will go into the prospectus, be provided to stock exchanges and be used in determining who will be bound by lock-up agreements. 4. Clean Up and Review of Material Agreements: a private company may not have accurate records of some of its material agreements or the business may be operating based on undocumented agreements. To the extent possible the company should finalize arrangements on all material agreements which may impact value on a sale transaction or public offering. The company should review each of its material agreements to determine whether a liquidity event transaction may trigger a consent, notice or other requirement which would require the company to obtain approval from a third party. These types of revisions are common in debt or equity financing arrangements, lease agreements, lease finance agreements and third party supply agreements to name a few. 5. Directors and Offering Liability Insurance: as will be described below, a sale transaction and a public offering each give rise to increase risk of a claim against directors and officers of a company, among others. A company should review its directors and officers liability insurance policy and consider whether additional coverage is required. If the company is pursuing a public offering, most likely additional coverage will be necessary. The company may want to negotiate run-off insurance for directors and officers who will cease to be directors or officers following completion of a sale transaction. Directors who are nominees of a private equity or venture Page 2

4 capital investor should review their blanket directors and officers liability insurance policies to determine whether they are covered in the context of a liquidity event transaction. 6. Stock Options: private companies are notorious for keeping poor records of stock option grants. These records need to be cleaned up in advance of a liquidity event. In a public offering, it will most likely be necessary to amend stock option plans to comply with stock exchange requirements. In a sale transaction it will be necessary to access how the company can deal with stock options. This may mean ensuring that option holders are subject to a drag along clause or determining whether the options can be rolled over into options granted by the successful bidder. 7. Review of Principal Agreements: most private companies have a shareholders agreement. Some companies may have entered into a registration rights agreement with investors. It will be necessary to determine what approvals are required of shareholders before the company can proceed with a liquidity event transaction. One or more investors may be able to veto a transaction. As part of a public offering it may be necessary to negotiate an amendment or termination of registration rights with investor shareholders. 8. Planning for a Shareholders Meeting: it will often be necessary to hold a shareholders meeting in order to take certain actions. For example, it will likely be necessary to convert all preferred shares in a private company to common shares prior to completion of a public offering. As well, a sale transaction in the form of an amalgamation may require shareholder approval and there may be shareholder approval requirements in a shareholders agreement which the company may need to comply with. Initial Public Offering Pursuing an initial public offer ( IPO ) can be a daunting task for any company. Analysis and careful planning are essential to its success. Before going down this road, a company should first understand the complicated process and evaluate the associated risks and benefits. The Pros and Cons of Being Public Potential benefits to being a public company include the following: 1. Superior Financing Terms: compared to debt financing and private equity financing, the terms imposed on a company completing an IPO are generally less restricted and the company typically has more freedom in putting to work the capital raised. 2. Access to Capital: going public may allow a company to more easily raise capital through issuance of additional securities provided the company continues to be successful. 3. Liquidity: existing shareholders should, subject to regulatory and contractual hold periods and trading volumes, have a much easier time selling their shares once the company is public. Page 3

5 4. Use of Stock as Currency: a public company can more readily use its shares to finance acquisitions than it will be for a private company. Vendors receiving securities from a public company as part of a sale transaction should have an opportunity to monetize their interest within a reasonable time following an acquisition by a public company. 5. Establishing a Value: by completing a public offering, the company will most likely have its shares listed or quoted on an exchange or market. This should provide all shareholders with an independent valuation for the company on an ongoing basis. 6. Stock Options and Other Management Incentives: with publicly-traded shares a company s stock options and other equity based incentives are likely more attractive as part of an employee s compensation. Equity-based awards and ownership may also be spread more broadly among management and employees in a public company than in a private company. These factors should enhance the company s ability to attract and retain key employees. 7. Enhanced Corporate Reputation: disclosure requirements imposed on a company both during and after an IPO process allow investors, clients and others the company deals with regularly to access information about the company that is generally more complete and standardized than the information voluntarily disclosed by the company prior to a public offering. The company is subject to significant scrutiny from various industry players and regulatory authorities. The company s public status and listing on a recognized stock exchange give it a competitive advantage over privately held companies in the same industry by providing greater visibility and enhanced corporate image. While a public company has some clear advantages over a private one, there are also a number of potentially negative consequences to being public: 1. Dilution of Interests: with the issuance of a block of shares from treasury as part of the IPO, the interest of existing shareholders will be diluted. Depending on how significant the dilution, one or more shareholders may also lose a control position in the company. 2. Focus on Short-term Financial Results: public companies will be scrutinized by analysts and other market participants eager for the company s next quarterly and annual results. Management will most likely lose the opportunity to focus on longer term goals which may not have a positive impact in the near term. 3. Hold Periods and Escrow Requirements: most, if not all, existing shareholders will be subject to a contractual and possibly a statutory hold period for some amount of time following the completion of the IPO, likely at least 180 days. Depending on the size of the offering and the stage of development of the company, stock exchanges may require certain parties to escrow all or part of their shares for a period of time following the IPO. 4. Immediate and Ongoing Expense and Time Commitment: completing an IPO is an expensive process. Following completion of the public offering the company must factor in ongoing Page 4

6 expenses for regulatory and stock exchange fees, increased ongoing costs associated with accounting, legal and other professional advisors and increased administrative expense including those related to additional public relations personnel. 5. Management Time Commitment: pursuing an IPO will require management to devote significant time and effort. Moreover management should budget considerable time to meet ongoing continuous disclosure obligations and related activities. 6. Regulatory Burden: public companies are subject to continuous and timely disclosure reporting requirements of the various Canadian securities authorities. These requirements include filing annual and quarterly financial statements together with management s discussion and analysis with respect to such financial statements, annual information forms and material change reports to name a few. As well, directors, officers and shareholders with a controlling interest are required to file insider reports with respect to any acquisition or disposition of securities of the company as well as certain related indirect transaction. In addition, following corporate scandals in the United States, Canada and elsewhere, we have seen a significant increase in the regulatory burden on public companies, increasing the already high cost of compliance and requiring more time and attention on behalf of management. 7. Increased Risk of Liability: public companies operate in a more caustic environment than private ones. In the past few years we have seen an increasing number of claims against public companies and their directors and officers, particularly class action litigation brought by minority shareholders. In addition, regulators are more vigilant in pursuing potential offenders. In considering an IPO, a company will have to weigh these and other factors in considering how it intends to pursue its business plans. Important Factors in Considering an IPO A company that is serious about pursuing an IPO should have a clear understanding of the critical considerations that will be scrutinized by regulators, investment bankers, stock exchanges and others who will play a role in the IPO process. There are key factors which a company must consider in addressing whether a public offering is feasible. These considerations will shift depending on the nature of markets at the time. Often investment bankers will be able to articulate those considerations which are of particular importance at any given time. In addition to the general liquidity event considerations discussed above, some of the key factors specific to an IPO that a company should consider in making its decision are as follows: 1. Financial Results and Outlook: it is generally believed that only companies with a reasonable positive history and outlook of growth in revenue, earnings or positive cash flow are good candidates for going public. Some exemptions may apply in respect of biotechnology companies and other technology companies in particularly hot industry sectors. Specific criteria shift over Page 5

7 time depending on the marketplace and comparable companies that are already public. This is an area where it is important to seek input from investment bankers. 2. Financial Statements: a company will need to include audited financial statements for its three most recently completed fiscal years 2 and unaudited financial statements for the interim periods in the current fiscal year. If the company does not already have audited financial statements, it can be a time consuming and expensive process. If the company is serious about pursuing an IPO, it will it make sure it engages auditors early on in the process to ensure there are no surprises in producing financial results. 3. Management Team: skills that are required to manage a public company may be quite different from those required for a private company. A chief executive officer and chief financial officer with public company experience may be a significant asset. Management personnel in other critical areas of the business may need to be upgraded such as sales and possibly research and development in the case of a technology company. It can be time consuming to identify, recruit and integrate new management personnel, so the earlier the company pursues this, the less chance a change will delay a public offering. 4. Revamping the Board of Directors: a company pursuing a public offering will most likely need to recruit additional board members, particularly ones who are independent, have public company experience and, in some cases, financial expertise. The board of directors in a private company will often have little or no experience dealing with a public offering. It will also be necessary to the board of directors to quickly become familiar with their significant increase in responsibility. Stock Exchange Listing Requirements: to obtain a listing on the Toronto Stock Exchange, the TSX Venture Exchange or another market or exchange, the company must satisfy certain criteria. While it is possible for a company to complete a public offering without having a stock exchange listing, it is rare and could severely limit shareholder liquidity. Attached as a schedule is a list of the basic financial criteria for obtaining a listing on the Toronto Stock Exchange. As well, it should be noted that stock exchanges and markets will do detailed background checks of a company s officers and directors. It will be necessary to address the consequences of any officer or director that has a criminal record or has been the subject of a regulatory proceeding. Considerable advance planning is required in order for a company to take advantage of an opportunity to go public. In difficult markets, investors typically concentrate on quality and liquidity and there may only be a brief window of opportunity in such markets for companies that are well prepared to conduct their IPO. Careful planning may be the difference on taking advantage of or missing an opportunity. 2 The company will actually need audited statements of income, retained earnings and cash flows for the three most recently completed fiscal years and audited balance sheets as at the end of the two most recently completed fiscal years. See Ontario Securities Commission Rule There limited opportunities to obtain exemptive relief. If the company has been existence for less than three years, it will need audited financial statements since its incorporation. Page 6

8 Length and Timing of the Public Offering Process Typically, completion of an initial public offering in Canada takes approximately three to four months. Exact timing however can vary significantly depending upon circumstances of an offering. For example, considerable time can be saved if, prior to starting the prospectus process, the corporation has assembled all required information for due diligence, the corporation has carried out all necessary restructuring and its audited financial statements and applicable interim financial statements have been completed. Of course the state of the capital markets will have a significant impact on the timing of the public offering and may affect how long a selling period the underwriters may require. The following summary timetable outlines the primary milestones in completing an IPO in Canada (assuming no delays). Target Dates First Week First or Second Week Second through Fifth Week Second Week and ongoing End of Fifth Week Commencing in the Seventh Week Commencing in the Eighth or Ninth Week Milestones and Activities Engage Underwriters - and other professional advisors; the underwriters will require an engagement letter; Commence Due Diligence both the company, the underwriters, their respective counsel and the company s auditors will conduct detailed due diligence that will typically be ongoing until the preliminary prospectus and periodic after that until closing; Prospectus Drafting Sessions after circulating an initial draft preliminary prospectus there will be drafting sessions which will be ongoing, typically for upwards of three to four weeks but could be extended depending on a number of factors; Commence Related Matters the company will need to focus on various matters to the public offering that must be completed such as a listing application with the applicable stock exchange, a shareholder meeting, appointment of board members, lock-up agreements with applicable shareholders; Filing of Preliminary Prospectus this is filed on SEDAR, together with other required materials, with the applicable Canadian securities regulatory authorities; a receipt is typically issued the next business day provided materials are in order; Dealing with Comment Letters see discussion below; Marketing of the Offering the marketing of the offering or road show usually commences following receipt of the first comment letter provided no significant issues come to light; End of Eleventh Week Price Offering, Enter into Underwriting Agreement and File Final Prospectus once all issues raised in comment letters have been settled with the applicable Canadian securities regulatory authorities pricing can be settled, the parties can execute the underwriting agreement and file the final prospectus in applicable jurisdictions; a receipt is typically issued the next business day provided all materials are in order; and A Few Days to a Few Weeks after Pricing Closing completion of sale of shares and listing of securities on applicable exchange. Page 7

9 The timeline in the foregoing chart is only a guideline for a straight forward public offering. Issues often arise during the course of an offering that were unforeseen at the outset. The company should assume that there may be some delay in the process at one or more stages. Due Diligence In addition to the general liquidity event due diligence activities described above there will be considerable complementary public offering specific due diligence. This usually involves the circulation of questionnaires to each director and senior officer of the company to obtain background information to be included in the prospectus. As well, the underwriters will conduct formal due diligence meetings prior to filing the preliminary and final prospectus attended by all of the directors and senior officers, the company s legal counsel and auditors and by the underwriters and their lawyers. One such meeting is held just before filing the preliminary prospectus and the second is held immediately before filing the final prospectus. Through these questionnaires and meetings relevant parties are asked to review the prospectus and respond to specific questions (often numbering in the hundreds) concerning its contents relating to their particular areas of knowledge and expertise. The Prospectus General Considerations Each province and territory of Canada has its own securities regulator that must review and approve any prospectus which is to be used to sell securities to the public in such province or territory and in the case of Ontario such review and approval is undertaken by the Ontario Securities Commission. The policy behind prospectus requirements and procedures is to provide all potential investors with the same level of information about any proposed offering, to establish disclosure requirements and to ensure, as far as possible, that all such information is accurate. Generally, in order to ensure as large a market as possible, any sizable offering will be made in all provinces of Canada. With the exception of the Province of Québec, there is very little additional cost involved in qualifying a prospectus in all provinces as opposed to just one or two provinces. In the case of Québec, its securities laws require that the prospectus be translated into French if shares are to be offered for sale there. Translation of the prospectus adds somewhat to the cost of filing the prospectus. In order to maximize its investor-base, the company may also use its Canadian prospectus to concurrently carry out a private placement of some of the offered shares to qualified institutional buyers in the United States under applicable securities rules there. This can usually be accomplished at a small additional cost and may provide a larger market for the offering. Most of the major Canadian underwriters have U.S. affiliate offices through which such private placements can be carried out. Prospectus Content The general requirements under applicable securities laws concerning the content of a prospectus is that it contain full, true and plain disclosure of all material facts concerning the company and the securities Page 8

10 being offered. Rules under applicable securities laws include forms that prescribe the contents of a prospectus to be used by the company. 3 While the forms typically provide guidance about the type of information to be disclosed it is only a starting point. Some of the categories of information to be disclosed in the prospectus include the following: description of the business a prospectus will contain a detailed and extensive description of the business carried on and intended to be carried on, including a description of business objectives, principal products and services, operations, competitive conditions and principal markets; financial statements these are discussed above; use of proceeds the prospectus must disclose how the corporation proposes to use the net proceeds of the public offering; management s discussion and analysis the prospectus must contain a discussion and analysis by management of the company s financial results and changes in its financial condition for the most recently completed fiscal year and a comparison against the previously completed fiscal year, as well as interim MD&A which discusses changes in financial condition and results of operation for the completed quarters of the current fiscal year. executive compensation a prospectus must disclose annual compensation 4 of the chief executive officer, the chief financial officer and each of the next three most highly paid executives whose salary and bonus during the most recently completed fiscal year exceed $150,000. plan of distribution the prospectus must describe the arrangement between the company and its underwriters concerning the public offering. This will basically describe the details in the underwriting agreement including the number and classes of shares sold, the offering price and the underwriters commission. material contracts the company must describe particulars of every material contract, other than contracts entered into in the ordinary course of business. Copies of all such material contracts must also be filed with applicable securities regulatory authorities and made available for review by the public on SEDAR. risk factors the prospectus must describe the material risk factors affecting the company, the offering and related matters. Preparing the Prospectus The prospectus procedure involves two stages a preliminary prospectus and a final prospectus. Although the preliminary prospectus must comply with the form requirements, the company may 3 4 See for example Ontario Securities Commission Form F1. See Form F6 Statement of Executive Compensation which requires details regarding various components of annual compensation include salary, bonus, stock options and other compensation. Page 9

11 exclude information with respect to the offering price of the securities and any other matters which are dependent upon price. 5 Generally the company and its legal counsel assume overall responsibility for the drafting of the prospectus with assistance from the underwriters and their legal counsel. The auditors assist the company in the preparation of financial statements, MD&A and related financial disclosure. Drafting sessions typically take place over a significant period of time during which details of the prospectus finalized. Because of the high risk associated with distributing an incomplete or inaccurate prospectus, these discussions tend to be time consuming. Once all aspects of the preliminary prospectus are finalized it is submitted for approval to the board of directors of the company and signed by the underwriters and by the CEO, CFO and two directors of the company. The preliminary prospectus is then filed electronically with the applicable securities regulatory authorities in which the offering is to be made. A receipt for the preliminary prospectus is issued by the applicable securities regulatory authorities. Dealing with Comment Letters In approximately ten working days after the preliminary prospectus is filed (but possibly later), the principal jurisdiction in which the company will distribute securities (designated by the company) will send a letter outlining its comments on the prospectus to the company, its legal counsel and the other securities regulatory authorities. The other securities regulatory authorities then have an opportunity to provide additional comments on the prospectus. Depending upon the extent of the comments and the degree to which matters cannot be settled quickly with the regulators there may be a second and possibly third round of comment letters from securities regulatory authorities. Typically it takes four to six weeks from the date the preliminary prospectus is filed to settle all the comments and receive approval from securities commissions to file a final prospectus. Waiting Period The underwriters normally use the period between the filing of the preliminary prospectus and the final prospectus, which is typically referred to as the waiting period, the ascertain the extent of public interest in securities being offered. The preliminary prospectus is frequently used by the underwriters to solicit expressions of interest during the waiting period. Because the prospectus at this stage will not have been approved by securities regulatory authorities, there are limits on the contents of a company and its underwriters in marketing the proposed offering during the waiting period. During the waiting period, the preliminary prospectus can be given to potential purchasers and the underwriters can solicit non- 5 The preliminary prospectus also excludes a signed report of the auditors on the financial statements. Page 10

12 binding expressions of interest from potential purchasers. However, advertising and other promotion of the offering is limited. 6 Pricing and the Final Prospectus When all of the comments from the applicable securities regulatory authorities have been resolved and the interest in the offering has been determined as a result of the marketing activities during the waiting period, the company and its underwriters will be in a position to decide on the size and pricing of the offering for purposes of the final prospectus. The underwriters will typically present their underwriting offer as to deal price and size immediately prior to the planned filing date for the final prospectus. Once all necessary amendments have been made to the prospectus to satisfy the comments from the securities commissions, all parties are satisfied with the due diligence and the final prospectus and underwriting agreement have been approved by the board of directors of the Corporation, the underwriting agreement is signed and the final prospectus is executed and filed in each province and territory in which the shares are to be sold. A receipt for the final prospectus is usually received on the day it is filed or on the next business day. Closing of the IPO Once the receipt for the final prospectus has been received from the securities commissions, the underwriters can begin accepting orders and payment from purchasers for the shares. Each person who buys shares must be provided with a copy of the final prospectus. A purchaser has until midnight on the second business day following delivery of the prospectus to him or her in which to withdraw from the sale. Once the selling period is complete, a formal closing is held at which the underwriters deliver payment for the shares and in return the company delivers the share certificates to the underwriters and pays the underwriters commission. Sources of Liability for the Company and its Directors and Officers An IPO gives rise to significant legal responsibilities for the company, its directors and those officers who sign the prospectus. In addition, directors and officers who sign the prospectus may have direct and personal liability and quasi-criminal liability. Securities legislation in all of the Canadian provinces contains important provisions relating to the responsibilities of directors in connection with such a public offering. The discussion is this publication is limited to the Securities Act (Ontario) 7 (the Securities Act ), which tends to contain the most extensive provisions concerning directors and officers liability. 6 7 Advertising is restricted to distributing a notice, circular, advertisement letter or other communication which may only identify the security to be issued and the price (if then determined) and the name and address of a person or company from whom purchaser securities may be made. R. S. O. 1990, c. S-5, as amended. Page 11

13 Full, True and Plain Disclosure of All Material Facts As mentioned above, the Securities Act requires that a prospectus contain full, true and plain disclosure of all material facts relating to the securities offered by the prospectus and that the prospectus not contain an untrue statement of a material fact or omit a material fact. The term material fact is defined in the Securities Act to mean a fact that would reasonably be expected to have a significant effect on the market price or value of the securities being offered. It is essential for each director and officer to take certain steps to ensure that the prospectus meets the disclosure standard required under the Securities Act. Disclosure should give appropriate emphasis to all facts or matters, both adverse and beneficial, which might reasonably be expected to affect an investor s decision to purchase the securities to be offered pursuant to the final prospectus. Approval and Certification At the directors meeting at which the prospectus is brought forward for approval, the directors will be invited to pass resolutions approving the prospectus and authorizing the chief executive officer ( CEO ) and chief financial officer ( CFO ) of the Corporation and two directors, on behalf of the board of directors, to sign the certificate contained in the prospectus. The certificate states, in effect, that the prospectus constitutes full, true and plain disclosure of all material facts relating to the securities offered by the prospectus as required by the Securities Act and the regulations thereunder. 8 Each director will be responsible for this certificate whether or not he or she personally signs it and therefore may be exposed to personal liability if the certificate is untrue. This is the case in respect of a director regardless of whether or not the director reviewed the prospectus, signed the certificate or was present at the meeting at which it was approved. Statutory Civil Liability The Securities Act imposes responsibility for the prospectus and liability upon the company, its directors and the officers who sign the prospectus if the prospectus is defective. In summary, the Securities Act provides that where a prospectus contains a misrepresentation, each purchaser of the securities offered by the prospectus is deemed to have relied on the misrepresentation if it was a misrepresentation at the time of purchase, and that each such purchaser is entitled to the various remedies outlined below. A misrepresentation is an untrue statement of material fact or an omission to state a material fact that is required to be stated or that is necessary to make a statement not misleading in the light of the circumstances in which it was made. The term misrepresentation, therefore, covers not only errors and incorrect statements, but also omissions. There are a number of reported cases where directors have been held personally liable to purchasers of securities for damages where a prospectus was found to contain a misrepresentation. See for example Kerr v. Danier Leather Inc. 9 in which the defendant CEO and CFO were both found liable, together with 8 9 See the Securities Act s. 56(1) and OSC Rule (2004) 23 C.C.L.T. (3d) 77 (Ont. S.C.J.) Page 12

14 Danier, for failing to disclose that assumptions underlying a forecast contained in a prospectus were untrue, the failure of which constituted a misrepresentation. The court determined that at a point in time after the prospectus had been filed but before the IPO had closed the CEO and CFO ought to have known that the forecasts contained in the prospectus were no longer accurate. This constituted an omission of material facts and therefore, a misrepresentation on the part of the defendants. 10 Deemed Reliance A purchaser need not prove actual reliance upon a misrepresentation in making his or her purchase since the Securities Act deems a purchaser to have relied on any misrepresentation. This means that a purchaser will succeed in an action for rescission or damages if the purchaser proves the mere existence of a misrepresentation at the time of his or her purchase. The purchaser need not prove that he or she was misled, relied upon or even read the misrepresentation in making his or her purchase. Remedies Where a prospectus does contain a misrepresentation, a purchaser has a variety of remedies, including (i) an election to pursue a remedy of damages or rescission against the company 11, (ii) a remedy of damages against each officer signing the prospectus and each individual acting as a director of the company at the time the prospectus was filed; and (iii) the same remedies for damages or rescission against the underwriters as a purchaser has against the company. Liability Joint and Several The class of possible defendants, including the company, officers signing the prospectus and each of the directors, will likely be jointly and severally liable to plaintiff purchasers. A purchaser can seek payment of the full amount of his or her damages from any one of the defendants and a person liable to make a payment is entitled to seek contribution from any other person liable to make the same payment. 12 This effectively means that a plaintiff can pursue a claim against the deep-pocketed defendant first so in the event the company is insolvent or close to it the plaintiffs may prefer to pursue one or more high net worth directors It should be noted that the decision in this case is currently under appeal. The remedy of rescission entitles a purchaser to the return of the entire purchase price paid for the securities. Electing to rescind the transaction, however, bars the pursuit of an action for damages. The directors and officers signing the prospectus are exposed to joint and several liability with the company and the underwriters for a claim in damages, but not for repayment of the purchase price if a purchaser elects to exercise his or her right of rescission against the Corporation or the underwriters. Page 13

15 Limitation Periods In an action for rescission, the plaintiff has until 180 days after the transaction giving rise to the cause of action to commence such action. In an action for damages, the plaintiff has until the earlier of three years after the date of the purchase and 180 days after he or she first had knowledge of the facts giving rise to the cause of action to commence such action. Defences The only statutory defence available to the company in an action for rescission is to establish that the purchaser bought the securities in question with knowledge of the misrepresentation. Among the defences available to the officers signing the prospectus and the directors against an action for damages are the following: Purchase With Knowledge there will be no liability if it can proven that the purchaser purchased the securities with knowledge of the misrepresentation. No Knowledge by Director or Signing Officer an officer signing the prospectus or a director or is not liable if he or she can prove that the prospectus was filed without his or her knowledge or consent, and that on becoming aware of its filing, the director or signing officer gave reasonable general notice that it was filed without his or her knowledge or consent. This defence is probably only available to an actively dissenting director who gives reasonable general notice. Withdrawal of Consent: an officer signing the prospectus or a director is not liable if, before the purchase of securities by the purchaser, on becoming aware of a misrepresentation the director or signing officer withdraws his or her consent and gives reasonable general notice of such withdrawal and the reason for it. Expertized Portions: an officer signing the prospectus or a director is not liable if, with respect to any part of the prospectus purporting to be made on the authority of an expert (such as an auditor s report, legal opinion or an engineer s report forming part of the prospectus) or purporting to be an extract from a report, opinion or statement of an expert, he or she had no reasonable grounds to believe and did not believe that there had been a misrepresentation or that such part of the prospectus did not fairly represent the expert s report, opinion or statement. Due Diligence Defence: an officer signing the prospectus or a director is liable for a misrepresentation contained in the non-expertized portions of the prospectus if (i) he or she failed to conduct such reasonable investigations as were necessary to provide reasonable grounds for a belief that there had been no misrepresentation, or (ii) he or she believed that there had been a misrepresentation. Page 14

16 Establishing the Due Diligence Defence By far the most important of the defences available to the directors and signing officers is the due diligence defence. A director or signing officer can escape liability if he or she proves a reasonable investigation was conducted and, as a result of that investigation, he or she had reasonable grounds for a belief that there was no misrepresentation. In determining what constitutes a reasonable investigation, the standard of conduct required is that of a prudent person in the circumstances of the particular case. An assessment of what is reasonable in the circumstances is contextual. It may be different for each director depending on his or her degree of participation, access to information and particular skills. 13 If a director or signing officer believed there had been a misrepresentation, he or she would be liable regardless of the diligence of his or her investigations While there is no specific list of acts which a director or officer may take to ensure the due diligence defence is available there are a number of steps that a director or officers may take that might help in this regard. The director or officer should: carefully review the prospectus for completeness and accuracy; address any doubts or concerns as to the accuracy of a portion of the prospectus with the responsible personnel within the company; review the due diligence record; if a member of a committee which has particular responsibility, ensure the prospectus accurately deals with the material affairs of such committee and consult with personnel within the company and outside advisors reporting to the committee; review supporting documentation in respect of any matters that are of concern; satisfy him or herself as to the accuracy of any expertized portions of the prospectus which may require special meetings with the experts; and at or prior to the time that the prospectus is approved, consider meeting with personnel responsible for details contained in the prospectus, outside advisors (and in particular the auditors) and counsel engaged in the preparation of the prospectus. Each director should make every effort to be personally present at such meetings and obtain confirmation that those individuals are satisfied with the prospectus and if not able to participate in the meeting, follow-up with management beforehand or afterwards. Criminal Liability under the Securities Act In addition to an action by a purchaser under the Securities Act, every person or corporation who makes a statement in any prospectus that is a misrepresentation or contravenes the Securities Act or the 13 Re: YBM Magnex International Inc. (2003), 26 O.S.C.B. (5285). Page 15

17 regulations thereunder in any way is guilty of an offence and, on conviction, is liable to a fine of not more than $5 million or to imprisonment for not more than 5 years less a day, or both. Also, where a corporation is guilty of such an offence, every director or officer of such corporation who authorized, permitted or acquiesced in such offence is also guilty of an offence and, on conviction, is liable to a fine of not more than $5 million or imprisonment for a term of no more than 5 years less a day, or both. A defendant may claim as a defence that he or she did not know, and in the exercise of reasonable diligence, could not have known, that a particular statement was a misrepresentation. Finally, it should be noted that a claim under the statutory rights granted under the Securities Act does not preclude a claim at common law for negligent misrepresentation, breach of contract or some other basis of liability. However, in the case of a common law claim for misrepresentation, the plaintiff would have to establish it relied upon the misrepresentation in entering into the sale transaction whereas under the statutory right for damages or rescission the purchaser is deemed to have relied upon the misrepresentation. Sale Transaction Private Auctions in General While a sale transaction may take a myriad of forms the focus of the discussion here is on a sale resulting from a private auction process. 14 Private auctions have become increasingly popular as a means of selling a company or a part of it. Through a private auction the company and its advisors attempt to establish a competitive environment through which expressions of interest in the company are solicited. This competitive process is designed to maximize value. For this to work there must be at least two credible bidders, if not more to accommodate the possibility that one or more bidders will inevitably drop out of the process at various stages. Much of the discussion below in the context of a private auction can also be applied in a less formal sale process. For example, the duties of directors and officers in the context of a sale transaction will generally be the same regardless of whether the company is responding to an unsolicited offer from an otherwise unknown suitor long before a sale transaction is even contemplated or the company is reacting to multiple bids und the context of a private auction process. Some of the advantages and disadvantages of a private auction compared against a negotiated transaction with a single bidder are as follows: Advantages the company may be able to increase the value realized by selling shareholders; the selling shareholders and the company have more significant input into the terms of the deal; 14 Often also referred to as a controlled auction. Page 16

18 the company may have greater control over the process and as a result be able to enhance its bargaining power; Disadvantages with more parties involved in the process it may be more difficult to maintain confidentiality among bidders and employees; an auction process can be time consuming and possibly cost more to run and maintain; if the company pursues an auction process that does not result in a competitive bids from at least two bidders then the company will lose much of its bargaining power; and if the company chooses to discontinue or delay the process it may be difficult to commence it again. Conducting any sale transaction also carries with it significant sources of risk. Without careful execution a private auction is unlikely to be successful. Worse, the company, its directors and officers and the company s shareholders could be the subject of one or more of a variety of claims such as: a claim against the company and its directors by an unsuccessful bidder that the private auction was not conducted fairly; a claim against the selling shareholders under the purchase agreement or otherwise for breach of representation and warranty; and a claim by selling shareholders that directors did not act in the best interest of shareholders in agreeing to a sale to a particular bidder. Forethought, planning and decisive execution by the various parties involved will be instrumental in addressing these risks and mitigating against possible claims. The Bidding Process In a private auction process there are some common practices but, generally speaking, the process employed by the investment bankers in soliciting and pursuing bids will largely depend upon the circumstances of the company and the potential interest of bidders. The stages of a typical process are as follows: Engage Investment Banker: the process usually begins by engaging an investment banker or sales agent. Collection of Due Diligence Documentation and Organization of Data Room: the company and its advisors will need to collect and compile material information to be included in the confidential information memorandum ( CIM ) and will need to establish a data room before spending a considerable time contacting potential bidders. Page 17

19 Preparation of CIM: the investment bankers, the company and their counsel will prepare the CIM. Contact Bidders: the investment bankers will often send teasers at this stage to potential bidders. Confidentiality Agreement and Initial Access by Bidders: for a bidder to gain access to the process it will have to enter into a confidentiality agreement following which the bidder will typically be provided with a copy of the CIM and other bid related documents. Expression of Interest: it is not uncommon to require bidders to provide expressions of interest prior to an established deadline. The CIM or other sale process documentation will typically set out the seller s expectation with regards to the terms of an expression of interest. Generally speaking, an expression of interest will include a price or range of prices at which the bidder is prepared to consider an offer and any qualifications or terms under which it is prepared to entertain such price. Review Expressions of Interest and Narrow to Qualified Bidders: once the sellers and there professional advisors have reviewed expressions of interest they may narrow down the field of potential bidders to a subset who meet criteria or are likely to meet acceptable criteria for the sellers. Management Presentations and Data Room Access: these qualified bidders are then typically given the opportunity to participate in a management presentation and undertake due diligence in the company s data room. Binding Bids: the qualified bidders will then be expected to submit a formal binding bid together with a mark-up of the seller s form of purchase agreement and other documentation which the sellers may require such as evidence of financing or some form of deposit. At this stage the sellers hope to have multiple bids within an acceptable range of prices and other terms. Final Negotiations with One or More Bidders: it will then be up to the sellers and their advisors to conduct final negotiations with one or more bidders to then reach an agreement with the successful bidder. Circumstances may arise at any stage during the process which may result in the sellers and their advisors modifying the process. If the sellers are unhappy with the process they may also wish to terminate it or delay it for a significant period of time. If the confidentiality agreements are well drafted and details of the process and the fact that it may change are properly described in the CIM, the risks to the sellers and the target of a claim with regards to procedural unfairness should be limited. In this process however it is important that the sellers and their advisors give consistent messages to bidders. In one case a bidder sued, in part alleging that, because it was not provided with an opportunity to bid after a superior offer was received the special committee of the board had unreasonably truncated the Page 18