Mergers & Acquisitions Recent Developments Of Importance. William M. Ainley, Kenneth G. Klassen and Paul Pasalic

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1 Recent Developments Of Importance William M. Ainley, Kenneth G. Klassen and Paul Pasalic

2 William M. Ainley Kenneth G. Klassen Paul Pasalic Davies Ward Phillips & Vineberg LLP As the global economy emerges from a tumultuous recession, Canadian Mergers & Acquisitions activity levels are improving from a six-year low. The uncertainties of the recession are giving way to economic recovery, however, valuations continue to be depressed, albeit well off the historic lows experienced earlier this year. Prospective purchasers continue to be motivated by significantly reduced share prices to evaluate Canadian targets with attractive assets, just as they were during the recession. As the economic recovery gains traction, unconstrained investors (both strategics and financials alike) will be induced to reconsider the fiscally conservative wait and see approach to M & A that has gripped most market participants in favor of opportunism driven by attractive valuations of Canadian companies. Further, Canadian capital markets have been very accommodating throughout 2009 which has permitted potential acquirors to strengthen their balance sheets and raise financing for acquisitions. Shareholder activism in 2009 has injected some uncertainty into the Canadian M&A legal framework regarding private investment in public equity (PIPE) financings. The Ontario Securities Commission (OSC) decision requiring HudBay to obtain shareholder approval of its proposed acquisition of Lundin facilitated a successful proxy contest to replace HudBay s Board of Directors, and prompted significant changes to the TSX rules requiring shareholder approval for dilutive business combinations. Initial reactions to these events suggested they would have significant implications for the Canadian M&A legal framework, however, these conclusions are not yet entirely clear. The Current Valuation Proposition While stock prices have been subject to significant volatility, strategic considerations remain unchanged. Prices on the TSX have generally emerged from their historic declines during the recession, but continue to be depressed relative to year ago levels. This prevailing value proposition will give well financed buyers the opportunity to acquire blue-chip assets at meaningful discounts. The prospect of a large capital outlay will become less daunting as the current indications of modest economic growth return confidence and liquidity to the markets. Buyers with strong balance sheets will likely capitalize on the opportunity to acquire discounted assets. In addition to an attractive value proposition in and of itself, buyers will be motivated by the prospect of gaining a strategic advantage over their peers, further compounding the benefit to be derived from the execution of a decisive acquisition strategy in the coming period. Bridging the Valuation/Price Gap While cash on hand will afford select buyers the opportunity to acquire assets that would not otherwise be attainable in the ordinary course, a major point of friction in the current Canadian M&A space is the disconnect between buyers views on value and sellers views on price. This discrepancy has been a significant hurdle over the last year, and in order for transactions to be successful, buyers will necessarily require a prudent strategy designed to bridge this valuation/price gap. Many companies shares are currently trading at a fraction of the prices seen in the recent past, and in the context of a proposed acquisition, a premium of 100 per cent or more would often be required to merely match the price at which a stock was trading a year ago. Among other things, these deep discounts may make it difficult for a buyer to gain the support of a target s board of directors by offering typical bid premiums (20 to 30 per cent, for example) over current trading prices. A buyer can circumvent an unsupportive target board by putting its offer directly to a target s shareholders, giving those shareholders the opportunity to decide whether the offer represents fair value. The Canadian M&A regulatory framework generally requires that an offer remain open for at least 35 days, subject to any required regulatory approvals, and will generally require boards of directors to allow target shareholders to consider an unsolicited offer without boards in Canada having available to them the so-called just say no defense. The success of an offer for a Canadian target will generally turn on whether a target s shareholders perceive the consideration to be adequate, and will not be decided by other collateral considerations such as the presence of a shareholder rights plans, or poison pill. In Canada, poison pills do not generally have the effect of blocking an unsolicited offer altogether, but rather, they are a mechanism by which a target s board is afforded additional time (usually in the range of 45 to 70 days) to consider and present to target shareholders various alternatives. It is not a question of whether a poison pill will be cease traded by the securities regulators, but rather, it is a question of when the pill will be cease traded. Accordingly, we expect to see an increase in the number of unsolicited or unagreed offers for Canadian targets. Buyers may also seek to address the valuation/price gap by offering the buyer s own shares or other securities in whole or partial consideration for a target s shares. Employing a share-for-share exchange may afford selling shareholders the opportunity to unlock value (without bringing their investment to an end) and thereby participate in the upside potential of future business opportunities such as cyclical recovery, a superior management team, economies of scale or strategic synergies. A share-for-share exchange is generally completed on the same timeline and with the same offer and circular as an all-cash offer, with the addition of LEXPERT /AMERICAN LAWYER

3 prospectus level disclosure about the buyer s securities. Unlike many other jurisdictions, in Canada a share-for-share exchange offer does not suffer a timing disadvantage as compared to an all-cash offer as the offer and circular are not reviewed or cleared by securities regulators. Upon successful completion of a share-forshare exchange offer, the buyer will assume Canadian public reporting obligations and, often to make the offer attractive, a Canadian listing of its securities. It should be noted, however, that Canadian taxable shareholders that accept a security-based offer from a non-canadian buyer will generally be required to pay cash taxes on any gain. A tax rollover or deferral may be achievable if a buyer sets up a Canadian acquisition-subsidiary to make the offer via an exchangeable share structure which establishes a mechanism for the shares of the acquisition subsidiary to be exchanged for the shares of the foreign parent buyer for an agreed period of time. Accordingly, we expect to see an increase in the number of share-for-share offers for Canadian targets. PIPE Financing Opportunities Financial Hardship M&A While the capital markets have opened up in the past two quarters for certain Canadian public companies, many Canadian companies have still been unable to regain access to public and/or private financing. In certain situations, companies may face the ominous prospect of a cash crunch. Absent a fortuitous cash balance, companies that have been unable to generate significant operating cash flows have found themselves particularly vulnerable to problems associated with limited access to capital. This is especially true of early stage companies with robust future prospects that are not yet generating positive cash flows, and certain other categories of issuers that are cash flow negative such as mining and oil and gas exploration companies, as well as research and development companies. Companies that are heavily dependent on access to capital markets in order to fund operations and growth have been forced to explore alternative financing options in order to adapt to the current credit squeeze. PIPEs have proven to be an effective financing method for these companies as well as PIPE investors, with these investors often being an existing shareholder(s) of the financially troubled company. A by-product of these PIPE financings is that they may involve massive dilution, with the PIPE investor acquiring control of the financially troubled company. As a result of depressed market values (which are further exacerbated by potential insolvency discounts), these equity injections are necessarily highly dilutive. PIPE financings in these circumstances often face legal issues more akin to an M&A transaction than to those that are present in a traditional financing structure. Canadian securities laws, as well as the TSX rules, provide companies in serious financial difficulty with exemptions from the shareholder approval requirement for transactions involving share issuances which materially affect control of the company. Provided that the transaction has been approved by an independent committee of the board, and is designed to improve the company s financial situation, the TSX will generally defer to the company s independent board of directors in determining what constitutes serious financial difficulty. Increased shareholder activism, as well as adverse public reaction to certain high profile examples of dilutive PIPE transactions in early 2009, have caused the TSX to change its practice regarding when it would grant the approval necessary for the PIPE share issuance. Until early 2009, the TSX s practice was to grant conditional listing approval of the PIPE share issuances prior to the public announcement of a PIPE financing, so long as the TSX had received confirmation of the application of the exemption. In April of 2009, the TSX announced that it would no longer issue conditional listing approval of these PIPE financings until five days after the proposed PIPE financing had been publicly announced. The change in practice had the effect of increasing the level of deal execution risk of these PIPE financings. Arguably, this procedural change was not necessary, although it does not appear to have had an adverse impact on these financings to date. One reason for this may be that, when forced to choose between a massively dilutive transaction whereby a significant shareholder infuses the necessary financing and the prospect of insolvency, minority shareholders will ultimately concede that massive dilution is the preferred course of action. The Proposed HudBay Acquisition of Lundin Mining Shareholder activism was at the root of what was arguably the most significant event in Canadian M&A in 2009, the OSC decision in The Matter of HudBay Minerals Inc., where the OSC considered the effects and implications of dilutive business combinations on shareholders of TSX listed companies, precipitating changes to the rules surrounding these transactions. Prior to the HudBay decision, TSX listed acquirors were exempted from the requirement to obtain approval from their shareholders for dilutive mergers involving share consideration if the transaction involved the acquisition of a public company. The TSX did, however, have a broad discretion to impose a shareholder approval requirement if, in the opinion of the TSX, the transaction would materially affect control of the issuer. This was in stark contrast to other major exchanges, such as New York, London and Hong Kong, which rely on bright-line tests to restrict companies listed primarily on those exchanges from issuing additional shares without shareholder approval if certain dilution thresholds are met or exceeded, generally between 20 to 30 per cent. GUIDE TO THE LEADING 500 LAWYERS IN CANADA 371

4 HudBay is an integrated mining company with its common shares listed for trading on the TSX and, at the relevant time in late 2008, had a market capitalization of approximately C$800 million. Lundin Mining is a diversified base metals mining company with its shares listed for trading on the TSX and NYSE and, at the relevant time in late 2008, had a market capitalization of approximately C$394 million. In November 2008, the Boards of Directors of HudBay and Lundin agreed to combine their two companies, subject to Lundin shareholder approval and other customary approvals. The economics of the transaction translated into a 103 per cent premium per Lundin share based on closing prices the day before the transaction was announced, and a 32 per cent premium based on the 30-day volume weighted average price of Lundin s shares. The transaction also represented greater than 100 per cent dilution for HudBay shareholders. Since the transaction was structured as a plan of arrangement of Lundin, the Lundin shareholders were required to approve the transaction, however, neither Canadian corporate law nor the TSX rules required that HudBay shareholders be afforded the same opportunity. The OSC Decision Certain HudBay shareholders, following repeated unsuccessful attempts to requisition a special meeting of shareholders, petitioned the TSX to exercise its discretion to require HudBay to obtain its shareholder approval of the transaction. While the TSX determined that these were not appropriate circumstances in which to exercise its discretion, on appeal, the OSC reversed the TSX s decision and required that a HudBay shareholder vote be held. The OSC ruled that, notwithstanding the importance of deal certainty, shareholder approval was required because the completion of the transaction absent that approval could significantly and adversely affect the quality of the marketplace. The OSC further commented, in obiter, that it was concerned over financial advice received by the special committee of independent directors of HudBay. The services provided by the financial advisor included, among other things, advice as to whether the transaction was fair from a financial point of view to HudBay shareholders. In connection with its services, the financial advisor was to receive a signing fee when the arrangement agreement was entered into and a much larger success fee payable if the transaction was ultimately consummated. The OSC was of the view that such fees create a financial incentive for an advisor to facilitate the successful completion of a transaction when its principal focus should be on the financial evaluation of the transaction from the perspective of shareholders. Furthermore, the OSC commented that a fairness opinion prepared by a financial advisor that is being paid a signing fee or a success fee did not assist a special committee in demonstrating the due care in complying with its fiduciary duties in approving a transaction. Implications for Shareholder Voting Subsequent to the HudBay decision, the TSX revisited a proposed amendment to the TSX Company Manual which was designed to address concerns surrounding the rules governing dilutive business combinations. The fact that TSX listed acquirors had been able to offer shares as merger consideration for a public target without the requirement to obtain shareholder approval had historically been a tactical advantage because, in the case of multiple bids that are economically equivalent, a bid which was not conditional on shareholder approval was much more attractive than a bid subject to shareholder approval. This exemption had provided a degree of deal certainty for TSX listed acquirors that could not otherwise be attained by competing bidders whose shares were primarily listed on other major exchanges that imposed a bright-line test for shareholder approval requirements in acquisitions involving dilution of 20 to 30 per cent or more. On September 25, 2009, the TSX announced changes to its rules governing public company acquisitions by TSX listed acquirors. TSX listed acquirors are now required to obtain approval from their shareholders when the number of shares issued in payment for an acquisition exceeds 25 per cent of the number of issued and outstanding shares of the listed acquiror which are outstanding (on a nondiluted basis). These changes have resulted in the removal of the shareholder approval exemption for a listed acquiror acquiring a public company. By adopting a bright-line test similar to that employed by other major exchanges, the TSX has eliminated the strategic advantage previously enjoyed by TSX listed acquirors. TSX listed acquirors will now be required to submit bids for public targets which are conditional upon obtaining approval from their shareholders, effectively levelling the playing field as between TSX listed acquirers and their international counterparts listed on competing exchanges. Implications for Fairness Opinions In the context of an acquisition, a financial advisor will typically be seized with the dual mandate of running an auction and rendering a fairness opinion. Although discussed in obiter, the OSC s principal area of concern with this arrangement appeared to be the contingent nature in which the financial advisor s compensation was structured and the apparent conflict of interest that would result. This suggests that, in order to avoid an actual or apparent conflict of interest, an independent financial advisor should be retained (at a flat fee) for the purpose of rendering a fairness opinion in order for the special committee to properly LEXPERT /AMERICAN LAWYER

5 discharge its fiduciary duties. In practice, it seems unlikely that an actual conflict of interest would materialize in an industry that is so heavily dependent on reputational capital and the quality of advice. It is questionable whether shareholders should be forced to bear the added expense of hiring a second independent financial advisor simply to avoid the appearance of impropriety when the factual underpinnings of the suggested conflict of interest were not put to a matter of proof before the OSC. As such, a balance must necessarily be struck as between investor protection and the commercial concerns of shareholders. It is unclear whether the OSC will propose rule changes to address these concerns, however, financial advisors should exercise caution when assessing future mandates. Concurrent Private Placement and Acquisition The PIPE financing structure that employs a concurrent private placement of up to 19.9 per cent connected to, but not conditional upon, the completion of a proposed acquisition has played a significant role in 2009 and is a structure that could potentially have an important role in the future. It can provide significant advantages not only to prospective acquirers, but also to existing target shareholders and directors alike. This transaction structure will typically be employed when a target issuer is in need of financing. The transaction is a mutually beneficial arrangement because it provides a degree of deal protection for a buyer, while at the same time it provides a cash infusion for a target that will address financing concerns and allow the target to operate normally, subject to the restrictions of the merger agreement, including considering fully any potential interloper offer. As the private placement is announced concurrently with the proposed acquisition (at a time when the buyer is not a related party of the issuer), the buyer will have the added advantage of being able to vote the 19.9 per cent private placement shares in favor of any second step transaction. The application of this structure is narrowed by the corporate necessity for the target to have a valid business purpose for the private placement (such as financial distress), and the buyer must be prepared to accept a minority stake in the target company if the change of control transaction is unsuccessful. This transaction structure was briefly addressed in obiter in the HudBay decision (described more fully above), as HudBay had employed this structure in connection with its attempted acquisition of Lundin Mining.The OSC held that, as a matter of principle, an acquirer should not generally be entitled, through a subscription for shares carried out in anticipation of a merger transaction, to significantly influence or affect the outcome of the vote on an anticipated merger transaction because the acquiror in a merger transaction has a fundamentally different interest in the outcome than the existing shareholders of the target. The OSC expressed these views despite its concession that it was probably a foregone conclusion that the Lundin shareholders would approve the transaction regardless of whether HudBay voted those shares in favour of the transaction. As a result of the obiter dicta in HudBay, there has been significant uncertainty as to whether a private placement investor proposing a merger will be able to vote the newly acquired shares in the merger vote. Re: Arc Equity Management (Fund 4) Ltd. The Alberta Securities Commission decision (the ASC ) in Re: Arc Equity Management (Fund 4) Ltd., released August 10, 2009, has cast new light on the applicability of concurrent PIPE financings and M&A change of control transactions. In Arc Equity, the ASC considered the applicability of the obiter statements in HudBay in determining whether or not to employ its public interest jurisdiction to bar the voting of private placement shares acquired by a buyer in connection with a proposed amalgamation for purposes of reaching the 66 2/3 per cent voting threshold required under the Business Corporations Act (Alberta). Profound Energy is a junior oil and gas company with shares traded on the TSX. Paramount Energy Trust is an energy focused trust with units listed on the TSX. On March 31, 2009, Profound and Paramount Energy Trust entered into a support agreement providing that Paramount would offer to acquire all of the shares of Profound, for either a specified amount of cash or Paramount trust units, or a combination of cash and trust units. The transaction reflected a premium of approximately 100 per cent over the Profound share price prior to announcement. The transaction included a concurrent private placement of Profound special warrants to be issued to Paramount at a price representing a 15 per cent premium over the Profound share trading price prior to the announcement. The warrants were exercisable for 19.9 per cent of the outstanding Profound common shares on a post-transaction basis. The subscription proceeds were placed in escrow, and upon the occurrence of certain conditions, including Paramount not taking up at least 50.1 per cent of Profound shares, the special warrants would automatically convert into Profound shares and the proceeds would be released to Profound from escrow (providing for certainty of funding for Profound regardless of the outcome of the Paramount offer). In addition, there were specified Redemption Events (including Paramount taking up at least 50.1 per cent of Profound shares under the bid) on the occurrence of which, Paramount would have the option of either converting the special warrants into private placement shares, or redeeming the special warrants and receiving back its subscription proceeds. Paramount also agreed to vote the private placement shares in favour of a GUIDE TO THE LEADING 500 LAWYERS IN CANADA 373

6 Superior Proposal accepted by a majority of Profound shareholders. Finally, Profound adopted a shareholder rights plan which would trigger a dramatic dilutive effect in the event of an acquisition of 20 per cent or more of Profound shares, or in the event that an existing Profound shareholder with shareholdings of 20 per cent or more, acquired additional Profound shares in excess of 0.25 per cent. Profound s largest shareholder (and the only shareholder holding more than 20 per cent), ARC Equity Management, which held 31 per cent of the Profound shares, was not supportive of the transaction and refused to sign a lock-up agreement prior to the announcement. Conditional listing approval of the private placement shares was granted by the TSX on April 9, 2009, and the Paramount bid was formally launched on April 24, Paramount extended its bid on several occasions, and when the minimum tender condition of 66 2/3 per cent was not met, Paramount reduced this condition to 50.1 per cent of the outstanding shares. On June 30, 2009, Paramount announced that it had acquired approximately 59.4 per cent of the outstanding Profound Shares (not including the private placement shares). Paramount also announced concurrently that it was converting the special warrants which, together with the shares otherwise acquired, gave Paramount an aggregate interest of approximately per cent. Paramount proceeded to implement a second-step going private transaction and on July 20, 2009, more than three months after initially voicing its opposition to the transaction, ARC began its application before the ASC to prevent Paramount from compelling the acquisition of all the Profound shares Paramount did not already own, including the shares held by ARC, in the going private transaction. Implications of the Arc Equity Decision The ASC ultimately decided that it would not prevent the private placement shares from being voted in the going private vote. It concluded that a private placement of shares to a buyer in connection with a take-over bid is not necessarily abusive of the capital markets or abusive of the rights of shareholders, and there are circumstances when a bid-related private placement can plausibly deliver benefits to minority shareholders. It is under these circumstances that parties to a business combination could potentially employ this form of financing structure to their mutual benefit. The factors that seemed to carry the most weight with the ASC seemed to be the challenging business environment in which Profound found itself, and the expectation that Profound s primary lender would soon reduce its operating line of credit to an amount potentially below what had already been borrowed. Furthermore, the transaction received significant consideration from the Profound special committee of the board of directors which came to the conclusion that the status quo was not sustainable. Finally, the ASC acknowledged that the private placement shares were used at least in part as a tactical tool in order to assist Paramount (if needed or desired) in order to acquire control of Profound, however, the financing was a real financing, not a sham as the subscription proceeds were immediately used by Profound to pay down existing bank debt. While the decision did not explicitly deal with the business judgement rule, it is clear that the ASC gave deference to the decisions made by management, which the ASC acknowledged were made under difficult financial circumstances. In light of HudBay, one must still be cognizant of the diverging interests of an acquirer and existing shareholders, and care must be taken in assessing the benefit to target shareholders, however, as described by the ASC in Arc Equity: Obiter is Obiter. The obiter in HudBay merits careful reading and thoughtful attention, but by its very nature it is not and cannot be taken as determinative. Arc Equity serves to clarify that regulators will be loathe to impose a blanket limitation on the exercise of voting power associated with private placement shares obtained in accordance with the Canadian legislative framework. In that case, the ASC concluded that under the appropriate circumstances, and provided there is a legitimate business purpose, a private placement employed in connection with a tender offer can be used as an effective tool to the mutual benefit of all parties. Relationship Investing A newly developing form of PIPE financing which has gained traction during these challenging economic times is relationship investing, whereby large (usually institutional) investors look to make strategic private placement investments in mid- to large-cap public companies experiencing credit or cash flow challenges. The investment will be a meaningful minority stake ranging from five per cent to 30 per cent, and relationship investors will approach the investment from a long-term perspective with a view to establishing sustainable commercial relationships that will generate long-term returns at the expense of short-term cost cutting. These investors will look to take a hands-on approach, and will establish relationships with management in order to assume a role in effecting strategic and certain other changes to improve long-term value. For management, relationship investors can be a source of equity financing that may not otherwise be attainable by way of prospectus offering through the bought deal market in the event that a large sum is required. Because of the size and liquidity of relationship investors, they are able to quickly source the required funds for these investments. In addition, management is also afforded the opportunity to significantly reduce refinancing risk when structuring future expansion. When faced with the choice between incurring additional short-term LEXPERT /AMERICAN LAWYER

7 financing to address credit or cash flow issues, and issuing large sums of additional equity to relationship investors, management can employ the capital provided by relationship investors as a means of mitigating leverage and reducing refinancing risk on short-term borrowing. The full impact of relationship investing has not yet been felt in the Canadian marketplace, and only time will tell the extent to which this form of investing will become a viable form of PIPE financing. Conclusion This confluence of dynamic factors provides a unique opportunity for wellfinanced buyers to make opportunistic Canadian acquisitions that may not otherwise be possible under normal market conditions. These opportunities will require a comprehensive acquisition strategy that addresses, among other things, the valuation/price gap between what a willing buyer will pay for a target and the price at which a willing target shareholder will sell. William M. Ainley, Davies Ward Phillips & Vineberg LLP Tel: (416) Fax: (416) wainley@dwpv.com Bill Ainley is a senior partner in the mergers & acquisitions and corporate finance & securities practices and is a member of the firm s Management Committee. Bill has acted as lead counsel for bidders and target boards in numerous solicited and unsolicited public take-overs and merger and acquisition transactions. He has also acted as lead counsel in a wide variety of private equity and leveraged acquisitions. Bill also practices extensively in the corporate governance area and has acted for independent and special committees of a number of public corporations in special mandates. Kenneth G. Klassen, Davies Ward Phillips & Vineberg LLP Tel: (416) Fax: (416) kklassen@dwpv.com Ken Klassen is a partner in the Toronto office of Davies Ward Phillips & Vineberg. Ken practices primarily in M&A and corporate finance. He has extensive experience in negotiated and hostile public M&A across a broad range of industries, including extensive transactional experience in mining and oil and gas. Ken regularly advises on cross-border and Canadian public offerings, high yield debt offerings, structured finance deals and innovative transactions, such the first outsourcing by a Japanese company in the semiconductor industry and the restructuring of the National Hockey League. He serves as Canadian General Counsel to a leading international investment bank and has significant experience in technology, having practiced in Silicon Valley at the world s leading technology law firm. Ken continues to be a member of the California Bar. Paul Pasalic, Davies Ward Phillips & Vineberg LLP Tel: (416) Fax: (416) ppasalic@dwpv.com Paul Pasalic is an associate in the corporate/commercial, mergers & acquisitions, and corporate finance & securities practices. He has been involved in a number of public and private acquisitions, and regularly advises companies and investment dealers in a wide variety of capital market transactions. GUIDE TO THE LEADING 500 LAWYERS IN CANADA 375