Shareholders Agreement Uncertainties
By Michael Herman and Myron Dzulynsky
Corporate management and exits are key considerations in private equity fund acquisitions of portfolio companies, and are often the subject of a "unanimous" agreement between all of the shareholders of the portfolio company. It is important to note, however, that there may be some uncertainty relating to how such provisions operate under Canadian law.
(a) Decision-Making
One of the key issues with respect to corporate management is the way in which directors and shareholders can make decisions in respect of the business and affairs of the portfolio company. Under Canadian law, the analysis of this issue can be fundamentally altered if the agreement between all of the shareholders is also a "unanimous shareholders agreement" under the applicable corporate statute, as further described below (for purposes of this article, we will refer to the provisions of the Canada Business Corporations Act ("CBCA")).
A unanimous shareholders agreement is generally an agreement among all shareholders that restricts, in whole or in part, the powers of the directors to manage, or supervise the management of, the business and affairs of the corporation (CBCA Section 146 (1)).
Issues which stem from how a shareholders agreement is characterized include how fiduciary obligations affect decision-making and whether directors or shareholders can fetter or limit in advance the manner in which they exercise their discretion.
Fiduciary Obligations Generally
As a general rule, shareholders do not owe fiduciary duties to the corporation or other shareholders. Directors, on the other hand, are required to act honestly, in good faith and in the best interest of the corporation (CBCA Section 122(1)(a)), an obligation generally viewed as a codification of the common law fiduciary duty imposed on directors.
It is clear, based on recent Supreme Court of Canada decisions, that a director's fiduciary duty is owed to the corporation, not to the shareholders. As such, to the extent that the best interests of the corporation may diverge from what is in the best interests of the shareholders, the directors must act in the best interests of the corporation. This principle applies regardless of whether the director in question is nominated or appointed by a particular shareholder, and whether the corporation in question is private or public.
The Supreme Court of Canada's decision in BCE Inc. v. 1976 Debentureholders, 2008 SCC 69 (BCE) is widely viewed as the definitive statement on the issue. In BCE, the Supreme Court held that there is no principle in Canadian law that "one set of interests – for example, the interests of shareholders – should prevail over another set of interests" even in a change of control situation. The Court recognized that the interests of shareholders are often aligned with the interests of the corporation, but in situations where such interests are in conflict, the director's duty is to the corporation. The Court noted that a corporation has numerous stakeholders, including employees and creditors, all of whose interests should be considered. The Court also affirmed the "business judgment rule" (which provides for general judicial deference to the decisions of boards of directors) when assessing whether directors have satisfied their fiduciary duties. While no doubt intended to clarify the law, the BCE case, combined with prior Supreme Court decisions, has sparked considerable concern that directors' abilities to satisfy their fiduciary duties has been made more uncertain.
Fiduciary Obligations and Unanimous Shareholders Agreements
To the extent shareholders of a portfolio company have restricted the powers of the directors under a unanimous shareholder agreement and assumed such powers themselves, such shareholders also assume all of the duties and liabilities of a director (CBCA Section 146(5)). Commentators disagree on whether or not shareholders would then have the same fiduciary duties as the directors. However, as Canadian case law is currently silent on whether shareholders assume fiduciary duties in this context, shareholders which have assumed the power of directors should be very careful in how they exercise their discretion in respect of such powers.
Fettering Discretion
As part of their fiduciary obligations, directors of Canadian corporations are generally prohibited from agreeing to pre-agree, or fetter, the manner in which they exercise their discretion. On the other hand, shareholders exercising the powers of directors pursuant to a unanimous shareholders agreement are expressly permitted to fetter their discretion (CBCA Section 146(6)).
Consequently, to the extent that a private equity fund seeks to fetter decision-making that would typically be within the purview of the directors of a portfolio company, it can only do so through a unanimous shareholders agreement. Further, in order to minimize risks associated with the interplay of fettering and fiduciary duty described above, it is prudent to set out in reasonable detail in such unanimous shareholders agreement exactly how the discretion is being fettered.
(b) Waiver of Rights
Typically, private equity funds insert provisions into shareholders agreements to prevent or restrict minority shareholders from interfering with the control or ultimate sale of the portfolio company or its business. For example, such shareholder agreements may contain waivers of certain statutory rights, such as the right to vote as a separate class (if more than one class of shares is outstanding) or rights of dissent. Canadian case law is currently silent on the enforceability of such waivers (whether in the context of unanimous shareholders agreement or otherwise), and many commentators suggest that any such purported waiver may be unenforceable.
There may be alternatives to outright waivers of fundamental rights. For example, with respect to control, all or certain shareholders can pool their shares into a voting trust and grant the trustee full discretion in how to vote such shares. Also, in certain situations funds will structure ownership so that "minority shareholders" do not own shares but instead hold options, warrants or other instruments to acquire shares which are only exercised immediately prior to the completion of a sale transaction and do not have rights to vote or dissent in connection with shareholder approval of the transaction. To the extent practicable in the circumstances, it is recommended that private equity funds explore ways to structure their relationships with minority shareholders to maintain maximum flexibility without having such shareholders waive fundamental statutory rights.
IOSCO Publishes its Final Report on Private Equity Conflicts of Interest
By Naim Antaki and Nicholas Dietrich
On November 15, 2010, the Technical Committee of the International Organization of Securities Commissions ("IOSCO") published its final consultation report on the concerns surrounding conflicts of interest in private equity. IOSCO's final report, entitled "Private Equity Conflicts of Interest", provides an opportunity to better understand the current views of various securities commissions, which is especially important in light of the current round of fund formation and the involvement of private equity firms and private equity funds in public-to-private and private-to-public transactions in respect of portfolio companies. In particular, the report can assist private equity firms in (i) identifying and mitigating conflicts of interest throughout the life cycle of a private equity fund, and (ii) reviewing and revising fund compliance documentation and processes, such as a code of ethics as well as conflict management committees. The IOSCO report is one of various recent initiatives by regulators and investors focusing on the mitigation of conflicts of interest and best practices in private equity, such as those contained in the U.S. Dodd–Frank Wall Street Reform and Consumer Protection Act, the European Union's Alternative Investment Fund Management Directive and the Private Equity Principles Version 2.0 of the Institutional Limited Partners Association (ILPA) (please refer to our February 2, 2011 issue of PEG for more details).
The final report builds on IOSCO's earlier work that identified conflicts of interest in the private equity industry as a key risk to fund investors as well as the efficient functioning of financial markets. IOSCO's final report identified a total of 18 specific areas of risk to private equity firms that may arise during the typical course of a fund's life cycle. In particular, the report identified 2 areas of risk at the fund raising stage (engagement of third party investment advisors and impact of fund size on return to limited partners), 5 areas of risk at the investment stage (transaction fees, conflicting investment strategies, investment allocation, co-investments by general partners and deal specific co-investments by limited partners), 6 areas of risk at the management stage (other fees payable to a fund manager, fees payable to an affiliate of a fund manager, directorship appointments to portfolio companies (please refer to the preceding article for more details), allocation of management resources by private equity firms, enforcement of default remedies in a fund's partnership agreement and rescue financing of portfolio companies) and 5 areas of risk at the exit stage (extension of a fund's term, market value fees, divestment timing of assets held by multiple funds, retention of minority interests by a fund in an investee company and sales of fund interests in the secondary market). For each risk identified, IOSCO identified the following 4 best practices in the private equity industry:
- the use of performance based compensation arrangements (for example, calculating compensation based on calculations as a percentage of realized profits after investors realize a return on investment plus a "cost of money" hurdle);
- the use of negotiated contractual agreements (for example, the fund's limited partnership agreement and related side letters);
- disclosure to investors (for example, the frequency and content of "core investor reporting" while addressing disclosure disparity between larger investors and smaller investors); and
- consultation with investor committees (also known as advisory boards).
We note that a number of the risks identified at the three later stages also deal with various types of fees and their structure, which remain a key interest alignment matter for GPs and LPs alike. In light of the 18 areas of risk identified and mitigation methods proposed, IOSCO set forth the following 8 principles for effective mitigation of conflicts of interests by private equity firms:
- manage conflicts of interest in a way that is in the best interests of its fund(s), and therefore the overall best interest of fund investors;
- establish and implement written policies and procedures to identify, monitor and appropriately mitigate conflicts of interest throughout the scope of business that the firm conducts;
- make the policies and procedures available to all fund investors both at inception of their relationship with the firm and on an ongoing basis;
- review the policies and procedures, and their application, on a regular basis, or as a result of business developments, to ensure their continued appropriateness;
- favour conflicts management techniques which provide the most effective mitigation and greatest level of clarity to investors;
- establish and implement a clearly documented and defined process which facilitates investor consultation regarding matters relating to conflicts of interest;
- disclose the outcome of discussions from the investor consultation process and any related actions taken to all affected fund investors in a timely manner (save where to do so would breach any other legal or regulatory requirement or duties of confidentiality); and
- ensure that all disclosure provided to investors is clear, complete, fair and not misleading.
While developed for multi-fund, multi-strategy private equity firms, IOSCO notes that the foregoing principles can be applied to all private equity firms, while taking into account that the size, structure and operations of a fund will have an effect on the application of these principles. Considering the heightened public scrutiny in the political realm, funds that are at the intersection of private equity and politics either by design (sovereign wealth funds) or by advisors (that "cross over"), will have to consider conflicts of interest matters with particular care.
The IOSCO report presents an opportunity to review fund compliance documentation and processes, especially in light of the fact that the report is only one of the various initiatives being undertaken by regulators and investors for increased and more formalized transparency, disclosure, alignment of interest and conflict management in the private equity industry. While the take-away recommendations primarily focus on the GP/LP interface in fund documentation and practice, the private equity community can also benefit secondarily from suggested recommendations related to downstream investment in, and divestment of, portfolio companies.
Accelerated Recognition of Partnership Income
By Ash Gupta
The predominant investment vehicle in most private equity structures is a limited partnership due to the flow-through nature for tax purposes as well as the limited liability afforded to investors under most provincial limited partnership statutes. In many instances, different functions within a typical private equity structure are effected through the use of separate partnership vehicles acting in conjunction with one another, resulting in a "stacked" partnership structure. The 2011 Canadian Federal Budget ("Budget 2011") announced significant changes which, if enacted, would materially alter the manner in which a corporate investor's partnership income is calculated. The proposed rules are significantly more complex where a stacked partnership structure exists.
The dissolution of Canada's Federal government on March 25, 2011 resulted in the legislative death of Budget 2011. The consensus from observers prior to the dissolution of Canada's Federal government was that the additional tax revenues arising from the rule changes in Budget 2011 (estimated to be $2.8 billion over the first 5 years) will prove too irresistible for the new majority Conservative government to pass up and that such changes will be resurrected.
Under current income tax rules, partnership income earned by a corporation is included in the income of the corporation for the taxation year in which the fiscal period of the partnership ends. Deferral can arise where the partnership's fiscal period ends after the end of the corporation's taxation year. In that case, partnership income earned up to the end of the corporation's taxation year is not brought into the corporation's income until the following taxation year.
Under the proposed measures, partnerships will be permitted to maintain fiscal periods that differ from that of its corporate partners but doing so may result in accelerated taxation. Such accelerated taxation could cause unforeseen administrative burdens and result in the risk of additional income for one or more corporate partners. The proposals in Budget 2011 affect only corporate partners (other than professional corporations) that, together with affiliated and related parties, are entitled to more than 10% of the partnership's income (or assets in the case of wind-up) at the relevant time (the 10% threshold is intended to exclude investors in so-called "publicly" traded limited partnerships).
Income Accrual
Corporate partners affected by the proposed new rules (if enacted) for taxation years ending after March 22, 2011 would be required to accrue partnership income for the portion of the partnership's fiscal period that falls within the corporation's taxation year (a stub period) resulting in the recognition of partnership income for the stub period.
In the absence of relief, when the rules first apply the result could be the recognition of more than one year of partnership income by a corporate partner. To mitigate the initial impact of accruing stub period income, transitional relief will allow a corporate partner to bring the stub period amount into income over five taxation years. The transitional rules will apply only if certain conditions are met and, in some cases, continue to be met throughout those five taxation years.
A corporate partner's stub period accrual is determined by formula. Generally, the stub period accrual will be the corporate partner's share of the partnership's income, pro-rated for the period ending at the corporation's taxation year end. Alternatively, a corporation may designate a stub period accrual amount that is lower than the amount determined under the formulaic approach but, by doing so, will be exposed to the risk of an additional income inclusion (essentially a penalty). Corporate partners in a typical private equity structure will want to seek tax advice to ensure that the designated amount is carefully chosen so as not to trigger such penalties.
Election to Change Partnership's Fiscal Period
To address the administrative inconvenience resulting from these proposed measures a single-tier partnership may make a one-time tax election to change its fiscal period if the following conditions are met:
- the last day of the partnership's new fiscal period must be (i) after March 22, 2011 and (ii) no later than the last day of the first taxation year of a corporate partner that ends after March 22, 2011 (subject to the requirement that the corporate partner continuously maintained its status as partner prior to March 22, 2011);
- the election is in writing and filed on behalf of the partnership on or before the earliest of all filing due dates for the return of any income of any corporate partner for the taxation year in which the new fiscal period ends;
- at least one corporate partner would, in the absence of the election, have an adjusted stub period accrual greater than zero in its first taxation year ending after March 22, 2011; and
- all members of the partnership are corporations, other than professional corporations.
If a partnership has one or more partnerships as members, and the partnerships are not required under the existing rules to adopt December 31 as their fiscal year end, the 2011 Budget proposals require that those partnerships adopt a common fiscal period. The partnerships are required, on a one-time basis, to choose a common fiscal period by filing an election in writing. The filing of an election will not be a practical solution in all circumstances and especially in a private equity context where fund-on-fund structures are involved or where aggregator partnerships are used to manage co-investments by separately managed funds.
Modified stub period accrual rules and transitional relief will apply to income earned by each corporate partner in a tiered partnership structure whose taxation year is not aligned with the fiscal period of the partnership.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.