In each of these decisions, the actions taken by the target boards were seen by regulators as constituting (or potentially constituting) inappropriate interference by those target boards in the takeover process. The actions taken by the regulators in both cases appear to reflect the prevailing view of many Canadian securities regulators that the role of directors, while important, should be strictly limited both in terms of time and available tactics, and that ultimately decisions regarding whether or not to accept a hostile bid should be left to shareholders, not directors.
In 2013, new rules on the use of shareholder rights plans may be coming which give target boards more power
The Ontario Securities Commission (OSC) has announced that in early 2013 it intends to publish a new proposal for dealing with shareholder rights plans which it believes will continue to adhere to the general concept that ultimate power to accept or reject hostile bids should rest with shareholders. It is expected that the OSC will propose granting more latitude to target boards to adopt and use shareholder rights plans to defend against hostile bids, particularly where those plans are approved by target shareholders. It is not yet clear how much support these new proposals will get from other Canadian securities regulators, some of whom appear to believe the current system works quite well. However, if the effort is ultimately successful and is implemented broadly across Canada, this would be a significant development for M&A practice in Canada and would likely make the process of completing a hostile bid in Canada more expensive and subject to significantly more uncertainty from the point of view of a hostile bidder.
To read more about these topics, please click here.
TRENDS IN KEY DEAL TERMS
Jeff Barnes
Adjusting Consideration and Risk in Purchase and Support Agreements
General trends in the drafting of agreements relating to the acquisition of shares of public entities will reflect the caution shown in 2012. Buyers will be attempting to limit transaction risk and both parties will try to bridge the gap between buyer and seller in determining future value. Adjustment provisions in both directions can be very flexible in a private M&A context, and can include
- Escrow provisions, holding back consideration to cover representations generally and to cover specific representations which go to the core value
- Use of earn-outs in various forms, including cash top-ups and retaining an ongoing interest in convertible instruments or preferred shares in public situations
However in public M & A for shares, these adjustment mechanisms are rare. The difficulties in providing for post-closing flexibility in public M&A transactions may feed a preference for the acquisition of desirable assets from public companies, rather than bids for shares. Alternatively, instruments could be distributed which provide potential additional consideration on an earn-out basis or represent an interest in any net holdback. There has been limited past use of similar value-tracking instruments where the value of an asset (e.g. litigation) has been highly conditional.
Closing Conditions in Support Agreements in Public M&A
Some interesting recent studies have posited that the failure of markets to consistently reflect the different conditionality of different acquisition agreements should result in a different approach to merger agreements [Manns, Jeffrey David and Anderson, Robert, The Merger Agreement Myth (July 15, 2012), Cornell Law Review, Forthcoming; 7th Annual Conference on Empirical Legal Studies Paper. Available at SSRN]. That paper suggested that failure to meet most conditions should result in price adjustments (or "contingent consideration") rather than deal failure (or "contingent closing").
Closing Periods and Reverse Break Fees
A more trying climate in terms of meeting closing conditions (especially government approvals) may be reflected in longer closing terms coupled with higher reverse break fees.
Confidentiality Agreements and Standstills
There has been significant turbulence in U.S. courts in interpreting standstill terms, which leaves an apparent gap between the views of Canadian and U.S. courts on assessing directors' decisions to agree to tie their hands. Expect further experimentation. For a review of recent relevant cases, click here for our bulletin on this topic.
Advisory Agreements
A more turbulent financial market continues to be reflected in comings and goings (but mainly goings) in advisory areas. Changes in service businesses may be reflected in engagement terms. For example, "tails" for financial advisers may be made conditional on preservation of the individual members of the targeted working team within the advisor.
USING SPIN-OUTS TO BRIDGE VALUATION GAPS
Paul A. D. Mingay and Steve Suarez
While companies are reportedly sitting on piles of cash (so much so, that it has become somewhat of a political issue with Canadian cabinet ministers and the Governor of the Bank of Canada urging companies to spend this "dead money"), one might expect such companies to be free spenders when it comes to acquisitions. However, persistent economic uncertainty has made potential purchasers reluctant to spend accumulated cash on acquisitions and we expect this trend to continue until an economic recovery is firmly established.
In the M&A area, this reluctance to overspend is often coupled with the fact that a target company may have, in addition to its desirable assets, other assets that are less attractive, at least from the prospective acquirer's perspective. This is particularly true in the resource sector where smaller exploration companies will often have a number of properties at different stages of development. If one or two properties prove to be promising and attract the attention of a major resource company, there may be a wide gulf between the value that the target company puts on its other properties and the value that the acquirer is willing to pay for them. Indeed, in many cases the acquirer may view them as superfluous and have no interest in continuing their exploration or development.
Of course, the easiest answer might be for the target to simply sell the valuable asset and keep the other assets and continue their development. This is not always advantageous to the shareholders, however, as such a sale often triggers a taxable event for the target and there may be no tax-effective way to flow the sale proceeds into the hands of shareholders. Similarly, the use of earn-outs (or, in a public company context, contingent value rights), the tool often used to bridge valuation gaps, is not well-suited to long-term projects like mining or oil and gas projects. A spin-out transaction may be a possible alternative solution.
Under a spin-out coupled with an M&A transaction, the acquirer purchases the shares of the target company, but the assets which the acquirer doesn't want are contemporaneously spun-out of the target into a new company, the shares of which are distributed to the target shareholders as part of the transaction. Thus, the target shareholders get paid full value for the target's core assets but also are able to continue to participate in the development of the other assets. Similarly, the acquiror only has to pay for what it actually wants. Such spin-out transactions can often be completed in a reasonably tax-effective manner, depending on the facts.
For these reasons, we anticipate spin-outs will continue to be a feature of M&A in 2013 as a tool for bridging value gaps in acquisition transactions. Beyond their use in M&A, we can also expect that spin-outs will continue to appear as a way of enhancing value within diversified enterprises: see for example the pending Loblaw Companies Limited spin-out of its real estate into a new REIT and the coming proxy battle to push Agrium Inc. to spin out its farm store business.
To read more about these topics, please click here.
NEW TAX ISSUES FOR FOREIGN BUYERS
Steve Suarez
One of the most important considerations for M&A purchasers (especially in cross-border transactions) is managing the tax issues. Foreign purchasers of Canadian entities will need to plan around significant changes to the Income Tax Act (Canada) enacted in 2012.
First of all, revisions were made to Canada's "thin capitalization" rules in 2012. These rules limit the extent to which a Canadian-resident corporation ("Canco") can deduct interest expense incurred on debt owing to "specified non-residents": non-residents of Canada who either are 25%+ shareholders of Canco or who deal non-arm's length with such 25%+ shareholders. Effective January 1, 2013, Canco can only deduct interest expense on an amount of debt owing to specified non-residents equal to 150% of Canco's "equity" (start-of-year unconsolidated retained earnings plus the paid-up capital ("PUC") of Canco shares owned by a non-resident 25%+ Canco shareholder). Previously, the limit had been 200% of such equity. In addition, disallowed interest is now treated as a dividend and subject to dividend withholding tax. See here for more on changes to these rules.
Since most foreign purchasers of a Canadian target use a Canco to make the purchase (for tax and non-tax reasons), a foreign purchaser can now only loan a reduced amount to its Canadian acquisition vehicle to make the purchase, and reduced interest expense deductions must be factored into the purchase price, Going forward, we expect to see Cancos financed to a greater extent with equity or with loans from arm's-length lenders (no thin capitalization limits apply to debt owing to Canadian or arm's-length lenders).
Separately, Canada introduced complex new rules ("foreign affiliate dumping" rules) in 2012 that can apply whenever a foreign purchaser acquires shares of a Canco that itself owns an equity interest in one or more foreign corporations. These rules may apply to either the initial M&A transaction or post-acquisition to any ongoing investment the Canco makes in foreign corporations. Where applicable, they effectively deem Canco to have paid a dividend or effected a capital distribution to its foreign parent. Accelerated or double taxation can arise in various circumstances, and we anticipate foreign purchasers working through these rules carefully whenever the Canadian target has interests in foreign entities. See here for a detailed analysis of these important new rules.
UNEXPECTED EMPLOYEE TERMINATION COSTS
Matthew L.O. Certosimo and Kate Dearden
Hiring new employees and ending employment relationships are often part of the activity in M&A deals (whether deals are on the rise or the decline). A well-drafted termination clause can provide clarity on the cost of job losses, whenever they occur. A recent change to the law makes employment contracts worth revisiting.
In Bowes v. Goss Power Products, 2012 ONCA 425 ("Bowes"), the Ontario Court of Appeal considered a case where the employer ended the relationship after three years, and offered salary continuance in accordance with the six-month notice period in the contract. The employee found a new job within two weeks of termination. Relying on the common law principle that a dismissed employee must mitigate his or her damages, the employer argued that the employee's salary continuance should end upon his finding new employment (provided, of course, that he had received his minimum statutory entitlement to three weeks' termination pay).
The Court disagreed; by entering into a fixed notice period, the parties had "opted out" of the common law approach that would normally require an employee to mitigate his or her damages. The Court noted that the employer could have specifically included a mitigation provision in the employment contract, but did not do so.
The significant points for employers include:
- Employment contracts remain important. We continue to recommend employment contracts to employers. They provide a certain level of clarity with respect to rights and obligations that govern the employment relationship, including what occurs when the relationship is terminated (whether for just cause, resignation or otherwise). Contracts can include a variety of terms, such as a fixed-term, probationary period, compensation and benefits, and confidentiality clauses.
- Termination clauses remain important. An employment contract could include a termination clause that permits an employer to end salary continuance where a dismissed employee finds new employment, provided the minimums for statutory notice of termination, or pay in lieu thereof, and statutory severance pay (where applicable) had been satisfied.
- Review employment contracts. The Court's decision in Bowes is a reminder that employment contracts should be periodically reviewed and revised to reflect changes in employment law. Employment contracts with notice periods beyond the statutory minimum, whether a fixed amount or a formula, should be revisited.
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INVESTMENT CANADA AND SOEs
Colin P. MacDonald and Jeffrey S. Thomas
The last six months of 2012 saw the most significant political debate in Canada on foreign investment in a generation. The CNOOC/Nexen and the Petronas/Progress transactions in the Canadian oil patch caused the Government of Canada to review its guidelines on how it will evaluate proposed acquisitions of Canadian businesses by foreign investors and, in particular, "state owned entities" ("SOEs"). The revised guidelines and the Government's announced policy as it relates to SOE investment in Canada continues to allow the Government a lot of flexibility in its decision-making process as it relates to such investors. What is clear for SOEs is that investments in Alberta's oil sands will only be permitted in exceptional circumstances, that the review threshold for SOEs will remain at $330 million indexed annually, and that other investments will be reviewed more carefully both on a company and industry basis, including a determination of the potential for a foreign state to exercise control or influence on the SOE making the proposed Canadian investment. However, minority investments and investments in joint ventures by SOEs are being encouraged and remain non-reviewable in most circumstances.
Foreign investors other than SOEs can look forward to the threshold for review being raised initially to $600 million and eventually to $1 billion (enterprise value) at some point in 2013 – although this higher threshold has been promised by the government for several years. Both SOEs and all other foreign investors seeking to make an investment that is subject to review will continue to have to pass the nebulous "net benefit" test in order to obtain approval.
For more information, please click here.
THE IMPACT OF PENSION DEFICITS ON M&A
Andrew Harrison and Linda Tu (Articling Student)
Deficits in defined benefit pension plans will continue to be an issue in 2013. Persistently low interest rates and volatile capital markets, along with changing accounting standards, result in ongoing difficulty for sponsors of these plans. That, in turn, affects both potential purchasers and financiers. Purchasers and lenders need to review carefully the financial position of the target company's pension plans and the target's current and future legal obligations under those plans, and determine the impact of those obligations on the value of the enterprise.
Canadian companies which offer a pension plan to their employees are regulated under pension benefits standards legislation. This legislation imposes strict funding requirements on a pension plan and provides a limited time over which employers can fund plan deficits. Combined with a tough economic climate, these rules have led to many underfunded defined benefit pension plans in Canada. Even the small fraction of pension plans that are fully funded are under pressure, and there is no guarantee that they will remain fully funded. Potential purchasers want to avoid or contain this liability since it can lead to onerous financial obligations.
There are ways to structure an M&A transaction through a share or asset purchase that can specifically address, and potentially avoid, pension plan liabilities. See here for more details on these types of arrangements and on this topic.
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