Canada: M&A Top Trends – 2014

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The year 2013 saw boardrooms continue to undergo change. A rise in shareholder activism is influencing corporate governance practices, and boards are more active than ever before. In the M&A context, target boards are becoming engaged at an earlier stage. They are meeting more frequently and supervising management's negotiations more closely, especially where conflicts of interest are prevalent. We expect this focus on robust sales processes will continue in 2014.

With boards becoming more engaged, they will increasingly demand broader rights to protect their fiduciary duties. And we expect deal terms will come under pressure. For related party transactions, we predict that special committees of independent directors will take centre stage in negotiating transactions in order to benefit from the most deferential treatment by the courts and regulators and to help withstand criticism from discontented shareholders.

The tough deal-making environment in 2013 created acquisition opportunities for firms that had access to capital and, in some cases, spurred innovative deal practices. In other cases, it encouraged corporations, particularly in the resource sector, to shed non-core businesses and focus on capital efficiencies – a trend we expect will continue in 2014. Sales of quality assets are drawing interest from a significant number of private equity firms, especially U.S.-based firms. Private equity firms are doing what it takes to win competitive auctions and gain an advantage in this environment, including by building deep sector-specific expertise in-house. The presence of U.S. financial buyers in Canada will also continue to influence deal financing terms, as acquisition financing takes cues from the United States.

Foreign buyers of Canadian targets will encounter stricter tax rules that will have an impact on the planning and structuring of cross-border deals in 2014. Although some buyers may be concerned that they will also face longer regulatory review timelines, we predict that in most cases, these concerns are not warranted.

Torys looks ahead to the 10 trends that will shape business in 2014.

January 2014

THE SPECIAL COMMITTEE WILL TAKE CENTRE STAGE
James Tory, Andrew Beck, Aaron Emes

The use of special committees of independent directors has long been a feature of both Canadian and U.S. M&A practice as a means to address conflicts in related party transactions. It is well established that if a special committee approves or recommends a transaction, this may help in defending the transaction against attack from minority shareholders or securities regulators. However, the special committee process requirements to qualify for deference from courts or regulators and the degree of deference that will be shown have been subjects of legal debate.

Recent developments in Canada and the United States confirm the utility of special committees in related party transactions and emphasize the importance of their being broadly empowered for the transaction to qualify for the most deferential treatment from courts and regulators. As a result, we expect to see a more prominent role for special committees in related party transactions, with a potentially significant effect on deal dynamics.

The leading development in the United States was the recent landmark decision of the Delaware Court of Chancery in In Re MFW Shareholders Litigation. The Court held that a freeze-out merger with a controlling shareholder that was conditioned from the outset on (i) negotiation and approval by a fully empowered special committee of independent directors, and (ii) approval by an un coerced and fully informed vote of a majority of the minority shareholders would qualify for the most deferential standard of review – the business judgment rule standard – rather than be subject to the more exacting "entire fairness" standard.

This is extremely important in the U.S. litigation context. It means that a strike suit attacking the transaction can be dismissed by summary judgment, depriving plaintiffs of the leverage they would otherwise have to extort a settlement as the price of removing the litigation obstacle to consummate the transaction. The Court held in MFW that to get the benefit of the most deferential standard of review, the special committee process leading up to an affirmative vote of a majority of the minority shareholders must satisfy the following significant preconditions that concern the efficacy of the special committee as a bargaining agent on behalf of the minority:

• independence: committee members must be free of conflicts;
• broad empowerment: the committee must have the power to negotiate, including to definitively say no to a transaction (not just review it and make a recommendation), and to select its own advisers freely;
• satisfaction of duty of care: in evaluating, negotiating and agreeing to a transaction, the committee must act on a fully informed basis.

In Canada, the legal framework for related party transactions has been largely prescribed by securities regulators rather than by the courts, through Multilateral Instrument 61-101, Protection of Minority Security Holders in Special Transactions, and its Companion Policy and through the regulators' intervention in transactions under their public interest jurisdiction.

Multilateral Instrument 61-101 compels the formation of a special committee of independent directors only in limited circumstances. However, the Companion Policy and the regulatory jurisprudence (most notably, Re Magna International Inc.) express both the expectation of regulators that special committees will normally be used in related party transactions and their view that for a transaction to qualify for deferential treatment based on the involvement of a special committee, process standards consistent with those articulated in MFW must be met. Ontario securities regulators have indicated that rule changes are coming to mandate such process requirements for related party transactions.

As a result of these developments, we expect to see special committees play a more prominent role in related party transactions, with their role shifting from overseeing negotiations and evaluating the resulting deal to one of directly negotiating the transaction. Special committee mandates will also be broader, reflecting the expanded authority of the special committee.

CONTINGENT VALUE RIGHTS AND SIMILAR TOOLS ARE BECOMING MORE COMMONPLACE
John Emanoilidis, Mile Kurta, Thomas Yeo

Of all the legal and business issues that arise in an M&A transaction, the most fundamental issue is valuation. If the buyer and seller cannot come to a meeting of the minds on the value of the business or the consideration to be paid, saving the deal becomes a matter of bridging that valuation gap. In 2014, we expect that buyers and sellers will increasingly use innovative pricing tools to reconcile their differences.

In the private company context, the most common way to bridge gaps in valuation is through an earn out formula. If the business performs as promised and achieves certain financial or other performance milestones over a period of time following closing, the seller is entitled to receive additional purchase price payments. This mechanism is attractive to sellers who have confidence in the long-term value of their business and want to be compensated for that value; earn outs are equally attractive to buyers who want to ensure they are getting what they pay for.

In the public company context, it is harder to find mechanisms to bridge valuation gaps between buyers and targets. One traditional method has been for the buyer to offer its stock as all or part of the consideration package to allow target shareholders to share in the upside of the combined company. However, that is not always an attractive alternative for target shareholders who may not want to be subject to the uncertainty associated with the buyer's stock, including fluctuations in the price between the signing and closing of the transaction. To solve this problem, collar mechanisms can be employed. With a collar, target shareholders receive additional cash or shares of the buyer if the trading price of the buyer's stock declines between the signing of the transaction and closing, or in some cases, during a period of time after closing.

Buyers and public company targets are also finding innovative structures to resolve uncertainty in the value of the target's business in much the same way that earnouts do in the private company context. Contingent value rights (CVRs) give target shareholders a right to receive additional consideration if a specified milestone or threshold is achieved in the future. That payment can be a fixed amount or can vary according to a specified formula. CVRs have become fairly common in the pharmaceutical sector when the future value of a particular drug is highly uncertain and contingent on events such as regulatory approval or the outcome of a clinical trial. A CVR can be used to provide additional consideration to target shareholders if the drug achieves specified milestones. CVRs have also been used in other contexts, such as where the outcome of significant litigation is uncertain, allowing target shareholders to share in a successful result.

Given the more widespread acceptance of the CVR structure in the pharmaceutical industry, we expect to see this structure used more frequently in other sectors. CVRs are complex and raise a host of legal issues, including issues related to transferability and ongoing public reporting requirements under Canadian or U.S. securities laws if the CVR is considered a "security," as well as tax and accounting issues. Care must also be exercised in the negotiation and drafting of the milestones and payment calculations under CVRs. Earn outs have historically been viewed as being prone to disputes and litigation as a result of differing interpretations of accounting formulas, or buyers manipulating outcomes to avoid or minimize the cost of an earn out. However, if properly structured, CVRs could provide the missing piece to getting the deal done.

As CVRs become more commonplace in other industries, there will be added pressure to develop payment triggers and formulas that are easily determined and quantifiable, as well as covenants to ensure that the buyer is not motivated to manage the business to deliberately avoid triggering a CVR payment.

HOW FAIR IS FAIR? THE SPOTLIGHT WILL BE ON THE M&A SALES PROCESS
Sharon Geraghty, James Scarlett, Scott Cochlan

As M&A activity revives in 2014, we expect to see greater focus on building a sales process that establishes fairness and satisfactory price discovery. One clear marker of this trend is the increased frequency with which target boards obtain two fairness opinions: one from the company's adviser on the transaction and the second from an independent firm whose compensation is not tied to deal success, and which acts for the board or its special committee.

Market participants continue to debate the value of a second, independent opinion. Concerns are sometimes expressed that the independent adviser typically has not been close to the negotiations and therefore may be at a disadvantage in assessing the deal or might slow down the sales process and add to transaction costs. Set against these concerns is the view often expressed by board members that there is considerable value in an opinion that is independent of the success or failure of the proposed transaction. It is important to remember, however, that one approach does not fit all deals. The incremental value of an independent opinion can vary depending on the circumstances of the deal. For example, how significant is the transaction adviser's success fee? Was an effective market check on price conducted before the deal was signed? How serious are the conflicts of interest of board members or within the management group? What is the level of M&A experience at the board and management levels? Is there an effective post-signing procedure to perform a market price check?

Buyers have sometimes obtained fairness opinions when issuing significant share consideration. Although the buyer's board must consider the fairness of any transaction to its own stakeholders, it is rare to obtain a formal fairness opinion, particularly if the value of the consideration is transparent. However, when there is substantial share consideration, the buyer's board must also consider the potential dilutive impact on the buyer's shareholders and may be required to obtain shareholder approval of the share issuance. Obtaining an opinion can help explain the deal to shareholders and acts as a discipline and a shield against attack.

Although obtaining a fairness opinion offers evidence of reasonable board governance, the trend toward enhanced sales processes is also taking place at a more nuanced level. Boards are becoming engaged at an earlier stage, meeting more frequently and supervising management's negotiations more closely, especially where conflicts of interest are prevalent. We anticipate that this will continue, with directors and their legal and financial advisers more rigorously challenging the sales process, the validity of the assumptions that support their adviser's financial analysis and the appropriateness of deal-protection terms in the circumstances.

These developments are the natural outcome of improved governance practices, shareholder activism (see article 6, Shareholder Activism Will Increasingly Influence M&A Governance Practices), more extensive disclosure and recent cases, particularly in the United States, where sales processes have been challenged. Delaware courts have held that there is no single blueprint for a reasonable board process, and their judges are knowledgeable about M&A transactions and scrutinize board actions in great detail. They have criticized boards for failing to adequately test the market and for waiving standstills before signing an exclusive deal. They have also questioned the financial adviser's discounted cash flow analysis, management's negotiating tactics and the degree to which the board has supervised management.

Although Canadian courts tend to be more deferential, boards in Canada are facing greater scrutiny than in the past. Criticism of the sales process increases execution risk and jeopardizes reputations. With the continuing increase in U.S.-based shareholder activism and cross-border M&A, we expect Canadian boards to heed this trend and become similarly focused on establishing a robust sales process.

FIDUCIARY OUTS ARE BROADENING
Patricia Koval, Andrew Gray, Janan Paskaran

In Canada and the United States, it has long been typical for targets to be prevented from soliciting competing proposals through "no-shop" and "no-change-in-recommendation" covenants – but these covenants are often subject to a number of qualifications, the most significant of which are "fiduciary-out" provisions. Fiduciary-out provisions give a target board the right to accept a superior proposal or otherwise change its recommendation to shareholders in order to get out of the deal with the acquiror. These provisions bring the parties' competing interests into play. While an acquiror wants certainty that the deal will be done even if an alternative proposal for the target is made, the target board wants to ensure that it can appropriately execute its fiduciary duties regarding the change-of-control transaction, including getting the most favourable deal for the securityholders. In both Canada and the United States, the trend is for target boards to press for broader rights to change their recommendations.

In the United States, target boards increasingly demand broader rights that allow them to change their recommendation to shareholders in light of an "intervening event" – usually defined as a material change that was unforeseeable when the agreement was signed (other than a competing bid). The use of this right typically allows for the possibility that the acquiror and target will attempt to negotiate mutually acceptable changes to their agreement in light of the intervening event. The acquiror will typically also have the option to terminate the agreement if the target board changes its recommendation before any shareholder vote and thereby receive a break fee. Acquirors will often seek to restrict the scope of "intervening event" provisions so as to limit the target's right to walk away from the deal. Exceptions to these provisions may include intervening events relating to the target's industry or economy as a whole, changes in the target's stock price, better-thanexpected earnings or the timing of regulatory approvals.

"Intervening events" provisions may begin to appear in Canada, where we are seeing target boards increasingly seek greater flexibility within the terms of an acquisition agreement to change their recommendation to shareholders in the face of new information or changed circumstances. This is part of a broader trend toward more robust sales processes, which we discuss in article 3, How Fair Is Fair? The Spotlight Will Be on the M&A Sales Process. There are also provisions that permit the target to disclose information to shareholders in circumstances in which the target board, acting in good faith and upon advice, believes the same to be necessary for it to comply with its fiduciary obligations or applicable laws. These provisions are sometimes described as "backdoor fiduciary outs" – although the target board is not expressly permitted to change its recommendation except in limited circumstances where it pays a break fee, the disclosure may arguably permit a "backdoor" change in recommendation, allowing a target board effectively to encourage shareholders not to support the transaction without triggering a break fee.

The broadest form of fiduciary out would be for the target board to insist on the ability to change its recommendation in order to comply with its fiduciary duties. The board may negotiate an unqualified right, before shareholder approval of the transaction, to withdraw, qualify or change its recommendation if it determines, in good faith and after consultation with external advisers, that the failure to do so would be inconsistent with its fiduciary duties. In that case, the acquiror will typically have the option to terminate and receive a break fee. If provided in the acquisition agreement, the acquiror could force the target to hold the shareholder meeting despite such change in recommendation.

The scope of fiduciary-out provisions will continue to face scrutiny in court. The Delaware decision In Re Compellent Technologies, Inc. Shareholder Litigation is just one recent example of a long line of cases carefully examining the duties of target boards and the deal protection provisions utilized. In considering a settlement of that deal litigation, the Delaware Court scrutinized buyer-friendly no-shop and change-in-recommendation provisions in a merger agreement and found that, as originally negotiated, they had the effect of impairing the ability of the target board to obtain a higher price for shareholders.

As Canadian boards become more engaged on establishing robust sales processes, we expect that there will be greater focus in the upcoming year on the ability of target boards to exercise fiduciary outs.

BUYERS WILL FIND NEW WAYS TO GAIN AN EDGE IN PRIVATE COMPANY AUCTIONS
Richard Willoughby, Matthew Cockburn, Neville Jugnauth

Competition for proprietary deals, coupled with the availability of private equity capital, has led to increasing numbers of financial buyers participating in organized sales processes to originate deal flow. Prospective buyers in competitive auctions for private companies continue to push the boundaries to achieve an advantage in this environment – a trend we expect will continue in 2014.

On the buy-side, every competitive auction appears to be attracting a significant number of private equity firms, especially U.S.-based firms. The U.S. firms and their Canadian competitors are increasingly using industry specialization to differentiate themselves – not just through research, but often through investments in sector-specific companies and, in some cases, through establishing in house operations teams. The result is that these financial buyers can match strategic players with deep industry insight and, with this confidence, they are often prepared to bid up the price or accept more post-closing risk. These new hybrid financial/strategic buyers are squeezing out other private equity firms without the same specialization and are competing more effectively against strategic buyers. Since they are also better positioned to partner with other industry players, make ambitious business plans more realistic and provide greater value through strategic planning and operational improvements, they can ultimately support higher purchase prices for businesses.

Timing and certainty of closing are other factors that potential buyers are using to differentiate themselves in a competitive bidding environment. A firm with industry expertise and a strong track record of closing deals and creating value in the relevant sector can increase a seller's confidence in that firm's bid in terms of both the bidder's ability to execute the transaction and its ability to carry the business forward post-closing. This will be particularly important to sellers rolling a portion of their equity into the acquired business. Firms planning a combination with an existing investee company have the added advantage of third-party financing sources already in place, which usually increases certainty and reduces the time to closing. Sellers are also working to improve the efficiency of the bid process and ensure the completeness of bids submitted during the auction. They are, for example, pre packaging key due diligence matters to fully educate buyers on inherent risks associated with the business being sold and to facilitate timely bids that are less conditional on, or subject to, price renegotiation pending due diligence review.

In some circumstances, buyers have attempted to gain a timing advantage by pursuing transactions on an immediate "sign-and-close" basis, without an interim pre-closing period that would ordinarily be used to obtain regulatory approval of the deal. Efficient sign-and-close transactions require a preliminary determination that regulatory approval is perfunctory. Buyers that have arrived at that assessment may initiate the regulatory process at their own cost in advance of a signed deal to allow for immediate signing and closing of the transaction once regulatory approval is obtained. This approach also helps avoid unnecessary friction with management that may come from negotiating a suite of interim operating and other protective covenants designed to safeguard the buyer's interest in the transaction pending closing.

Some prospective buyers are also seeking to increase their chances at successful bids through representation and warranty insurance. A buyer can purchase a policy to cover indemnity claims for breaches of representations and warranties in a purchase agreement. This coverage is relatively inexpensive – typically a one-time premium of 2% to 3% of the coverage. Without reducing the buyer's indemnification coverage, the insurance allows a buyer to reduce its indemnification demands on a seller, including reducing the need for a portion of the sale proceeds to be held in escrow. It has the added benefit of preserving goodwill with management by reducing the need for buyers to possibly pursue claims against sellers, who often remain on the management team after the change of ownership.

Although representation and warranty insurance has been available for many years, interest in the coverage is growing. This tool, along with the specialization of financial buyers, and prospective buyers' focus on tightening timing and the closing certainty on transactions, will affect private company auction dynamics in the year to come.

• Shareholder Activism Will Increasingly Influence M&A Governance Practices
  Michael Siltala, Patrice Walch-Watson, Cornell Wright
• Acquisition Financing In Canada Will Take Cues From The United States
  Adam Delean, Kevin Fougere, Jonathan Wiener
• Some M&A Deals Will Take Longer To Close— But Most Will Not
  Jay Holsten, Stefan Stauder, Derek Flaman
• Resource Companies Will Focus On Capital Efficiencies
  Michael Amm, Stephanie Stimpson, Kevin Morris
• Foreign Buyers Beware: The Taxman Cometh
  Corrado Cardarelli, Jerald Wortsman, Craig Maurice

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