Canada: Directors’ Discretion In The Sale Of Corporate Assets

In an environment where Canadian corporations are increasingly being offered enhanced multiples by enthusiastic private equity groups and moneyed international buyers, directors may find themselves in the position of having to decide (and in many cases decide quickly) whether to sell a significant subsidiary or business unit and lock in historically high prices in return for the opportunity to, among other things: (i) reduce debt; (ii) make needed capital expenditures; or (iii) focus on core competencies.

Making such decisions is of course what directors are there to do. Under Canadian law, directors have the power to manage or supervise the management of the business and affairs of the corporation. This means that they generally have the discretion required to make important strategic decisions and to allow the corporation to take advantage of economic opportunities identified by them. Provided that the board’s decisions fall within a "range of reasonableness", Canadian courts will generally defer to their judgment in accordance with the "business judgment rule".

But the directors’ discretion to bind the corporation is not unlimited. Canadian corporate statutes require a shareholder vote with respect to certain decisions that are seen as fundamental to the corporation’s purpose or existence. This article considers one restriction that can significantly affect an M&A transaction: the requirement that a sale of "all or substantially all" of the corporation’s assets must be approved by a special resolution of shareholders, being approval of two-thirds (or three-fourths, depending on the corporate statute) of the votes cast in person or by proxy. This requirement is found, for example, in s. 189(3) of the Canada Business Corporations Act (CBCA), the federal business corporation law statute, and is more or less mirrored in most of the CBCA’s provincial counterparts.

Why is the "special resolution" requirement a problem? One reason is that, in the public company context, obtaining shareholder approval takes time. Buyers can grow impatient and look elsewhere to purchase similar assets more expeditiously and with more certainty. Further, perhaps, a transaction triggering a vote under s. 189(3) gives rise to shareholder dissent rights under the CBCA. In other words, even where two-thirds majority approval of a sale has been obtained, any shareholder who voted against the transaction is entitled to have its shares bought out by the corporation at fair market value. Determining "fair market value" can be a frustrating exercise in its own right.

Sellers may try to avoid the need for special resolutions and appraisal rights by structuring the transaction to avoid the "all or substantially all" requirement. However, sellers can be frustrated in these efforts by the fact that the CBCA, like other corporate statutes, does not offer a definition or guidance in respect of what constitutes "all or substantially all".

For example, could it be argued that any sale in excess of 50% of the corporate assets is sufficient to trigger a shareholder vote? Or is the "substantially all" threshold met when a corporation seeks to divest itself of one its core, even most important divisions, regardless of size?

Given the absence of a clear threshold, caution might appear to dictate that any proposed sale of substantial corporate holdings be put to shareholders. However, courts have begun to provide some guidance to directors as they seek to determine the scope of their discretion and the requirement to seek shareholder approval.

The gap in the CBCA with respect to the meaning of "substantially all" has been filled by the courts—albeit with some residual uncertainty. Three tests have emerged in Canadian jurisprudence:

1. Is the sale out of the ordinary course of the business? (the "ordinary course test")
2. Is the property being sold vital to the corporation’s business in strictly quantitative terms? (the "quantitative test")
3. Will the proposed sale substantially or fundamentally change the way in which the corporation currently carries on business, or make it impossible for the corporation to continue to carry out its objectives? (the "qualitative test")

The ordinary course test has been defined in Canada as applying to a sale that is "not part of the common flow, not part of the ordinary day-to-day activities of the company." However, while this is an important "threshold" consideration, it is unlikely to decide the issue by itself. Many cases that involve disposition of property outside of the corporation’s day-to-day affairs are clearly not intended to be caught by the "substantially all" language of the CBCA and similar statutes. To finally determine the issue, the quantitative and qualitative tests will still generally be necessary.

The quantitative test is a mathematical one that analyzes the proposed transaction based on the value of the asset being sold. Courts have quantified this value in various ways, grounding the analysis in either the book or market value of the asset in question or on the revenues and profits produced by it. Regardless of the standard used, the analysis focuses on the transaction’s size in relation to the corporation. Canadian courts have generally been unreceptive to proposed "bright-line" tests of "substantially all", although one Quebec Court of Appeal ruling states that a shareholder vote may be automatically required where a proposed asset sale would involve 75% or more of the value of a corporation’s assets. The dominant view in Canada appears to be better represented, however, by an Ontario Court of Appeal ruling that explicitly rejects "mechanistic and potentially arbitrary" thresholds in this context. Thus, in a series of rulings beginning in the early 1990s, Canadian courts have, for example, rejected suggestions of a 50% threshold and declined to order a shareholder vote merely on the basis that the asset in question is the most valuable division of the corporation. In one set of circumstances, a sale of 65% of a corporation’s assets was held to satisfy the quantitative test while, in another, a sale of 85% was not.

Whether a large disposition of assets constitutes the sale of "substantially all" of a corporation’s property often comes down to the qualitative considerations emphasized in the third of the three tests. The qualitative test focuses on the impact that the proposed transaction is likely to have on the corporation and whether the sale would "fundamentally change" or "effectively destroy" the corporation’s business. Where the transaction would prevent the corporation from carrying out its business objectives, would result in a radical corporate restructuring or would fundamentally re-orient the nature of the corporation’s business, the qualitative test will generally be satisfied. Qualitative considerations will supplement the quantitative assessment of a sale and help to distinguish a "substantial" transaction from what is merely a large disposition.

To return to an example mentioned above, 65% of corporate assets has been found to be "substantially all" where the sale would have fundamentally changed the business, while another proposed sale of 85% of total assets was held not to be "substantially all" where the 85% was a tangential investment without which the corporation would continue to transact business much as it always had.

By reviewing the entire nature of the transaction, rather than focussing on arbitrary percentage figures, Canadian courts have attempted to strike a balance between affording directors the greatest possible deference to make informed business decisions and recognizing shareholders’ legitimate expectations about the nature and value of their investments. However, the case law on this point is relatively limited, and the possibility exists that in certain circumstances a court would favour the more "mechanical" approach favoured in the Quebec decision referred to above.

Courts increasingly appear to view the qualitative and quantitative test as two aspects of a single analysis, although this is rarely as explicit as it was in the recent Delaware Court of Chancery decision in Hollinger Inc. v. Hollinger International.¹ While this judgment has not yet been endorsed in Canada, Delaware corporate law decisions are received in Canada with much interest and the court’s reasoning is likely to be persuasive here.

Hollinger International owned a number of newspaper groups throughout North America, the United Kingdom and in the Middle East, including Britain’s very profitable Telegraph Group. When Hollinger International agreed to sell Telegraph Group, its controlling shareholder, Hollinger Inc., brought a preliminary injunction to restrain the impending sale on the grounds that the disposition of the Telegraph Group, representing approximately half of Hollinger International’s assets, required shareholder ratification as a sale of "substantially all" of the property.

In denying the request for injunctive relief, the Court of Chancery noted the confusion surrounding the qualitative and quantitative tests, suggesting that, rather than separate tests, the two were more accurately viewed as related prongs in a unified fairness test geared toward assessing the nature of the proposed transaction. Since the purpose underlying requiring shareholder ratification of substantial sales of corporate assets is to protect the "rational economic expectations of reasonable investors," the proposed transaction must be assessed on its economic importance to the corporation, both in terms of the size of the disposition and its effect on the nature of shareholders’ investments. The directors are not required to get shareholder approval merely where a major asset or "trophy" is sold. The threshold for shareholder approval is set higher. The phrase "substantially all" is not to be read as "approximately half" but instead as referring to a proposed sale of assets of sufficient economic importance that this disposition would leave shareholders with an investment that is different from the one that they currently possess.

The Hollinger court held that even though the Telegraph Group was a significant asset of Hollinger International—even its "crown jewel"—this was not sufficient to trigger the statutory requirement of a shareholder vote. The sale of the Telegraph Group did not undermine the reasonable expectations of investors. Hollinger International would continue to operate as a profitable entity and would remain a plausible investment in the newspaper industry post-disposition. As a result, Hollinger International’s decision to sell the Telegraph Group was a "classic" example of business judgment and would not be interfered with by the courts or subjected to shareholder approval.

Canadian law affords directors a wide degree of latitude when dealing with corporate property. Courts are generally deferential to the diligent and reasonable efforts of directors to act in the best corporate interest. Shareholder approval of property disposition is required by law only where the transaction deals with "all or substantially all" of the corporation’s assets. Courts have taken their cue from the broad language of the CBCA and other corporate statutes, and tend to eschew set formulas or precise standards, preferring to consider whether the sale would fundamentally change or jeopardize the continued existence of the corporation, contrary to the expectations and investment purposes of shareholders.

Directors are not prevented from pursuing advantageous transactions merely because the assets involved are large or are central to the business. Instead, the limit on dealing freely with corporate property is placed higher—the assets involved must be of significant size and of such importance to the corporation that the disposition would have to fundamentally change the nature of the corporation, in either shifting its business objectives or preventing it from continuing to operate as a profitable enterprise.

¹ Hollinger Inc. v. Hollinger International, 858 A.2d 342 (Del. Ch. 2004).

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.