Originally published in Lexpert,® October 2006
Nature and Scope of Canada’s M&A Boom
Canada is in the midst of an M&A boom, with growth in transaction value significantly outpacing robust growth in the United States and worldwide. During 2005, the dollar value of announced Canadian deals increased by nearly 85 per cent over 2004 levels, compared to growth of 33 per cent in the United States and 38 per cent worldwide. In the first half of 2006, the growth of Canadian M&A activity was even more dramatic: 784 deals with an aggregate value of US$93.5 billion—nearly triple the value of announced deals for the same period in 2005, compared to US growth of 23 per cent and worldwide growth of 44 per cent. (These statistics are based on the value of announced transactions and other data compiled by Thomson Financial.)
The growth in M&A activity in Canada, the United States and worldwide over these periods is the result of increasing transactional value; the number of transactions has remained relatively stable.
Driving the growth of Canadian M&A activity are several important factors, some global and some unique to Canada. One key factor is the confluence of Canada’s significant resource-based economy with high commodity and materials prices. Other factors have been the overall strength of Canada’s economy during the last four years, with relatively low interest rates and inflation; Canada’s openness to foreign investment; availability of funding from private equity firms and hedge funds; and the attractiveness of Canada to US acquirors, given the country’s familiarity and physical proximity.
The resources sector has seen the most visible frenzy of M&A activity, including the competing multi-billion dollar proposals to acquire Inco and Falconbridge involving Xstrata, Phelps Dodge, Teck Cominco and CVRD. Significant oil and gas transactions have included China National Petroleum Corporation’s acquisition of Canadian-owned and -listed Petro-Kazakhstan and Kinder Morgan’s acquisition of Terasen. There have also been several significant transactions involving non-resources companies with a strong North American or global platform, including AMD’s proposed acquisition of ATI, TUI’s acquisition of CP Ships, Arcelor’s acquisition of Dofasco, Kingdom Hotel International and Colony Capital’s acquisition of Fairmont Hotels and Constellation’s acquisition of Vincor. A significant majority of the recent large and high-profile transactions have involved US and other foreign acquirors.
In this article we highlight the following significant trends and strategic considerations relevant to US and other foreign entities seeking to participate in Canadian M&A transactions:
- hostile deals and defensive tactics;
- influence of private equity and hedge funds;
- going-private transactions;
- income securities;
- certain unique structuring considerations;
- foreign investment review.
Hostile Deals and Defensive Tactics
Prevalence of Hostile Deals
The Canadian market has recently experienced a significant number of tender offers (referred to as "takeover bids" in Canada) made on an unsolicited or hostile basis. In the 12 months ended June 30, 2006, more than a dozen hostile takeover bids were launched, including some of the largest and most high-profile transactions such as Xstrata’s bid to acquire Falconbridge, Teck Cominco’s bid to acquire Inco and Barrick’s acquisition of Placer Dome.
However, hostile transactions entail significant completion risk for the initiating party. According to statistics for Canadian hostile bids made between January 1, 1998 and July 31, 2006, a change of control transaction took place in 82 per cent of cases, but the hostile bidder was successful in only half of those cases (this figure is based on statistics compiled by a leading Canadian investment bank as of July 31, 2006). In the other half of those cases, the successful acquiror was a "white knight" supported by the target company. It has been relatively rare for the target company to remain independent once a hostile bid has been launched. (These figures are based on statistics compiled by a leading Canadian investment bank as of July 31, 2006.)
Hostile deals benefit from a favorable regulatory environment that makes it easier to complete a hostile takeover bid in Canada than in the United States. Generally, in the face of a hostile bid, a Canadian target cannot "just say no" without allowing shareholders to consider the offer. Structural defenses that may be available in the United States, such as staggered boards and special anti-takeover provisions in incorporating documents and bylaws, are generally ineffective under Canadian corporate law. In addition, share buy-backs are not permitted under Canadian law unless they are offered to all shareholders on an equal basis.
Under Delaware law, boards generally have greater latitude to engage in defensive measures to counter unwanted takeover proposals, and the Revlon duty to obtain the best price is triggered only if the target board has initiated a change of control transaction or is seeking alternatives to a hostile transaction. However, when the Revlon duties are engaged, a board’s conduct will be subject to a heightened standard of reasonableness review. In contrast, Canadian companies are considered to "always be for sale." Canadian corporate law has been interpreted to require directors to seek out value-maximizing alternatives for shareholders in any potential change of control context, even when not initiated by the company; however, Canadian courts have declined to adopt the US concept of enhanced scrutiny of board actions.
In Canada, regulation of defensive tactics has in practice primarily been a matter for securities regulators rather than the courts. Canadian securities regulators have adopted a National Policy regarding takeovers that seeks to encourage open and unrestricted auctions to maximize target company shareholder value and choice between competing alternatives.
One of the most common forms of defensive measures in Canada is a shareholder rights plan, or "poison pill." As in the United States, a poison pill is intended to protect against creeping takeovers and bids not supported by a target’s board. Poison pills may be put in place in advance when no bids are pending, but subsequent shareholder approval is necessary in accordance with stock exchange requirements. They may also be put in place in the face of an actual bid in order to buy time. In Canada, a poison pill is not a semi-permanent show-stopper as it may be in the United States, but is generally permitted only to buy a relatively short period of time for the target to conduct a reasonable search for, or to develop, value-maximizing alternatives.
As a result, it is a matter of when, not if, the pill will be struck down—a balance between allowing the target board a reasonable opportunity to search for or develop value-maximizing alternatives and ensuring that shareholders are not deprived of an opportunity to decide whether to accept the bid.
Canadian securities regulators will generally take action to terminate a poison pill once it has served this purpose, often after a period of 45 days following the initial bid. Against this backdrop, it is not uncommon, as in the case of Barrick’s bid for Placer Dome, for a target to agree to voluntarily terminate its poison pill after a specified period in exchange for the hostile bidder’s commensurate extension of the expiry date of its offer.
In an interesting recent decision involving Xstrata’s unsolicited takeover bid for Falconbridge, the Ontario Securities Commission temporarily upheld Falconbridge’s poison pill upon a challenge from Xstrata. The commission concluded that the poison pill was actually protecting Falconbridge shareholders by preventing Xstrata from increasing its then almost 20 per cent ownership of Falconbridge to a blocking position that could frustrate competing bids (i.e., Inco’s bid). Consistent with prior decisions, however, the poison pill was permitted to remain in place only for a specified limited period to give competing bidders additional time to advance their bids. This decision effectively signals that a target board may have more latitude to adopt and maintain defenses when one of the bidders has a significant ownership position that could block other bidders and leave shareholders without any offer.
Influence of Private Equity and Hedge Funds
In recent years private equity and hedge funds have raised large amounts of capital, which they are under pressure to effectively deploy. US and other foreign private equity groups and hedge funds are becoming increasingly active in Canada. This activity has resulted both in direct acquisitions of Canadian public companies (e.g., KKR’s acquisition of Masonite and Golden Gate Capital’s acquisition of Geac Computer) and minority investors exerting pressure on management to seek a sale or other value-maximizing transaction (or to seek improved terms for such transactions).
Carl Icahn’s partial bid for Fairmont Hotels at the end of 2005 is a prime example of this type of shareholder activism. It was widely speculated that the bid was designed to put Fairmont into play to solicit a higher offer or other strategic alternative. Icahn stated that Fairmont and its shareholders would benefit if Fairmont was acquired by a larger hotel operator that could more effectively take advantage of economies of scale. Fairmont was ultimately purchased by Kingdom Hotels International and Colony Capital at a price materially higher than Icahn’s offer.
Other examples of shareholder activism in favor of a sale or other strategic alternative include the sale of Geac Computer to Golden Gate Capital following agitation by Crescendo Partners; Paulson & Co.’s proxy battle for control of Algoma Steel; and KKR’s decision to increase its offer for Masonite in response to agitation by hedge fund shareholders.
However, some activities of hedge funds with respect to Canadian public companies have sparked controversy recently with multi-million dollar lawsuits launched by Biovail and Fairfax against SAC Capital Management and certain other parties alleging stock price manipulation and other interference.
Going-private transactions involving the acquisition of all the shares of a public company by certain of its existing investors and/or management have led to significant recent transactions in Canada. They are expected to increase in volume as a result of the relatively high proportion of Canadian public companies with controlling shareholders, availability of capital from private equity investors and the mounting regulatory compliance burdens and short-term performance expectation pressures on public companies. Recent major going-private transactions in Canada have included Magna’s privatization of its Tesma, Intier and Decoma subsidiaries and Sears Holdings’ bid for all the publicly held shares of its Sears Canada subsidiary.
In Canada, the conduct of going-private transactions is primarily governed by rules enacted by the securities regulators (in contrast to the United States where the principal substantive requirements are governed by caselaw and determined by the courts). The Canadian rules are complex and may require, subject to certain exemptions, obtaining a formal independent valuation of the target company, approval by minority shareholders and disclosure of prior valuations and prior offers to acquire the target company. These rules can potentially apply to any M&A transaction involving management, significant shareholders and other related parties or any differential treatment of securityholders. Therefore, even in the case of a transaction that appears to be arm’s length, it is important to confirm that the rules don’t apply.
The recent Sears transaction exemplifies certain issues that may arise in the context of a going-private transaction. During the course of Sears Holdings’ bid for the publicly held shares of Sears Canada, Sears Holdings entered into a lockup agreement with a significant shareholder that included a release of any claims against that shareholder regarding its dealings with Sears Canada shares. In addition, Sears Holdings entered into agreements with two other significant shareholders that provided that they would vote their shares in favor of a second-stage squeeze-out transaction.
As consideration for the voting agreements, Sears Holdings agreed to delay the implementation of this squeezeout transaction until December 2006 and use only certain structures for that transaction so that those two shareholders could obtain more favorable tax treatment upon the disposition of their shares. Dissident shareholders successfully argued before the Ontario Securities Commission that these agreements constituted a special or "collateral" benefit to the three shareholders. As a result, the commission held, among other things, that the shares of the three shareholders could not be counted toward the minority approval required to complete any necessary second-stage squeeze-out transaction. Sears Holdings has announced that it will be appealing this August 2006 commission decision.
Income funds and other income securities issuers (which own underlying operating businesses and pay out substantially all of their available cash flow to investors on a tax-efficient basis) have become a major component of Canadian capital markets in almost all industry sectors, including oil and gas, real estate, power/pipeline assets and specialty businesses. There are now more than 250 income fund issuers with aggregate market capitalization of more than C$200 billion, representing more than 10 per cent of the total market capitalization of the Toronto Stock Exchange. Given the significant size and maturity of the sector, income funds will likely become increasingly significant participants in M&A transactions both as acquirors and as targets.
Income fund structures are sufficiently flexible to permit significant merger and acquisition activity. Given attractive income fund multiples due to their tax structure efficiencies and market demand, income fund bidders may be able to deliver higher values to sellers. Large mergers and acquisitions are often financed by the issuance of new income securities to the securityholders of the target or to the public and by the vendor’s retaining an interest in the combined business, in addition to senior debt. Subscription receipt offerings allow an acquiror to raise funds before (but conditional on the completion of) an acquisition. However, as a practical matter, acquisitions by existing income funds must be accretive to their distributable cash. In addition, in negotiated "friendly" transactions, the amount of break fees that an income fund may be willing to pay may be constrained, given that the fund pays most of its cash flow to unitholders.
There have been several major income fund M&A transactions within the last year. In one of the largest income fund M&A transactions to date, Penn West Energy Trust completed its C$3.5 billion merger with Petrofund Energy Trust on June 30, 2006. At the end of 2005, successful hostile bids were launched by Livingston International Income Fund for PBB Global Logistics Income Fund and by Agrium for Royster-Clark (an issuer of income deposit securities). As these two transactions demonstrated, a hostile acquisition of an income fund or income securities issuer is more complex than a hostile bid for a corporation, particularly when the acquiror is seeking to achieve a taxfree roll-over transaction for unitholders.
Some Unique Structuring Considerations
The following are some unique structuring considerations relevant to Canadian cross-border M&A transactions that US and other foreign acquirors should be aware of.
Toeholds and Open-market Purchases
One of the key issues often facing acquirors is whether to obtain a toehold position by buying shares of the target before launching a formal takeover bid, both for strategic purposes and possibly to serve as "insurance" in the event of a successful higher bid by a third party. Before the commencement of a formal bid, an acquiror may purchase up to 9.9 per cent of the outstanding shares of a target before being required under Canadian law to publicly disclose the purchases and its intention (compared to a disclosure requirement at the 5 per cent level in the United States). However, the Canadian rules impose a disclosure requirement at the 5 per cent level after a formal bid has been commenced by another party.
Subject to certain restrictions, the Canadian rules also permit an acquiror to purchase up to 5 per cent of the shares of a target through open-market purchases during the course of its bid. However, any shares owned by the acquiror before the commencement of its bid or acquired in openmarket purchases during its bid are not counted as part of the minority for the purposes of the minority approval that may be required for a second-stage squeeze-out transaction. In addition, under the Canadian pre-bid integration rules, an acquiror must, in a formal bid, offer consideration at least equal to the highest consideration it offered in any private acquisition of shares during the prior 90-day period.
Plans of Arrangement
A statutory plan of arrangement is a highly flexible acquisition method that is unique to Canadian corporate statutes. It is a court-supervised merger or reorganization process that offers significant flexibility to carry out creative and complex transactions. For example, in addition to serving as a means of acquiring target company shares, a plan of arrangement can be used to squeeze out debenture holders or convertible securities, to cancel options or to effect complex tax-driven reorganizations. The court must be satisfied, however, that the arrangement is fair and reasonable from both substantive and procedural perspectives.
An acquisition by plan of arrangement would typically involve holding a special meeting of shareholders to approve the transaction. The parties would seek court approval of the process before mailing the information circular and would be required to obtain final court approval following the shareholder vote. An important advantage of a plan of arrangement in cross-border transactions is that if securities are being issued to US securityholders, the court-approval feature may form the basis for an exemption from US securities registration requirements under section 3(a)(10) of the US Securities Act of 1933.
Takeover Bid Financing
Under Canadian law, an offeror in a takeover bid must make adequate arrangements before making the bid to ensure that the required funds are available to purchase all securities for which the bid is made. In practice, this has meant that bids cannot be subject to a financing condition, unlike bids in the United States. In a recent case, an Ontario court held that a bid condition to the effect that all the conditions to the bid had to be satisfied to the lender’s satisfaction violated the rule. Subsequently, Canadian securities regulators have taken the position (which is proposed to be incorporated into a new rule) that financing arrangements may be subject to conditions if "at the time the bid is commenced, the offeror reasonably believes the possibility to be remote that, if the conditions to the bid are satisfied or waived, the offeror will be unable to pay for the securities deposited under the bid due to a financing condition not being satisfied."
Bidders should therefore structure their financing arrangements to ensure that they avoid offending the financing restriction. There are no restrictions on financing conditions for acquisitions completed by way of merger squeeze-out or plan of arrangement, but in those cases the board of the target may not agree to a financing condition.
If a Canadian target is listed on US and Canadian stock exchanges, a takeover bid extended to both Canadian and US shareholders of the target may be exempt from the US tender offer rules by virtue of the Canada-US multi-jurisdictional disclosure system (MJDS). Under the MJDS, the bidder would be able to comply with Canadian takeover bid rules and use Canadian takeover bid documentation, thereby avoiding duplicative regulation.
The MJDS exemption from the US requirements is generally available if fewer than 40 per cent of the target’s shareholders reside in the United States. However, unless US shareholdings are no more than 10 per cent (calculated by excluding any greater than 10 per cent holders), any securities offered as consideration would have to be registered with the SEC and, if the target is being de-listed in the United States, the US going-private rules will apply.
Foreign Investment Review
An investment by a non-Canadian that would result in the acquisition of control of a Canadian business with gross assets in excess of C$265 million (which level is adjusted annually for inflation) requires approval of the Canadian government under the Investment Canada Act (ICA). Investments will be approved if they meet a "net benefit to Canada" test; however, investments in certain culturally sensitive areas such as publishing and media may be subject to a greater level of scrutiny. Canada has historically been highly receptive to foreign investment and ICA review has not been a significant impediment to transactions, although it can cause delays (because there is an initial review period of up to 45 days, which can be extended) and an acquiror may be required to agree to a number of undertakings regarding the future operation of the target business (e.g., maintaining certain operations and/or the head office of the target in Canada for a number of years).
National Security Considerations
Unlike the US Exon-Florio statute, the ICA currently does not expressly permit the review and potential rejection of a transaction on the basis of national security concerns. In 2005, the previous Canadian government introduced amendments to the ICA to explicitly provide for review of foreign investments of any size that could be injurious to "national security" (which term was undefined).
Those proposed amendments apparently resulted, at least in part, from China Minmetals’ proposed acquisition of leading Canadian base metal producer Noranda, and the rumored interest of other Chinese companies in Canadian assets.
The new Canadian federal government has signaled that it plans to introduce similar amendments before the end of 2006. In light of the proposed amendments, market participants should consider national security implications, broadly defined, in their transaction planning, and develop proactive strategies to minimize potential regulatory risk.
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.