Originally published in 2007 Lexpert/The American Lawyer.
Courts and securities regulators have recently released significant decisions in three areas of transaction-related corporate litigation: (1) contested plans of arrangement, in which the test for approving arrangements were considered; (2) challenges to takeover bids based on financing conditions; and (3) the takeover bid rules regarding poison pills and collateral benefits.
Contested Plans of Arrangement
The approval of plans of arrangement was contested in the courts in Alberta, Yukon Territory and British Columbia, leading to important decisions that considered and confirmed the test for court approval of arrangements.
In considering a challenge to the plan of arrangement involving PetroKazakhstan, an Alberta court clarified which considerations are relevant to court approval of an arrangement. The challenge came from Lukoil, which was neither a party to the arrangement nor a securityholder of the corporations involved in the transaction. Rather, Lukoil had a business relationship with PetroKazakhstan and objected to the arrangement because Lukoil’s interests would be damaged by the arrangement. The Alberta Court of Queen’s Bench rejected the challenge, making it clear that Lukoil’s concerns were not relevant to the approval of the arrangement.1
The arrangement involved the acquisition by CNPC International (the Chinese state-owned oil company) of PetroKazakhstan’s shares. The arrangement was approved by over 99% of PetroKazakhstan’s shareholders and optionholders, and also by over 99% of the minority shareholders. The court applied the well known test for the approval of an arrangement: (1) the statutory requirements must be satisfied; (2) the arrangement must be put forward in good faith; and (3) it must be fair and reasonable.2
Lukoil objected to the approval of the arrangement. Lukoil and PetroKazakhstan were engaged in an oil project in Kazakhstan and were parties to a shareholders’ agreement. Lukoil alleged that the arrangement would result in a breach of the shareholders’ agreement in that PetroKazakhstan’s shares in the oil project would become the property of CNPC International in violation of Lukoil’s preemptive right to acquire those shares. Lukoil argued that a plan of arrangement that was contrary to law could not be put forward in good faith, nor be fair and reasonable.
The court was satisfied that the arrangement met the three-part test for approval. The only issue was Lukoil’s objection, which the court dismissed. The court held that Lukoil was a stranger to the proposed arrangement and that its concerns could not defeat the transaction on the basis that it was not fair and reasonable. The concerns that Lukoil raised were extraneous to the court’s approval of the arrangement since they did not bear on whether the transaction was fair and reasonable to PetroKazakhstan. The interests of its shareholders were fundamental to that consideration.
In Scion Capital v. Bolivar Gold Corp.,3 a shareholder of Bolivar objected to a proposed plan of arrangement and raised concurrent allegations of oppression. The Bolivar decision is significant in addressing the extent to which procedural flaws at the negotiation and securityholder approval stages will affect the determination that an arrangement is fair and reasonable, and in confirming the applicability of the business judgment test when determining the substantive fairness of an arrangement.
The proposed arrangement involved the acquisition by Gold Fields Ltd. of Bolivar’s outstanding shares, options and warrants. Scion, the holder of 16% of Bolivar’s shares as well as some warrants and options, objected to the arrangement (with some other shareholders) because the consideration that Gold Fields offered was insufficient. At the securityholders’ meeting to consider the arrangement, 76.65% of the shares were voted in favor of the arrangement, and it was also approved by securityholders representing 82% of the options and warrants. Scion and some other shareholders asked the court to decline to approve the arrangement because it was not fair and reasonable due to a number of flaws in the process by which Bolivar’s directors negotiated the arrangement and the process by which its securityholders approved the arrangement.
In attacking the procedure, Scion attacked Bolivar’s independent committee and its financial advisers because, for example, a fairness opinion was not provided before a letter of agreement was signed. The court agreed that this procedure was not perfect but rejected the allegation as a basis for defeating the arrangement. Scion challenged the conduct of the securityholder meeting, before and during which procedural changes were made that were, arguably, favorable to the approval of the arrangement.
The court held that it was required to consider both procedural and substantive fairness. With respect to the former, procedural imperfections do not necessarily result in unfairness. In a consideration of substantive fairness, the business judgment of the securityholders as a whole is significant. Although the court found that there were minor procedural flaws, they did not, absent bad faith, amount to procedural unfairness. The court observed that while it was not in a position to pass judgment on the commercial merits of the arrangement, it nonetheless had to consider substantive fairness. In that regard, the court applied the business judgment test and noted that the securityholders approved the arrangement and that Scion had an opportunity to dissent. Further, the basis for Scion’s opinion that the consideration that Gold Fields offered was insufficient could have been, but was not, placed before the other securityholders at the meeting when the arrangement was considered. The court concluded that the arrangement was fair and reasonable.
The grounds of Scion’s objections to the arrangement also formed the basis for its oppression claim, which was also dismissed. The court commented on the interrelationship between the arrangement test and the oppression remedy. It observed that an arrangement that was fair and reasonable could not be oppressive, but that lack of oppression did not necessarily mean that an arrangement was fair and reasonable. The Court of Appeal for Yukon Territory affirmed the lower court’s conclusion with respect to the oppression claim, but without addressing the application judge’s reasoning. The relationship between the approval of an arrangement and the oppression remedy therefore remains uncertain in other jurisdictions.
Takeover Bid Financing
The 2005 takeover of Financial Models Co. (FMC) resulted in regulatory and court proceedings in Ontario relating to the rules and practice regarding takeover bid financing, and led to regulatory reform in this area.
FMC was owned by individuals (Katotakis and Waters), by BNY Capital Corp. and by minority public shareholders. Katotakis, Waters and BNY were parties to a shareholders’ agreement that included mutual rights of first refusal. Given the size of their shareholdings, a party’s exercise of those rights would trigger an obligation under Ontario’s Securities Act (the Act) to make a takeover bid. The acceptance of a selling notice under the shareholders’ agreement required compliance with the Act, including s. 96, which deals with the financing of takeover bids and requires an offeror to make "adequate arrangements" to ensure that the bid is financed.
FMC struck a special committee that favored an acquisition by Linedata Services S.A. In accordance with the shareholders’ agreement, Waters and BNY delivered selling notices giving Katotakis the right to buy their shares and therefore to make a bid for all the shares of FMC, failing which they would sell to Linedata.
On December 29, 2004—the last possible day to accept the offer—Katotakis accepted the selling notices, agreeing to make a bid for all the shares of FMC. Katotakis published a notice of his offer. Among other things, the notice stated: "ABRY [Mezzanine Partners L.P., the lender to the bidder] shall have the right to terminate its commitment to provide the Funding . . . if the FMC Board of Directors or any committee thereof recommends that the holders of FMC Common Shares reject the Offer." The Ontario Securities Commission raised concerns about the financing conditions expressed in this notice, which appeared too extensive. Katotakis later issued a modified notice of the takeover bid, disclosing more conventional financing conditions.
The OSC held a hearing to consider an application by the special committee of FMC’s board of directors for an order cease trading the sale of FMC shares to Katotakis. The issues that were to be considered at the hearing included the financing conditions for Katotakis’s takeover bid and compliance with s. 96 of the Act. The OSC hearing proceeded, but not on that issue. With respect to the remaining issues, the OSC dismissed the application.
BNY commenced an application in the Superior Court of Justice to determine whether Katotakis’s takeover bid complied with s. 96 of the Act, thereby requiring BNY to sell its shares to Katotakis.
Justice Ground found that Katotakis’s acceptance of selling notices from BNY and Waters under the shareholders’ agreement did not comply with s. 96 of the Act, and therefore BNY and Waters were not contractually obligated to sell their FMC shares to Katotakis.4 Justice Ground found that as of December 29, 2004, the date the selling notices expired, Katotakis had not accepted them in accordance with s. 96 of the Act because of the conditions placed (at that time) on the financing of his takeover bid. For that reason, there had been no valid acceptance of the selling notice, and BNY and Waters were not obligated to sell their shares to Katotakis.
With respect to s. 96 of the Securities Act, Justice Ground made this statement regarding bid financing conditions:
"Adequate arrangements" has been interpreted to mean that there must be accurate, clear and unequivocal assurance that the financing is in place in the sense that a public shareholder contemplating tendering his or her shares to the bid can be unequivocally assured that the funds are available to complete the purchase.5
He concluded that "this requirement [i.e., adequate arrangements] was not met by the wording of the first funding letter and the advertisement as of December 29, 2004."
Justice Ground’s comments with respect to s. 96 of the Act suggested that the financing for a takeover bid must be free of conditionality. This was not previously the view of practitioners, nor of the OSC, as reflected in its written submissions in the OSC proceeding:
Although section 96 uses the word "ensure," it is generally accepted that the arrangements between the bidder and the lender can include some conditions to cover unexpected events. Virtually all bid financing arrangements have at least some standard conditions; otherwise, such financings would unlikely be available.
Justice Ground’s decision poses potential difficulties for takeover bids that include conditional financing. It could be used, for example, by target companies to obstruct a takeover bid. In response to the FMC decision, the OSC made Rule 62-503:
For the purposes of section 96 of the Act, the financing arrangements required to be made by the offeror prior to a bid 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 of the bid are satisfied or waived, the offeror will be unable to pay for securities deposited under the bid due to a financing condition not being satisfied.
Rule 62-503 has now been approved. It was kept general in nature so that it can be applied flexibly, depending on the specific facts, and can allow bidders and lenders to tailor their conditions to the specific circumstances of their transaction.
Takeover Bid Rules
There have been a number of important recent decisions in the regulation of takeover bids and the enforcement of the rules applicable to those transactions. The decision in Re Falconbridge Ltd. 6 may signal a different approach to evaluating poison pills. In Re Sears Canada Inc.,7 the OSC considered a challenge to a takeover bid on the basis of allegations that a collateral benefit had been offered to certain shareholders, shedding important light on this issue.
The OSC’s decision in Falconbridge is an important development in the approach taken by the OSC to poison pills. Although the decision is based on what the OSC called "unique circumstances," it appears also to represent a greater willingness by the OSC to defer to the business judgment of the directors of a target company that implements a poison pill.
The decision in Falconbridge arose in the context of the bidding war between Inco Ltd. and Xstrata plc for Falconbridge Ltd. In August 2005, Xstrata acquired a 19.9% interest in Falconbridge. On September 22, 2005, after having had discussions with both Xstrata and Inco, Falconbridge’s board adopted a shareholder rights plan. Inco commenced its bid on October 10, 2005. Inco and Falconbridge entered into a support agreement that required Falconbridge to support the Inco transaction and not to solicit other offers, subject to a "fiduciary out" for unsolicited superior proposals.
The Inco offer was extended three times in 2005 and 2006 while the parties sought regulatory approval for the acquisition. In the interim, the shareholder rights plan adopted in September 2005 was not put to the Falconbridge shareholders for approval, as required by its terms. Before the original shareholder rights plan was set to terminate in March 2006, the Falconbridge board adopted the replacement rights plan, which was substantively similar to the original. Under the replacement rights plan, a "permitted bid" was an offer to all Falconbridge shareholders to acquire all of their shares, and included an irrevocable condition that a majority of Falconbridge shares, other than the bidder’s, be tendered under the bid.
Inco made an improved offer for Falconbridge on May 13, 2006, and the support agreement was amended accordingly. Five days later, Xstrata made a competing offer to acquire all the Falconbridge shares it did not already own. The Xstrata offer included a waivable minimum tender condition. Both outstanding bids contained a majority-of-the-minority tender condition, as required by the replacement rights plan. Under the terms of that plan, the Inco bid was a permitted bid because that condition was irrevocable. However, because Xstrata’s minimum tender condition was waivable, its bid was not a permitted bid.
After Xstrata commenced its bid, Inco announced a proposed combination between Inco, Falconbridge and Phelps Dodge Corp. It also announced an increased offer for Falconbridge.
Xstrata applied to the OSC to cease trade the replacement rights plan. Falconbridge made a cross-application for an order prohibiting Xstrata from making further acquisitions of Falconbridge as allowed under s. 94(3) of the Act. In its decision released on August 17, 2006, the OSC allowed the replacement rights plan to continue for a further four weeks, and it allowed Falconbridge’s cross-application.
Whether to allow a poison pill to continue is a matter of weighing "the public interest regarding the right of the shareholders of the target to tender their shares to the bidder of their choice against the duties of the target board to maximize shareholder value."8 The OSC considered the full range of factors relevant in balancing these interests and decided that the Falconbridge poison pill should continue for another four weeks. In the circumstances of this case, the outcome of the OSC’s balancing arguably favored deference to the business judgment of the Falconbridge directors who adopted the replacement rights plan.
A number of factors appeared to weigh against allowing the poison pill to continue: (1) it was not approved by the shareholders; (2) it had been in place for a very long time, taking into account the original rights plan as well as the replacement rights plan; and (3) Falconbridge had adopted other defensive measures through the Inco support agreement.
The main arguments in favor of the continuation of the poison pill were the effect it was likely to have on the auction process and the potential for the Xstrata bid to be coercive to Falconbridge shareholders. The OSC found that the support agreement made it unlikely that a competing bid would come forward—under the terms of the agreement, only an unsolicited superior offer could be entertained. However, the OSC also found that there may be further and better offers by either Inco or Xstrata, and therefore the auction process was not necessarily inhibited by the poison pill.
The OSC also found that the size of Xstrata’s shareholding, together with its waivable minimum tender condition, gave rise to the significant risk that Xstrata could achieve a blocking position. That would have a detrimental effect on the auction process—a result that would not be in the public interest and was potentially coercive. It was on that basis that OSC also allowed Falconbridge’s cross-application to prohibit further acquisitions by Xstrata under s. 94(3) of the Act, because further acquisitions could assist Xstrata in achieving a blocking position.
It remains to be seen whether the OSC will continue to show equal deference to the target directors’ judgment in future poison pill cases.
The Sears decision arose in the context of a takeover bid for Sears Canada by its parent, Sears Holdings Corp. The bid was challenged on the basis that the bidder had offered a collateral benefit to certain shareholders and that it was abusive or coercive.
When its takeover bid was commenced, Sears Holdings owned more than 50% of the shares of Sears Canada. The offer was for the remaining shares of the target, and contemplated a second-step going-private transaction. On the basis of an opinion from its financial adviser that the price offered by Sears Holdings was inadequate, the special committee of Sears Canada recommended that Sears Canada shareholders reject the offer.
The offer initially was to expire on March 17, 2006, but was extended to March 31, 2006. On March 28, 2006, Sears Holdings entered into a support agreement with Scotia Capital Inc. and the Bank of Nova Scotia; on April 1, 2006, it entered into a deposit agreement with Vornado Realty Trust; and on April 5, 2006, it entered into a further support agreement with the Royal Bank of Canada. These agreements gave Sears Holdings the votes it needed to complete the second-step going-private transaction.
The deposit agreement with Vornado increased the offer price and gave price protection and a release to Vornado. The support agreements provided that the expiry of the bid would be extended to August 31, 2006, and that the second-step transaction would take the form of a share consolidation or a plan of arrangement to be completed in December 2006. As part of the support agreements, the banks agreed to vote in favor of the second-step transaction. The restructuring of the bid— the extension of the expiry date and the timing and form of the second-step transaction—allowed the banks to take advantage of favorable tax treatment on the disposition of their shares.
Three minority shareholders challenged the restructured bid on the basis that, among other things, it violated Ontario’s takeover bid rules by providing Vornado and the banks with illegal collateral benefits. Section 97 of the Act prohibits a bidder from entering into an agreement with a shareholder that has effect of providing consideration greater than that offered to the holders of the same class of securities.
The OSC found that the release granted to Vornado in the deposit agreement, and not extended to other Sears Canada shareholders, was a collateral benefit. The OSC also found that the restructuring of the bid through the support agreements allowed the banks to realize tax benefits, and that the banks were therefore being offered collateral benefits. The OSC noted that, while there is nothing wrong with bidders taking into account the tax-planning objectives of shareholders in structuring a bid, and while the after-tax consequences of an offer will be different for different shareholders, in this case the bid was restructured after it was commenced specifically to accommodate the banks. It was this midbid restructuring that led to the OSC’s conclusion on the issue of collateral benefits, and which will likely provide guidance in future transactions.
The OSC cease traded the offer until changes were made to Sears Holdings’ takeover bid circular, disclosing (1) the terms of the support agreements, and the fact that the shares of the banks will be excluded from the majority-of-the-minority vote on any second-step transaction; and (2) the terms of the Vornado release, and the fact that an identical release will be granted to all shareholders who tender to the bid, and that the shares of Vornado will be excluded from the majority-of-the minority vote on any second-step transaction. The OSC stated that it would have made this order based on either the breach of the takeover bid rules or, even if there was no breach, based on its public interest jurisdiction, taking into account all the circumstances of the bid.9
Although the circumstances of the Sears decision are unusual, the OSC’s reasons are an important consideration of the issue of collateral benefits. It sheds important light on the issue of collateral benefits in takeover bids, and because it involves standard kinds of agreements between bidders and shareholders, it may also affect the way that takeover bids are structured and carried out in the future.
1. PetroKazakhstan Inc. v. Lukoil Overseas Kumkol B.V. (2005), 12 B.L.R. (4th) 128 (Alta. Q.B.) [PetroKazakhstan].
2. Ibid. at para. 21.
3.  Y.J. No. 17 (Y.T.S.C.), aff’d  Y.J. No. 11 (Y.T.C.A.) [Bolivar].
4. Linedata Services S.A. v. Katotakis (2005), 2 B.L.R. (4th) 71 (Ont. S.C.J.), aff’d (2005), 1 B.L.R. (4th) 168 (Ont. C.A.) [FMC].
5. Ibid. at para. 5 (emphasis added).
6. (2006), 29 O.S.C.B. 6783 [Falconbridge].
7. Available online: www.osc.gov.on.ca/Enforcement/Proceedings/RAD/rad_20060808_searscanada.pdf [Sears].
8. Falconbridge, supra note 6 at para. 33.
9. On September 18, 2006, an appeal of the OSC’s order to the Ontario Divisional Court was dismissed. Sears Holdings announced that it will seek leave to appeal to the Court of Appeal for Ontario.
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