Mergers & Acquisitions: The Pace Of An Ever Changing Environment

2006 was another record-breaking year for mergers and acquisitions activity in Canada. By the end of the year, the dollar value of all announced transactions was Cdn$296.5 billion, almost twice the Cdn$151.3 billion of activity for 2005. It has been a banner year in the U.S. as well, with announced deals having a value in excess of US$1.6 trillion.

The increased level of activity has led to a number of interesting developments in public-market M&A as bidders, targets and shareholders look for new and innovative ways to protect their interests and put their own stamp on significant transactions. These key developments include:

• An unsuccessful challenge to the ability of an acquiring company to complete a proposed acquisition without shareholder approval, despite significant share dilution.
• The increasing proliferation of "go-shop" provisions in merger agreements, allowing the target to auction the company after a deal has been signed.
• Using poison pills to prolong auctions - whether by leaving the pill in place or by removing it, as the circumstances require.

In private transactions, where the parties have fewer legal constraints, the trends in mergers and acquisitions are less public and perhaps less dramatic, but continue to have a significant effect on Canadian and international markets.

The market is accustomed to shareholders of a target company having a voice in whether or not an acquisition will be consummated. If a transaction is structured as a "one-step" transaction, such as an amalgamation, plan of arrangement or merger, shareholder approval (usually with super-majority requirements) must be obtained. Similarly, if a transaction is structured as a take-over bid, the shareholders of the target company choose whether or not to tender their shares to the bid.

In a number of foreign jurisdictions, shareholders of an acquiror also have to approve acquisition transactions. The need for this approval generally stems from the amount of share dilution that will flow from the successful completion of the acquisition or the size of the proposed acquisition. For example, if a company with its primary listing on the New York Stock Exchange proposes an acquisition that will result in the issuance of common stock representing 20% or more of its outstanding common stock, the company has to convene a shareholder meeting and obtain the approval of at least 50% of the shareholders voting on the matter.

Xstrata's acquisition of Falconbridge is a similar example in respect of a London Stock Exchange listed company. In that case, although the offer for Falconbridge was all-cash, because of the size of the transaction, Xstrata was required by the Listing Rules of the United Kingdom Financial Services Authority (FSA) to obtain shareholder approval.

On the other hand, most of the common acquisition structures used in Canada do not trigger shareholder approval requirements on the part of the acquiror. This traditional approach was challenged in the plan of arrangement involving Goldcorp and Glamis in late 2006. The arrangement, which contemplated Goldcorp issuing common shares equal to approximately 67% of its outstanding capital to acquire Glamis (well above the NYSE and Nasdaq dilution thresholds), would have required Goldcorp shareholder approval under the respective rules of the NYSE, Nasdaq and the FSA. One of Goldcorp's shareholders challenged the company's ability to proceed with the transaction in the absence of shareholder approval. The court concluded that the transaction did not require shareholder approval under Goldcorp's governing statute and further concluded that it was not oppressive to the interests of shareholders. Accordingly, the court confirmed the ability of a Canadian company to issue significant amounts of equity to target shareholders and complete large acquisition transactions without obtaining shareholder approval.

The ability of Canadian companies to complete acquisitions without obtaining shareholder approval can give them a competitive advantage in a battle for control of a target company, in particular in the case of a takeover bid. For example, a prospective acquiror required by U.S. or U.K. rules to obtain shareholder approval before taking up shares would have to leave its bid outstanding for long enough to accommodate the practicalities of setting record dates, preparing and mailing meeting materials and conducting a meeting. This could easily be longer than the minimum 35-day period that would be available to a prospective acquiror not required to obtain shareholder approval. In the case of a onestep transaction, the acquiror's ability to unconditionally commit to the transaction without the need to obtain shareholder approval increases the certainty that the transaction will be successfully completed and reduces the opportunities available to interlopers who might seek to use a shareholder approval requirement as an opportunity to upset a negotiated deal.

The ability of a dissident shareholder to cast a cloud over the acquisition plans of an acquiror was evident in the bid by Phelps Dodge for the combined Inco and Falconbridge. Because the transaction would have involved the issuance of shares in excess of the NYSE's dilution thresholds, Phelps Dodge required the approval of its shareholders to complete the proposed US$40 billion acquisition transaction. Within hours of Phelps Dodge's announcement of the transaction, its largest shareholder, hedge fund Atticus Capital, announced its opposition to the transaction, raising doubts about whether Phelps Dodge would get the shareholder approval it needed and constraining Phelps Dodge's ability to subsequently raise its offer price in response to a higher all-cash bid for Inco made by Brazilian miner CVRD.

When entering into a "friendly" transaction, one of the key areas that must be negotiated is the provisions that will protect the deal. Generally, potential acquirors seek the strongest possible protections that the target company is willing to give (and is able to give, in light of the target board's fiduciary duties). A new development in this area is the increasing use of a "goshop" provision. This is a provision that allows the target to conduct an auction after a merger agreement is signed, seeking out a higher price for the target company from an alternate acquiror. Of course, the initial prospective acquiror will often receive a break fee, quite possibly a generous one, in exchange for being a stalking horse for any resulting auction.

Go-shop provisions were used in a number of deals in 2006, including Ripplewood's proposed acquisition of Maytag (which was topped by Whirlpool), Providence Equity's acquisition of Kerzner International (after a price bump by Providence and early termination of the go-shop by Kerzner) and Blackstone's acquisition of Freescale Semiconductor, in the U.S., and, indirectly, Algonquin Power's acquisition of AirSource Power Fund (where AirSource retained the right to solicit other offers) and Vector's acquisition of Corel (where Vector did not have any exclusivity arrangements with Corel) in Canada.

At first blush, it looks like a go-shop provision would allow the target company to obtain the highest possible price for its shareholders. They can be attractive to the target company's board of directors because they may provide comfort that the final selling price for the target company is the best possible price, not to mention providing insulation from claims that the price agreed to with the initial acquiror was not sufficient. For this reason, in 2007 there will likely be increased pressure from target companies to include go-shop provisions in merger agreements.

A go-shop provision can be attractive for an acquiror as well, in particular if the alternative is a pre-signing action for the target company. The initial proposed acquiror's signed deal may have a number of advantages over potential competing bidders, including timing advantages, the obligation on the target to pay a break fee and compressed timetables during which potential competing aquirors must assess the target and make a proposal. Often the target company is obligated to keep the initial proposed acquiror informed of its progress with respect to shopping the company and in some cases the initial acquiror will also have a right to match competing offers.

There is still great variety among the various go-shop provisions that have been used, including in relation to:

• the amount of the break fee and whether it is lower during the go-shop period;
• the length of the go-shop period;
• whether the target company is obligated to advance the proxy materials necessary to approve the transaction with the initial proposed acquiror during the go-shop period;
• restrictions on the number or types of aquirors (such as private equity or strategic buyers) that can be approached during the go-shop period; and
• the initial proposed acquiror's right to match competing offers.
• If go-shop provisions become increasingly common in 2007 and beyond, these areas will become the focus of important negotiations between targets and acquirors.

There have been a number of important developments relating to poison pills, also known as shareholder rights plans. In recent years there have been few hearings on this issue in Canada - the general amount of time poison pills are permitted to remain is reasonably predictable and securities commissions (which have been responsible for policing this area) have encouraged target companies to deal with their poison pills without regulatory intervention. This year, however, two large proposed take-over bids resulted in poison pill hearings before the Ontario Securities Commission (OSC), leading to developments that will likely affect poison pills and take-over bids in the future.

In connection with its unsolicited take-over bid to acquire Falconbridge (competing with an existing friendly offer from Inco), Xstrata sought to have Falconbridge's poison pill terminated. At the time of the hearing, Xstrata held 19.8% of Falconbridge's common shares and its bid was weeks away from receiving the regulatory clearances that would be required for Xstrata to take up shares under the bid. In the absence of Falconbridge's poison pill, following the commencement by Xstrata of its take-over bid, Ontario take-over bid rules would have permitted Xstrata to acquire up to an additional 5% of Falconbridge's outstanding shares through normal course market purchases. However, the continued operation of the poison pill prevented Xstrata from making market purchases and therefore increasing its stake in Falconbridge to 24.8%.

On the one hand, Falconbridge had been "in play" for over 8 months at the time of the hearing. This is much longer than the securities commissions would generally allow a poison pill to stand, as the view is that this would have provided Falconbridge's board with plenty of time to identify the highest possible offer for the company. On the other hand, Falconbridge argued that if Xstrata were permitted to acquire an additional 5%, Xstrata's aggregate 24.8% interest in Falconbridge would be equivalent to a blocking position and make it practically impossible for the friendly bidder, Inco, or any other bidder to succeed, resulting in the end of the auction for Falconbridge.

Ultimately, the OSC permitted Falconbridge's poison pill to continue until the earlier of the date on which at least 50% of Falconbridge's common shares (other than those owned by Xstrata) were tendered to Xstrata's takeover bid and July 28, 2006, approximately one month after the date of the hearing. The OSC panel's reasons for allowing the Falconbridge poison pill to continue in effect for a further limited period were to allow Inco and Phelps Dodge a further limited amount of time to conclude their friendly merger before Xstrata would be able to increase its ownership stake in Falconbridge to 24.8%. The panel displayed little concern for the fact that the poison pill had not been put to Falconbridge's shareholders for approval, a fact which in usual circumstances can cause the panel to be sceptical that the poison pill is in the best interests of shareholders.

Falconbridge also pointed out that Xstrata could obtain a true blocking position (i.e. 33% of the common shares), which would prevent any bidder from acquiring 100% of Falconbridge except with the cooperation of Xstrata, by waiving its minimum purchase condition and taking up a mere 13.5% of the outstanding shares. Put another way, a relatively small percentage of the independent shareholders could effectively preclude any future takeover bid for Falconbridge by any bidder other than Xstrata by giving Xstrata the shares it would need to own a 33% stake in Falconbridge. Falconbridge argued that it should be permitted to retain its poison pill in order to prevent this outcome - an argument to which the panel appears to have been sympathetic.

This argument could also be advanced in the context of a bid by an acquiror that commences its bid owning no shares of the target company. The percentage of the target company necessary to acquire a blocking position is always less than 50%, meaning shareholders representing less than a majority of the target company can sell a blocking position to a bidder. This could all but eliminate the likelihood that any new bidder will emerge in the future. In addition, the bidder with the blocking position would be under no obligation to extend the bid to the remaining (majority) shareholders after the blocking position is acquired. There is no certain exit for the remaining shareholders, nor any assurance that they will be offered equivalent terms. The OSC's apparent sympathy for this concern therefore raises the question whether in the future target companies will be permitted to maintain poison pills in effect beyond the traditional period for the purpose of preventing the take-up of a minority of the outstanding shares.

Inco, the initial bidder for Falconbridge, was itself the target of an unsolicited take-over bid which led to another OSC decision in the area of poison pills. Teck Cominco made an unsolicited bid to acquire Inco while Inco's bid for Falconbridge was outstanding. Inco then agreed to be purchased by Phelps Dodge on a friendly basis and the auction was on. Teck and Inco were able to negotiate a settlement of the poison pill in advance of the OSC hearing - they drafted an agreed form of order to come from the OSC that would terminate the poison pill in respect of the Teck bid only at an agreed date about three weeks in the future. The OSC refused to issue an order in the form requested by Teck and Inco.

Counsel to Inco argued that it was appropriate to leave the poison pill in place as against other bidders because the terms of any future bid were unknown - they could be coercive or otherwise unfair to Inco's shareholders, and Inco's management needed the poison pill in order to protect against any such bid. The OSC, applying the principle that unrestricted auctions produce the most desirable results in take-over contests, rejected this position. It concluded that lifting the poison pill as against all bidders would ensure that the pill would not stand in the way of allowing the shareholders to decide between all offers, including any future offers that might come forward. Ultimately, a competing bidder, CVRD, did come forward and was successful in acquiring Inco.

Both the Xstrata/Falconbrige and the Teck/Inco decisions indicate that the OSC is focussed on enabling auctions for target companies. In the case of the Falconbridge plan, the OSC allowed the poison pill to remain in place in order to prevent Xstrata from acquiring a potential auction-ending position. In the case of the Inco pill, the OSC required the pill to be lifted as against all bidders, removing a potential impediment to a competing bid and facilitating a continued auction.

Income trusts have been a hot topic in Canada for some years, accounting for significant activity in Canadian capital markets and as a considerable draw for M&A activity. In late 2006, income trusts were again a big story, but for quite a different reason - the federal government's October 31, 2006 announcement that most income trusts will no longer benefit from favourable tax treatment promptly put an end to the income trust conversions that have been feeding the Canadian market so successfully over the last few years.

Looking back, just a year ago the Davies Ward Phillips & Vineberg LLP lawyers participating in our January 2006 law@work on-line seminar on 2006 Canadian legal trends had this to say about income trusts: "…frankly it's been a boon for investment bankers, it's been a boon for private equity firms and it's been a boon for law firms." "Private equity firms just love the income trust market. This has become one of the great and easy exit strategies globally for these firms. That's one of the principal reasons why they are coming to Canada chasing the bigger deals."

And this: "We really wonder what the market would have been like in 2005 without income trusts."

Now in 2007 we will find out what the market is like without the "easy exit" of an income trust conversion. We've already seen a slowdown in initial public offerings in the last quarter of 2006, but going forward, alternative exit strategies for private investors may well sustain high levels of activity in the private marketplace, as sales to private equity firms, pension funds and strategic buyers remain a viable option, a recent example being the proposed $3.42 billion acquisition of BCE's Telesat Canada by an acquiror formed by Canada's Public Sector Pension Investment Board and Loral Space & Communications Inc. announced in December.

Private equity and pension funds remained active players in the Canadian M&A market in 2006, and they are expected to continue as such in 2007. These funds still have more than ample money to spend and are continuing to raise capital which they have to place. The Canadian market, with accessible debt financing at low interest rates and a solid economy, is attractive to both Canadian and international investors. Fund sizes keep growing, with Canada's Onex now having raised a US$3.5 billion fund and Blackstone raising a US$15.6 billion fund in July. Recent announcements of smaller funds indicate that the mid-market is also still a desirable target.

The large and growing supply of interested and deep-pocketed buyers has contributed to somewhat of a seller's market in Canada, the U.S. and globally, with perhaps more money than available transactions. The growth of auctions is both a contributing factor to, and a result of, this trend.

Sellers are doing well both on price and deal terms in auctions because of the competition for attractive targets. Furthermore, multiple competitive bids can give a seller the added luxury of choosing its buyer or investor based on perhaps less tangible, but nevertheless significant, factors. If management is retaining a substantial stake in the business, as is most often the case, the relationship with the private equity firm, and how the private equity firm will be involved after closing, are often key in determining the winning bid.

From the private equity firm's perspective, the relationship with management can also be an important driver. While the private equity model is based on finding (or creating) an exit, the exit has to be a profitable one and that requires working with management to create value and continued growth. In addition, a company leveraged from acquisition financing is often a carefullymonitored, carefully-run company. Good corporate governance in the private sector may not have sold newspapers over the last few years the way public governance issues have, but governance is often just as important in the private sector, where companies are being groomed for an eventual IPO or sale, and this is not likely to change.

Another development emerging in North America, usually in an auction context, is vendor due diligence. In vendor due diligence a seller, working with its legal, financial and other advisors, will prepare a due diligence package on itself and provide it to prospective buyers. While it's still more common in Europe, we are now beginning to see vendor due diligence in the U.S. and Canada. It gives a seller the chance to carefully review its own business and address any negative issues (and highlight the positive ones) before showing the business to buyers, which can be a significant advantage. It can also give the seller better control of an auction and the confidentiality of its documents, make the auction process more orderly and less time-consuming, especially when there are multiple bidders, and can attract potential buyers who might not have been interested had they had to do their own full due diligence to understand the business enough to enter the auction. Vendor due diligence doesn't stop buyers from doing their own due diligence, but their review is likely to be more confirmatory and focussed when they have access to a vendor due diligence package.

Cross-border, international and multi-national transactions continue to increase. As deals get ever more global, buyers with the necessary skill set will continue to have a competitive advantage both in getting the deal done and in the success of the deal post-closing. The buyer and its advisors need significant transaction management skills, cultural sensitivity and an ability to understand local issues, be they legal, regulatory or social, and to integrate these issues into the global transaction strategy to ensure success. On the flip side, multi-jurisdictional M&A is also seeing more and more "internet transactions", with due diligence in virtual data rooms, agreements negotiated by e-mail and teleconference, and the parties rarely meeting face to face. While convenient, this approach can have a damaging effect on the parties' relationship and inevitably on the deal itself, and we are seeing that smart buyers resist the temptation of the internet-only deal.

2006 also saw the continuation of complementary trends at both ends of the M&A spectrum: growing consolidation in some sectors, with continued divestitures as companies return the focus to their core businesses. The consolidation highlights in 2006 were resource companies both in Canada and globally, with some noteworthy transactions being Xstrata acquiring Falconbridge, Barrick Gold acquiring Placer Dome, as well as Pioneer Metals and an interest in Vancouver's Nautilus Minerals, Goldcorp acquiring Glamis and CVRD of Brazil acquiring Inco. On the steel front, Arcelor of Luxembourg acquired Dofasco, quickly followed by Mittal Steel's bid for Arcelor and attempt to sell Dofasco to ThyssenKrupp AG.

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.