Conflicts of interest in corporate transactions can present thorny issues for directors, management and their advisors. A British Columbia company recently found itself in a prickly situation when a proposed deal was challenged on the basis that directors and management had failed to disclose interests that conflicted with those of the company. The BC Supreme Court agreed, finding also that the directors had acted oppressively in approving the transaction, and ordered that the matter be put to shareholders. The result was not only a failed transaction, but also presumably unwelcome publicity for what the Court viewed as poor corporate governance.
This summary focuses on the Court's finding of conflicts of interest by directors and management. The lesson, for public companies in particular, is that failing to observe best practices in negotiating, structuring and approving a transaction can be fatal to its success.
The decision involved Alternative Earth Resources Inc. (AER), its largest shareholder, Jaguar Financial Corporation (Jaguar), and AER's proposal to acquire a mineral exploration company called Black Sea Copper & Gold Corp. (Black Sea).1
AER is a British Columbia company based in Vancouver whose shares are listed on the TSX Venture Exchange. Prior to 2014, AER had been in the business of geothermal exploration and development. In August of that year, it sought and received shareholder approval of the sale of its geothermal assets and the "potential acquisition of [a] mineral property." It then proceeded to sell its principal assets and seek a new business.
The shareholder resolution approving the change of business was worded vaguely, presumably to allow AER latitude as to which aspect of the mineral exploration, development or production industry it would pursue. AER's subsequent public disclosure noted that it had "plans to pursue late-stage mining project acquisitions and/or merger opportunities." Other disclosure referred to its intention to "focus on advanced-stage resource projects."
In October 2015, AER entered into a letter of intent under which it proposed to acquire Black Sea, a privately held British Columbia company with mineral exploration assets in Eastern Europe and Turkey. One of AER's directors, Gavin Cooper, was also Chief Financial Officer and a minor shareholder of Black Sea.
The transaction contemplated the issuance of shares equal to approximately 125 percent of AER's float in exchange for all of the shares of Black Sea, as well as a concurrent equity financing.2 Pursuant to the transaction, AER's board would be increased from three to four members, with two of AER's directors remaining on the board and two of Black Sea's directors filling the vacancies. AER's CEO and CFO would resign as officers but the CEO would continue as a director, and both would act as consultants and be eligible for option grants. AER's CFO (Mr. Cooper) would also step down as a director of AER, but would be appointed CFO of the combined company.3
The transaction was scheduled to close approximately two months after the date of the letter of intent which, in the circumstances, was ambitious. It was also conditional on AER not being required to seek shareholder approval.
On November 24, 2015, Jaguar filed a petition with the Court to halt the transaction pending a shareholder vote. In a news release announcing the litigation, Jaguar cited, among other things, undisclosed conflicts of interest, significant dilution of AER's shareholders and the early-stage nature of Black Sea's assets which, Jaguar claimed, was inconsistent with AER's plans to acquire a "late stage" or "advanced stage" project.
AER and Black Sea signed the definitive agreement in respect of the transaction (the Share Exchange Agreement) on December 2, 2015, which contemplated that closing would occur by December 18, 2015.
The hearing of Jaguar's claims occurred on December 4 and 10, 2015, and the decision was delivered orally on December 10. Four issues were considered by the Court, all of which were decided in Jaguar's favour. This summary will focus on the finding that AER's directors and officers had interests in the Black Sea transaction that conflicted with the company's interest. The other issues were whether the transaction was fair and reasonable, whether it was oppressive or unfairly prejudicial to Jaguar, and what the appropriate remedy should be. The main remedy awarded was to halt the completion of the transaction pending a shareholder vote. The Court also ordered AER to refrain from undertaking activities outside of the ordinary course of business prior to the shareholders' meeting, and to file on SEDAR statements of its cash position on a continuing basis and a number of documents related to the transaction.
All Canadian corporate statutes have provisions governing conflicts of interest by directors and officers, with some variations, including as to what interests must be disclosed and how potential liability can be avoided. The common premise is that directors and executives owe their company a duty to act honestly and in good faith with a view to the company's best interests.
The British Columbia Business Corporations Act (the BCBCA) provides, at sections 147-150, that any director or senior officer who has a material interest in a contract or transaction that is material to the company (a disclosable interest) must disclose such interest and, if he or she is a director, abstain from voting.4 If all directors have a disclosable interest then they can all vote on the contract or transaction, but each director and interested senior officer risks being liable to the company for any resulting profit. That liability can be avoided by obtaining either: (i) a court order, if the contract or transaction is "fair and reasonable" to the company; or (ii) a special resolution of the shareholders approving the contract or transaction. If a court deems a contract or transaction in which one or more directors or senior officers has a material interest not to be fair and reasonable, and if the contract or transaction is not properly approved by the non-conflicted directors or by shareholders' resolution, the court can enjoin the transaction or make any other order it sees fit.
Analysis and commentary
Finding of conflicts
The key question in determining whether a director or senior officer of AER had a disclosable interest in the Black Sea transaction pursuant to the BCBCA was whether such person had a "material interest" in the transaction. Without citing any case law, the Court held that each director and senior officer of AER had such an interest because:
"[completing the transaction] will, for some, mean they keep their jobs with the company, (b) others will remain as directors, (c) Mr. Cooper...will become AER's new chief financial officer, and (d) others who resign their management positions will continue to serve as paid consultants for AER with stock option incentives."5
This rationale, as it applies to Mr. Cooper is sound; he was a director of AER, as well as an officer and shareholder of Black Sea, so his duties were divided. That fact was not in issue, however, as he had disclosed his interest to AER and abstained from voting.
In relation to the other directors and officers, this finding is problematic. It appears to suggest that a director or senior officer would have a disclosable interest in any material transaction in which the individual would keep his or her job or directorship following the transaction, or would remain as a consultant eligible for stock options.6 There was no discussion by the Court as to how a director or officer could retain his or her position with the company without triggering the conflict provisions of the BCBCA.
The Court's finding with respect to conflicts, if taken at face value, could yield some harsh results. If a director or senior officer is conflicted in respect of a material transaction merely because that individual would either keep his or her position as a result of the transaction, or lose his or her job but land another position with the company, it is likely that entire boards and management teams would be conflicted in many transactions. In such case, a company would be compelled to seek either: (i) approval of the transaction by special resolution of shareholders, or (ii) a court order that the transaction is fair and reasonable. This would greatly increase the cost, time and uncertainty of completing transactions that do not otherwise require shareholder approval.
The Court's finding that all directors were conflicted likely stems less from the directors' continuing positions with the company than from the circumstances surrounding the negotiation and approval of the transaction.
The Court found fault with the process observed by AER in negotiating and approving the transaction. As is typical in mergers, a special committee of AER's board was tasked with considering the potential acquisition of Black Sea. AER submitted that the committee members, being the two directors other than Mr. Cooper, were independent of the company, but the Court found their independence to have been compromised:
"because they acted after Mr. Cooper was allowed to influence them by making a full presentation to them about the merits of the transaction, including a comparison of the relative values of Black Sea and AER."7
The Court also found that the attempted merger was rushed.8 It inferred that AER's board had decided to proceed with the transaction well before a geological report on Black Sea's main property and a fairness opinion were available.9 It also noted that, in granting conditional approval, the board relied in part on a preliminary valuation prepared by an advisor to the company who had been retained only two days prior to the date of such board approval.10 Furthermore, the Court noted that AER appeared motivated to close the transaction prior to its AGM so as to dilute shareholders, such as Jaguar, who wanted to vote out the incumbent board.11
The final matter considered by the Court in respect of the conflict issue was whether the transaction was "fair and reasonable". As noted above, if all of the directors of a company are conflicted and the shareholders have not approved the transaction by special resolution, a finding that the transaction is not fair and reasonable to the company allows a court to order a remedy.
The Court found that the Black Sea transaction was not fair and reasonable to AER, on both procedural and substantive grounds. In finding procedural unfairness, the Court pointed to its findings that: (i) the transaction proceeded with "undue haste", (ii) it was not negotiated at arm's length, and (iii) AER's board had approved the transaction before receiving all the relevant facts.12 In finding substantive unfairness, the Court focused on the exploratory nature of Black Sea's properties, as contrasted with AER's previously disclosed intention to acquire an "advanced stage" project, and on the significant dilution of existing shareholders.13 The Court also expressed concern about the geological report as to the merits of Black Sea's property, which did not state that the property hosted any mineral resources, but rather only that it warranted further exploration.14
AER has announced that it intends to appeal this decision. Nonetheless, the case is a reminder that good governance practices are critically important to the success of a transaction, in particular when a director or officer has a disclosable conflict of interest. In such circumstances, a company should take extra precautions to ensure that the transaction is reviewed and approved by a committee of independent directors who are provided with adequate time and information to evaluate the transaction. Rushing a significant transaction—even one that does not require shareholder approval—is rarely good practice.
This summary was co-authored by Daniel McElroy, Knowledge Management Lawyer in Dentons' Vancouver office.
1 Dentons did not represent any of the parties to this transaction. The facts cited in this summary have been gleaned from the decision as reported and from the public disclosure of AER and, to a lesser extent, Jaguar.
2 The transaction was not deemed a "reverse takeover" under the TSXV rules requiring shareholder approval because, according to a subsequent news release of AER, Black Sea's shareholder base was sufficiently diffuse that no "change of control" of AER would result from the issuance of AER shares to Black Sea shareholders.
3 The judgment indicates at paragraph 48 that Mr. Cooper would be a director of the combined company, as one of Black Sea's nominees, but the Share Exchange Agreement provided that he would be CFO and not a director.
4 There are some nuances to the rule that are inapplicable to this case, such as exceptions in the event that a director is the sole shareholder of the company.
5 Jaguar Financial Corporation v. Alternative Earth Resources Inc., 2015 BCSC 2436 (Jaguar v. AER), at paragraph 47.
6 The decision also did not consider section 147(4)(c) of the BCBCA, which provides that directors and senior officers are not conflicted in considering a contract or transaction merely because it relates to remuneration in their capacities as directors, officers, employees or agents of the company, and which has equivalents in other Canadian jurisdictions. It may be arguable that in this case the conflict stemmed not from any potential remuneration but from the fact that the transaction would change the directors' and executives' relationship to the company (in some cases) or change the nature of the company. That argument is not consistent with the decision's findings, however, and the failure to address this provision may have been an oversight.
7 Jaguar v. AER, paragraph 19.
8 Jaguar v. AER, paragraph 25.
9 Jaguar v. AER, paragraph 63.
10 Jaguar v. AER, paragraph 20. The decision does not use the term "conditional approval", but rather states that on October 3 the board determined that the transaction was "in the best interests of AER and its shareholders." Since that preceded the letter of intent by 12 days (and the Share Exchange Agreement by two months), it is inferred that only conditional approval was given on October 3.
11 Jaguar v. AER, paragraph 29.
12 Jaguar v. AER, paragraph 63.
13 Jaguar v. AER, paragraph 65.
14 It is arguably not out of the ordinary for a junior listed company to stake its fortune on a grassroots exploration property, such as that of Black Sea. This decision, however, does not demonstrate that perspective.
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