Canada: Increased Scrutiny On Board Process In Arrangements

Last Updated: November 29 2016
Article by Jack Schroder

Introduction

On November 4, 2016 the British Columbia Court of Appeal, sitting as the Yukon Court of Appeal (the "Court of Appeal") overturned a lower court ruling that had approved a proposed US$2.3 billion dollar plan of arrangement (the "Arrangement") pursuant to which InterOil Corporation ("InterOil") would be acquired by Exxon Mobil Corporation ("Exxon"). The Arrangement was opposed by Philippe E. Mulacek ("Mulacek"), a shareholder and former director of InterOil. The Court of Appeal found that the lower court (the "Lower Court") erred in disregarding a number of deficiencies in the process followed by the InterOil board of directors. The Court of Appeal was unable to satisfy itself that the Arrangement met the fair and reasonable standard due to these deficiencies, and dismissed the application for approval of the Arrangement.

There are several major points to be considered in the wake of the Court of Appeal's decision:

  • court approval is an important step in arrangement transactions, and should not be viewed as just another box to check on the closing agenda. Courts must consider the principles developed in BCE Inc. v 1976 Debentureholders1, ("BCE") to ensure that the arrangement is fair and reasonable when viewed substantively and objectively;
  • objective review of corporate governance practices is a step in determining the fairness of a transaction. Deficiencies in corporate governance procedures will not be automatically overcome by shareholder or market support for the deal. Issuers should have good governance procedures in place and document their adherence to these procedures throughout the span of the deal;
  • financial fairness opinions provided by advisors that receive a success fee may be of little use in indicating the fairness of a potential transaction. Best practices may now require an independent opinion be obtained on a flat fee basis containing a summary of the facts and analysis on which the opinion is based; and
  • an indicia of fairness that may be considered, according to BCE, is shareholder support for an arrangement. However, shareholder support for a transaction will be of limited utility to the court in a fairness analysis if the shareholders were not provided with the information necessary to make an informed choice, such as information concerning the value they would be giving up and the value they would receive.

Background

Incorporated in the Yukon, InterOil's main asset is an interest in an undeveloped oil and gas field in Papua New Guinea ("PRL 15"). In mid-2015, InterOil began evaluating a potential sale of its assets, or of the entire company. In May 2016, Oil Search Limited ("Oil Search") approached InterOil with an offer that valued InterOil's equity at US$40.25 per share plus an uncapped contingent value right ("CVR") tied to the volume of contingent resources associated with PRL 15. The CVR contemplated a cash payment of US$6.044 for each 1 trillion cubic feet equivalent ("tcfe") of PRL 15 contingent resources above 6.2 tcfe. Immediately prior to the announcement of the Oil Search offer, Interoil's shares were trading at US$31.65.

However, before InterOil's shareholders had the chance to vote on the plan of arrangement to implement the offer by Oil Search, Exxon made an unsolicited offer for InterOil, valuing the InterOil shares at US$45 per share. The Exxon offer contained a contingent resource payment ("CRP") which entitled InterOil shareholders to cash payments of US$7.07 for each tcfe of PRL 15 contingent resources above 6.2 tcfe, but capped the maximum value of the CRP to 10 tcfe. Oil Search indicated that it did not intend to revise its offer, and Exxon paid the break fee of US$60 million so that InterOil could terminate its agreement with Oil Search and proceed with the Exxon offer.

Corporate Process and Fairness Opinion

Upon receipt of the Oil Search offer, InterOil formed an independent transaction committee of the board (the "Committee"). However, the Court of Appeal found that once InterOil began moving forward with the Exxon transaction, the Committee took a passive role in matters regarding the Arrangement, and there was no evidence that the Committee had independently approved the Arrangement. Instead, InterOil's entire board participated in the vote to approve the Arrangement, including two management directors who negotiated the Arrangement and had major financial incentives to support the deal, including severance payments and the payout of restricted share units, which would be accelerated on the change of control. InterOil's management circular sent to shareholders in connection with the Arrangement fully disclosed the interests of management in the transaction, including the value of restricted share units held by the CEO and the CEO's right to a termination payment.

InterOil engaged Morgan Stanley to advise on the deal and to provide a fairness opinion in connection with the Arrangement (the "Fairness Opinion"). A significant portion of Morgan Stanley's fee was contingent on the success of the Arrangement (a "Success Fee"), although the details and amount of the Success Fee were not disclosed. The Fairness Opinion provided a list of the information that was reviewed, but did not provide reference to any specific documents. While Morgan Stanley advised that they had considered the potential value of the CRP under different possible outcomes, they did not attribute a specific value to the CRP for the purposes of arriving at the conclusion expressed in the Fairness Opinion. The Fairness Opinion also did not provide details of the facts and analysis used by Morgan Stanley in coming to their conclusion. The Fairness Opinion concluded that the consideration to be received by InterOil's shareholders pursuant to the Arrangement was fair from a financial point of view.

Shareholder Meeting

On September 21, 2016, a special meeting was held to consider the Arrangement. The Arrangement resolution passed, with approximately 80% of the votes cast at the meeting in support of the Arrangement. Mulacek, and other shareholders that collectively held approximately 10% of the issued and outstanding InterOil shares, opposed the Arrangement.

Mulacek opposed the Arrangement because in his view, the Exxon transaction did not adequately represent the value he believed should be attributed to InterOil's interest in PRL 15. Mulacek testified that the contingent payments could be worth up to 37% of the value of the transaction. While the contingent payments could have added substantial value to the deal, the PRL 15 resource estimates were uncertain, and it is possible that contingent payments from either offer could have ultimately been worthless.

Decision of the Lower Court

The Lower Court recognized that although fairness opinions are only a part of a board's overall consideration of a transaction, they play a significant role in that assessment, as they show financial fairness has been assessed. The Lower Court held that the Fairness Opinion contained a number of serious deficiencies. The noted deficiencies in the Fairness Opinion and corporate process included:

  1. the absence of any discussion of the potential contingent value attributable to the PRL 15;
  2. the absence of any disclosure of the fees payable to Morgan Stanley or value of the Success Fee;
  3. the lack of reference in the Fairness Opinion to any specific documents reviewed; and
  4. the lack of facts, information or analysis in the Fairness Opinion to indicate what the opinion was based on, preventing a shareholder from being able to fairly consider the merits of the Arrangement.

The Lower Court also considered an opinion on the Arrangement prepared by Paradigm Capital. The opinion included details of the analysis used to arrive at its conclusion, and concluded that the consideration offered by Exxon was inadequate from a financial perspective.

The Lower Court held that the lack of an independent fairness opinion on a flat fee basis was further indicia of deficient discharge of the fiduciary obligations of InterOil's board given the conflicts involved. The Lower Court adopted the view of the Ontario Securities Commission ("OSC") expressed in Hudbay Minerals Inc. (Re)2, ("Hudbay") that fairness opinions prepared by advisors who are paid a success fee do not assist directors in demonstrating they have complied with their fiduciary duties.

The Lower Court also found, based on the opinion of an expert, that the process undertaken by the InterOil board in considering and recommending the Exxon arrangement was deficient from a corporate governance perspective and provided inadequate disclosure.

Ultimately, despite the deficiencies, the Lower Court approved the Arrangement, as it found the Arrangement to be fair and reasonable. The approval was primarily due to the fact that the Arrangement had been approved by InterOil's shareholders. The Lower Court stated that although the process may draw the criticism of the courts, the shareholders should not be prevented from realizing the substantive increases in value represented by the Exxon transaction. Mulacek appealed the Lower Court's decision, and the appeal was heard on October 31, 2016.

Court of Appeal Decision and Impacts

In overturning the Lower Court's decision, the Court of Appeal generally accepted the Lower Court's legal analysis but was unwilling to accept the finding that the transaction was fair and reasonable. The Court of Appeal's decision focussed primarily on three factors:

  • the corporate governance procedures were inadequate, particularly with regards to the Committee, and as a result deference could not be given to the business judgment of the directors;
  • there was no discussion or analysis of the value attributable to the PRL 15 and the value of potential contingent payments; and
  • the deficiencies in the Fairness Opinion and lack of an independent fairness opinion.

The Court of Appeal held that these three factors needed to be considered in the context of the guidance provided by the Supreme Court of Canada in BCE — that is, the courts have a responsibility to ensure an arrangement is fair to the interests of the parties whose legal rights are being arranged.

Corporate Governance Process

The Court of Appeal took issue with what they saw as the passive operation of InterOil's Committee. Of particular concern was that the CEO and another management director were involved in negotiating and approving the Arrangement when they had significant financial incentives to see the Arrangement proceed. The Court of Appeal held that in such cases where management is in a position of conflict, it is the board's responsibility to obtain independent financial fairness advice. Accepting the highest bid in a competitive bidding process will not alone be sufficient to demonstrate to the courts that a board discharged its duties and that a transaction is fair and reasonable. The Court of Appeal's decision suggests that independent directors should take the lead in negotiating transformative transactions rather than leaving it in the hands of management which may inherently cause apparent conflicts.

The Court of Appeal did not provide any guidance on whether the business judgment of the board would have been respected had they followed more robust procedures, notwithstanding the other disclosure deficiencies. Despite this lack of guidance, it is likely that an issuer with solid corporate governance policies and practices will receive deference from the courts on their decisions regarding major transactions. The business judgment rule as described in BCE provides directors with broad discretion to determine what is a reasonable and fair course of action, provided they follow a proper process in the discharge of their duties. To ensure compliance, boards should form an independent committee and document that committee's activities throughout the process.

Disclosure

The Court of Appeal agreed with Mulacek's argument that the shareholders did not receive adequate financial information on the deal. The Court of Appeal thought shareholders should have been provided with: (i) the potential value of the PRL 15; (ii) the impact of the cap on the CRP; and (iii) the range of value that shareholders would forego in the event the PRL 15 exceeded the cap. The Court of Appeal accepted opinion evidence of Mr. Peter Dey, a former chair of the OSC, that InterOil should have obtained advice on these values and provided that information to the shareholders. The Court of Appeal agreed, stating that without these value determinations, shareholders were not in a position to make an informed decision on the fairness of the Arrangement.

InterOil did provide evaluations of the PRL 15 resources in their annual information form, which was incorporated by reference into the circular sent to shareholders. The Court of Appeal's decision suggests that monetary value should have been attributed to the PRL 15 resources, despite their classification as development unclarified. Under National Instrument 51-101 — Standards of Disclosure for Oil and Gas Activities and related policies and notices, issuers are cautioned about providing information regarding this class of resource. This is due to the degree of risk and uncertainty inherent in estimates of the value of contingent resources, and the fact that such estimates may be misleading as a result. The Court of Appeal's decision raises uncertainty about what level of disclosure is expected from issuers in Arrangements, particularly where much of the value is attributable to contingent resources or other classes of resources other than reserves, and whether additional evaluation work will be required to determine the commercial viability of such resources. Notably, the Court of Appeal did not address the fact that even without taking into account the potential value added by the CRP, the Fairness Opinion stated that the transaction was fair.

Fairness Opinion

The Court of Appeal was also concerned about the Fairness Opinion. One area of concern was that Morgan Stanley did not provide reference to any specific documents that had been reviewed or any discussion or analyses of information that led them to their conclusion. This, in addition to the payment of the Success Fee, led to the Court of Appeal's finding that the Fairness Opinion was of no value in helping the board determine the fairness of the deal.

The Court of Appeal was of the view that InterOil should have engaged an independent financial advisor to provide a fairness opinion on a flat fee basis. The Court of Appeal agreed with the Lower Court, that an opinion provided pursuant to a success fee arrangement does not assist directors in demonstrating they exercised their fiduciary duties. The need for an independent fairness opinion in this case was exacerbated by the fact that management directors had such significant interests in seeing the deal succeed. Therefore, the Court of Appeal believed that the board needed independent advice on financial fairness to properly assess the Arrangement.

The Court of Appeal was unclear about their view of prior transactions where a fairness opinion has been considered and utilized by the board of directors in discharging their fiduciary duties in making a recommendation to shareholders, but not necessarily as evidence to the court as to the fairness of the transaction.

A fairness opinion may be used as an indicia of fairness in a transaction, but there is no legal requirement to obtain one. However, in light of this case and the OSC commentary in Hudbay, it may be prudent for issuers to obtain independent fairness opinions when proceeding with major transactions. While potentially not necessary when robust corporate governance procedures are in place and followed, obtaining an independent fairness opinion could provide further assurances that the board has discharged its duties in recommending a particular transaction. Issuers should consider insisting that the text of any fairness opinion to be provided to shareholders provides details of the information considered and discusses the financial analysis used to conclude that a deal is fair from a financial point of view.

Role of the Courts in Approval Process

The Court of Appeal held that due to the various deficiencies in the process, the shareholders were not provided with sufficient information to make an informed choice on the Arrangement. The Court of Appeal acknowledged that shareholders had a right to decide when an arrangement was in their best interests, but they also need to be in a position to properly evaluate their options. The Court of Appeal stated that in almost all plans of arrangement before the court, a majority of shareholders will have approved a transaction in what they see to be their own interests. However, a court must be satisfied that the transaction is objectively fair and reasonable in a more general sense. Reaching the conclusion that a transaction is fair and reasonable entails an analysis of the deal in accordance with BCE. Through the lens of this analysis, the Court of Appeal ultimately rejected the application due to the lack of discussion regarding the values of the CRP and the PRL 15 in a deal where there were potential conflicts of interest from both management and the financial advisor. As a result, the shareholders were unable to make an informed decision.

Conclusion

The decisions of the Lower Court and the Court of Appeal were clear on a number of matters: (i) court approval of a plan of arrangement is an important step that should not be overlooked; (ii) boards should strive to operate within the bounds of best corporate practice, particularly in the context of transformative transactions; (iii) disclosure must be sufficient to allow shareholders to make an informed choice, as courts cannot otherwise rely on shareholder support as an indicia of fairness; and (iv) fairness opinions provided pursuant to a success fee arrangement are of little use to a board in determining the financial fairness of a deal and the fairness opinion must provide details of the facts and analysis relied upon.

However, a number of open questions remain in the wake of the Court of Appeal Decision:

  • What level of management participation in negotiating a transaction is appropriate? Should this role be completely assumed by independent directors?
  • Can a board rely on a fairness opinion provided pursuant to a success fee when they have good corporate governance policies in place and adhere to them?
  • What level of reserves or resource disclosure and evaluation/valuation is required so that shareholders have adequate information to consider the transaction?
  • If a board of directors adheres to best corporate practices, how important are these other factors in an analysis of what is fair and reasonable?

It remains to be seen what course of action InterOil takes going forward. The Lower Court and Court of Appeal decisions can be found here, and here respectively.

Footnotes

1 2008 SCC 69

2 2009 CarswellOnt 2219

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.