Canada: Increased Scrutiny On Board Process In Arrangements

Last Updated: November 29 2016
Article by Jack Schroder


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.


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.


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.


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.


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.

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