Canada: OSC Decision Provides Guidance On Timing Of Disclosure Of A Merger Transaction As A Material Change

The Allegation

This was a hearing before the Ontario Securities Commission (the Commission) to decide whether Deborah Weinstein (Weinstein) authorized, permitted or acquiesced in a breach of the Securities Act (Ontario) (the Act) and acted contrary to the public interest by authorizing, permitting or acquiescing in AiT Advanced Information Technologies Corporation’s (AiT) failure to disclose forthwith the merger transaction between AiT and 3M Company (3M) as a material change by April 25, 2002, and in any event not later than May 9, 2002 (the Relevant Period).

AiT is a federally incorporated company located in Ottawa. At the time it was a reporting issuer in Ontario, and its shares traded on the Toronto Stock Exchange (TSX).

Weinstein is a partner in the law firm LaBarge Weinstein LLP in Ottawa, and practises in the areas of securities and corporate finance. At this time, she was outside legal counsel and a director of AiT.

It was alleged that AiT contravened Section 75 of the Act and engaged in conduct contrary to the public interest by failing to disclose forthwith the merger transaction (the Merger Transaction), between AiT and 3M, as a material change; and that AiT’s Chief Executive Officer (CEO) who was also a director, and Weinstein committed an offence pursuant to Section 122(3) of the Act and engaged in conduct contrary to the public interest by authorizing, permitting or acquiescing in AiT’s failure to disclose forthwith the Merger Transaction as a material change.

Prior to this hearing, AiT and its CEO had entered into a Settlement Agreement and so the hearing was held solely to determine the merits of the case brought against Weinstein.

In order to succeed, staff of the Commission (Staff) would have had to prove that:

  1. The status of the negotiations with 3M constituted a "material change" in the business, operations or capital of AiT during the Relevant Period as alleged by Staff, in which case AiT would have been required by Section 75 of the Act to issue a news release forthwith providing notice of the material change and file a material change report, or in the alternative, file a confidential material change report with the Commission; and
  2. Weinstein in her capacity as a director of AiT, authorized, acquiesced or permitted the breach by AiT of Section 75 in contravention of subsection 122(3) of the Act and contrary to the public interest under subsection 127(1) of the Act.

The Commission held that during the Relevant Period no "material change" had in fact occurred. It therefore dismissed the allegations against Ms. Weinstein.


Events before April 25, 2002

The events leading up to April 25, 2002 can be summarized as follows:

  1. On February 28, 2002, the CEO of AiT and an employee of 3M met in Ottawa to discuss opportunities for AiT and 3M. As a result of this meeting, AiT deferred a decision its Board had taken on February 19, 2002 to engage an advisor to investigate strategic opportunities for AiT — something necessitated by the failure of AiT to raise financing during the fall of 2001.
  2. AiT was informed that 3M would use a detailed process to conduct their due diligence and to make a decision on the proposed purchase of AiT. The timetable included two phases of due diligence: first, an overall high-level version of due diligence, and second, a much more defined and rigorous review process that 3M adhered to. The latter required certain approvals by the 3M Board and Executive.
  3. Between March 26 and April 24, 2002, the first phase of due diligence was conducted, which included a visit to AiT by 3M mid-level management. At this time AiT gave management presentations and product demonstrations. In addition, a series of valuation discussions took place.
  4. On April 24, 2002, a value was agreed upon for AiT between the CEO and several of 3M’s mid-level managers. The deal was structured as a share purchase. It was agreed the next step was to inform the AiT Board.

The April 25 Board meeting and the Letter of Intent

Given Staff’s allegation that AiT experienced a "material change" on April 25, 2002, the events of that day and those following are important.

At the AiT Board meeting on April 25, 2002, the CEO updated the AiT Board regarding the phone calls and meeting with 3M since the beginning of April and asked for the AiT Board’s support for the proposed valuation of AiT, in order to enable 3M to proceed with the next step in the negotiations — the preparation of a non-binding LOI.

The minutes of the AiT Board meeting on April 25, 2002 reflect that the Board was informed of the discussions, that 3M had offered to draft a non-binding letter of intent to acquire all the shares of AiT, and that the parties had agreed to work diligently toward a definitive agreement and announcement.

The minutes of the meeting record that, following this update, the AiT Board unanimously "approved the recommendation to shareholders of the acquisition by 3M of all of the outstanding shares and options in [AiT] at a cash purchase price of $2.88 per share […]." In addition, those minutes state that the approval was subject to "… confirmation of the fairness of this price by AiT’s financial advisor, CIBC Investment Banking, and satisfaction of the Board with the final terms of the transaction, including the tax consequences to the Company’s shareholders." At the OSC hearing, evidence was presented that the minutes of this meeting had not been drafted until late June 2002 and had been amended in early July 2002 to conform with the disclosure included in AiT’s information circular for the shareholders’ meeting at which approval of the transaction was obtained.

On April 26, 2002, the CEO signed the LOI on behalf of AiT. That letter stated, among other things, that any definitive agreement would be subject to due diligence and agreement on the definitive terms of the final agreement. It also stated that the indication of value and the letter itself were non-binding.

Events Subsequent to April 25, 2002

The events following the Board meeting on April 25, 2002 can be summarized as follows:

  1. On May 1, 2002, AiT received 3M’s second due diligence checklist, which outlined the issues to be discussed and addressed during the second due diligence visit. AiT had previously prepared due diligence binders for the first due diligence visit on March 26, 27 and 28, 2002, however, the volume of information required by the May 1, 2002 checklist was much greater.
  2. On May 7, 8 and 9, 2002, the second due diligence visit took place in the offices of Ms. Weinstein’s law firm, LaBarge Weinstein, and of AiT. Close to 20 people attended this session on behalf of 3M, including a new group from 3M Canada.
  3. On May 9, 2002, the CEO was made aware, by an AiT administrative assistant, that rumours were being circulated by AiT employees that 3M was buying AiT. That day, AiT received a phone call from Market Regulation Services Inc. (RS) regarding an unusual increase in the trading volume and price of AiT shares. AiT informed RS that AiT did not have any news and was not planning on sending out any news. RS encouraged AiT to send out a press release. At the end of the day on May 9, 2002, after trading had closed, AiT issued a press release entitled "AiT Comments on Recent Stock Activity." It stated that AiT was "exploring strategic alternatives that would ultimately enhance value for our shareholders." It further stated that AiT had "no further announcements to make at this time" and did "not intend to provide updates in respect of this process as we consider the various alternatives available to AiT." No material change report was filed with respect to the press release.
  4. On April 26, 2002, after the signing of the LOI, the CEO requested counsel to prepare a first draft of a pre-acquisition agreement as a way to move the potential transaction forward. 3M subsequently provided its draft of an agreement. Approximately ten drafts went back and forth during the negotiation process to reach the final merger agreement. The structure of the transaction ultimately took the form of an amalgamation for tax reasons, not a share purchase, so that the merged company could utilize AiT’s tax losses.
  5. On May 14, 2002, 3M’s Board of Directors approved the acquisition of AiT, subject to the 3M CEO’s approval of the due diligence report and the integration plan. A number of assessments by 3M took place from May 14 to 20, 2002, including: sales and marketing assessment, manufacturing assessment, finance assessment, R&D assessment, IT assessment, real estate assessment, service assessment, insurance assessment, human resources assessment, environmental health and safety assessment, and office of intellectual property assessment. On May 21, 2002, the due diligence report and integration plan was completed. On that date, the 3M CEO also gave final approval of the transaction following an internal 3M management meeting held to consider the matter and the approval of the report and plan.
  6. On May 22, 2002, the AiT Board approved the definitive Merger Agreement and related documents and received a fairness opinion from CIBC Investment Banking, which concluded that the consideration offered to the shareholders of AiT in connection with the Merger Transaction was fair, from a financial point of view, to shareholders.
  7. On May 23, 2002, AiT and 3M executed the definitive Merger Agreement.
  8. On the same day, AiT issued a press release and subsequently filed a material change report announcing that it had entered into the definitive Merger Agreement.

The Decision of the Commission

The Commission concluded there was no clear and cogent evidence that a material change occurred during the Relevant Period and dismissed the allegations against Weinstein. In so doing, they made the following findings and observations:

  1. The standard of proof applicable in Commission proceedings is the civil standard of the balance of probabilities. Where the allegations relate to an individual’s professional career and livelihood, it was of the view that this burden can only be discharged by clear and cogent evidence. As stated in Re Lett (2004), 24 O.S.C.B. 3215 at paragraph 31: Requiring proof that is "clear and convincing and based upon cogent evidence" has been accepted as necessary in order to make findings involving discipline or affecting one’s ability to earn a livelihood. This finding is important as it may distinguish this panel’s reluctance to accept Staff’s position on some evidentiary issues that might not have been the case had the allegations been made against only the issuer. The Commission’s treatment of the amendment of the crucial April 25 Board meeting minutes is unusual in that instead being concerned that minutes had been altered almost three months after the meeting, they used the amended minutes as evidence of the true state of affairs.
  2. A material change can occur in advance of the execution of a definitive binding agreement, and therefore, the determination of whether a material change has occurred is not a "bright-line" test. The assessment of whether a material change has occurred, particularly in the context of an arm’s-length negotiated transaction, will depend on the specific facts and circumstances of each case and will vary case to case.
  3. The fact that negotiations are underway may be material to investors, but that in itself does not require disclosure. This may be a material fact that would mean trading in the stock would be prohibited, as would disclosure of the fact to those not requiring such information in the ordinary course of business, but this does not make the fact disclosable as a material change. In the situation under review, in order to be a material change, the fact needed to relate to "a change in the business, operations or capital of the issuer" or a decision to implement such a change made by the AiT Board or a decision to implement such a change by AiT management, who believed the confirmation of the decision by the Board was probable. The legislature specifically chose to distinguish material changes from material facts and to create different disclosure requirements for them. This was emphasized in Kerr v. Danier Leather Inc., [2005] O.J. No. 5388 (C.A.), and adopted by the Commission in this hearing.
  4. While noting that the Act is silent regarding the definition of "implement," the Commission noted that it had addressed this issue in Re Burnett (1983), 6 O.S.C.B. 2751 where it stated: "An intention by a person or company to do something, which once implemented would constitute a material change in the affairs of the reporting issuer, but which at the time the intention is formed, for reasons beyond the control of the person or company, is still not capable of achievement, is not ordinarily a material change in the affairs of the issuer. As the Commission stated: "A decision by a board of directors of an issuer to pursue a transaction that is not yet within its control to put into effect (and therefore is not capable of achievement) would not ordinarily be a material change in the business, operations or capital of an issuer at that point in time unless the board has reason to believe that the other party is also committed to completing the transaction."
  5. In considering whether a board resolution constitutes a decision to implement a material change within the definition of "material change" in the Act, in the context of an arm’s-length negotiation of a merger transaction before a definitive agreement has been reached, there must be sufficient evidence by which the board could have concluded that there was a sufficient commitment from the parties to proceed and a substantial likelihood that the transaction would be completed. On this point the Commission found that there was insufficient evidence available at the time of the signing of the letter of intent to determine that: (i) 3M was committed to proceed with a transaction; and (ii) there was a substantial likelihood that the transaction being discussed would be completed. As such, no material change had occurred. The Commission was unable to conclude from the evidence that 3M was committed to the transaction at the LOI stage, or that the AiT CEO or the AiT Board could reasonably conclude at that time that there was a substantial likelihood that the LOI conditions would be satisfied and that the transaction would be completed, citing the following:
  • The AiT CEO and several AiT directors had serious reservations that the due diligence and other stages of 3M’s internal approval process would be favourably determined so that 3M could complete the transaction.
  • With an organization as large and as complex as 3M, it is important to distinguish between the business team’s enthusiasm for doing a transaction that will enhance their operating unit’s size and contribution to the 3M organization’s success, and the corporate-level approvals that had to be in place before 3M was committed to proceed with the acquisition of the AiT shares. Here it was clear that at the time the LOI was signed, a second level of due diligence was necessary, and it was not just a pro-forma exercise. Secondly, it was clear the certain corporate approvals required within 3M had not yet been given.
  • AiT had an experienced Board that was knowledgeable about corporate-level approvals and that was aware the 3M negotiation had been conducted by a "middle management" team three levels below the CEO. This was not a transaction negotiated by 3M’s senior management, whose approval would have been required. There was "no clear and cogent evidence" adduced by Staff that [the CEO] or the AiT Board members had any factual basis by April 26, 2002 to conclude that the essential 3M corporate-level approvals were reasonably likely to be obtained, or that there was a substantial likelihood that 3M would complete the transaction."

Practice Points

Although there is no bright-line test, negotiations do not need to be disclosed until the parties are committed to proceed with a transaction as evidenced by their actions and there is a substantial likelihood that the transaction being discussed will be completed. Under some unusual circumstances, this could occur at the time a letter of intent is signed, notwithstanding the finding in AiT.

Premature disclosure of a transaction is very problematic. It is the role of counsel to advise clients about this issue at the beginning of transactions and to ensure the parties to the transaction do not unwittingly cross the disclosure threshold.

At the commencement of negotiations, it is important for the parties to specify to each other the details of their approval process, and this should be recorded. As the negotiations progress, those areas requiring further discussion before being considered agreed upon must be listed. Thirdly, the parties should monitor developments and regularly determine that the deal has not progressed enough to make disclosure necessary. Lastly, communications between the parties and board minutes must properly reflect the level of commitment to a transaction and should include details of those activities that remain outstanding before both parties can commit. Obviously, a Board should not make a decision without first considering all factors relevant to the decision. Recording that the Board has approved a transaction subject to "confirmation of the fairness of the price" is not helpful as the Board clearly should make its decision after reviewing the fairness opinion and any qualifications to it.

In determining whether to make disclosure at any point in the negotiations, counsel for an issuer should consider the following, once it has been determined that a fact is material to the reporting issuer who is one of the negotiating parties and it becomes necessary to determine whether the material fact amounts to a material change:

  1. Have all material terms been agreed upon or is it likely they will be agreed upon given the conduct of the parties and the course of the negotiations? In making this determination, it is clear that the Commission will look at the conduct of the negotiation to see if, in fact, serious issues remain unresolved. Therefore, if such issues form the basis for non-disclosure, they should be recorded.
  2. Has each party to the transaction received the necessary internal approvals required to bind themselves to the agreement or is it likely that such approval will be granted? The Commission noted that 3M’s senior management had not been involved in the discussions, so that despite the enthusiasm of 3M’s middle management, the latter’s assurances were not the final word — whereas the heavy involvement of the AiT CEO and the AiT Board might have been taken as evidence of the commitment of AiT.
  3. In determining if approval is likely to be granted, what is the normal process each party follows in negotiations of this type? Is it reasonable to conclude that the party is likely committed given its usual process leading up to formal approval? The fact that 3M had a formal due diligence process, and that they followed it in previous transactions and had articulated it to the AiT Board was important. From that, it was clear that the second stage due diligence to be conducted by 3M was a serious review and that the preliminary due diligence review was merely an exercise in 3M agreeing to look more closely at AiT.

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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