Canada: OSC Raises Some Uncertainty On Prevailing Practice On Fairness Opinions And On Directors’ Duties In Face Of Shareholder Complaints

Copyright 2009, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Mergers & Acquisitions, May 2009

On April 28, 2009, the Ontario Securities Commission released its reasons for its January 23, 2009 decision on the HudBay Minerals Inc./Lundin Mining Corporation transaction that was proposed late last year.

The reasons for its decision include two statements that could create uncertainty for directors in the context of proposed M&A transactions. One statement related to the ability of a board of directors to rely on a fairness opinion provided by a financial advisor that was receiving a fee that depended upon the success of the transaction. The statement could signal a heightened sensitivity to this issue by the OSC that might have an impact in the retention of financial advisors and the structuring of their compensation arrangements in a wide variety of transactions. The other statement raises issues on how directors should respond to shareholder desires to be given a vote on proposed transactions in cases where such votes are not required by law.

The HudBay/Lundin Transaction

The proposed transaction would have resulted in HudBay issuing shares in excess of 100% of its outstanding share capitalization to the Lundin shareholders, resulting in severe dilution to existing shareholders. It was vigorously opposed by several HudBay shareholders, and the market price of HudBay shares declined significantly after the announcement of the transaction. The case involved a consideration by the OSC of how the TSX had reviewed the proposed transaction, and whether the transaction should have been allowed to proceed without the approval of the shareholders of HudBay. The OSC ruled that the TSX did not properly consider the transaction and ruled that the transaction could not proceed without HudBay shareholder approval. For a review of this decision, please see our January 2009 Blakes Bulletin on Mergers & Acquisitions: Ontario Securities Commission Determines Fair Treatment of Shareholders Requires Purchaser to Obtain Shareholder Approval for Dilutive Acquisition.

Financial Advisor Issue

In the reasons for its decision, the OSC noted that it had concerns with the retention of a financial advisor to the special committee of HudBay. The OSC stated that the financial advisor "among other things, is advising the Special Committee whether the Transaction is fair from a financial point of view to HudBay shareholders." In particular, the financial advisor was "to receive a signing fee when the arrangement agreement is entered into and a much larger success fee payable if the Transaction is consummated." The OSC went on to say:

"Such fees create a financial incentive for an advisor to facilitate the successful completion of a transaction when the principal focus should be on the financial evaluation of the transaction from the perspective of shareholders. While the Commission does not regulate the preparation or use of fairness opinions, in our view, a fairness opinion prepared by a financial advisor who is being paid a signing fee or a success fee does not assist directors comprising a special committee of independent directors in demonstrating the due care they have taken in complying with their fiduciary duties in approving a transaction." (emphasis added)

The OSC did not decide this case on the basis of the retainer of the financial advisor in question, and therefore we do not know how the OSC would have dealt with the issue had the transaction been challenged solely on the basis of the advisor's perceived conflict. Indeed, these comments are made in a section at the end of the reasons that is headed "Other Matters". It may be that the OSC considers these comments to be obiter. However, it is clear that the OSC considered the utility of the fairness opinion given on this transaction was seriously undermined by the existence of the success fee to be received by the advisor.

Implications Of OSC Statement

The statement has the potential to cause market participants to consider significant changes in the structuring of customary retainers for corporate transactions. It also may have implications on the number of financial advisors giving business opinions to a party in respect of a transaction. A survey conducted by Blakes of the 50 most significant M&A deals completed from mid-2007 to mid-2008 indicated that in only about one-quarter of the deals was a second financial advisor retained to provide a fairness opinion.

Typically, issuers and advisors will consider the retainers of financial advisors on a case-by-case basis, taking into account the particular facts associated with the issuer and transaction in question; in appropriate cases, second advisors may be retained to deal with potential conflicts or other issues. There are often good reasons why an advisor fills multiple roles on a transaction, including the fact that the familiarity of an advisor with the issuer in question may be of particular assistance to a special committee in allowing the special committee to complete its work, enhance shareholder value and receive a fairness opinion within the tight timeframes that often are associated with substantial transactions.

However, the categorical nature of the statement by the OSC may bring into doubt the advisability of a board or special committee relying on a fairness opinion provided by a financial advisor that is earning a success fee on the transaction. The statement should be taken into consideration by special committees, since having a fairness opinion is a key part of the due diligence of the committee and evidence that it, and the board that appointed it, have satisfied their fiduciary duties. This OSC comment may result in greater use by parties to a transaction of second financial advisors to provide fairness opinions on a flat-fee basis.

Ability To Rely On Legal Rights

The decision indicates that some HudBay shareholders, including the applicant to the OSC (which acquired its shares after the announcement of the transaction, in the expectation that it could profit from a termination of the deal), advised management of their opposition to the transaction almost immediately after its announcement. The announcement stated that the Lundin shareholders' meeting would be held in the first quarter of 2009 and that the transaction would close prior to May 30, 2009. Three days after the announcement, the applicant and other shareholders requisitioned a HudBay shareholders' meeting to replace the existing board of directors. The request was rejected on the basis that the parties were not registered shareholders and therefore had no right to requisition a meeting. A further, effective, requisition was acknowledged by HudBay on December 21, with the statement that it would respond to the request by January 2, 2009. On December 22, Lundin issued the notice and proxy circular for its shareholders' meeting to approve the transaction, which had been accelerated to January 26, 2009. HudBay then fixed the date for its requisitioned shareholders' meeting as March 31, 2009.

As part of its decision, the OSC addressed the actions taken by HudBay and Lundin in dealing with the opposition of some HudBay shareholders to the transaction. It stated, at paragraph 248:

"While HudBay and Lundin may have the legal right to make these decisions under corporate law, they appear to us to be actions taken for the purpose of frustrating the legitimate exercise by HudBay shareholders of their right to require a shareholders' meeting to consider the replacement of the HudBay board, in effect, a shareholder vote on the Transaction. If the Transaction is completed before the requisitioned shareholders' meeting, the principal purpose for that meeting will be frustrated. That is manifestly unfair to the shareholders of HudBay. If shareholders wish to challenge a transaction by exercising their fundamental right to elect or remove directors in accordance with their legal rights to do so under corporate law the board of directors should not be permitted to actively frustrate that objective in this manner."

At paragraph 350, the OSC, in commenting on the foregoing, stated:

"These considerations raise serious concerns as to the appropriateness of HudBay's governance practices as they relate to the approval of the Transaction and the fair treatment of HudBay shareholders."

These statements, unlike those relating to the utility of fairness opinions provided by incented advisors, are not under the "Other Matters" heading in the decision. They indicate a serious concern on the part of the OSC respecting reliance by issuers on what the OSC acknowledges are their legal rights. Read literally, these paragraphs suggest that directors should comply with requests from shareholders (albeit, in this case a vote on replacing the existing board of directors) if some shareholders are unhappy with the board's decision on a proposed transaction, even though there is no legal requirement that the shareholders approve the transaction. It is difficult to be sure of the intended scope of these statements and the level of shareholder concern that would be considered by the OSC to be material enough to warrant special treatment by the directors.

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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