M&A Developments in 2005
December 2, 2005
In Canada, unlike the United States, there is a statutory legal requirement that cash take-over bids be financed prior to the launching of the bid, so that it is not possible to make a take-over bid in this jurisdiction conditional on securing the necessary financing. In Ontario, the rule is in Section 96 of the Ontario Securities Act which provides that where the consideration offered in a take-over bid is to be paid in cash, the bidder must make "adequate arrangements prior to the bid to ensure that the required funds are available to effect payment in full for all securities that the offeror has offered to acquire".
In late 2004 and early 2005, a hostile bid was launched for a Toronto-based financial software development company named Financial Models Company Inc. The circumstances were highly unusual in that although the Board of Directors of Financial Models opposed the bid, it was coming from the President and Chief Executive Officer of Financial Models who was also one of the founders of the company and who owned some 40% of its outstanding shares. The Board of Directors was resisting the offer and seeking to solicit higher bids from other parties. Prior to launching its hostile bid, the bidder sought to secure the necessary financing by signing a term sheet with a private equity fund in the U.S. That term sheet provided that the cash needed in the take-over bid would be available subject to a number of conditions, some of which appeared to be different from the conditions in the bid itself, and all of which had to be satisfied within the absolute discretion of the private equity fund. Financial Models, looking for ways to beat back the hostile bid, challenged the adequacy of the financing and pointed to Section 96 of the Ontario Securities Act. The Ontario Superior Court of Justice in BNY Capital Corp. vs. Katotakis found that the hostile bid did not comply with Section 96. The Court’s judgment included the following statement:
"Adequate arrangements" has been interpreted to mean that there must be accurate, clear and unequivocal assurance that the financing is in place in the sense that a public shareholder contemplating tendering his or her shares to the bid can be unequivocally assured that the funds are available to complete the purchase."
This interpretation of Section 96 imposes a very high standard with respect to the availability of financing prior to the commencement of a bid. Bidders in Canada very commonly have not satisfied all of the conditions to drawing down funds under their credit arrangements prior to the completion of the take-over bid process. How then can the shareholders of the target company know with "unequivocal assurance" that the bidder’s financing will not fall away?
In an attempt to clarify the situation, the Canadian securities administrators have proposed a new Rule 62-503 which is very short and simply provides as follows:
"For the purposes of Section 96 of the Act, the financing arrangements required to be made by the offeror prior to a bid may be subject to conditions if, at the time the bid is commenced, the offeror reasonably believes the possibility to be remote that the offeror will be unable to pay for securities deposited under the bid solely due to a financing condition not being satisfied."
The securities administrators have invited comment on this proposed Rule and it is possible the final version will differ from what is set out above. The language of the proposed Rule is sufficiently different from what the Court said in BNY Capital Corp. vs. Katotakis that one can imagine circumstances that might satisfy one rule but not the other. Hostile take-over bids may have a particular challenge because they will often have fairly broad conditions in both the financing and the bid, and the target company sometimes conducts itself so as to cause those conditions not to be satisfied. How in that circumstance does the hostile bidder satisfy itself that it has complied with the Canadian securities administrators’ proposed Rule by being in a position to satisfy itself that it reasonably believes the possibility to be remote that the financing will be unavailable, or that it has complied with the tougher test set by the Court in BNY Capital Corp. vs. Katotakis that public investors will be "unequivocally assured" that the funds are available?
Presumably, either a more detailed Rule from the Canadian securities administrators, or further litigation, will be necessary to resolve these issues.
Conflicts Continue to be an Issue
There are a relatively small number of legal firms in each of the cities across Canada that are regularly active in the public company M&A market. The result has been continuing problems for these law firms and their clients from conflicts of interest.
The most recent case, GMP Securities Ltd. vs. Stikeman Elliott LLP (Ontario Superior Court of Justice, August 4, 2004) involved a situation where the law firm concluded it had no conflict of interest and could proceed representing different clients with respect to different transactions, but the Court disagreed.
GMP Securities Ltd. is a Toronto-based investment banking firm that was retained in March 2004 to provide investment banking and underwriting services to Wheaton River Minerals Ltd. for a proposed transaction whereby Wheaton would sell certain assets to a third party and GMP would provide advice on the transaction and assist with the financing. GMP retained the very experienced and highly-regarded firm of Stikeman Elliott to represent them. The Stikeman’s lawyer reviewed an engagement letter for GMP and then provided advice with respect to the proposed transaction generally and how it could be made to work with various other events that were transpiring about the same time.
Some months later, in May 2004, another partner at Stikeman Elliott received a call from Coeur d’Alene Mines Corporation who wanted to approach Wheaton River about a friendly merger. In Canada, we have the Supreme Court of Canada decision in R. v. Neil (2002) which defines a duty of confidentiality and a duty of loyalty owed by a law firm to its client. The general rule set out in that case is that a lawyer may not represent one client whose interests are directly adverse to the immediate interests of another current client – even if the two mandates are unrelated – unless both clients consent and the lawyer reasonably believes that he or she is able to represent each client without adversely affecting the other.
Stikeman Elliott took the position at the time it accepted the Coeur retainer that the interests of Coeur and GMP were not directly adverse. Coeur was proposing to make a friendly approach to Wheaton and the law firm speculated that if a friendly merger resulted, GMP might achieve a retainer for a financing for the merged entity. Before the Court, Stikemans argued that the proposed transaction had stalled in any event and that GMP and Wheaton were now seeking to have Stikeman Elliott disqualified from continuing to act for Coeurs for strategic reasons. By this time, of course, the friendly approach from Coeurs had been rebuffed by Wheaton and Coeurs was proceeding with a hostile take-over bid.
The Ontario Court ruled that Stikeman Elliott was disqualified from continuing to act for Coeurs. It accepted the evidence of GMP and Wheaton that if the Coeur offer succeeded, the asset transaction from which GMP stood to receive a substantial fee would not proceed.
The result has been increased vigilance by Canadian law firms around issues of conflict of interest.
Dual Class Share Structures - The Molson-Coors Merger
Dual class share structures are one of a variety of methods used to allow a controlling shareholder or a group of shareholders (often a founder or members of the founder’s family or management) to continue to control a company while permitting it to raise capital through the issuance of additional equity. The company creates two classes of shares, one of which has superior voting power to the other. Often established in anticipation of an IPO, the only consistent difference between the two classes of equity is in the voting rights or the number of votes attached to the shares.
The Molson-Coors merger in February 2005 presents a cross-border transaction where two dual class share companies merged to continue with a dual class share structure. Both companies were family controlled corporations prior to the merger. A Coors family trust held all of the voting shares of Adolph Coors Company ("Coors"). Molson family members held 50.45% of the voting shares of Molson Inc. ("Molson") with the remaining 49.55% held by public shareholders.
In order to achieve the goal of combining the two brewing companies, a mechanism needed to be found that would obtain the approval of the non-voting shareholders of the two companies while satisfying the controlling family shareholders’ desire that they preserve their control of the merged company. The structure was achieved through a negotiated merger agreement. The Molson and Coors controlling family shareholders agreed to enter into a voting trust agreement pursuant to which they agreed to vote together on significant matters.
The merger was achieved through the use of a court approved arrangement under the Canada Business Corporations Act whereby Molson shareholders exchanged their shares for shares of Coors. Coors amended its certificate of incorporation and by-laws to change its name to Molson Coors Brewing Company ("Molson Coors") and adopted a new governance structure. Shareholders of both companies were effectively asked to consider a merger which would provide a structure similar to that of the companies in which they had previously invested, but with two controlling family groups instead of one. The share conditions of the non-voting shares were amended to give the holders the right to elect three directors, a right enjoyed previously by the holders of the Molson restricted voting class of shares. A conversion feature was added to permit the voting shares to convert to non-voting shares, which was a feature of the Molson voting shares.
The certificate of incorporation and by-laws of Molson Coors provide for a nominating committee and two sub-nominating committees, whose members are selected by the controlling family groups. The board is restricted to fifteen members, a majority of whom must be independent. The three directors elected by the holders of Class B (non-voting) shares are nominated by the full board. The two sub-nominating committees, together with an independent director named by them, form a nominating committee. Five directors, a majority of whom must be independent, are nominated by each sub-committee. Initially, the two former CEOs were also named as directors.
The certificate of incorporation also requires the approval of two-thirds of the members of the board of directors for certain significant matters such as the compensation of the CEO, an increase or decrease in the number of directors, assignment of directors to committees, amendments to the articles and payment of dividends.
Introduction of Alberta Unlimited Liability Companies
Bill 16 of the Alberta legislature proposing to amend the Business Corporations Act (Alberta) ("ABCA") was proclaimed in force on May 17, 2005. Among various other amendments, the ABCA now provides for the creation of Alberta unlimited liability corporations ("ULCs"). In Canada, ULCs were previously permitted only in Nova Scotia under the Nova Scotia Companies Act (the "NSCA"). Nova Scotia ULCs have been attractive for U.S. businesses expanding into Canada because of their "hybrid" nature for U.S. income tax treatment. A hybrid entity in this context is a corporation for Canadian income tax purposes and a disregarded entity or partnership for U.S. income tax purposes. A common reason to use a ULC is to consolidate ULC activities with the U.S. parent for U.S. income tax purposes, allowing deductions of the ULC, including interest expenses, to be treated as having been incurred by the U.S. parent. Hence, the new law may afford U.S. corporations an alternative to the Nova Scotia ULC.
The following is a list, although not exhaustive, of some differences between the ABCA and NSCA which are relevant when choosing a ULC jurisdiction:
- Conversion to a ULC - A non-Alberta corporation may continue into Alberta directly as a ULC whereas the procedure for continuing into Nova Scotia as a ULC requires a transfer of all the shares of the continuing corporation into a new ULC and a subsequent winding-up or amalgamation of the continuing corporation with the new ULC. An existing Alberta corporation may convert to a ULC by simply filing articles of amendment or by amalgamating with an existing ULC.
- Amalgamations – The ABCA permits short-form amalgamations (a simpler procedure requiring only board approval for parent/subsidiary or subsidiary/subsidiary amalgamations) and long-form amalgamations which typically require two-thirds shareholder approval. Nova Scotia permits only long-form amalgamations which require three-quarters shareholder approval as well as court approval. In Nova Scotia, certain internal reorganizations also require court approval.
- Return of Capital - A return of stated capital by a ULC to its U.S. parent shareholder can occur free of Canadian withholding tax. To reduce ULC share capital, Alberta requires a two-thirds shareholder approval and satisfaction of the solvency test, whereas Nova Scotia requires a three-quarters shareholder approval, satisfaction of the solvency test and, in certain cases, court approval. The simplified process in Alberta regarding both amalgamations and returns of capital will be helpful for some transactions.
- Contributions of Capital – The ABCA permits direct contributions of capital without the issuance of shares. Nova Scotia does not permit such contributions.
- Liability, Residency and Duties of Directors – The ABCA codifies director liability, while the NSCA relies on the common law fiduciary duty for determining director liability.
As a result of the amendments to the ABCA, one quarter of the directors of an Alberta ULC, or any other corporation, must be resident Canadians. Nova Scotia has no Canadian residency requirements for ULC directors. Under the amended ABCA, directors are charged with managing, or supervising the management of, the business of the ULC, under the statutory duty of care, diligence and skill of a reasonably prudent person in comparable circumstances. The NSCA, on the other hand, provides shareholders with the power to manage the ULC, subject to the subjective common law duty of care which requires acting honestly and reasonably.
There are, it should be noted, certain differences between the Nova Scotia and Alberta corporate statutes relating to shareholder liability. Under the amended ABCA, shareholder liability is unlimited in extent and joint and several in nature for any liability, act or default of the ULC, including those arising within two years after dissolution. In Nova Scotia, shareholders are liable only to creditors who obtain a court order for winding-up the ULC or if the ULC becomes bankrupt. In addition, shareholders who dispose of their shares of a Nova Scotia ULC more than one year before winding-up is commenced have no liability at all. Consequently, shareholders of a ULC established in Alberta have greater risk of liability. However, despite greater potential for liability in Alberta, a U.S. corporation with limited liability or other entity is generally inserted between ULC shareholders and the ULC to shield shareholders from such liability in any event.
Proposed Changes to Investment Canada Act ("ICA")
In late 2004, the Canadian federal government began to work to reform the ICA and introduced Bill C-59 , An Act to amend the Investment Canada Act, in parliament on June 20, 2005. Bill C-59 has received its first reading and its second reading is expected to occur this fall at which point it will be referred to the House of Commons Standing Committee on Industry, Science and Technology for further consideration. Under the proposed amendments, the ICA will now recognize "the importance of protecting national security". The scope of potentially reviewable investment is very wide, and no guidance is provided as to what type of transaction might be subject to screening. The term "national security" is not defined, there are no time frames given for the government review process, and a national security review can be ordered even after an investment is completed.
If the minister of industry has reasonable grounds to believe that a non-Canadian investment "could be injurious to national security", the minister will notify the non-Canadian investor to refrain from implementing the investment pending the review. The Governor in Council then decides whether a full national security review is warranted. If so, the minister will conduct an investigation. The investor will have an opportunity to make in-person representations to the minister as to why national security is not threatened by the investment. The minister will either accept the investment or make a report to the Governor in Council. The Governor in Council may order that the investment proceed or proceed subject to conditions. In the case of a completed investment, the Governor in Council could make an order of divestiture.
At this early stage of the Parliamentary process, many questions remain unanswered. While the Bill is likely to be further clarified before it passes into law, and the Minister has stated that national security reviews under Bill C-59 are likely be rare, there is a major potential impact on those transactions subject to review.
Privacy Obligations Relating to the Disclosure of Personal Information During the Course of a Business Transaction
The Alberta Information and Privacy Commissioner published a report in July 2005 which clarifies privacy obligations relating to mergers and acquisitions. The report was issued pursuant to Alberta’s Personal Information Protection Act, (PIPA), but the requirements could be applicable under other private-sector privacy statutory regimes.
An Alberta company (Builders) was acquiring securities of a target company (Remote) and ultimately amalgamated with it. The purchase and sale agreement between Builders and Remote included representations and warranties, which required Remote to provide schedules including a list of employee names, a list of employment agreements and details regarding employee benefits plans. The employee schedule identified Remote employees, but also provided their home addresses and social insurance numbers. Remote provide the schedule to its legal counsel, who in turn provided it to legal counsel for Builders. Because the agreement with Remote was considered a material contract, Builders’ legal counsel filed the agreement including the schedules on SEDAR (the Canadian equivalent of EDGAR). It was unclear whether either law firm had reviewed the contents of the schedule. The Commissioner held that the disclosure did not comply with the obligations under PIPA as although the agreement was a "business transaction" allowing for disclosure of personal information without consent, the disclosure of the home addresses and SINs of employees was not "necessary" for the purposes of the transaction or the securities filing. The Commissioner was critical of the lack of attention to the impact of privacy laws shown by the law firms involved, stating "Privacy laws are complex, and have implications for their clients on many different types of transactions, including mergers and acquisitions…"
Taxation of Payments for Restrictive Covenants
Draft legislation released by the Department of Finance on July 18, 2005 contained revised proposed amendments to the Income Tax Act (Canada) to deal with the taxation of certain restrictive covenants, including non-competition payments. The general purpose of the new provisions is to prevent the further application of decisions of the Canadian Federal Court of Appeal which held that amounts received by shareholders for non-competition covenants in a share sale context were non-taxable.
Pursuant to proposed subsection 56.4(2), amounts received or receivable in consideration for a restrictive covenant is a receipt fully taxable as ordinary income, subject to important exceptions. For this purpose, a "restrictive covenant" is broadly defined to be "an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer (other than an agreement or undertaking for the disposition of the taxpayer’s property or for the satisfaction of an obligation described in section 49.1 that is not a disposition), whether legally enforceable or not, that affects, or is intended to affect, in any way whatever, the acquisition or provision of property or services by a taxpayer or by another taxpayer that does not deal at arm’s length with the taxpayer." Of interest to non-resident vendors, amounts subject to the new rules may also be subject to Canadian withholding taxes in the absence of the elections described below.
In the case of asset sale transactions, where the amount is an eligible capital receipt (i.e., on account of goodwill of a business for Canadian income tax purposes), there is an important exception from the general rule requiring income treatment for non-compete payments. In particular, where the parties file a joint election there will be no inclusion under subsection 56.4(2) and, therefore, the non-compete amount would be taxable in accordance with the normal regime for eligible capital property (goodwill).
In the case of share sales, there is another relevant exemption that provides relief from ordinary income treatment where the recipient of the payment has disposed of an "eligible interest" to an arm’s length party and a joint election is made. "Eligible Interest" is defined to be capital property that is a partnership interest or shares in a corporation but the partnership or corporation must carry on a business (or in certain circumstances be a holding corporation). Where the payment under the restrictive covenant "directly relates" to the taxpayer’s disposition of an eligible interest to the payer (or person related to the payer) and is in consideration for an undertaking by the taxpayer to not compete with the purchaser (or person related to the purchaser), some or all of the payment may be treated as proceeds from the disposition of the eligible interest. The maximum amount that the parties can elect to be treated as proceeds of disposition is the lesser of (i) the amount of the consideration for the restrictive covenant, and (ii) the amount by which the fair market value of the taxpayer’s eligible interest would be increased if the restrictive covenant was granted to the purchaser for no consideration. As the examples in the Explanatory Notes issued with the Draft Legislation illustrate, the effect of the limit under (ii) is that where the recipient is not the sole shareholder of the corporation, only the amount of consideration for the restrictive covenant that is proportional to his or her share ownership in the corporation can be treated as proceeds of disposition under this exception.
The proposals also contain provisions designed to ensure that, to the extent one of the exceptions to ordinary income treatment applies, the tax implications to the purchaser are "mirrored". For example, the amount elected in an asset sale to be treated as an eligible capital receipt will be considered to be an outlay incurred on account of capital for purposes of the definition of "eligible capital expenditure" and the amount elected in a share sale to be treated as proceeds for the disposition of an eligible interest will be added to the purchaser’s cost for such property.
A final important proposed amendment in this context will allow the Canadian revenue authorities to reallocate proceeds from a disposition of property where part of the total consideration "can reasonably be regarded as being in part the consideration…for a restrictive covenant…" The portion of the total consideration that can reasonably be regarded as being in consideration for the restrictive covenant is deemed to be the amount received or receivable for such covenant "irrespective of the form or legal effect of the contract or agreement."
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