A recent decision of the Yukon Court of Appeal (comprised of justices of the British Columbia Court of Appeal) has confirmed the importance for boards of directors to ensure not only that a proposed plan of arrangement is substantively fair and reasonable, but that the process by which an arrangement is presented to shareholders for consideration be consistent with best practices in corporate governance and disclosure. In InterOil Corporation v. Mulacek, the Yukon Court of Appeal unanimously set aside an order of the Supreme Court of Yukon approving a plan of arrangement which had been overwhelmingly supported by shareholders. This decision continues the current trend of heightened judicial scrutiny of plans of arrangement and provides particular guidance on the importance of process, including the role of fairness opinions in assisting shareholders – and courts – in scrutinizing proposed arrangements.
Following a sale process focused principally on monetizing certain assets owned by InterOil Corporation (InterOil), InterOil entered into a share exchange arrangement in May 2016 with Oil Search Limited (Oil Search). Immediately prior to the announcement, InterOil’s shares were trading at US$31.65 per share. The arrangement valued InterOil’s equity at US$40.25 per share, and included a potential contingent payment tied to the volume of contingent natural gas and condensate resources (determined on a “best case” or 2C basis), from InterOil’s most prospective asset, the PRL 15 field, located in Papua New Guinea. After completion of a work program, a certification was to be made by petroleum valuers, and a cash payment of US$6.044 per share was to be made for each one trillion cubic feet equivalent (tcfe) of 2C contingent gas and condensate resources above a threshold of 6.2 tcfe. The Oil Search arrangement was subject to the approval of InterOil's shareholders, as well as court approval.
In July 2016, several weeks before the Oil Search arrangement was to be considered at a special meeting of InterOil shareholders, Exxon Mobil Corporation (ExxonMobil) made an unsolicited proposal to buy all of the shares of InterOil. ExxonMobil’s bid valued the InterOil shares at US$45 per share, and included a contingent payment akin to the Oil Search payment. The ExxonMobil payment was also based upon 2C contingent gas and condensate resources in the PRL 15 field based upon certification by petroleum valuers. However, the ExxonMobil payment was to be larger—in the amount of US$7.07 per share for each one tcfe above 6.2 tcfe baseline of resources. Additionally, unlike the Oil Search bid, ExxonMobil’s contingent payment was capped based upon a maximum resource assessment of 10 tcfe.
After the InterOil board determined that the ExxonMobil proposal constituted a “superior proposal,” and it became clear that Oil Search would not revise its bid, the board unanimously approved entering into the ExxonMobil arrangement agreement and recommended that InterOil shareholders vote in its favour. The management information circular issued to InterOil shareholders in support of the ExxonMobil transaction indicated that the InterOil board had determined that acceptance of the ExxonMobil bid was in the best interests of the company and that the consideration to be received by shareholders was fair. In making its recommendation, the InterOil board relied, in part, on a fairness opinion evaluating the ExxonMobil bid prepared by Morgan Stanley, which had also prepared the fairness opinion for the Oil Search transaction. The majority of Morgan Stanley’s fee for preparing the fairness opinion was a “success fee” contingent on the ExxonMobil arrangement being completed.
On September 21, 2016, at a special meeting of shareholders, InterOil shareholders voted to approve the ExxonMobil arrangement, with approximately 80 percent of votes cast by shareholders at the meeting being in favour of the proposal.
It is noteworthy that the InterOil board did not appear to establish a “special committee,” with an articulated mandate to negotiate either of the proposed transactions, and tasked with providing a recommendation to the full InterOil board. Instead, the InterOil board established a “transaction committee” comprised of non-management directors. While the transaction committee had an oversight role, it did not appear to have a clear mandate akin to a typical special committee, did not engage its own independent counsel, and appeared to rely upon InterOil’s transaction counsel. Further, the Chief Executive Officer of InterOil was also a director and was to receive significant financial benefits from the transaction, from the acceleration of “restricted share units,” as well as a change of control termination entitlement.
The court decisions
Armed with shareholder approval, InterOil applied to the Supreme Court under Section 195 of the Business Corporations Act (Yukon) (the Act) (the roughly analogous provision to Section 192 of the Canada Business Corporations Act) for a final order approving the ExxonMobil arrangement. This application resulted in a contested hearing on September 27, 2016.
After an unusually lengthy period of deliberation for the approval of an arrangement, the Supreme Court approved the application and issued the final order in favour of the ExxonMobil arrangement on October 7, 2016. Philippe E. Mulacek, a founder and former chairman and director of InterOil, who had dissented from the ExxonMobil arrangement and previously commenced an unsuccessful proxy battle for InterOil, appealed the Supreme Court decision to the Court of Appeal.
On November 4, 2016, the Court of Appeal set aside the order of the Supreme Court and dismissed the application to approve the ExxonMobil arrangement. The Court of Appeal’s decision was rooted in the view that notwithstanding the approval of the plan of arrangement by a significant majority of InterOil shareholders, “court approval was also required by the Act to ensure that the decision of the shareholders was fair and reasonable in the sense of being based on information and advice that was adequate, objective and not undermined by conflicts of interest.” In the Court of Appeal’s unanimous view, the decision of a significant majority of the shareholders was insufficient to meet this standard.
Central to the Court of Appeal’s conclusion that the ExxonMobil arrangement failed to meet this standard was the fairness opinion prepared by Morgan Stanley. Two aspects of the fairness opinion were particularly troubling to the Court of Appeal. First, the Court of Appeal found that Morgan Stanley was conflicted on the basis of the fee being contingent on the success of the ExxonMobil arrangement. The Court of Appeal adopted the Supreme Court’s view that while “an opinion obtained from an independent financial advisor ‘retained on a flat fee’ is an important factor in assisting the court to scrutinize the arrangement before it,” a conflicted fairness opinion does not meet the standard of good corporate governance.
The Court of Appeal’s second concern with the fairness opinion was its author's explicit choice not to attribute any specific value to the contingency payment in the ExxonMobil offer which was capped, unlike the Oil Search bid. The Court of Appeal endorsed the view that a board engaged in a proper and robust review of a proposed transaction would have obtained independent advice on the value of the contingency payment in relation to the potential value of the interest in the oil and gas field.
Ultimately, the Court of Appeal concluded that there were deficiencies in InterOil’s approval processes, among which the compromised fairness opinion appears to have been given significant weight. Other factors included the Chief Executive Officer’s compensation-related position of conflict, and the Court of Appeal’s view that the “transaction committee” was passive and lacked independence from management. As a result, the Court of Appeal concluded that the Supreme Court was required to “do more than accept the vote of the majority as a ‘proxy’ for fairness, or the cash amount of ExxonMobil’s offer as a proxy for reasonableness.”
At the time of writing, InterOil's public disclosure indicates that it remains in discussions with ExxonMobil with respect to extending the outside date for the arrangement, and is also considering options to file for leave to appeal the decision of the Court of Appeal to the Supreme Court of Canada.
The Court of Appeal took the position that InterOil’s approval process, both at the board and shareholder levels, was compromised by several negative factors and that, in the face of such a compromised process, the Supreme Court should have looked beyond shareholder approval in determining whether the arrangement was fair and reasonable. Based on the InterOil decision, parties that are involved in or propose to undertake an arrangement should consider the following takeaways:
- Governance process – Companies undertaking a plan of arrangement should take great care in terms of governance process. Clearly, the establishment of a special committee consisting of independent unconflicted directors, with a clearly defined mandate, is important. The engagement by the special committee of independent counsel and an independent financial advisor will also assist the company to assert that it has adopted a meaningful and robust approval process.
- Independence of financial advisor – A party providing a fairness opinion that receives a success fee may not be considered to be independent, and the success fee may cast doubt on the effectiveness of the fairness opinion provided. In a Canadian merger transaction, the financial advisor to the target will generally negotiate a success fee. In these circumstances, the target should also consider engaging a second independent financial advisor who is tasked with providing a fairness opinion on a “flat fee” basis.
- Form of fairness opinion – The Supreme Court was critical of the form of the fairness opinion, and the Court of Appeal did not offer a contrary view in defence of the form relied upon by the InterOil board. The Supreme Court considered the fairness opinion to be deficient because it was “devoid of facts or analysis.” Mr. Mulacek apparently provided sample fairness opinions from other transactions which contained detailed analyses to demonstrate the inadequacy of the fairness opinion that had been relied upon by the InterOil board. However, preparation of a fairness opinion with a detailed analysis is not market practice in Canada, and there is no Canadian legal requirement for a fairness opinion to contain a detailed analysis. The Court of Appeal's view on the express carve-out in the fairness opinion of the attribution of “any specific value” to the contingent payment mechanism was also noteworthy. It appears that the form of the fairness opinion, which was consistent with Canadian market practice, may have received heightened scrutiny and judicial criticism because it resulted from a governance process that was considered to be flawed, and was provided by a financial advisor that was considered to be conflicted by a success fee. This outcome creates added incentive for a board to follow a proper governance process, in order to ensure that a fairness opinion prepared in a manner consistent with Canadian market practice will withstand judicial scrutiny.
- De facto adoption in British Columbia – While the Yukon Supreme Court may not be required to rule on the same number of arrangements as courts in Ontario, British Columbia and Alberta, the panel of the Yukon Court of Appeal that heard InterOil was comprised of justices of the British Columbia Court of Appeal, suggesting that the determination of the Yukon Court of Appeal could also be considered to be a de facto decision of the British Columbia Court of Appeal, binding in British Columbia, as well as being an important precedent for the remainder of the Canadian jurisdictions.