A recent decision of the Ontario Securities Commission contains important guidance for issuers that enter into transactions with related parties. In a carefully crafted decision released in December 2009, the OSC held in MI Developments Inc. that an issuer is permitted to structure its transactions so as to qualify for, and benefit from, the exemptions in Multilateral Instrument 61-101 – Protection of Minority Security Holders in Special Transactions (“MI 61-101”).
Certain minority shareholders of MI Developments Inc. (“MID”) brought applications before the OSC seeking a determination that certain transactions entered into by MID with Magna Entertainment Corp. (“MEC”), a company controlled by MID, violated MI 61-101, and resulted in substantial destruction of MID shareholder value through MID’s continued support for MEC at a time when it was experiencing financial difficulties. At issue were certain transactions entered into just prior to the announcement of certain related party transactions that the applicants argued were artificial, a sham and lacking in bona fides. Although the minority shareholders of MID were not successful, the decision reinforces the need for an issuer to seek experienced counsel when contemplating a related party transaction, to ensure that the legal effect of any pre-transaction structuring allows the issuer to fit within the language of an exemption and to be able to show that the structuring has successfully aligned the interests of the issuer with those of its minority shareholders.
Related Party Transactions
Reporting issuers in Ontario and Québec are subject to MI 61-101. MI 61-101 recognizes that certain types of transactions, such as related party transactions and nonarm’s length business combinations, can be abusive or unfair to the interests of minority security holders. While MI 61-101 does not prohibit these transactions, it regulates them by requiring, in certain circumstances, that formal valuations be prepared for, and that minority security holders approve of, the transactions.
Conceptually, a related party transaction is a transaction between an issuer and a related party in which “value” could be shifted, directly or indirectly, between the issuer and the related party. More specifically, a related party transaction includes the sale of an asset, a lease of property, the lending or borrowing of money, or a material amendment to pre-existing debt, between the issuer and a related party. Examples of a related party of an entity include a control person of the entity, an entity of which the entity is a control person, a person who owns or controls 10% or more of the voting rights attached to securities of the entity, and a director or senior officer of the entity.
The minority shareholders of MID alleged that MID had entered into several related party transactions and contravened the valuation and minority approval requirements of MI 61-101. MID is a public company whose shares are traded on the TSX and the NYSE. MID is controlled by a group of related persons (the “Stronach Group”) including Frank Stronach and Fair Enterprises Limited (“Fair”). MEC is a public company engaged in the horse racing business. MEC began experiencing financial difficulties in the fall of 2008 and ultimately filed for bankruptcy on March 5, 2009. The Stronach Group controlled MEC through its interest in MID; however, Fair also held a direct interest in MEC. These relationships are depicted in Diagram A.
Although the decision dealt with several transactions, only two will be considered here. In late November 2008, MID provided a new loan of US$125 million to MEC (the “Loan”) and extended the maturity date of an existing US$312 million loan to MEC (the “Extension”). The Loan was a related party transaction, as the issuer, MID, was loaning money to MEC, an entity that it controlled. Likewise, the Extension could constitute a related party transaction if, as provided by MI 61-101, the extension constituted a material amendment to the terms of the debt owing by MEC to MID.
The day immediately preceding the announcement of the Loan and Extension, the Stronach Group arranged its affairs so as to permit MID to qualify for the downstream transaction exemption under MI 61-101 (discussed below).
To do so, Fair sold its shares in MEC (the “Sale”) to a newly formed trust, the 2008 Azalea Trust (the “Trust”). In exchange for its MEC shares, Fair received a noninterest bearing promissory note from the Trust. By its deed, the Trust was required to dispose of the MEC shares and repay the note. But, recourse against the Trust under the note was limited to the amount for which the Trust could sell the MEC shares. If the MEC shares were sold for an amount greater than the face value of the note, then the excess would be donated to charity. If the MEC shares were sold for less, then, Fair, and not the Trust, would suffer the loss. MID’s minority shareholders argued that Fair had merely “parked’ its MEC shares with the Trust, and nevertheless continued to hold an economic interest in the MEC shares, thus disqualifying MID from the downstream transaction exemption. They attacked the Sale as artificial, a sham and lacking in bona fides. The relationships of the relevant parties subsequent to the Sale are depicted in Diagram B.
Prior to entering into any of the foregoing transactions, the transactions were reviewed and recommended by a special committee of disinterested directors of MID and approved by the board of directors of MID. According to the OSC, rigorous board and special committee process is a relevant consideration in deciding whether to exercise its public interest jurisdiction. Had MID not followed such exacting governance processes, the outcome of the decision may have been different.
Downstream Transaction Exemption
As the OSC explained, the downstream transaction exemption “is based on the assumption that when an issuer enters into a transaction with a related party that it controls, the issuer will act in its own best interests, thus also benefiting minority shareholders” and eliminating the need for a valuation and minority approval. However, this assumption may be jeopardized where a related party of the issuer (i.e., the Stronach Group) holds a direct interest in the related party to the transaction (i.e., MEC). In such case, the Stronach Group could theoretically cause MID to enter into a transaction beneficial to MEC (and ultimately the Stronach Group), but detrimental to MID, and its minority shareholders.
An issuer must meet two requirements in order to qualify for the downstream transaction exemption. First, the issuer must be a control person of the related party to the transaction. Second, to the knowledge of the issuer after reasonable inquiry, no related party of the issuer may beneficially own or exercise control or direction over more than 5% of the voting or equity securities of a class of the related party to the transaction (other than through its interest in the issuer).
MID argued that it met this second requirement after Fair completed the Sale to the Trust. In conceptual terms, the purpose of the Sale was to align the Stronach Group’s interests in MID with the interests of MID’s minority shareholders. The OSC stated that “there is nothing inappropriate in a person organizing its affairs or completing a bona fide transaction in order to qualify for” the exemption.
The OSC reasoned that a two-pronged analysis of the Sale, Loan and Extension was required to determine whether or not MID qualified for the downstream transaction exemption. First, the OSC considered these transactions from a strict textual interpretation of MI 61- 101. Second, the OSC considered the economic substance of the transactions to determine whether they complied with the spirit and intent of MI 61-101.
While the OSC stated that it was a “close call”, on balance, the OSC was prepared to recognize the legal effect of the Sale in accordance with its terms and that the Trust had acquired voting or dispositive power over the MEC shares. Thus, from a strict textual interpretation of MI 61-101, MID qualified for the downstream transaction exemption, with one exception.
The downstream transaction exemption must be met at the time transactions were agreed to. MID’s minority shareholders asserted that because MID had agreed to the Loan and Extension, prior to Fair executing the Sale, the exemption was not available at that time. The OSC found such an interpretation too technical and that MI 61-101 does not establish a completely inflexible rule. Rather, it stated that “if after a transaction has been agreed to and before it is completed, steps are taken to ensure that an exemption is available under MI 61-101 for that transaction, there does not seem to us to be a reasonable basis to challenge the availability of that exemption, absent some abuse in relying on the exemption in the circumstances.”
As an interesting aside, MID’s minority shareholders argued that MID could not rely on the exemption because it failed to make “reasonable inquiry” into the ownership of MEC shares by the Stronach Group. MID relied on brief email exchanges between counsel, a draft news release (that failed to make full disclosure of the terms of the Sale) and public filings in determining that the Stronach Group’s only interest in MEC was through MID. The OSC was not satisfied that MID had made “reasonable inquiry” and indicated that MID should have made more inquiries with respect to the specific terms of the Sale. Nevertheless, it concluded that the “failure to make reasonable inquiry does not disqualify a person from relying on the [exemption] if it is otherwise available on the facts”. Further, the OSC noted that “if reasonable inquiry is made and a person has no knowledge to the contrary, that person is entitled to rely on the responses to the inquiry in determining the availability of the [exemption] regardless of what the actual facts and circumstances” may be. Although MID failed to make reasonable inquiry, it was still entitled to qualify for the exemption because on the facts, after the Sale, the Stronach Group no longer held any direct interest in MEC.
Having reached this conclusion, the OSC went on to the second prong of the analysis to consider the economic substance of the Sale. It noted that in spite of the Sale, Fair maintained an economic interest in the MEC shares (albeit, without an “upside”). This economic interest could lead to the type of conflict that the valuation and minority approval are meant to remedy. Rather than reach a conclusion on the matter, the OSC shortcircuited its analysis: it assumed that a substantive conflict existed that could disqualify MID from relying on the exemption, but found that MID could rely on the 25% market capitalization exemption in respect of the Loan and Extension.
25% Market Capitalization Exemption
The 25% market capitalization exemption permits an issuer to dispense with the valuation and minority approval requirements where neither the “fair market value of the subject matter of the related party transaction, nor the consideration for the transaction, exceeds 25% of the issuer’s market capitalization”. The purpose of this exemption is different from the downstream transaction exemption. In this case, MI 61- 101 is balancing the costs, in both money and time, of preparing a valuation and obtaining minority approval, with the protection that each provides to minority shareholders.
MID’s minority shareholders took the position that the amount of the Loan and the amount of existing debt, the maturity of which was extended by the Extension, should have been aggregated. Since the aggregate amount was greater than 25% of MID’s market capitalization, the exemption, they argued, was not available to MID. The OSC disagreed and found that the exemption was available for two reasons. First, in order for the Extension to be classified as a related party transaction, the extension of the maturity date of the debt would have to constitute a material amendment from MID’s perspective. Given the dire financial position of MEC, the Extension was not a material amendment to the debt from MID’s perspective, because MID “likely could not have been repaid by MEC in any event”. Second, the OSC held that, even if the Extension was a material amendment, because the Extension was not a new loan, the amount of the Loan was not to be included for the purposes of determining whether the 25% market capitalization threshold had been exceeded.
Conclusion and Commentary
The OSC concluded that MID was able to rely on the 25% market capitalization exemption and thus did not need to prepare a valuation or receive minority approval in respect of the Loan and Extension. And, although the OSC did not decide, as a matter of substance, whether the downstream transaction exemption applied to the Loan or Extension, it did provide some useful insight into the interpretation of the exemption.
Based on the foregoing, it seems reasonable to conclude the following:
- an issuer may arrange its affairs so as to qualify for exemptions under MI 61-101; and
- when engaging in pre-transaction structuring so as to qualify for, and benefit from, the exemptions in MI 61-101:
the terms of the pre-transaction structuring must be carefully considered so that the pretransaction structuring (i) is given legal effect thereby allowing the issuer to satisfy the textual requirements of the exemption, and (ii) achieves the spirit and intent of the exemption, which in many cases is the removal of a potential conflict of interest such that when the issuer enters into a related party transaction, its interests are aligned with those of its minority shareholders; and
as always, the process followed by boards of directors in approving any pre-transaction structuring is of utmost importance.