The Ontario Securities Commission recently released its full decision in respect of HudBay Minerals Inc.’s proposed share exchange acquisition of Lundin Mining Corporation. The OSC set aside the decision of the Toronto Stock Exchange which had approved the listing of additional common shares of HudBay in connection with the acquisition without requiring the approval of HudBay’s shareholders. The decision raises a number of issues that should be considered in structuring acquisition transactions, including the need of the acquirer to consider the impact of the transaction on its shareholders.

Background

The matter arose out of an application made by Jaguar Financial Corporation, a shareholder of HudBay, requesting that the OSC set aside the TSX decision approving the listing of the additional common shares of HudBay to be issued in connection with the acquisition transaction of Lundin and order that HudBay obtain shareholder approval of the transaction.

A TSX listed issuer is required to obtain TSX acceptance to any transaction involving the issuance of listed securities. Generally the TSX will require security holder approval as a condition of acceptance of the transaction if the transaction materially affects the control of the issuer or in certain circumstances where the transaction involves insiders. The TSX also has discretion to impose other requirements (including shareholder approval) on the issuer as a condition of its acceptance of the transaction. In exercising that discretion, the TSX Company Manual notes that the TSX will consider the effect the transaction may have on the “quality of the marketplace” and identifies a number of factors, including corporate governance and disclosure practices, that it would consider.

Several other shareholders, in addition to Jaguar, raised concerns about the transaction. These shareholders took a number of steps to voice their concerns, including submitting letters to the TSX, commencing an oppression action against HudBay and requisitioning a shareholder meeting for the purpose of removing and replacing HudBay’s directors.

Clearly a number of shareholders were not pleased with the proposed transaction.

OSC Decision

The OSC concluded, based on a number of factors, that the quality of the marketplace would be significantly undermined by permitting the HudBay transaction to proceed without the approval of the shareholders of HudBay. In the OSC’s view, fair treatment of shareholders is a key consideration going to the integrity and quality of the capital markets and permitting the transaction to proceed without the approval of the shareholders of HudBay would be contrary to the public interest.

Key Factors that the OSC Considered in Arriving at its Decision

The following factors were relevant to the OSC’s conclusion that the transaction could have a significant and adverse effect on the quality of the marketplace if the transaction proceeded without HudBay shareholder approval.

Dilution

The OSC noted that the level of dilution under the transaction was extreme. Under the transaction, just over 100% of the number of HudBay shares currently outstanding would be issued, leaving former shareholders of Lundin owning approximately 50% of the shares of the merged entity following the transaction. Based on this level of dilution, the OSC concluded that the transaction is a “merger of equals” and not an acquisition by HudBay of Lundin, raising questions as to why the shareholders of Lundin were entitled to vote when the shareholders of HudBay were not.

Although the OSC indicated that the level of dilution was not determinative, it was an extremely important factor given that dilution can fundamentally affect the economic interest of shareholders, having a direct affect on voting, distribution and residual rights of shareholders.

Economic Impact on HudBay’s Shareholders

The OSC reported that following the public announcement of the transaction, the share price of HudBay fell by approximately 40%, clearly showing that the transaction had an enormous impact on the rights and economic interests of HudBay’s shareholders. In that regard, the OSC commented that the impact on the share price exceeded the market reaction that one would expect to the announcement of such a transaction.

Corporate Governance

Change to HudBay’s Board – The OSC noted that the transaction subjects shareholders of HudBay to a radical change in the composition of the HudBay board without their consent. As a result of the transaction, five of the nine directors of the merged entity will be former directors of Lundin, thus substantially reconfiguring the board. According to the OSC, this underscored that the transaction would constitute, in effect, a merger of equals.

Timing of Shareholder Vote – The OSC indicated that the board of HudBay knew as early a November 24, 2008 that shareholders opposed to the transaction were attempting to requisition a meeting to remove the board, and delayed as long as legally possible the date for the requisitioned HudBay shareholders’ meeting to March 31, 2009. At the same time Lundin accelerated its shareholders’ meeting to January 26, 2009, thus setting up the possibility that the transaction could be completed before the HudBay shareholders’ meeting. Although the OSC conceded that the actions of the HudBay board were entirely legal, in denying the HudBay shareholders the right to challenge the transaction through the requisitioned meeting, in the OSC’s view, the HudBay board actively frustrated the legal rights of HudBay shareholders. These actions raised 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 and given that these actions were taken after the TSX had rendered its decision, provided the OSC’s with new and compelling evidence to consider.

Transformational Impactof the Transaction on HudBay and its Shareholders

The OSC noted that the transaction would have a transformational effect on HudBay’s business, citing significant increase in HudBay’s risk profile in particular. The OSC commented that the acquisition of Lundin’s business would expose HudBay to higher-risk jurisdictions around the world, and to minority interests in joint ventures and other investments with corresponding capital and financial obligations. The OSC indicated that where a transaction would have a transformational effect on an issuer and its business, that effect was relevant in considering whether shareholder approval would be required.

Fair Treatment of HudBay Shareholders

The OSC concluded that the combined effect of the foregoing factors raised serious concerns as to the fair treatment of HudBay shareholders. In that regard, the OSC believes that fair treatment of HudBay shareholders is fundamental in assessing the impact of the transaction on the quality of the marketplace.

Additional Related Issues

HudBay Vote of Shares in Lundin – In connection with the transaction HudBay agreed to vote 19.9% of common shares of Lundin acquired by HudBay pursuant to the private placement under the transaction. The OSC questioned the voting of those shares in view of the different and potentially conflicting interest that HudBay had in the outcome of the vote relative to other Lundin shareholders. The OSC noted that in its view, an acquirer should not generally be entitled, through a subscription for shares carried out in anticipation of a merger transaction, to significantly influence the outcome of the vote. Although the OSC’s view may not have affected this transaction given the other issues, it may be a relevant consideration in other transactions.

Financial Advice to the Special Committee – The OSC also questioned reliance on a fairness opinion issued by a financial adviser entitled to a success fee upon successful completion of the transaction as such fees create a financial incentive for the adviser to facilitate successful completion of the transaction when the principal focus should be on the financial evaluation of the transaction from the perspective of shareholders. Typically, fairness opinions are obtained as part of the directors’ due diligence in exercising their duties under the company’s corporate statute. In the OSC’s view, a fairness opinion prepared by a financial adviser who is being paid a success fee does not assist the independent directors on the special committee in demonstrating the due care they have taken in complying with their fiduciary duties in approving a transaction. This seems to draw into question the reliability of a fairness opinion prepared by a financial adviser where the fee paid to the adviser is based on the successful completion of the transaction. Again, although the OSC’s comments on the financial adviser’s conflict of interest were not key to the conclusion reached by the OSC in the hearing, it may be a relevant consideration in other transactions.

Impact of the Decision

The decision of the OSC will likely impact the structuring of share acquisition transactions by TSX listed issuers, requiring the acquirer to consider the impact of the transaction on its shareholders. In that regard, the key considerations appear to be the level of dilution and economic impact on the acquirer’s shareholder. Also relevant will be fundamental corporate governance practices followed by the parties, in particular in the circumstances where shareholders raise significant concerns. In essence, this decision may require boards to consider more than just base line compliance with corporate and securities laws, but also whether overall their actions are fair to shareholders.