Following the release of its January 23, 2009 decision, the Ontario Securities Commission (OSC) released its full Reasons for Decision (Reasons) in repect of the proposed transaction between HudBay Minerals Inc. (HudBay) and Lundin Mining Corporation (Lundin) on April 28, 2009. The OSC’s decision has already prompted the Toronto Stock Exchange (TSX) to propose a “bright line” test requiring a listed company to obtain shareholder approval when issuing more than 50% of its shares (on a non-diluted basis) in connection with the acquisition of a public company. In addition, the OSC’s Reasons include a number of telling remarks concerning the structuring of financial advisor engagements, the use of private placements in the context of acquisition transactions and the ability of directors to conclude a transaction in the face of a challenge by dissident shareholders. All of these comments have the potential to significantly affect the M&A landscape.

The OSC’s Decision

On November 21, 2008, HudBay agreed to acquire Lundin through an all-stock plan of arrangement that would have resulted in just over 100% dilution to HudBay. Consistent with its past practice, the TSX did not require HudBay shareholder approval of the proposed share issuance. One of HudBay’s shareholders appealed the TSX’s decision to the OSC.

On January 23, 2009, the OSC overturned the TSX’s decision on the grounds that permitting the transaction to proceed without a HudBay shareholder vote would undermine the quality of the marketplace and be contrary to the public interest. The OSC characterized the proposed level of dilution as “extreme.” As matters unfolded, this decision effectively led to the termination of the transaction.

On April 28, 2009, the OSC issued its final Reasons, which included a number of comments concerning matters that were expressly acknowledged by the OSC not to have been directly raised or argued in the application. In particular, the OSC expressed its views regarding the fairness opinion obtained by HudBay in the context of the transaction, raising specific concerns about the fact that the financial advisor that provided the opinion was to receive a “signing fee” when the arrangement agreement was entered into and a larger “success fee” upon completion of the transaction. The OSC concluded as follows:

While the Commission does not regulate the preparation or use of fairness opinions, in our view, a fairness opinion prepared by a financial adviser 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.  

Similarly, the OSC commented on the ability of HudBay to vote the 19.9% shareholding in Lundin that HudBay had acquired in a private placement connected to (but not conditional upon) the completion of the arrangement at the Lundin shareholders meeting to approve the transaction. The OSC expressed the view that an acquiror should not generally be entitled to influence the outcome of a vote on a merger transaction through a subscription of shares carried out in anticipation of the transaction because the acquiror “has a fundamentally different interest in the outcome of the transaction than the shareholders of the target.”

Finally, the OSC’s reasons contain critical remarks about the collective efforts of HudBay and Lundin to close the transaction as quickly as possible in the face of a requisitioned HudBay shareholders meeting to remove the HudBay board of directors. In particular, the OSC commented on the “manifestly unfair” decision of the parties to schedule the Lundin shareholders meeting before the requisitioned HudBay shareholders meeting, notwithstanding the acknowledgement that such action was undertaken within the bounds of their legal rights.

The Impact of the OSC’s Ruling

Proposed TSX Shareholder Approval Requirement for Dilutive Acquisitions

Following the OSC’s decision, the TSX proposed a “bright line” test requiring a listed company to obtain shareholder approval when issuing more than 50% of its shares (on a non-diluted basis) in connection with the acquisition of a public company. In setting the dilution at a level that exceeds 50% – as opposed to, for example, the 20% level on the NYSE and Nasdaq – the TSX took into consideration the comparative size and maturity of issuers listed on the TSX as compared to other exchanges. The TSX also noted the significant number of listed resource issuers which tend to be more active in M&A activity and which frequently offer securities as consideration rather than cash. The comment period on the TSX’s proposal expired on May 4, 2009. The final rule will only become effective following public notice and OSC approval.

Structuring Financial Advisor Engagements

Canadian boards of directors have traditionally engaged financial advisors to deliver fairness opinions in connection with M&A transactions. Although there is no legal obligation to obtain a fairness opinion, Canadian corporate law provides directors with a defence from a claim that they have breached their fiduciary duties if they have relied in good faith on an expert report or opinion.

The OSC’s criticism of the fairness opinion obtained by HudBay raises the need for directors to consider the ability of any financial advisor holding a direct financial interest in the outcome of the underlying transaction to assist members of a special committee or, by extension, a board of directors, in demonstrating that their fiduciary duties have been adequately discharged.

The OSC’s observation was surprising, both because the OSC, by its own admission, does not regulate the preparation or use of fairness opinions, and because it is at odds with longstanding market practice in Canada and elsewhere whereby financial advisors are frequently paid success fees in connection with their engagements. Moreover, the discharge of directors’ fiduciary duties is not within the OSC’s jurisdiction or special expertise.

Notwithstanding that the decision did not turn on this issue, the OSC’s comments may nevertheless have an impact on the structuring of engagement agreements with financial advisors in the context of future M&A transactions. Indeed, in certain situations, the OSC’s comments may give rise to a perceived need for independent “second opinions” from financial advisors whose compensation is not tied to the success of the transaction.

While there may be circumstances in which a second opinion is desirable, such as where a financial advisor has a conflict due to its relationship with the counterparty to the transaction, there are also circumstances in which a second opinion may be unnecessary. For example, where a financial advisor has in-depth knowledge of its client and the universe of potential buyers and has assisted the board of directors in designing and implementing a proper sales process, the time and expense associated with obtaining a second opinion is arguably not warranted.

Although success fees may be seen to create an incentive for a financial advisor to conclude that a transaction is fair in order to facilitate its completion, success fees can also align the interests of financial advisors and their clients. Additionally, in rendering fairness opinions, financial advisors are subject to reputational and legal risks which counteract the potential conflict of interest noted above.

Directors will ultimately need to exercise their business judgment, in consultation with their legal advisors, in determining how best to structure financial advisor engagements and whether to obtain an independent or second opinion in the context of the particular circumstances they face.

Private Placements in the Context of Acquisition Transactions

The OSC expressed the view that HudBay should not be permitted to vote the 19.9% shareholding in Lundin that HudBay acquired through a private placement that was negotiated concurrently with the arrangement agreement. While, again, these comments were made outside the context of the strict ruling, they nevertheless raise questions about the future use of private placements in conjunction with M&A transactions.

Although private placements can provide much-needed capital to the target, the acquiror may view a private placement in this context as also providing a degree of additional deal protection. One of the benefits to the acquiror is the ability to vote the shares in favour of the transaction. If the acquiror no longer has this right, then this may discourage an acquiror from completing a private placement in connection with voting transactions. In circumstances in which both the target and acquiror would still like to complete a private placement, it may be preferable to structure the acquisition as a take-over bid, where the private placement shares can make it easier to satisfy the minimum tender condition.

Responding to Challenges by Dissident Shareholders

The OSC noted that the requisition of the shareholders meeting to replace HudBay’s board of directors was “intended as a means for HudBay shareholders to, in effect, vote on the Transaction.” The OSC found that if the arrangement was completed before the requisitioned meeting, “the principal purpose for the meeting will be frustrated.” The OSC concluded by stating as follows:

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.  

These comments do not take into consideration the fact that HudBay’s ability to terminate the transaction was constrained by the limited termination rights in the arrangement agreement, which would have continued to apply following a change in HudBay’s board of directors. In addition, they are distinctly at odds with a cardinal rule of M&A practice that parties try to close a transaction as quickly as possible. The holding suggests that if dissident shareholders challenge a transaction by requisitioning a shareholders meeting – regardless of whether there is a legal requirement to obtain shareholder approval – then the directors are precluded from closing the transaction until the requisitioned meeting has been held.

If so, this would provide dissident shareholders with the power to delay transactions and introduce considerable transactional uncertainty. That said, it may be that the OSC only intended for its statements to apply in circumstances where the dissident shareholders are (or otherwise ought to be) entitled to a vote on the transaction, as the OSC found to be the case in connection with HudBay’s proposed business combination with Lundin.