In early 2002, Bernard Ashe, CEO of Ottawa-based Advanced Information Technologies Corporation (AiT), advised his board that the company was at a crossroads. Its future viability required that it raise new capital or find a strategic or merger partner to access post-9/11 U.S. opportunities for its document security technology. The board opted for raising additional capital, but failed. Just as the company was about to hire an M&A adviser to pursue its last remaining option, it was thrown a lifeline in the form of an unsolicited telephone call from a mid-level manager at 3M in St. Paul, Minneapolis, inquiring whether AiT might be interested in a possible transaction that would give 3M access to its technology.
Five years forward, in early 2007, Canada was experiencing the apex of an M&A cycle. In such a climate, the Ontario Securities Commission (OSC) publicly declared that it was monitoring the markets for merger-related insider and tippee trading, and for the timeliness of M&A-related "material change" disclosure required by securities laws. In a speech to the Economic Club of Toronto on April 26, 2007, OSC Chair David Wilson put it this way:
"Let's be clear about something: The overwhelming majority of issuers and market participants are honest practitioners. They work hard to comply with the rules. They know that it's in their best interests for the markets to have integrity. But a small minority of firms and individuals prey on investors. Unfortunately, this small group has a disproportionate impact on the perception of Canada's capital markets…"
"We conduct in-depth investigations of every instance of unusual trading. We search for an inside connection - we seek out every possible source of information."
On February 8, 2007, OSC Staff commenced a regulatory proceeding against AiT, Mr. Ashe and Deborah Weinstein, a prominent Ottawa securities lawyer and corporate director, who was a director of AiT and also served as its external legal counsel. The OSC alleged that AiT breached the Ontario Securities Act in 2002 by failing to make timely disclosure of a material change during the negotiation of its merger transaction with 3M. The OSC's investigation arose as a result of unusual trading activity in AiT stock following the descent of 3M personnel upon AiT's offices to conduct due diligence. No one was charged with insider trading, but OSC Staff commenced proceedings against Mr. Ashe and Ms. Weinstein for the offence of "engaging in conduct contrary to the public interest" under the Ontario Securities Act by authorizing, acquiescing in or permitting AiT's alleged breach of the Act. AiT (now wholly-owned by 3M) and Mr. Ashe, who had become CEO of another company, both settled with the OSC. They agreed to pay financial penalties that were insignificant when compared to the cost of fighting the case. As part of his settlement, Mr. Ashe also agreed to cooperate with the OSC in its continuing case against Ms. Weinstein. The settlement agreements with AiT and Mr. Ashe also stated that "by failing to make disclosure of the merger transaction in a timely manner, [AiT and Mr. Ashe] engaged in conduct contrary to the public interest" (emphasis added). It was this statement, suggesting that disclosure was required at a time before the definitive agreement was entered into, that confounded the securities bar and made this decision the most anticipated OSC decision for M&A practitioners in recent times.
As a securities lawyer and corporate director, a settlement agreement was a non-starter for Ms. Weinstein. Any voluntary admission or finding against Ms. Weinstein could have had serious repercussions on her professional career and livelihood, and could also have impacted the livelihoods of other lawyers in her firm. Moreover, it would have negatively affected her suitability to serve as a director of a public company because the law requires companies to disclose securities-related penalties imposed during the previous 10 years on any person serving as a director of the company. In short, the stakes were very high.
OSC Staff alleged that AiT had a legal obligation to disclose its potential acquisition by 3M as a "material change" at some point in time well before the transaction was announced on May 23, 2002. The relevant points in time included: (i) April 25th when AiT's board approved 3M's proposed price of $2.88/share, this approval being required by 3M as a pre-condition to incurring the time and expense of due diligence; (ii) April 26th when the parties signed a non-binding letter of intent, again a requirement of 3M in which it laid out its approval process and other pre-conditions; and (iii) May 9th when 3M's mid-level management team completed their on-site due diligence information gathering in Ottawa and returned to St. Paul to consider the information and present the transaction to senior management for corporate-level approval. (The relevance of this latter date was not explained in either the OSC Statement of Allegations or the decision, but it coincides with the completion of 3M's on-site due diligence and the occurrence of the unusual trading activity that prompted the OSC investigation.)
The Decision and Legal Implications
On January 14, 2008, the OSC rejected the OSC Staff case, a decision that will sit well not only with corporate directors, company executives and securities lawyers but also anyone else subject to the regulatory jurisdiction of the OSC. The case turned on two factors: (i) the difference between a material fact and a material change; and (ii) the determination of when a material change occurs (and, accordingly, when public disclosure is required).
The Commissioners carefully analyzed all of the steps in the negotiating process in arriving at the conclusion that AiT's board support of 3M's proposed offer price and its execution of a non-binding letter of intent (LOI) did not constitute a material change. Therefore, AiT was under no obligation to issue a news release and file a material change report at that stage in the process. Since AiT did not breach any securities laws, Ms. Weinstein, in her capacity as a director of AiT, could not be held to have authorized, acquiesced in or permitted a breach of the Act contrary to the public interest. The Commissioners found that, prior to the execution of the definitive agreement, "there remained substantive and fundamental elements to be completed in 3M's approval process. These were beyond AiT's ability to resolve" and, as a result, neither "Ashe [n]or the AiT board could reasonably conclude at that time that there was a substantial likelihood that the LOI conditions would be satisfied and that the transaction would be completed."
Some of the most compelling observations of the Commission in its reasoning include the following:
- There is no "bright-line" test in an M&A transaction as to when a material change has occurred, and in appropriate circumstances a material change can occur before definitive agreements are executed.
(The fact that 3M had a complex, non-subjective and clearly documented approval process seems to have been an important factor for the Commissioners in concluding that no "commitment" to complete the transaction existed on the part of 3M until its approval process was complete and a definitive agreement was signed.)
- The assessment of whether a material change has occurred in an arm's length negotiated transaction will depend on the specific facts and circumstances of each case and will vary case to case.
(The fact that AiT was a very small company negotiating with a corporate behemoth - and with middle managers who didn't have corporate decision making power - seemed to be persuasive. In fact, 3M's corporate-level approvals were only obtained at the time that the definitive agreement was approved by the 3M board.)
- In an M&A transaction that is speculative, contingent and surrounded by uncertainties, the commitment of one party is insufficient to constitute a material change.
(This is the area where OSC Staff was attempting to expand the law of material change, arguing that AiT's decision to be acquired by 3M if it could, was a material fact and a material change for AiT because certain board minutes (found by the Commissioners to be inaccurately drafted) indicated that AiT's board had approved the transaction. This line of reasoning ignores the fact that 3M would have to form an intention to proceed with the transaction for a "change" to occur in AiT's business, operations or capital.)
- To conclude that a material change has occurred before a definitive agreement is reached in a negotiated merger transaction, there must be sufficient evidence for the board to conclude that "there was a sufficient commitment from [both] parties to proceed and a substantial likelihood that the transaction would be completed."
(On the evidence of this case, at no point during the period in question did it appear that AiT's board had a strong sense that the 3M corporate approvals would be forthcoming, and in fact, directors who testified indicated that they had various serious concerns that the transaction would fail, either because AiT's aggressive forecasts might not be confirmed by 3M's due diligence, or because 3M would decide to develop competitive technology on its own once the transaction was considered at the corporate level.)
It should be noted that the Commissioners resisted the temptation of applying today's standards of corporate governance to a situation that occurred five years previously. They note that Ms. Weinstein was both a director and external legal counsel, and that this would not be appropriate today. However, they implicitly acknowledge that this was not the case in 2002 and accepted that in providing legal advice to the AiT board she was not biased on account of her role as a service provider to the corporation.
Under the law as it existed in 2002 and as it exists today, just one question had to be answered to determine the point in time at which a material change occurred, and hence when public disclosure was required. The question is: at what point in the process did 3M become committed to completing the transaction and communicate that commitment to AiT.
As a legal precedent, this case largely restores common sense as the key ingredient in determining when disclosure is required. Once proceedings were initiated, the capital markets required the OSC's definitive view of the law, rather than the uncertainty that resulted from a settlement agreement. Securities lawyers and their clients should take comfort that the decision applies the law exactly as most securities lawyers interpreted it to be before the proceedings were launched.