Despite the uncertainty and volatility continuing to affect both the global economy and North American capital markets, controlled auction transactions in the Canadian marketplace remain remarkably active, especially in the mid-market. Before venturing into these tempting waters, sellers and buyers alike should take note of some key Canadian legal considerations.
- Controlled Auctions vs. Negotiated Sale Transactions. Under Canadian law, a formal Revlon-style auction is not always necessary for a target board to satisfy its fiduciary duties in a change of control context. In many circumstances, a privately-negotiated sale, combined with a less formal canvass of the market, may be sufficient.1 At the same time, sellers must be cautious about any public statements which create a reasonable expectation among shareholders (among others) that an auction will be conducted or that it will be held on an unconditional or unrestricted basis. Under most Canadian company law regimes, these types of statements can potentially give rise to an "oppression" action should the auction turn out to be either highly conditional or not held at all.2
- Maximization of Shareholder Value. Canadian jurisprudence has also rejected the general applicability of a strict Revlon duty to focus exclusively on the maximization of shareholder value in the context of change of control transactions.3 Instead, a director's fiduciary duty in Canada is defined with respect to the longer-term interests of the company.4 It even permits some consideration of the interests of non-shareholder stakeholders, such as creditors and employees.5
- Setting the Rules of the Game. A seller choosing to hold an auction must carefully consider what the "rules of the game" will be. Although relatively few disputes over auction processes have been litigated in Canada, it is highly likely that Canadian courts would give wide deference to the auction or bid rules established by a seller,6 including the right of the seller to change the auction or bid rules in certain circumstances.7 As noted above, a seller needs to be wary of creating expectations with its shareholders and others as to the process. These principles apply equally to distress scenarios or in more formal insolvency and bankruptcy proceedings in Canada where auctions are also common, including stalking horse bid processes.
- Confidential Information Memoranda. With input from financial and legal advisors, sellers need to consider the nature and content of a "teaser" and a confidential information memorandum (CIM) or similar document. It is worth noting the recent Canadian trend toward shorter (or no) CIMs, particularly with well-organized and robust electronic data rooms. Comprehensive disclaimers are often included in the definitive transaction agreement, typically to preclude any reliance on the CIM.
- Confidentiality Agreements. While Canadian confidentiality agreements are similar to those in other jurisdictions, the terms of the pre-bid confidentiality agreement still merit some strategic consideration. Failure to use market provisions could lead to delays as a result of dealing with comments of auction participants and their counsel. Conversely, yielding too much to auction participants could put a seller at a competitive disadvantage in the marketplace in the event of a broken auction. It is worth noting that, as in the United States, market-accepted terms and their duration in Canada are often different for public and private targets, as well as for those applicable to strategic buyers as distinct from financial buyers (e.g. non-solicitation, no-hire, standstill, survival and other related provisions).
- Transaction Agreements. Presenting potential buyers with an overly seller-friendly definitive transaction agreement - as opposed to one with only key seller-focused deal protections - could also impact the transaction timetable and the success of the auction process. As in all jurisdictions, in certain transactions, seller-favourable deal terms, including aggressive indemnity profiles (with low caps and very limited escrow amounts as the exclusive remedy of a buyer) and substantial reverse break fees (for financing, regulatory or other conditionality), may be appropriate. In our experience, it is not market practice in Canada to include a "fiduciary out" in a non-public deal. Another seller strategy for auction success is to include a copy of the disclosure schedules or letter as part of the distribution of the transaction agreement.
- Due Diligence and Data Rooms. Data rooms have been long recognized by Canadian courts as an essential element of an effective auction.8 Like elsewhere, electronic or online data rooms are now the norm in Canada for completion of the diligence process and, if Canadian capital markets are favourable, to run a dual-track strategic process in connection with a possible initial public offering or other alternative transaction. One European trend we are still not seeing in Canada is the use of seller-prepared due diligence reports (other than in limited situations for Canadian financial and/or tax diligence).
- Gun Jumping. As in the United States, pre-merger integration, coordination and/or information sharing is an important antitrust issue under Canada's Competition Act. Although there is little case law yet in Canada on "gun-jumping", merging parties must be careful in sharing competitively sensitive information - particularly when it comes to observing the applicable waiting period. The consequences for failure to do so can be severe (fines of up $10,000 per day, orders prohibiting certain actions, and even divestiture). That said, ordinary course due diligence processes, integration planning and certain types of restrictive pre-closing covenants are, generally speaking, uncontroversial in Canada and, with appropriate guidance from counsel, can be implemented in a manner that minimizes antitrust risk while at the same time allowing the parties to achieve their business objectives.
- Industry Specific Issues. Depending on the target or industry, the sale of a regulated entity in an auction process in Canada may present specific regulatory hurdles for certain non-Canadian buyers under the Investment Canada Act or for both Canadian and foreign buyers under other applicable Canadian federal or provincial legislation in certain regulated industries (e.g. transportation, financial services and insurance, telecommunications and agriculture). An early assessment should be made of the execution risk associated with each bidder in the process and considered in the context of (i) selecting the short-listed potential buyers and (ii) definitive transaction terms and deal protections (i.e. regulatory conditions and reverse break fees). Auctions conducted in certain industries in Canada (such as natural resources) have historically been very competitive and in some cases combative among domestic industry participants - prospective foreign buyers should be cognizant of these dynamics in such industries.
The Auction Process - Seller's Considerations
- Targeting Buyers. Capturing the highest possible value is typically the seller's most important goal in an auction process. In most recent competitive auctions in Canada, participation by U.S., European and certain other global strategic and financial buyers has been very prevalent - in addition to customary domestic strategic and financial participants, including the Canadian pension funds. With input from their financial and legal advisors, Canadian sellers often strategize on whether to undertake an extensive market canvass of prospective buyers or focus on a select, targeted group of strategic and/or financial participants. Targeting a selected buyer may accelerate the time for completion but a delay or failure in identifying and/or completing a transaction with such a buyer will usually result in a longer sale process, with the seller running the risk of missing the "market window" (which happened to many sellers in Canada in 2008).
- Responding to Proposals. Sellers need to consider the number of participants and the quality of, and variance between, bidders' initial proposals before deciding whether to permit one or more first round participants to "sharpen their pencils" and submit a revised proposal (or, conversely, whether to focus efforts on completing a definitive transaction agreement with a single standout bidder). In Canada, given the lack of depth in the financial marketplace generally and in the relative number of possible competitive strategic buyers in any given industry (as compared to that of the U.S.), it is not uncommon for one or a small number of bids to be received. In these circumstances, while there is enhanced pressure for the seller to ensure that the auction process remains as competitive as possible, the focus often turns to completing a transaction in a very condensed timeframe with the result that the definitive transaction agreement has more buyer-friendly deal protections than originally desired.
- Litigation Risk. As in other jurisdictions, a hotly contested auction among strategic competitors in Canada could result in enhanced litigation risk by an unsuccessful participant following the announcement of the transaction. While a Canadian court may give deference to the rules set by the seller, how closely a seller needs to follow those rules is not yet clear. In the absence of significant Canadian case law on controlled auctions, it is uncertain whether the Canadian courts would follow principles similar to those that they have followed in public tender cases which require bidders and sellers to adhere strictly to the tendering process or look to the U.S. courts for guidance. Accordingly, seller's counsel needs to ensure that adequate protections are included in the definitive transaction agreement to protect the seller against prolonged delay in the event of an application for an injunction or other remedies. However, Canadian courts can and do take into account the harm that could be caused to a business and its employees when considering whether to grant an injunction to an unsuccessful prospective acquiror.9
- The Role of Management. Managing the auction process and ensuring its integrity is crucial. Due to the resources required to properly manage a company through the auction process, "stay bonuses" (typically tied to the success of the auction) are often used to retain and motivate senior management and key employees. At the same time, sellers need to be mindful of the inherent conflicts of interest of key management. If some prospective buyers impose conditions designed to retain or "lock up" key management, this could understandably tempt management to favour their bids. Sellers (especially in management buyout (MBO) scenarios) can use strategies to safeguard against this inherent bias (and potential characterization as a related party transaction) if the board of directors or an independent ad hoc special committee manages the auction process, or by segregating, limiting or even preventing management's participation in the process, other than for pre-organized scheduled management presentations, facility tours and site visits.10 MBOs are generally not as prevalent in Canada as in the U.S., in part due to more limited access to financing but also due generally to a lower appetite for leverage and risk. Additionally, because Canadian securities laws require all holders of a class of securities to be offered identical consideration,11 enhanced offers aimed directly at management are generally forbidden, including any benefit to be derived from participation in a subsequent transaction with the acquiror.12
The Auction Process - Buyer's Considerations
- Partnering. On the buyer's side, one key consideration in an auction process is whether to go it alone or, alternatively, to partner with another strategic or financial player. This decision will be influenced by the prospective bidder's estimation of how competitive the process is likely to be, by its beliefs with respect to likely competitors in the auction, and by the state of financial and M&A markets generally. In most Canadian controlled auctions, the rules expressly prevent partnering without the consent of the target or its advisor and the consequences of partnering have to be considered in the light of the auction rules.13 In most competitive auctions in Canada, prospective buyers with limited resources pre-emptively identify key partners or leading clubs or consortiums at the early stages of the process to bolster their probability of success. This avoids scenarios where such buyers determine to "go it alone" with transaction values ultimately exceeding their financial capability. Securing a partner in the later stages of the auction is not only impractical but often not permitted, necessitating withdrawal of the buyer from the process.
- Initial Proposal. Buyers need to tactically consider whether to be successful they put their best bid forward initially or hold back more "powder" for later stages. Where to draw this delicate balance will depend on the competitiveness of the auction process, the uniqueness of the target's business, reaction by competitors, the financial position of the buyer and economic conditions generally. A "bait and switch" tactic by a potential buyer is not uncommon in Canada in perceived less competitive auction situations, especially in markets where access to capital is more difficult and the range of likely strategic and financial buyers is more limited. However, failure to properly assess the robustness of the auction or the marketplace could result in a buyer not being invited to participate in the second stage or a seller going exclusive with another buyer.
- "Mark-up" of the Transaction Agreement. Success at the second stage will often depend on the position taken with respect to "qualitative" deal variables such as (i) financing or regulatory conditions (and conditions generally), (ii) closing dates and outside or "drop dead" dates, (iii) extraordinary termination rights, (iv) indemnity profile (including possible tax liability), and (v) other onerous deal protections (e.g. no shop provisions or termination, break or similar fees). In some transactions, these will count for more than quantitative variables such as purchase price or form of purchase price consideration. For example, in some circumstances, a strategic buyer with Canadian antitrust risk may mitigate that risk through a "fix it first" approach, requesting confidential pre-transaction guidance from the Canadian Competition Bureau in an attempt to furnish the seller with deal certainty in its proposal (i.e. without any regulatory conditionality) to put it on equal footing with the proposals of financial buyers. Prospective buyers need to ensure their transaction teams understand their objectives so that their chances are not harmed by unnecessary push-back on qualitative variables that they are willing to live with.
- Financing. Obtaining committed financing in connection with the submission of a proposal in an auction requires significant resources up front. Buyers need to focus on minimizing gaps between both customary and non-customary conditionality in commitment letters (including MAC provisions) and the conditionality in the proposed definitive transaction agreement. While it is not uncommon to use the Canadian capital markets for acquisition financing requirements - whether by way of a fully underwritten bought deal financing (including through the use of subscription receipts), accessing the Canadian high-yield market and/or obtaining bridge financing - there is no guarantee that such sources of financing will necessarily be available in an auction context or within the required auction timetable. The Canadian marketplace for acquisition financing is generally more limited than its U.S. counterpart. With Canada's recent abolition of withholding tax on interest payments to foreign lenders,14 most private equity or other financial buyers rely on their U.S.-based relationship banks for committed financing (often without paying commitment fees) in early stages of auction processes where success is uncertain. Canadian lenders are typically included in the transaction once the buyer is successful in the auction process.
The use by sellers of the controlled-auction process continues to increase in Canada, as in other jurisdictions, primarily for flexibility, control and pricing reasons. However, as noted above, buyers and sellers and their advisors need to be constantly attentive to the nuances of Canadian law and M&A practice affecting auctions and to the need to adapt tactics and strategy during the auction process.