Written by Jon C. Truswell, Nicholas P. Fader, Jeffrey Kerbel and Michael A. Barrett
Transactions between related parties may create material conflicts of interest between an issuer and its directors, officers and related parties. In particular, material conflicts of interest may arise in the context of insider bids, issuer bids, business combinations and related party transactions. Multilateral Instrument 61-101 Protection of Minority Security Holders in Special Transactions (MI 61-101) was adopted in Alberta, Manitoba and New Brunswick on July 31, 2017, and prescribes procedural safeguards intended to mitigate the risks to minority security holders in material conflict of interest transactions. MI 61-101 has been in effect in Ontario and Québec since February 1, 2008, when it superseded Rule 61-501 in Ontario and Regulation Q-27 in Quebec.
On July 27, 2017, staff of the securities regulatory authorities in each of Ontario, Québec, Alberta, Manitoba and New Brunswick (the Staff) issued CSA Staff Notice 61-302 (the Notice) to provide guidance on transactions that fall within MI 61-101. Although the Notice is non-binding, it sets out Staff's views on compliance with MI 61-101. The Notice is also the first major pronouncement on MI 61-101 since the instrument was introduced in 2008.
The Notice follows various high-profile cases, such as InterOil Corporation v Mulacek [InterOil] and Re Magna International Inc [Magna], where material conflict of interest transactions were scrutinized and concerns about processes and disclosure were raised. Staff also conducted their own review of material conflict of interest transactions. The Notice provides important information for any participant in a proposed material conflict of interest transaction, suggesting that such transactions will be subject to greater regulatory scrutiny.
Staff expect market participants to take a broad and purposive interpretation to the requirements of MI 61-101 and adopt practices designed to effectively mitigate conflicts in material conflict of interest transactions with a view to ensuring that all shareholders are treated in a manner that is fair and perceived to be fair.
Transaction Review in "Real-Time"
A regulatory review will generally be triggered by the filing of a disclosure document relating to a material conflict of interest transaction. Once the review process is initiated, transactions will be assessed for public interest concerns and compliance with MI 61-101 "in real time"; the intention is to identify and resolve issues prior to security-holder approval or the transaction closing. We note that "real time" review represents a departure from past practice where Staff typically conducted reviews only after complaints were made. It also deviates from U.S. practice, as the SEC often reviews proxy circulars before they are sent to shareholders.
In conducting a review, Staff will focus on: (i) compliance with disclosure requirements; (ii) compliance with the conditions of any exemptions (in MI 61-101) from valuation and minority approval requirements relied upon by the issuer; and (iii) the substance and disclosure of the process conducted by the board of directors or a special committee (or both) in considering the transaction. Any complaints received by Staff will be considered as part of the review. Staff will generally consider the following factors when reviewing disclosure documents:
- compliance with disclosure requirements intended to enable security holders to make informed decisions, including the enhanced disclosure required by MI 61-101;
- if the formal valuation requirements of MI 61-101 are engaged, whether the issuer obtained a valuation that complies with MI 61-101 and included either a summary or the entire valuation in its disclosure document;
- if minority security holder approval is required, whether the issuer excluded all parties that are not properly part of the minority;
- if the issuer is relying on an exemption from the formal valuation or minority approval requirement (or both), whether the disclosure document provides a reasonable basis to conclude that the exemption relied upon is, in fact, available; and
- whether the process employed by the issuer's board of directors in negotiating and reviewing the proposed transaction (including the existence or non-existence of a special committee of independent directors) raises concerns that the interests of minority security holders have not been adequately protected and whether that process is adequately disclosed.
Issuers should be aware that they or their counsel may be contacted by Staff and asked to answer questions or provide supporting information (such as board or committee minutes and mandates). If Staff identifies instances of non-compliance with MI 61-101 or public interest concerns, Staff may seek corrective disclosure, a temporary cease trade or other order under securities legislation, or even pursue enforcement action.
A recognized method of managing conflicts of interest involves the formation of a special committee of independent directors. Although MI 61-101 mandates a special committee only in the case of insider bids, the Notice states that a special committee comprised of independent members (as defined in MI 61-101) is advisable for all material conflict of interest transactions.
To be effective, a special committee should possess a broad mandate, robust powers and be actively engaged. Staff therefore recommend that a special committee be empowered to negotiate or supervise the negotiation process, consider alternatives, make recommendations and hire its own independent financial and legal advisors. Individuals who are not independent should not be present at, or participate in, decision-making deliberations; the special committee's records should evidence that the process was free from coercive conduct on the part of interested parties.
In the Notice, Staff identified situations in which a special committee will be considered ineffective in protecting the interests of minority security holders:
- the committee is formed after a proposed transaction has been substantially negotiated; or
- the committee is passive and fails to conduct a robust review of the circumstances leading to the transaction, viable alternatives and the transaction itself.
Staff's emphasis on the importance of a robust and independent special committee process reflects the OSC's findings in Magna, as well as court and regulatory reactions to other Canadian and U.S. transactions where special committees were found to be ineffective or passive. In Magna, the OSC was concerned that the special committee's process was tainted by the participation of executive management, and that the committee was forced into a "take it or leave it" position in respect of the proposed transaction. The Notice affirms the OSC's finding in Magna that special committees must be afforded latitude to independently assess a proposed transaction, negotiate its terms and consider alternatives.
Enhanced disclosure constitutes a fundamental aspect of the minority security holder protections included in MI 61-101 and is intended to promote informed decision-making by security holders vis-à-vis proposed material conflict of interest transactions. Tactical or self-serving disclosure intended primarily to further the interests of a related party in the transaction is considered inappropriate by Staff.
Enhanced disclosure generally requires a thorough discussion of:
- the review and approval process;
- the reasoning and analysis of the board of directors and/or special committee;
- the board of directors' and/or special committee's views on the desirability or fairness of the transaction;
- reasonably available alternatives to the transaction, including the status quo; and
- pros and cons of the transaction.
- inadequately discloses the context and background of the proposed transaction;
- does not meaningfully discuss the board of directors' or special committee's process and rationale for supporting the transaction;
- fails to disclose the dissenting views of directors in respect of the transaction; and
- provides overly one-sided disclosure regarding a recommended transaction that does not identify potential concerns or alternatives.
Staff also noted that disclosure should contain a meaningful discussion of the analysis provided by advisors and how that advice was considered. In addition, when discussing the desirability or fairness of a transaction, the interests of minority security holders should be addressed; the board should not simply state that the transaction is in the best interests of the issuer. We note that corporate law requires directors to act in the best interests of the corporation and, in that context, to consider all stakeholders, while MI 61-101 focuses particularly on the interests of minority security holders. Although Staff believe that the best interests of an issuer and its minority security holders will generally not be in conflict when considering transactions regulated under MI 61-101, issuers should be aware of the potential for such a conflict to arise. If the board believes that a conflict exists, Staff expect that the disclosure document will explain the conflict and how it was addressed by the board in reaching its decision to propose the transaction for approval by minority security holders.
Staff also note that corporate and securities legislation do not require a board of directors or a special committee to make a recommendation regarding how minority security holders should vote on a proposed material conflict of interest transaction. While a board of directors generally makes a recommendation to security holders, there may be exceptional circumstances where the board or special committee determines that a transaction should be put to security holders for their consideration without a voting (or tender) recommendation. In such a case, Staff recommend that minority security holders be provided with enhanced disclosure, such that they receive substantially the same information and analysis that the board or special committee received in considering and addressing the legal and business issues raised by the proposed transaction. Staff expect the board to disclose its review and approval process and explain why the transaction is being proposed without a recommendation, including the reasons for not making a recommendation and the basis upon which minority security holders are expected to vote in the absence of a recommendation.
Staff are of the view that it is the responsibility of the board of directors or a special committee to determine whether a fairness opinion is necessary to make a recommendation to security holders. Similarly, the board or the committee should determine the terms and financial arrangements for the fairness opinion engagement. We note that although fairness opinions are non-compulsory, nearly all significant transactions will involve a fairness opinion.
If a fairness opinion is obtained, the Notice emphasizes that it should serve only a subsidiary role in the review process. The board or special committee cannot substitute a fairness opinion for its own assessment of the transaction's desirability and fairness, as a transaction must be considered from more than a financial perspective. A board or special committee is also expected to actively review the fairness opinion, assessing its methodology and assumptions.
Staff has found that fairness opinion disclosure is often limited and fails to provide security holders with a meaningful understanding of the fairness opinion and how it was used by the board or special committee. Where a fairness opinion is obtained, the disclosure document should:
- discuss the compensation arrangement with the financial advisor and how it affected the board of directors' or special committee's consideration of the advice provided;
- discuss any relationship or arrangement between the financial advisor and the issuer or an interested party that would create the perception of a lack of independence;
- include a clear summary of the methodology, information and analysis (including financial metrics) underlying the opinion, conveyed in a manner that allows the reader to understand the basis for the opinion; and
- note the opinion's relevance to the board of directors or special committee in coming to a determination to recommend a transaction.
Staff also refer market participants to the rules regarding fairness opinions prepared by the Investment Industry Regulatory Organization of Canada and The Canadian Institute of Chartered Business Valuators.
Staff's approach to fairness opinions reflects the judicial treatment of fairness opinions in InterOil and a number of Ontario court decisions. By mandating greater transparency in respect of advisor fees and requiring disclosure of the financial analysis underlying a fairness opinion, the Notice addresses two of the main issues raised by the Court in InterOil. However, we note that the Notice neither mandated nor recommended the use of fixed fee opinions, a significant element of InterOil. In addition, Staff do not require disclosure of the quantum of fees received by the advisor.
It appears that Staff is advocating a movement towards U.S.-style disclosure in respect of fairness opinions, which is significantly more detailed than the current practice in Canada. Such an approach will create additional burdens for financial advisors, as their opinions will potentially become subject to heightened scrutiny. This may create a perception of increased risk among financial advisors, likely translating into higher fees for issuers and more stringent limitation of liability provisions in financial advisory engagements.
The Notice is of significance to M&A lawyers, investment bankers, market participants and directors of reporting issuers who are involved in material conflict of interest transactions. The "real time" review of transactions, Staff's comments confirming the meaningful role to be played by special committees, guidance on the appropriate level of disclosure, voting recommendations and the use and disclosure of fairness opinions will likely require even more exacting processes and disclosure in the context of material conflict of interest transactions, which, among other things, will increase transaction costs and subject transactions to longer timelines.